Chinese telecoms embrace 3G

Institutional Investor, March 2011

China’s telecommunications industry is reaching a stage of maturity: three established operators, national 3G coverage, and widespread mobile phone usage. Yet the staggering rates of growth in the country show no sign of tailing off as they do in most mature markets. Instead, operators are now being propelled by a new trend: the shift to data, content and apps.

China continues to add nine to ten million new subscribers per month – far more than the entire population of Hong Kong. Numbers like this have been commonplace in China for years. But such is China’s extraordinary scale, penetration is still only 60%, leaving considerable opportunity for growth.

On top of that, as penetration grows, so too does the use of newer technology. China is aspirational and tech-savvy, and more and more phone users are no longer happy with 2G capability. The shift towards 3G is going to be the most important driver for Chinese telco operators in the coming years.

Last year 3G was something of a headwind for operators. They had to commit large amounts to capital and operational expenditure, and had to invest heavily in handset subsidies, discussed in more detail below. But the industry is at a tipping point. Today, 3G coverage is truly national – which means, strictly speaking, that the 335 population centres considered as cities in China have coverage. It is becoming more affordable, as smart phones drop in price, and the growth numbers here are already becoming impressive. Roughly 46 million new 3G users were signed up in 2010, compared to 10 million in 2009, according to CLSA; the figure is growing at around four million per month. “China 3G users will likely double next year to 94 million,” says Elinor Leung, analyst at CLSA.

Remarkably, despite this rapid growth, 3G take-up in China is a long way back from where the government expected it to be by now. Nomura analyst Leping Huang says the Ministry of Industry and Information Technology, which regulates the telecoms sector in China, had set a target of 150 million 3G subscribers by the end of 2011. Nevertheless, he thinks that growth is coming: he expects 100 million by the end of 2011, and that the 150 million target will be hit within 2012. Huang’s colleague Danny Chu, a China telecoms analyst at Nomura, adds: “In most Asian countries, it’s the second or third year after 3G launch that you see massive numbers of 2G subscribers migrating to it. This year in China will be the second year since the operators launched their services. If China goes through the same cycle, I expect this year we are going to see a whole lot more people migrating to 3G.”

Huang and Chu take the view that handsets are going to be instrumental in this growth. “When I have travelled inside China and talked to consumers, quite often the price of a 3G handset being relatively high was the main reason 2G subscribers were choosing not to migrate,” says Chu. “In very few cases it’s the monthly fee, but in most cases it’s the handset price.” Huang calls handsets “one major bottleneck to 3G growth,” and adds: “In 2011, we believe 3G subscriber growth will be a key theme for China’s telecom industry, and entry-level smartphones could be an important accelerant of it.”

Indeed, in a landmark January report, Nomura heralded “the RMB1,000 revolution” in Chinese telecoms – by which it means entry-level smartphones available at or below that price (roughly US$150). In fact, once operators apply their customary subsidies to bring subscribers in, the actual cost could be as low as RMB600. “We are seeing a boom in smartphone development among Chinese handset OEMs [original equipment manufacturers],” Huang says. “Most companies are aiming to capitalise on the growth opportunities presented by 3G in China and want to penetrate the mid-range segment of the global handset market.” This increased affordability, coupled with efficient distribution networks and attainable pricing for voice and data services, ought then to drive 3G usage. Huang’s report calls for the 3G handset market to grow from 37 million in 2010 to 151 million in 2012, boosting penetration from 6% to 17% as it does so, and overtaking the UK to become the world’s second largest smartphone market by 2012 alone the way.

Nomura is not alone in this view. Navin Killa at Morgan Stanley says in a January report that “the rapid development of mid-range smartphones in the RMB1,000 price range will lead to accelerated take-up of 3G services in 2011.” Killa points to a new scheme from China Unicom to offer RMB46 per month 3G plans, in addition to its existing RMB66 per month plan, in order to target the low-end market.

And James Sullivan, an analyst at JP Morgan, also believes this is a key theme for 2011. “The iphone gets a tremendous amount of press in China,” he says. “But the bigger story is the introduction of smart phones with full Android functionality [the free operating system for smartphones] coming in at around the US$100 price point. This serves to considerably increase the addressable market for data services in China and it will be a real driver of subscriber growth and data usage in 2011 and beyond. When you get lower priced, but still reasonably full-functioning, phones and put them into the hands of consumers, that really allows the next stage of revenue growth.”

There are several knock-on effects of these trends. One relates to the handsets themselves. The handset industry is intensely competitive and will remain so as operators compete for 3G users. The market research firm iSuppli says there are more than 400 handset design houses and more than 3,000 handset assembly vendors in China. Most are known as white box, meaning they do not have their own brands; many are not even legal, registered companies. “The initial wave of handset assembles make reasonably good money,” says Sullivan. “The danger is it goes down the path – as it did with 2G – of five guys making money to 150 all losing money. And I think that’s very likely. But, from an operator perspective, it’s positive because it drives down handset costs.”

Generally the big telecom operators subsidise handsets in order to improve business, and this trend isn’t going to go away. “Competition will remain intense next year as operators compete for 3G users,” says Leung. “China Mobile and China Telecom will likely step up their 3G promotions to attract high end users with better smartphones.” CLSA estimates that China Mobile will spend about RMB16 billion in subsidies in 2011 – it spent RMB15.5 billion in 2010 – and thinks China Telecom will spend RMB12 billion, and China Unicom RMB7-8 billion. There are contradicting pressures at work here: on one hand, handset prices are falling generally, meaning subsidies don’t need to be so high, but at the same time the growth of 3G services and users mean that subsidies then have to be applied to better and more expensive phones in order to win that business. There are some ways around it – China Telecom has renewed many CDMA contracts with offers of free minutes and tariff discounts rather than handset subsidies – but it will remain a big issue for operators.

Partly for this reason, average revenue per user (APRU, in industry terms) has been declining for some time and is likely to continue to do so. China Mobile’s ARPU fell 7.2% in 2009 and 5.6% in 2010, for example, and is still falling, although China Unicom’s is expected to rise as 3G becomes a larger proportion of its subscriber mix.

At the same time, these trends mean that data generally is going to become much more important to phone companies. This, too, presents enormous opportunity for growth. Internet penetration is only 30% in China, compared to 80% in the developed world, but it’s already clear that Chinese are keen to embrace internet access through their phones. Half of China Mobile’s revenue growth in the first half of 2010 came from non-messaging data usage, or ‘real data’.

“Real data growth should accelerate in 2010 with increasing supply of affordable smartphones and smart devices like tablets,” Leung says. “China is well positioned for mobile data growth given the strong demand for both wireless broadband services and mobile apps. China also has a large internet market and strong internet culture.” It’s worth remembering that 30% penetration might not sound much, but in a nation of over a billion people, it’s an extraordinary volume. CLSA says there are 294 million users using instant messaging – close to the population of the USA – and 200 million using social networking services alone, and 150 million digital books. “These internet content and users can be easily transferred to the mobile platform.”

All three Chinese telcos have launched their own apps stores to help capture the growth, such as China Mobile’s Mobile Market store, as well as its mobile payment and eReader services. Noting that it is starting from a small base – Mobile Market has just under 10,000 software apps compared to 300,000 on Apple’s iTunes and 100,000 on Google’s Android Market – China Mobile has launched a marketing campaign to encourage university students and other young people to develop apps for them, with the developers getting 70% of the revenue. Additionally, since smartphones are tending to use the Android platform – which is open to anyone – that encourages entrepreneurial content creation, unlike Apple, which exerts more centralised control.

But while there’s a clear market, there’s also a question of how it affects the bottom line. “The big question is the impact of wireless data on margins,” Sullivan says. “China is a reasonably good market in that network capex is done at a parent company level by most of the operators, so the additional burden won’t be felt on the listed companies.” But that’s only half the story, he says. “There is also the operating expense impact of wireless data, and there are a couple of ways that plays out.

“It’s good in that it will mainly be local language on Chinese servers, unlike Singapore, Malaysia or the Philippines, where content is English-language and incurs linkage costs. China avoids that because o the local level of content and the lower media presence.

“But on the other hand, one of the biggest drivers of operational expense is the number of base stations you are running. A lot of cost line items – site rentals, power, maintenance – are inextricably linked to the number of base stations you are running, and as data usage starts to explode, you have more base stations to service.” New technologies with greater efficiency help, but Sullivan says it can’t keep pace: if a new technology is 50% more efficient than an old one, that doesn’t help with a 300% increase in data usage. “It is critical that investors understand the cost characteristics of wireless data. Opex drives free cashflows and the ability to service reinvestment requirements.”

Chu agrees that the shift to data is a mixed blessing. “You would expect that as more subscribers use mobile data services, over time it should help operators to generate additional earnings,” he says. “But at the same time, there is the additional capex they may have to invest in the network. Back in 2009 I’m pretty sure no operators in Chian would have imagined the surge in data traffic in the network they are experiencing now.”

Despite these pressures, analysts are broadly positive about earnings in the industry. It has been one of the best sectors in the country to be exposed to: in 2010 the sector outperformed both the MSCI China Index and Hong Kong’s Hang Seng Index, by 6.8% and 3.5% respectively. Notably, that outperformance was most pronounced – around 15% – in the first half of 2010 when the Chinese government began macroeconomic tightening. The tightening dynamic is underway again in 2001: interest rates are rising and inflation is a challenge, all of which supports continued outperformance.

Chinese telecoms “will continue to do well in the uncertain market environment in the first half of 2011,” notes Leung at CLSA. “2011 should be a better year with accelerating 3G user and data growth.” She expects 11% growth in industry mobile revenue in 2011; in China Unicom’s case, she expects earnings to double (despite which, the broker does not recommend holding it, seeing it as too expensive, instead recommending China Telecom and China Mobile, based on earning recovery and valuations respectively). Elsewhere, Credit Suisse prefers China Mobile, then China Unicom, with China Telecom least preferred because of its heavier exposure to fixed line. Morgan Stanley prefers China Unicom as “the bet 3G play in China”. And JP Morgan is overweight Unicom and China Telecom, and neutral on China Mobile.

While these operators are the names that attract most attention among international investors, they are actually only a part of the overall chain that is open to them – with several non-Chinese businesses among the names to benefit from expansion in China. Looking only at Hong Kong or US listings, there are distributors and retailers (Digital China, Gome); handset OEMs (ZTE, TCL Com, China Wireless, Lenovo, BYD Electronics, Foxconn); manufacturers of handset components (AAC Acoustics), handset chipsets (Qualcomm, Spreadtrum) and handset software (Google). Including the universe to Taiwanese listings adds names such as Synnex, a distributor/retailer, Unimicron, a handset component manufacturer, and Mediatek, and handset chipset builder, to the mix.

So what next? Like the rest of the world, Chinese are fascinated by iphones, though they are by no means mass market devices given the costs involved. “High end phones like the Samsung Galaxy and iphone represent maybe 5% of Chinese mobile subscribers as an addressable segment,” says Chu. First out of the blocks – in terms of launching an iPhone on a network that can actually use it properly, with reasonably full functionality – was China Unicom, with its WCDMA system; China Telecom is working on a CDMA version which will be similar to what Verizon sells in the US. (An analogy would be to see AT&T and Unicom bracketed on one side, CT and Verizon on the other.) Killa at Morgan Stanley considers the “euphoria” about a CDMA iPhone “is overdone”; Chu sees that it has great branding potential for China Telecom, but wonders: “Is it earnings accretive? Once you sign a commercial agreement with Apple, you will bring in high-end customers but the amount of subsidy you incur will be much more significant than on most Android phones.”

And after 3G, inevitably, comes 4G: in essence, a secure broadband service to mobile phones. Japan and Scandinavia have already built commercial 4G services, and China Mobile has built trial networks.

Widespread use of this in China is some distance away, but is worth thinking about. “The advent of 4G technology will draw focus to the issue of frequency spectrum, as radio frequency spectrum allocation suggests congestion,” says Chu. He thinks this is going to present more of a problem in India and Thailand than it is in China, since spectrum fees are relatively low in China, but he is already factoring it into his stock recommendations, ranking China Mobile a buy partly because the 125MHz of spectrum it has is ample for data growth. “With available spectrum becoming more and more limited, we believe mobile operators with ample spectrum will be much better placed to compete going forward,” he says. Either way, moving to 4G is going to incur considerable additional capex. Progress is great, but it never comes cheap.