China Mobile (NYSE:CHL), the world’s largest wireless carrier by subscribers, is expected to release its second quarter 2014 earnings on Thursday, August 14. The carrier reported a mixed set of results last quarter, when its net profit declined 9.4% year-over-year (y-o-y) to RMB 25.24 billion (~$4 billion) even as its operating revenue grew about 8% to RMB 154.8 billion (~$25 billion). This decline in net profit was attributed to increasing competition from rival wireless carriers China Unicom (NYSE:CHU) and China Telecom (NYSE:CHA), and the growing popularity of Over-The-Top (OTT) applications. OTT applications such as WeChat allow users to share text/picture/video messages over their phone’s Internet connection, and their increased usage resulted in a massive drop in revenues from traditional SMS and MMS messaging services for the carrier last quarter. Overall SMS usage on the carrier’s network declined from about 164 billion messages in Q4 2013 to 153 billion in Q1 2014.
In the upcoming earnings release, we expect the company’s revenue growth to sustain its momentum backed by aggressive expansion in the 3G and 4G market. The carrier added about 25 million 3G and 4G users in the three month period ending June 2014, of which over 45% users were on the 4G network. This surge in high speed subscribers is also expected to positively impact the company’s Average Revenue Per User (ARPU), which declined from RMB 68 (about $11) in Q1 2013 to RMB 62 ($10) in Q1 2014. However, the rapid user growth would not have been possible without a comparable increase in the company’s handset subsidy costs, discount offerings and marketing expenses. This rise in operating expenses, in addition to the recent introduction of Value Added Tax (VAT) in the telecom industry, is likely to weigh on China Mobile’s net profit in the second quarter as well.
We currently have a price estimate of $53 for China Mobile, implying a slight discount to the market price.
Growing 3G-4G User Base to Drive Revenues
China Mobile added about 14 million 3G subscribers and over 11 million 4G subscribers in the April-June period this year, taking its total 3G-4G subscriber count to over 252 million, and 3G-4G penetration to almost 32%. In comparison, the carrier’s 3G penetration was about 25% at the end of 2013 and 29% at the end of Q1 2014. Higher 3G-4G penetration is good for the company’s top line, as high speed subscribers generally use more data than 2G users due to the network’s higher internet speed, which helps in increasing ARPU.
Despite the growing high speed user base, China Mobile’s overall ARPU declined by about RMB 6 ($1) y-o-y to RMB 62 (~$10) in the first quarter this year. This was likely because the increase in its internet ARPU could not offset the decline suffered by voice and SMS/MMS revenues. Going forward, we expect overall ARPU to improve as 3G penetration increases and sales of high-end smartphones such as the iPhone expand in the Chinese market. Growth in 4G is likely to drive ARPU levels even further, as 4G networks are about ten times faster than their 3G counterparts, thus encouraging subscribers to use even more data intensive applications such as high quality video calling and video streaming.
Handset Subsidies, Discounts and Marketing Expenses to Weigh on Profitability
China Mobile witnessed an unprecedented decline in earnings in 2013 owing to higher handset subsidy costs, discount offerings and higher marketing expenses, which continued in the first quarter as well. These expenses were necessary for China Mobile to improve the acceptability of its homegrown 3G network. The company faced intense competition in gaining 3G subscribers because rivals China Unicom and China Telecom used the internationally accepted WCDMA 3G standard, which was compatible with majority of the popular smartphones available in the Chinese telecom market, unlike China Mobile’s homegrown SCDMA standard. Therefore, because of the limited handset options available for use on its 3G network, China Mobile had to offer much more competitive handset pricing and discounts to attract subscribers, which put pressure on the company’s profit margins.
China Mobile announced in its Q4 2013 earnings call that its subsidy costs were likely to increase by about 30% y-o-y to $5.7 billion in 2014 as 4G adoption grows and demand for premium handsets rises. However, a recent report in the Chinese media suggested that the carrier is likely to trim its total subsidy costs by RMB 10 billion ($1.6 billion) this year, owing to profitability concerns. It stated that the carrier was likely to shift focus from the 3G subsidies towards 4G handsets. The report also stated that the carrier was looking to reduce – and eventually cancel – its free handset offerings as part of its contract phone sales, and instead switch to service package subsidies. If this happens, it could keep the company’s total subsidy expenses around last year’s levels of $4 billion. ((Rumor: China Mobile to Shift Handset Subsidies from 3G to 4G, Marbridge Consulting, July 7 2014))
Since 3G and 4G subscriber additions are expected to improve the carrier’s 3G/4G mix and ARPU due to higher internet data usage, we expect the company’s top line to grow rapidly in the near term. Combined with reduced operating expenses in the form of lower subsidies, this would translate into improved profits.
VAT Could Also Impact Profits
As part of its tax and fiscal reforms for the country, the Chinese government decided to impose a value added tax (VAT) on telecom services earlier this year, coming into effect across the country on June 1. The VAT rate applicable to basic telecom services and value-added services has been fixed at 11% and 6%, respectively. While the earlier Business Tax (BT) was calculated based on net sales, the VAT is calculated on the difference between net sales and cost of goods sold. This change is likely to increase the carriers’ tax burden and hurt profits, as the VAT is significantly higher than the currently applicable BT of 3%.
The VAT is likely to hurt China Mobile’s profitability in the near term even as tax experts argue in its favor, citing the need to plug loopholes in the existing Chinese taxation system. However, the new system does allow companies certain cost deductions in the form of input VAT credits, which could offset some of the increase in taxes. It will be interesting to see how much impact this makes on the company’s bottom line in the second quarter and how China Mobile plans to control expenses amid increasing competition.
Disclosure: No positions