Warren Buffett once remarked that Andrew Beyer's classic horse racing book "Picking Winners" is instructive for investors. The basic idea is that investing, like horse racing, comes down to identifying superior fundamentals and making those your picks to win the race.
Predicting the future is tough but the companies that possess a durable economic advantage are most able to weather any headwinds that come along. From a probability perspective, these types of companies are the most likely to create value for shareholders over time.
How do you know that a company has such an advantage? The best indication is that it has a high ROIC, or Return on Invested Capital, compared to peers. Consider China Mobile (CHL) as an example of this type of power. Look at its ROIC compared to its rivals China Telecom (CHA) and China Unicom (CHU):
How is it able to achieve this? Size and focus. China Mobile is the biggest telecom in China with a market share of 65% of subscribers. Its competitors offer land line phones and cable services which require large capital investments. China Mobile does not need crews to install modems or to work on land lines. As a result, their margins are far superior to competitors.
|Net Profit Margin||2009||2010||2011||TTM|
If the industry declined in some way, then CHA and CHU would be hurt the most; CHL has enough room in its cost structure to absorb more cost or manage intensifying competition.
From a brand perspective, China Mobile has the 10th most valuable brand in the world according to the 2012 Brandz annual report published by research firm Millward Brown. This puts it ahead of top names like GE (GE), Walmart (WMT), and American Express (AXP) globally and first in the Chinese market. CHA and CHU are ranked 11th and 15th respectively in China.
China Mobile has a strong financial position to further strengthen its brand. It is almost double the size of its nearest competitor and has far more room in its cost structure to spend more. If each company spent the same on advertising as a percent of sales, the total ad spend dollars would be far larger for China Mobile, resulting in customers receiving CHL ads versus competitor ads at a rate of 2:1. Furthermore, if China Mobile diverted advertising from markets where it had a monopoly, it could outspend rivals in competitive markets by as high as 3:1. This is economic power and the reason why China Mobile has such a strong brand.
State of Telecom in China
There are two trends happening in China telecom right now: the continuing penetration of cell phones (the 2G crowd that never owned a cell phone before) and income elasticity where people are buying more sophisticated, pricier phones as incomes rise (the 3G crowd that now buys smart phones). These are the numbers:
|% of Population||2009||2010||2011||TTM|
As you can see, there is still 20%+ of the market that does not even own a cell phone altogether and there has been a further shift into 3G services.
China Mobile's margins have been compressing because its revenue per subscriber has been declining as competition has intensified. Further, Apple's (AAPL) iPhone is not available on its 3G network and China Mobile has resorted to subsidizing unlocked iPhones for use on its 2G network, eating into profitability. Between the iPhone issue and the revenue per subscriber issue, investors have become hesitant. The revenue per subscriber looks like it will be bottoming out in the next few years especially as more people start to use 3G data services. See below.
So why is all of this important?
Because there may be a good buying opportunity here. As mentioned, China Mobile currently does not have the iPhone. Anyone who has followed Apple recently knows that CHL could be the key to an even higher AAPL stock price than current levels. Investors in CHL are preoccupied with this idea that CHL is missing out on the iPhone wave coupled with the revenue issue, preventing them from seeing the bigger value picture.
The fact is, CHL earns a higher ROIC and will continue to earn a higher ROIC relative to its peers as competition increases. This is the horse to bet on if the price is right.
So here is the valuation:
I assume a 10% hurdle rate. The base rate in China is 6% as compared to 1.75% in the US. A recent academic paper by Pablo Fernandez estimated that the median market premium used in China is 7.1%. That makes a market discount rate of 13.1%. CHL has virtually no debt and the business is not particularly volatile. 10% seems about appropriate as compared to the market.
If you expect a continued compression of margins, you might use a Net Margin of 20% which would be lower than any of the previous 10 years by about 2.5%. Assume that the depreciation rate is about the same as the capex rate over the long term. Because the ROIC is high, I feel good that any incremental capex will create value anyway.
For sales, use a 5% growth rate for 10 years, which is below any rate from the previous 10 years by about 3.5%. CHL is bigger now and it gets harder to move the needle. However, there is still 20% of the country that does not even own a cell phone and that number continues to shrink every year. China Mobile is the biggest brand and, in some cases, has a monopoly on certain markets; it will continue to grow its subscriber base, increasing revenues. For the income elasticity trend, sales per user is likely to bottom out in the next few years and increase as more 3G (and 4G) customers use more data. Both of these facts and that China's inflation rate has been about 4% every year for the last twenty years makes a 5% sales growth rate a very reasonable assumption over the next ten years. This rate is far below any year's growth rate from the recent past.
With all these conservative assumptions and an ultra conservative terminal value you get a company value of ¥1.72 trillion, or $273 billion. The current market cap is $219 billion or about 20% less than this conservative valuation.
As a further kicker, the CNY/USD exchange rate has been strengthening over the years and is likely to continue this trend as Chinese purchasing power increases. This means that 1 CNY will buy more USD in the future than it does today. China Mobile does business in CNY; as CNY strengthens, the company will be even more valuable in USD, the currency in which this ADR is traded.
The bottom line is that CHL looks like a good investment at a price that is below a conservative valuation. This is the horse to bet on and at a favorable price. People are so concerned that it does not have the iPhone or that competition is intensifying but they have failed to realize that this company is in a good position to deal with it. CHL has significant market power and will likely deliver strong results into the future.