China Mobile Ltd. (NYSE:CHL) has managed to maintain its position at the top of China's mobile services heap, holding over 60% share in a giant market of over 1.35 billion potential subscribers. This leadership has not come without a cost and a serious operational challenges, though, as Chinese regulators have worked to support China Unicom (Hong Kong) Ltd. (NYSE:CHU) and China Telecom Corp. Ltd. (NYSE:CHA) as viable rivals just as it pours billions into 4G network expansion.

It's the 4G network that holds the key to reviving China Mobile's fortunes and its stock multiples. Customers on the 4G network are expected to generate substantially higher revenue per user, but a lot of this growth depends upon the cooperation of handset OEMs.

3G to 4G is The Big Catalyst

China Mobile's TD-SCDMA (a Chinese-developed interface between mobile phones and towers) 3G network has been a thorn in the company's side almost from day one, as its poor data speed has facilitated meaningful share gains for China Unicom and China Telecom at Mobile's expense. Even through 2013, China Mobile's 2G network was still a cash cow. Meanwhile, through the first quarter of 2014 the 3G network accounted for under 30% of the company's subscriber base. Around 70% of the base was still 2G.

China Mobile will continue spending on 3G base stations in 2014, but the company is going to more than double its 4G base station spending in 2014, adding an expected 500,000 to support the network rollout and provide service in more than 300 cities by year's end.

China Mobile also realizes that building a 4G network is pointless if users won't switch over. That means they'll need to offer an attractive lineup of handset options. It has reached agreements with major handset OEMs including Cupertino, Calif.-based Apple, Inc. (Nasdaq: AAPL), South Korea's Samsung Electronics Co., Ltd., Japan's Sony Corp. (NYSE:SNE), Lenovo Group Ltd., Huawei Technologies Co. Ltd. and Xiaomi Inc., but as of mid-2014 the company's 4G handsets still skew to the high end of the price range. Apple, in particular, is going to be an interesting relationship to watch. It took nearly seven years for these companies to come together and the relationship should be an important one for both parties. China Mobile needs great phones to persuade switchovers to 4G, while Apple needs the potential hundreds of millions of China Mobile subscribers that could buy its phones. Cost is going to be an issue though; Apple's phones are expensive by the standards of the Chinese market and unlikely to drive the mass switches that China Mobile needs.

The company has priced 4G data about 20% to 30% below 3G, but the company has no plans for significant price reductions in voice. With handset subsidies and 4G network operating costs being what they are, China Mobile isn't likely to have the luxury of cutting 4G voice prices until 2015.

The Government Isn't Making It Easy

Government regulators have a major role in the profitability of mobile service providers operating within their borders, and China is no exception. Changes to mobile termination rates made in late 2013 (the first such changes in four years) should cut Mobile's earnings by about 6%. Further, a change in VAT policies made in May 2014 is going to take a further mid-single-digit cut out of China Mobile's earnings.

Looking beyond 2014, it seems implausible to think that the Chinese government will reverse policies and make life easier on China Mobile. Regulators don't need, or want, to cripple China Mobile, but having viable competitors in China Telecom and China Unicom should lead to better overall service quality through competition. Consequently, it seems reasonable to assume that the Chinese government will implicitly guarantee good enough returns for these competitors to justify ongoing network spending.

Likely To Remain A China Story

Given a large cash pile and significant year-to-year free cash flow generation but also a serious dependency upon the China market China Mobile is often named in merger speculation. China Mobile considered expanding into Myanmar, but pulled out when the bidding got too rich. China Mobile has also previously been tied to London-based Vodafone Group Plc (Nasdaq:VOD) and rumors of significant expansion into Africa. While diversifying into Africa would make sense given the significant role China has played in developing the continent's mineral and petroleum resources, China Mobile has thus far shied away these deals given its own prior experiences and those of other large national champions diversifying into unfamiliar markets.

The Bottom Line

As of mid-2014, China Mobile looks somewhat undervalued on a free cash flow basis, but at the high end of its recent EV/EBITDA band given lower EBITDA assumptions on the sell-side. As China Mobile transitions past the bulk of its 4G investment spending, the stock could re-rate if the ARPU growth materializes as expected. China Mobile does offer a strong dividend yield, one of the best in the mobile services space, though payout increases may be capped until the company has passed the peak of its network spending requirements.

Disclosure: As of this writing, the author owns shares of Lenovo Group.

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