China Mobile Trades Growth For Stability

By Stephen D. Simpson, CFA | June 24, 2013 AAA

Investors may be frustrated with some of the decisions that China Mobile (NYSE:CHL) management has made in recent years, but at least they can say that the company is what it is – a leading wireless service provider focused exclusively on China and built around generating solid and predictable returns on capital and free cash flow. With that in mind, China Mobile looks like a solid investment pick, particularly for those investors looking for above-average dividend potential. Will 4G Justify The Investment?China Mobile has been ramping up its 4G network plans, and spending on this rollout is likely to be a key story over the next couple of years. Management has targeted having 200,000 base stations in 100 cities by the end of the year, with an official launch of service either late this year or early next. Assuming the company keeps to that schedule, it should provide an effective one- or two-year headstart. SEE: How To Pick The Best Telecom StocksThe question for investors, though, is whether China Mobile will reap significant ROI on this rollout. The company's 2G network is still the cash cow for the company, providing the majority of its operating cash flow and supporting over 80% of its subscriber base. By comparison, the 3G network has largely been an albatross. Whether its fair to blame company missteps, government regulatory intrusions, or competition from China Telecom (NYSE:CHA) and China Unicom (NYSE:CHU) is to some extent moot – utilization/penetration has been relatively poor and the company's share lead in 3G is considerably narrower. 4G service should offer higher ARPU and it seems reasonable that most of those 2G subs will want to upgrade at some point. On the other hand, it's unclear what China Mobile's rivals are going to do with their 4G plans, with China Unicom seemingly suggesting that upgrading its 3G network is a better near-term option. Staying A Pure-Play On ChinaUnlike almost every other mobile service provider of any size, China Mobile has been content to stay within its borders. The company had been exploring a joint bid with Vodafone (NYSE:VOD) for a license in Myanmar (Burma), likely the last growth market in Asia, but pulled out due to concerns about the probable return on the investment. That's good and bad news for investors. It's hard to argue that global expansion and diversification hasn't helped carriers like Telefonica (NYSE:TEF), Bharti, or France Telecom's (NYSE:FTE) Orange. Likewise, a single-company focus leaves the company highly vulnerable to regulatory interference designed to improve competition. On the other hand, China is so large and China Mobile is so large within the Chinese market that China was always going to dominate the story here. What's more, the state's ownership stake in this company doesn't make it an appealing operator in many countries. Last and not least, the company's investment discipline is not such a bad thing. Many telco providers have piled into countries to chase growth, only to find that the actual returns on the investment are poor and destroy shareholder value. For China Mobile to resist the temptation to grow and focus on long-term returns is a positive in my book. Still A Top OperatorBeing a state-owned service provider in a regulated market in a country with a tenuous sense of free market competition would normally sound like a lousy proposition for investors. And yet, China Mobile's management makes it work. It's true that the 3G network hasn't panned out, but the company's marketing efforts are still paying off to some extent (with 44% of the net 3G adds in China in April) and the company boasts a very good return on invested capital for the sector and a very stable payout ratio (43% for seven years running). The Bottom LineThe Chinese government has no particular desire to see China Mobile hold any more share of the overall telecom market, so overall net sub adds are not likely to be a large part of the story. That said, converting subs from 2G or 3G to 4G could offer respectable growth opportunities. To that end, I think the company can maintain long-term growth in the mid single digits. Free cash flow will get compressed over the next year or two for the 4G rollout, but I expect the company to continue producing very strong free cash flow margins. Feeding that all into a DCF model, fair value for the shares would seem to be in the low-to-mid $60s, which when coupled with a dividend yield above 4% makes this a worthwhile stock for investors to consider.

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