China Telecom’s Network Buyback Helps Margins Improve Despite Subsidy Pressures

China Telecom’s (NYSE:CHA) decision to purchase its mobile network from the parent company seems to be paying off well with the carrier seeing margin improvements despite splurging on subsides and other mobile promotional activities. The largest CDMA carrier in the world saw its operating profits grow y-o-y by almost 23% last quarter, at a rate faster than its service revenues which were up by only about 10% over the same period last year. EBITDA margins for the quarter were almost 7 percentage points better than the year-ago quarter.

Most of the revenue growth was driven by the carrier’s 3G business where it has done well to convert almost half its subscriber base to 3G –  far ahead of the industry-wide 3G penetration of 25%. With 3G demand driving data usage, having full control of its network assets will help China Telecom derive greater operating leverage out of its business by eliminating a big variable component of its costs in network leasing fees.

However, buying the mobile network has left its balance sheet saddled with over $7 billion more net debt than at the end of 2011. With the addition of the mobile network to China Telecom’s assets, the carrier will also incur additional capital expenditure in maintaining and upgrading the network to 3G/4G. Its CapEx guidance for 2013 is RMB 75 billion, up by almost 40% from last year. Keeping all these factors in view, we maintain our $61 price estimate for China Telecom, about 20% ahead of the current market price.

See our full analysis for China Telecom’s stock here

3G competition heating up as 4G nears

China Telecom’s 168 million subscribers may put some of the biggest U.S. carriers such as Verizon and AT&T to shame. But when it comes to China, the carrier is only the third largest and less than one-fourth the size of the largest wireless carrier there, China Mobile. However, the difference is not nearly as wide in the 3G market. As of March 2013, China Telecom had around 78 million 3G subscribers, only about 30% behind the 114 million that subscribe to China Mobile 3G network. While China Telecom’s overall market share is only about 15%, it has close to 28% share of the 280 million strong 3G market. A low but steadily growing 3G penetration of about 25% is giving smaller wireless carriers such as China Telecom ample opportunity to compete on an even ground with the otherwise dominant China Mobile.

China Telecom has also been helped by the fact that the dominant carrier currently runs its 3G network on a homegrown proprietary TD-SCDMA standard that is not compatible with many smartphones. However, that may soon end as Qualcomm’s newly launched TD-SCDMA compatible chipsets see wider usage. It could also be possible that Apple launches a cheaper iPhone on China Mobile’s network in order to assuage its subsidy concerns, making it tougher for the smaller carriers such as China Telecom to compete. (see Qualcomm Paves the Way for an Apple-China Mobile iPhone Deal) Further, China Mobile’s push into 4G with a TD-LTE network, that is currently being tested out in several cities, is likely to give it access to a much bigger set of popular smartphones and make it harder for China Telecom to gain high-end 3G/4G market share going forward.

Low-cost smartphones to rule the roost

It would therefore be a bad idea for China Telecom to be over-reliant on just the iPhone to drive 3G adoption. Not only is the iPhone extremely costly to subsidize but is an unreliable way of differentiating oneself, especially when one doesn’t have an exclusive right to it. The arrival of 4G and the iPhone on China Mobile could potentially be a huge blow to China Telecom, which is why it is a good sign that the carrier is not banking on the popular smartphone alone to drive 3G adoption.

The carrier has therefore come up with a strategy to sell low-cost 3G smartphones made by ZTE, Huawei and Lenovo that run on its 3G network. Considering that the Chinese market is still in an evolving stage, the demand for cheaper Android smartphones is huge. Even Nokia, which is trying to push its Lumia line of smartphones and create a third ecosystem with Microsoft, is launching Lumia handsets at lower price ranges. The Lumia 800C was launched on China Telecom at about $200 cheaper than the iPhone last year. China’s huge potential is fostering healthy competition among handset makers and this will help China Telecom manage its subsidies better so as to lessen the impact on its margins going forward. (see Chinese Telcos Get Fat Margins Selling Cheaper Smartphones)

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