China Mobile: Good Co. / Bad Gov.

China Mobile is a telecommunications operator formed via a spin-off of Chinese government-owned entity China Telecom (spun off in 1999). The company provides cellular telecom services such as voice, voice value-added, data streaming, and network planning. China Mobile (CHL) is the largest telecom operator in China and in the world. It’s captured 64% of the 4G telecom market the Mainland, as well as 62% of the total wireless network. To add to its competitive advantages, CHL is rolling out its 4G capabilities faster than its two operating peers – China Unicom (CHU) and China Telecom (CHA). The company grows through four main levers: Households, Mobile, Corporate, and Emerging Business operations. Although there’s a lot to like about the company, the giant elephant in the room is obviously the fact that CHL is still 73% state-owned (and could very well be higher). I’ll touch on that later in the write-up.

The company starts off as one that would perk my interest: sustainable free cash flows, long runway for growth, tremendous competitive advantages, and no debt. Net margins and ROIC are better than 85% of its industry at 15.42% and 20% respectively. The company trades at a mere 5x EV/EBIT and only 1x EV/Revenues. Compare those multiples to the industry averages of 16.9 EV/EBIT and 2.05x EV/Revenue and you find a company that is relatively cheap compared to its peers on a quantitative basis.

Despite having clear and sustainable competitive advantages, share prices have fallen 14.5% over the last year. When looking at the operations of the business, it’s not clear as to why the share price fell; most times this is a good thing. In reality, Trump’s blocking of CHL’s attempt to obtain an FCC license to operate and sell their services in the US caused significant headwinds for price appreciation. Citing US National Security, the Trump administration quickly shot down the request that had been standing since 2011. This also plays into the narrative of tension between the US and China regarding “trade wars”. Moreover, the company reported its first negative subscription growth figure in April 2018. Yet when seeing China Mobile for the first time, I began to wonder if this was a case of throwing the baby out with the bath water. On one hand, yes, it would have been nice to have China Mobile enter the US market to sell its services, increasing its potential avenues of growth. However, current trade wars / talks don’t inhibit the core business of the company in China. In other words, no matter what comes of these trade wars, people in China still need their wireless services, still need to stream data at high capacities, and still need to switch from 3G to 4G in most areas. Secondly, it isn’t unpredictable that the company reported a negative 4G growth quarter with the market nearing saturation and its competitors taking some of scraps left over.

Business Overview

CHL breaks down their business model into a fairly simple-to-understand “Four Growth Engines” framework. The four growth engines are: Personal Mobile Market, Household Market, Corporate Market, and Emerging Business. According to the last annual report, the Personal Mobile Market accounted for 77.6% of revenues, with 5.3% coming from Household Market, 10.1% coming from Corporate Market, and Emerging Business bringing in the remaining 7%. Within the 77.6% revenue from personal mobile, 52% of that comes from their handset data traffic segment.

CHL demonstrates competitive advantages within each of these four engines. For instance, the company is the top market share grabber in mobile customers and leads in 4G customer satisfaction. Within the Household market the company sports the second largest market share. Corporate Market share is performing tremendously as well, with CHL capturing 36% of telecommunications and informatization service revenue market share. Finally, think of the Emerging Business segment of CHL as an asymmetric bet on the future of media and streaming within China. Within their Emerging Business segment the company offers video and reading programs which are enjoying significant growth.

To go along with this robust growth, the company is committed to reducing its CapEx. From 2016 – 2017 CHL reduced CapEx by 5.2%, and expects to reduce expenditures another 6.4% between 2017 – 2018 year-end.

Personal Mobile Market

Since CHL was originally spun-off as a strict mobile telecom company, it’s no surprise 77% of its revenue comes from this operating segment. The company uses two levers to drive revenues and margins higher in the Personal Mobile Market: Customer Growth & Handset Data Traffic. These go hand in hand. CHL increased their mobile customers from 849MM to 887MM, as well as increasing its Mobile ARPU (Average Revenue Per User) by $100K USD to $8.4MM USD. More importantly than overall mobile user increases are the increases in 4G customers. 4G customers garner higher price points and wider profit margins for CHL. Between 2016 and 2017 the company increased their 4G Customers from 535MM to 650MM, with 4G ARPU coming in at $9.8MM USD. Handset data traffic exploded over between 2016 – 2017, growing 121.3%, which in turn increased handset data revenue 27%.

Household Market

Revenues from the Household market grew substantially, a 56% clip. This comes from the company’s determined commitment to provide faster network speeds and higher quality connections. The increase in household revenue bolstered the company up to No. 2 in household broadband market share, up 7% from 2016 to 37%. Household broadband ARPU also increased 17% to $33.3MM. To spur the household growth the company initiated projects such a new family multi-media and digital surveillance systems.

Corporate Market

CHL’s Corporate market posted strong YoY revenue growth of 32.1% and captured a little bit over 36% of market share. Within the Corporate Market revenue stream, 41% of revenue comes from Corporate Voice, SMS & MMS; 23% from Corporate wireless data traffic, and the rest of revenue filled in with Dedicated Lines.

The company’s Dedicated Lines segment grew 31% due to new concessionary prices, improved customer service processes, and enhanced response times (take a hint, Comcast Customer Support). The aforementioned improvements bolstered Dedicated Lines market share. CHL’s IDC (Internet DataCenter) Service segment boosted revenues 86% thanks to an increased demand for internet data storage centers, as well as the global increased demand for “Big Data”. In response, the company opened up 4 national data centers and 45 province-level data centers.

Finally, within the Corporate Market segment the company generates revenues from its IoT services. The company grew IoT revenues by 44.4%, adding 126MM IoT connections (company total is now 229M). This IoT network is now the largest dedicated IoT network in the world in terms of connections. The growth in IoT connections is due to increased demand for autonomous vehicles as well as Virtual Reality.

Emerging Business

The Emerging Business segment is a (relatively) small part of the overall pie of revenues, but it’s extremely interesting. Within the Emerging Business, CHL develops applications and information services to help customers’ everyday lives (think of Apple apps that we use daily). For example, the company released “And-Wallet”, a digital wallet to enable digital transactions (read: Chinese Venmo). In 2017, And-Wallet surpassed 2B RMB in total transactions. To go along with the wallet, the company released “and-Video” service, which provides video-on-demand for mobile devices as well as streaming services. Finally, the company released “and-Reading” services, which is basically their version of Amazon Kindle for mobile devices. As more and more people rely on mobile devices for data, video, and streaming content, CHL is positioning themselves well to profit from the transition. The company is already seeing the fruits of their efforts with revenues growing 11% 2016 – 2017. And-Video and And-Reading both grew 67% and 11% respectively.

Targets For 2018 Year End

The company expects profits to keep growing while capital expenditures continue to decline. Total connections are expected to exceed 1.4 billion users (incredibly strong scale effect). The company expressed goals for each part of the Four Engines for Growth. In the Personal Media market, the company expects to add 50MM 4G customers by the end of 2018 with mobile ARPU staying on top of the industry. The company’s goals for the Household Market include adding 21MM household broadband customers while continuing its growth pattern of around 5 – 8%. The Corporate Market’s goal is to reach at least 40% market share by the end of the year, which seems reasonable given their current 36% position. Finally, the Emerging Business segment’s goal is to further increase revenues through adding net 120MM IoT connections, which would bring the new total of IoT connections to over 300MM.

Comparing the Competition

China Mobile’s top two competitors are China Unicom (CHU) and China Telecom (CHA). When comparing the three companies, it’s clear that China Mobile is not only the better business, but better positioned to capture most of the market over the next 5 to 10 years (which is what we really care about). Both CHU and CHA have long-term debt, something CHL doesn’t have to worry about. Margins don’t come close either with CHA sporting 7.4% and CHU sporting 1.6%. CHL also has a 9% advantage in Gross Margins (80% compared to 71% for CHA). Finally, CHL has the highest ROA at 7.4% compared to 2.8% for CHA and 0.8% for CHU.

After assuming CHL to be the superior company out of the three Chinese players, let’s take a look at some valuation multiples to see where CHL stands relative to its peers. Using EV/FCF we find CHL to be extremely cheap on a competitive basis as well as a sector basis. CHL’s EV/FCF is 11.8x, meaning it would take around 12 years for the company to earn back what its worth currently (assuming no growth). Compare that to the sector average of 22.5x and CHA’s EV/FCF of 32.6x the current trading price seems cheap.

Simply, CHL’s competitors don’t have the margin power, FCF generation, nor the financial flexibility to maneuver and position in the coming years like CHL does. Being the largest telecom provider in the world creates a large barrier to entry for competition, especially in China where capitalism isn’t fully adopted. Both CHA and CHU are growing companies that are benefitting from the tailwinds of the industry, there’s no doubt. Rising tides lift all ships. However, as a capital allocator, where am I most comfortable investing my money for the next 5, 10, or 20 years? There is something to be said about the network effect capabilities of CHL that its competitors cannot replicate unless they start taking market share away. That feat will be almost impossible to do given CHL’s monopoly in all of Rural China. If anything, I could see CHL rolling up the industry (should Chinese government decide to do so).

Finding Fair Value Range

Management is expecting $115B in revenues in 2018, $118B in 2019, and $120B in 2020. If we assume revenue growth of 3% for the last two years, we get a 2022 revenue number of $132B, we’ll call this our modest revenue number. Let’s say the company loses money after 2018 at a 3% clip. After losing 3% in revenues each year after 2018, the company would end up with $102B in revenues in 2022. We’ll call this our bad number. Finally, let’s assume the company is bolstered by aggressive demand for data and voice services, growing revenues at 5% a year after 2018. This gives us revenues of $140B in 2022. We’ll call this our optimist number. Let’s go through each scenario and its ending fair value range.

The “Modest” Valuation

We’ve already got our top line revenue number of $132B in 2022. From this, we take the historical EBITDA Margin of 36.5% to get $46B in EBITDA. Next, we’ll add in our Capital Expenditures. Although the company has recently been reducing its CapEx, I find it better to use historical averages to get a more fair range. Using the average of 25.4% of revenues, we end up with $31B in Terminal CapEx. Working capital’s historical average is -59%, which gives us a terminal Working Capital expenditure of $80B. Next we calculate our D&A, which we’ll use historical average of 19% to give us $27B. Finally, we’ll assume a tax rate of 23%.

Taking all expenditures into consideration, we end up with terminal FCF of $12B. To calculate our Enterprise Value, we’ll add up all the FCF’s from each year to give us $63B, our PV of Discrete Cash Flows. Choosing a 1% perpetuity growth rate and adding our discount factor, we end up with PV of Terminal Value of $124B. Adding the two PV’s together gets up an Enterprise Value of $187B.

Adding in the cash and investments, we come to a Value of Common Equity of around $276B. Dividing that number by total shares outstanding gives up an implied stock price range of $63 – $68, with an EV/Revenue of 1.47x.

The “Bad” Valuation

For our bad situation forecast, we’re assuming -3% revenue growth after 2018. This gives us revenues of $102B. Now, to add to this bad situation, let’s say the company’s plans don’t go accordingly and actually have to increase CapEx in the next two years from their expected % of revenues of 21% to 25%. This gives us terminal CapEx of $23B. Working capital we’ll keep the same as -58% of revenue, which gives us terminal WC of -$60B. D&A comes in at a terminal $22B, which is 95% of Capex. We will also hold tax rate of 23% constant.

Adding up all years’ cash flows gives us a PV of Discrete Cash Flows of $34B. Choosing a perpetuity growth rate of 0% we get terminal FCF of $8B. Apply our discount factor and we end up with PV of Terminal Value of $75B. Adding these PV’s together gets our Enterprise Value to $110B. From here, we add back in our cash and investments to reach Value of Common Equity of $198B. Divide that by our shares outstanding and you get a fair value range between $47 – $49, a 1.07 EV/Revenue multiple, and still 6% upside to current trading prices.

The “Optimist” Valuation

For our optimist valuation we’re assuming 5% revenue growth after 2018. This gives us 2022 revenues of $140B and EBITDA of $48B. Now, let’s also assume that the company makes good on its intentions to reduce CapEx in the years to come, bringing their average down from 25% to 22% over the course of the next five years. This gives us a terminal CapEx value of $31B. We’ll hold working capital constant at -59% of revenues to give us a terminal WC of -$86B. D&A stays constant at 19% historical average of revenues which leaves us with a terminal D&A of $29B. We will also hold the tax rate constant at 23%.

Adding up all FCF’s gives us a PV of Discrete Cash Flows of $67.2B. Now, since we’re anticipating stronger growth in this scenario, our perpetuity growth rate is 4%. By taking our terminal FCF of $16B and applying our discount factor we arrive at a PV of Terminal Value of $302B. Adding both PV’s together gives us an Enterprise Value of $369B. Taking that EV we add back in cash and investments to get to a Value of Common Equity of $458B. Divide that by the number of shares outstanding and you arrive at a stock price range of $96 – $113, or an EV/Revenue multiple of 2.4x – 3x (these multiples aren’t too much of a stretch given the sector average between 1.7x and 7.5x).

Where is My Fallibility?

Like I mentioned earlier in the piece, the biggest red flag for my thesis is the fact that CHL is 73% state-owned. This throws in smoke and mirrors when it comes to accounting, credit-ratings, and overall trustworthiness of the business operations. Taking a look at Glassdoor.com’s reviews of the business I found 3.9 stars out of 5 with 80 reviews. That’s not too bad. Most of the complaints in the company were along the lines of, “sometimes I have to work weekends”, and “I wish the pay was a little better.” In 2017, the company paid all of its executive management a total of $650,000 USD. Still, with the state owning 73% of shares outstanding, any business related decision might ultimately come down to whatever the Chinese government deems best.

China Mobile could also lose its market share in the 4G space, due to China Unicom’s dedicated spending efforts in the Mainland. Although CHL has a monopoly in Rural China, the mainland remains somewhat of a battleground between the three. It’s an “arms race” of R&D expenditure. If China Mobile starts using debt to finance its 4G expansion instead of its cash flows, that could signal a negative for the bullish thesis. This isn’t to say that a little bit of leverage is a bad thing, but I would be worried to see the leverage creep up above 5x EBITDA.

Not inherent to the business, but geopolitical quarries could keep the share price suppressed for longer than one is to stay sane (thanks, Keynes). Although we’ve demonstrated that tariffs don’t have a huge impact on business, the market is a herd, and the herd loves news-bites such as “Tariffs strike down business!”, sending the baby with the bath water.

Creating Asymmetric Risk/Reward

Since I am working with smaller amounts of capital, whenever I dig into a company with a high trading price (I consider high anywhere over $30, relative to the size of my investing account), the first place I seek to invest is in the options market through LEAPs. Joel Greenblatt in “You Can Be a Stock Market Genius” expresses the use of LEAPs as, “creating your own warrants”. By investing in LEAPs, you get automatic downside protection (you can only lose as much as the premium you paid), and the upside can have exponentially positive effects. Looking at the options chains for CHL, you can buy the $50 strike price for March 15 2019 for $0.55 (or $55 for one call). To breakeven on the LEAP, you would need the price to advance upwards of $52.50 – $53, or 12% from its current trading price between now and 222 days from now.

Once I get approved for options trading I will look to put this position on hopefully over the next couple of weeks.

Final Thoughts

The main drivers for underlying business growth are customer growth, increased mobile data traffic, and higher switch rates to 4G. As long as two-thirds of these drivers happen, CHL seems in proper place to increase their market share, widen their profit margins, and plow FCF back into the business. In a space-race for 4G, the winning company will be the one that has the greatest financial flexibility and the widest reach of customers, CHL has both. Never underestimate the power of a scalable business with dominating market share.

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