By Jack Huddleston, posted on August 1, 2011
Disclosure: Long position in CHL
Note: If you have trouble reading the tables, contact me and I will email them to you.
Assumptions and Limitations:
This analysis is based on limited knowledge of China Mobile and the analysis was mostly undertaken in May 2011. The main purpose of the analysis was not to determine how China Mobile will perform relative to other telecommunications companies, but if China Mobile appeared to be a good long term investment. Based on the analysis I bought China Mobile on 5-31-11 for $45.60 per share and as of 7-29-11 the price was $49.83. Please note that the analysis was written in May 2011 and the language is as of that time frame. Much of the report is from my notes.
Summary of Conclusions
China Mobile Limited (CHL), at a price of $45 per share, is selling at a price below what I believe it would sell for to a private buyer, which I believe would be between $65-100 per share. This means that the stock is undervalued by at least 44.44% and at most 122.22%. In other words, based on earnings of $4.55 for 2010, CHL should sell appropriately between a TTM P/E of about 14.29 and 21.98. This “private buyer” value is what I will refer to here as the “target price” or “intrinsic value.”
The low price, I believe, has three main causes: (1) a decline in earnings growth for 2009 and 2010, (2) a fear among investors of Chinese stocks which began late 2010, and (3) the perception of CHL as being too large to grow and operating in a “boring” industry. There are many other factors affecting the price – such as the trading price for its shares on the Hong Kong Stock Exchange (HKSE), the RMB (China’s currency) to USD exchange relationship, and so on – but these three are likely the most prominent.
Admittedly, CHL has not been given the same valuation as have reverse merger and small cap Chinese companies. What I have observed indicates that many people are altogether avoiding anything from China. I believe that the depressed price of CHL since the market crash of 2008 is heavily influenced by emotional factors.
It is well known that stock prices can move sometimes dramatically in response to recent earnings reports – it isn’t uncommon for a company to be revalued downward as much as 10% by the market because of a poor quarterly earnings report (often followed by a 10% upward valuation when the next quarterly report is favorable). This is may the case for CHL. The following table illustrates the story.
Table I: China Mobile Price Data1
This table requires some interpretation. In the past, the company has released its annual report between March and June. The exchange rate and share price data presented here are from July 15, or the closest day available, of each year. By July 15, the markets have had ample time to digest the annual report and adjust the stock price accordingly. “% change in market price” should be compared to the fundamental data for the previous year. Therefore, the change in market price by July 15, 2011 should be in response to a change in earnings per share – or any other fundamental measure – from 2010, which would have been reported just weeks before July 15, 2011.
The price of CHL has generally moved in motion with the market even in spite of strong fundamental changes. The share price declined about 25% in by the middle of 2009 from the same date the previous year despite of a recently reported increase in earnings of 44.28%. This was clearly the result of the stock market crash of late 2007 and 2008. Yet, while the general market has since increased to its previous level, CHL has frustratingly stagnated.
The reason is likely the result of very low earnings growth from 2008 to 2009 and from 2009 to 2010. Although China was relatively immune to the last recession, China Mobile’s earnings growth slowed for two main reasons: (1) slowing customer growth and (2) a decrease in revenue per customer. This slowdown and the reason as to why the past two years is likely temporary will be discussed in more detail below.
The other two causes of CHL’s undervaluation, although important, will not be given much consideration here as they are based on my limited observations and are not provable except in retrospect. The main refutation to both of these points is the valuations given to both of CHL’s main competitors, China Unicom (CHU) and China Telecom (CHA). Both of these companies, despite having no history of earnings growth, are being given extreme valuations by the market at the moment.
CHU, for example, is selling for 56 times the average of its EPS for the past 5 years and yet there has been no noticeable trend of growth in intrinsic value upwards or downwards since the year 2001. This is most likely the result of CHU’s exclusive rights to selling Apple (AAPL) products in China, but the current valuation is even more curious in that it is highly likely that this monopoly will be broken in the coming year.2 The future may show very high growth for CHU, but without a history of proof or any overwhelming reason to suppose it should happen, the current price is evidently speculative.
1 IFRS is the reporting method from 2010 to 2006 and U.S. GAAP is used from 2005 to 1999.
Competitive Position of CHL
CHL’s stock sells on both the NYSE and the HKSE. The actual shares are listed in Hong Kong and ADS’s (American Depository Shares) are listed on the NYSE. Each ADS represents 5 actual shares. CHL is one of the largest companies in the world, the largest telecommunications company in the world, and is listed in several indexes. The company is apart of the Hang Seng Index (HSI), one of the earliest indexes in Hong Kong.
CHL’s competitive strengths are threefold: (1) the oligopolistic nature of the telecommunications industry in China, (2) its pricing power as GDP-per-capita and inflation increases, (3) and the several million people right now in China who are without a mobile phone plan.
The telecommunications oligopoly in the PRC has been orchestrated by the government under the philosophy of “rational competition”. The Chinese government wants all the efficiencies that come about with economies of scale, yet want to avoid the creation of a complacent and sluggish monopoly. The current industry situation was created only a few years ago and there are no indications that the underlying philosophy will change in the near future. The PRC government has even gone in the past as far as to give assistance to CHL’s competitors by way of temporarily regulation that gives those competitors a shield from CHL, which was stealing market share from them.
CHL has a 70% market share at the moment and it is likely that this will decrease over time, as the company does not indicate to me that it has the managerial ability and industry economics to protect its moat perfectly from the two other firms in the industry and changing government policy. The degree that its moat or market share will decrease, if at all, is unknown, but the companies, like countries, need not last forever and it can be reasonably expected that its position will weaken over time.
The company’s current competitive position is advantageous in that it provides a great deal of stability and predictability of future earnings than in allowing for high growth rates. The infancy of the telecommunications industry, however, has allowed and will allow for strong growth into the future for some time. The mobile penetration rate in China was 64.40% in 2010. There is much more room for growth as a result of customer additions. Further, the average time spent talking on the phone per CHL customer per month was 8.70 hours. If China ever reaches the amount of wealth of the most advanced countries in the world, that amount of time should increase several-fold. Average revenue per user (ARPU), as well, will likely increase as Chinese GDP-per-capita increases.
2 See “Catalysts for a Valuation Reserval” below for further discussion.
Telecommunications Industry in China
China Unicom (CHU) and China Telecom (CHA), the two competitors of CHL, are valued at 50x and 20x historically demonstrated earnings power, respectively. Both companies have a history of increasing assets and sales several folds yet being unable to increase net income and earnings per share over the same time period. Being that one can increase earnings at the same rate as principal simply by depositing more money into a savings account, that is not entirely impressive.
Currently I am not very familiar with both companies in qualitative terms, but it appears that CHU’s valuation is based on it having exclusive rights to sell AAPL products in China. CHA’s high valuation is unclear, but it is presumably also related to 3G smart phones. It could also be because both companies are smaller and perceived as having greater growth opportunities (similar to the high valuations given to independent oil drillers, currently valued at about a 20 P/E, versus the major integrated oil companies, with P/E’s of about 10 on average). Where CHU and CHA have been awarded rights by the government to use internationally accepted standards of 3G technology, China Mobile has been required to use a homebrewed version of 3G referred to as “TD-SCDMA,” which is generally considered inferior and prevents the company from selling iPhones, as AAPL believes that standard may affect the quality of the phone and thus its reputation.
An expert of the industry may know better, but CHU and CHA, are without a doubt speculative. Without a proof of income growth in the entire history of the two companies, the analysis of future growth must qualitatively stated. The current prices could only be justified by an extraordinary earnings growth that can only be sustained by stealing customers from CHL. Presumably it is assumed these people will eventually flock to those companies to have access to western smart phones. This logic seems to ignore that the vast majority of Chinese customers are buying cell phones for practical purposes, rather than discretionary purposes (see section below “Calculation of Intrinsic Value”). This will change sometime in the future, but by then it would seem too late as CHL has long been in talks with AAPL to release AAPL devices utilizing either the TD-SCDMA or TD-LTE (4G) standard. AAPL obviously wants access to the rest of the Chinese population, of which CHL stands as a toll bridge (see “Catalysts for a Valuation Reversal” for further discussion).
Operational Statistics
The table below shows all the relevant operational statics relating to CHL.3
Table II: China Mobile Operating Statistics4
Profitability:
CHL’s return on equity (ROE) is very high in comparison to its industry and all businesses in general. A look at return on invested capital (ROIC) shows an even more favorable picture – CHL achieves its returns using little debt. The ROE is driven primarily by a high profit margin. This high profit margin, in turn, is mainly the result of a very strong industry position – the major firm in a triumvirate of general telecom providers – in a very strong economy. This profit margin has been maintained in spite of government-mandated decreases in the prices charged to customers.5
Operating ratios:
Interconnection appears to be an unprofitable business whereas SIM cards and handsets is enormously profitable. These statistics are of limited value, however, because it is unclear how the costs are distributed. For example, the costs relating to “interconnection” (see Appendix I for CHL’s income statement) could include overhead or other costs that benefit another part of the company. Similarly, the costs relating to “SIM cards and handsets” may not be including some expenses.
Efficiency ratios:
Asset turnover and other “asset efficiency” measures are not as important for CHL as it has little in inventory and receivables. In any case, the company beats its industry in the two figures shown.
Liquidity ratios:
The company has a sufficient amount of working capital to prevent any serious loss of business in the event of a liquidity crunch arising from a recession in China or such. CHL exceeds its industry average in both measures of liquidity shown here. Liquidity is not an issue overall and thus only two ratios are presented.
Credit ratios:
CHL’s capitalization is about 90% equity and is not at all pressured by debt or interest. The 20-F notes that the company’s credit rating by Standard and Poor’s is “AA-/Outlook Stable,” the same rating as the PRC’s sovereign debt.
Growth:
As explained later in this report, CHL’s future growth rate will most likely fall below the historic growth rate as the company faces diminishing returns. There are multiple reasons as to why the historical growth rate may continue for some period, but a core tenet of “value investing” is that the merit of an investment should not be based on the expectations of good future results. In value investing, the chief purpose is to guard against the future rather than bet on it.
It is noteworthy that the “total voice usage” growth rate is almost double that of net income. The reason for this is explained in more detail later and relates primarily to a regulatory-mandated decrease in prices charged by telecommunication operators in the PRC.
Payout ratios:
The company’s expected payout ratio for 2010 was 43%. The 20-F notes that the expected payout ratio for 2011 is also 43%.
Market-price ratios:
Table II shows that the company is being given a lower valuation by the market overall to its peers. It is hard to comment as to why this might be the case, as I have not investigated the prospects and competitive position of each and company in the industry. It seems to me that CHL would have better opportunities than most other companies, however, given its special position in China’s flourishing economy, which CHL will partake in at least as much as the average company. As stated above, I believe this relative undervaluation is attributed to recent slow growth, temporary distrust of Chinese companies, and it being just a large and boring sort of company.
The large price to sales and price to book ratios are the result of the company’s high profit margin and return on equity. Market capitalization to net income and net income to sales multiplied by one another results in the price to sales ratio. It follows that a higher profit margin will necessarily result in a high price to sales ratio. Similarly, price to book a function of price to earnings and return on equity. A higher ROE always results in a higher P/B because of the mathematical relationship.
Other ratios:
Net income has stayed slightly above free cash flow as a large portion of the company’s capital expenditures were for expansionary purposes and therefore were higher that year’s depreciation charge. This is not unusual for expanding companies.
3 See “Appendix I” for a balance sheet, income statement, and cash flow statement for CHL from 2010 to 2006; all the aforementioned statements stated as the percentage growth from the previous year; and all the aforementioned statements stated as a percentage of assets (balance sheet), revenues (income statement), and pre-tax cash flows from operations (cash flow statement).
4 Calculated from data stated in RMB terms, which accounts for the differences in earnings growth shown in Table I. With the exception of “Dividend yield” and “Operating margin,” industry average information is from MSN Finance and is current as of July 11, 2011. Industry average data is shown only where available and 5-year average industry data is used where available or can be by calculated using other available data (such as with the tax rate). See “Appendix II” for the exact formulas used in these calculations.
5 See “Estimation of Earnings for 2011” for further discussion.
Method of Calculating the Target Price Explained
The intrinsic value of an asset, in general, is the present value of its future cash flows. The intrinsic value of an asset, then, can be found by (1) taking the average of historical earnings, (2) projecting these earnings into the future at a conservative growth rate, and (3) discounting these earnings on the basis of the risk of those earnings not being realized. It is assumed in this calculation that the company will be a going concern at least 100 years from now, as earnings from that time forward have no worth in present value terms. History has shown that very few companies are capable of lasting that long as most either go bankrupt, get acquired, merge, and so on.
It is very easy to plug in numbers into such a model and deceive oneself into believing a stock is undervalued based on the output (“garbage-in, garbage-out”). For that reason, a high level of conservatism is used in this calculation and the final calculation of intrinsic value is discounted further about 25% to reflect the model’s weaknesses. Some may say that this level of “conservatism” is going overboard, but I believe it is necessary to achieve good results. If the company is selling at a strong discount to this number, in spite of my all efforts to make the company look bad, then it has a strong chance of being undervalued with an adequate “margin of safety.”
Some may also argue that this kind of calculation isn’t necessary and that CHL can be proven as an investment operation on the basis of its operations, its strong position in its industry and economy, and so on. I have, however, two reasons for making this calculation: (1) I have limited knowledge of the telecom industry and the Chinese economy and (2) there is no way to judge those factors relative to the price of the stock short of having the an intuitive feel gained from long experience and knowledge of studying companies in the industry. Qualititative aspects of CHL are more like the icing and cherry on top, rather than the substance of the reason for its stock purchase. Benjamin Graham, the father of “value investing,” once said that while it is a requirement that a security be justified on quantitative grounds, it is by no means sufficient – it must be justified on both quantitative and qualitative grounds.
I do believe, however, that the purchase of CHL is justified by the merit of its competitive position, which I summarized above. 7 out of every 10 people with a mobile phone in China use CHL as its service and this ratio has not changed significantly over the past decade.6 In addition, the mobile penetration rate was about 64% in 2010 whereas it was 7.79% in 2001.7 This means that CHL, up until today over several years, has attracted and retained about 7 out of 10 people in the past decade who were looking for a mobile phone service. The company must be doing something right, they will probably continue to do that, and there are still hundreds of millions of people in China without a mobile phone plan. CHL’s ability to attract as many customers as it has is probably related to its low price, which is one reason the company’s ARPU has declined as much as it has over the decade. In other words, most of its new customers are relatively poor.
In addition, the quantitative data presented in Table II, Appendix I, and Appendix III says a lot about the qualitative aspects of the company (its competitive strengths, managerial ability, and so on). That these ratios and figures have remained substantially unchanged over time speaks volumes.
6 Market share, according to the CHL’s 20-F statements:
2010: 69.30%
2005: 65.60%
2001: 69.60%
7 The mobile penetration figure is implied by other data available. Dividing the number of customers in 2001 by CHL’s published market share and then dividing that figure by China’s population in 2001 yields 7.79%. 2010’s figure is the official data of the Ministry of Industry and Information Technology (MIIT).
Estimation of the Growth Rate for 2011
As discussed above, a rate of earnings growth must be determine for the calculation of the target price. The primary determinant of long-term intrinsic value growth is return on equity (ROE) multiplied by the percentage of earnings that are to be reinvested into the company. Historic ROE provides a starting point, but it is marginal ROE that will ultimately determine future growth rates. It should not be expected that the fantastic growth rates so far experienced by CHL should continue indefinitely into the future as it (1) faces increased competition and (2) experiences diminishing returns.
The calculation of marginal ROE is somewhat complex, so the explanation will be as brief as possible. Below is the historical exhibit of ROE and marginal ROE in comparison to EPS (note that the earnings shown in Table I are the ADS figures stated in USD’s, while this table shows the earnings per Honk Kong share stated in yuan):
Table III: China Mobile Returns8
Marginal ROE for 2011 is expected, by my calculations, to be 15.45%. This adds to the evidence that CHL faces diminishing future returns and that the growth showing during 2009 and 2008 is probably temporary. This means that the overall ROE for 2011 is likely to decline slightly, probably somewhere from 19.00% to 20.50%. Discounting that ROE by the percentage of earnings that is expected to be reinvested (43% is expected to be paid in dividends), the expected growth rate for earnings – before accounting for changes in currency translation – for 2011 is between 10.83% and 11.69%.
8 Marginal ROE is calculated as follows:
Marginal ROE = (NIt – NIt-1) / (BVt-1 – BVt-2)
Where:
NI = Net Income
BV = Shareholders’ Equity
This formula takes into account that a reinvestment generally takes a year before the full effect is shown on the income statement.
Estimation of Earnings for 2011
The calculation of marginal ROE for 2011 requires estimating 2011’s earnings. The first step in this process is estimating revenues, which are a function – in CHL’s case – of the number of subscribers and the overall ARPU per month. This section will show the process taken in calculating earnings for 2011.
As of May 31, 2011, CHL has 611.17MM customers according to its investor relations website. Assuming that CHL’s customer base increases at about the same at as it has so far for 2011, it should add up to 650MM customers by the end of that year, which is about the same number added during 2009 and 2010. This method of estimation cannot be used forever, as the company will eventually reach a wall as there are a limited number of people in China, but it doesn’t seem unlikely that it will be reached in a big way within the next 7 months to December 31. The table below shows ARPU for the past decade:
Table IV: CHL ARPU 2010-20009
The downward trend of ARPU is obviously unsustainable, but it has some worried that it will lower future revenue growth. It has not thus far because the company’s increase in the number of subscribers has outpaced the decreases in ARPU. The decrease in ARPU is mainly the result of regulatory mandates implemented so that a greater percentage of the population may afford mobile service. The specific cause of the decrease for 2010 is attributed by the company to regulated price ceilings set by the PRC’s Ministry of Industry and Information Technology (MIIT) and increased competition. It is anyone’s guess as to where ARPU will be in the next year or two, but it probably will increase over the long-term as GDP per capita in China grows and “data” services (mobile internet, etc) – not facing as many government pricing regulations – becomes more popular.
The “prepaid” subscribers are apparently mostly rural citizens and that appears to be the cause of the decrease of ARPU. The company’s 20-F for 2010 states that it expects ARPU to decline further as its customer base expands. In addition, it notes that about half of new customers for 2010 were from such rural areas. It seems proper to assume 2011’s ARPU will be 73 yuan.
Thus far it is calculated that that total customers by the end of 2011 is expected to be 650MM and the ARPU on average for the year will be RMB 73. Using this data, total revenue for 2011 is expected to be RMB 540.49B.10 Multiplying this revenue number by the average of the profit margin over the past 5 years, 24.36%, results in expected net income of RMB 131.66B, or RMB 6.48 per share assuming no change in shares outstanding.
This estimation of earnings is a 10.05% change over 2010’s EPS of RMB 5.89. This is about in line with the expected earnings growth rate calculated above. The actual rate may vary considerably from this depending on changes in the exchange rate between the RMB and USD. If ARPU declines again for 2011 (meaning it will increase further in the future), growth for the next year will around 4-5%. This report, however, makes no attempt to predict near term prices, earnings, and so on. Any decrease in a year’s earnings because of a regulated price ceiling could just as easily result in a great increase in earnings as the ceiling in lifted and ARPU rises or as more customers begin buying data services.
The strengthening of the RMB in the past few years has allowed U.S. stockholders to receive more in value than created by the company intrinsically. I will not, however, make any attempt to predict exchange rates. If the U.S. government decides to clear away some of its debt by inflating the dollar, it does seem possible that U.S. inflation will outpace Chinese inflation, which is high because of demand, and thus result in the yuan strengthening further, resulting in an increase the growth rate of earnings beyond that aforementioned.
Additional data of a miscellaneous character regarding CHL customers, along with a brief commentary, is in Appendix III.
9 The company stopped including ARPU data for contract and prepaid customers as of 2007.
10 (584MM + 650MM) / 2 = 617; 617 x RMB 73 x 12 = 540,492. This method of calculation – taking the average of customers at the beginning of the year and the end of the year and multiplying by ARPU for the year – has proved a fairly accurate predictor of revenue for 2010 and 2009.
Calculation of the Target Price:
The growth of earnings is projected in the following way:
- 10% for 3 years
- 6% for 27 years
- 2% to infinity
The previous two sections dealt with the calculation of 10% growth. The 2% to infinity after 30 years is meant to reflect basic increases in inflation whereas earnings generally stagnate. The medium term growth rate, 6%, is simply a rough estimate of earnings growth that can be expected over the long-term based on:
- Mobile penetration rate increasing from 60% to about 90%.
- Higher ARPU as GDP per capita in China increases (presumes that there will be less “prepaid” users and more contract users paying more for data services such as mobile internet and so on).
- Inflation over the long-term of about 2%. Note that this is number is based on the average Chinese CPI from 2009 to 1996. 1994 had an usual spike of inflation and including 1994 into the calculation would have brought the average rate to about 4%.
- Moderate Chinese population growth of about 0.50%.
- CHL’s market share declining over time.
Long-term earnings projections defy calculation, but I think it can be reasonably assumed that the company’s volume of business and the ARPU of its customers will generally increase at a slow rate over time and thus that period deserves a higher rate than inflation. The following table shows the discounted cash flow table:
Table V: Calculation of Intrinsic Value11
The cash flows are distributed between retained earnings (which are expected to result in capital gains) and dividends. The dividends are assumed to be taxed at 35% (the qualified dividend rate will probably decrease in the future as the Bush-era tax cuts expire). This is not everyone’s tax rate, but it is probably a median figure.
The discount rate used in this calculation differs from some analysts in that I do not calculate them using the cost of equity capital or a function based on stock price volatility. The inherent stability of CHL’s mobile subscription revenues in the PRC and the company’s dominant position in its industry means there is less risk as the company is not as vulnerable to the vicissitudes of the economy. The discount rates used are instead calculated based on the 10-year T-bond plus a spread subjectively determined to reflect the risk of those cash flows not arriving by at least that amount.
It is important to remember that many of CHL’s subscription revenue are not a part of their customer’s discretionary spending – the business is not seasonal. Many Chinese today have mobile phone subscription plans because it is logically perceived as either a necessity or such a great convenience as to be too good to live without. This is evidenced by the fact that the ARPU annually for mobile services as a percentage of GDP per capita is 3% in China whereas it is 1.5% in the U.S.12 In addition, the average amount of time spent talking on the phone per CHL customer per month in 2010 was about 8.70 hours – or 17 minutes and 24 seconds a day on average. The average Chinese customer clearly isn’t subscribing to CHL for frivolous matters.
The intrinsic value using the discounted cash flow method – and hopefully conservative estimated inputs – is about $82. At a price of $45, this means that CHL is potentially undervalued by about 80%. Interestingly, the price of CHL’s common reached above this calculated value before the market crash in 2008. The importance of this calculation of intrinsic value is that it assumes no special performance by the company in the future. The company can perform quite poorly, even, and still be yield a good result. There is obviously quite a bit of speculative value well above this calculated figure if the company has exceptional performance.
This model can, at best, just give a ballpark estimate. The calculation here is quite sensitive to changes in the inputs. A difference of 1% in the discount rate for “Years 11-Infinity” can result in a change in the calculation of as much as $15. Moreover, the estimates in the model, while at a very low figure, are still quite speculative and it is almost certain that the actual figures in the future will differ. For those reasons, it is difficult to rely on the model blindly and instead set a range around which intrinsic value should lie reasonably. Therefore, as stated at the beginning of this report, the intrinsic value “range” is between about $65 and $100.
11 CHL, in its own DCF model for the purpose of calculating asset impairment, uses a perpetual growth rate of 0.50% and 10.00% as the discount rate.
12 U.S. ARPU calculated as the average of AT&T, Sprint, and Verizon.
Final Analysis:
The lower limit of $65 has been chosen kind of arbitrarily. The type of discounted cash flow analysis as described above can be misleading. I do not think it is prudent to make actual decisions rigidly based on such a quantitative model, despite the variables being so conservatively calculated, because of the number of estimates involved. Furthermore, many people may never attribute any value to earnings “to infinity” or even a hundred years from now.
Ultimately, a person can only sell an asset for what the other person is willing to pay. No matter how logical and conservative my calculations may be, the other person may never come to agree with them because of either differing opinions or some ideology. It is logical to not rely very heavily on the pure math of the matter.
Therefore, I believe this amount should be discounted to $65 for the following reasons:
- A discounted cash flow calculation is very easy to make mistakes in on account of how difficult it is to predict the future. It is easy to deceive oneself as to the surety of the calculated value because it very mathematical. The company’s lifespan may not last for 100 years, for example, or the telecommunications industry in China may be dramatically different from today’s.
- Even if the data rigidly states the intrinsic value is $82, the market may never agree with this calculation. CHL may perpetually stay below what a conservative discounted cash flow analysis say it should be.
- My own limited experience and knowledge in regard to CHL creates the need to discount for any chance my analysis is mistaken.
Therefore, a lower limit intrinsic value of $65 has been chosen as the absolute minimum value that should be attributed to the value of China Mobile as of today. This is about 25% less than the “true” intrinsic value calculated above. The reason for choosing $65 is a little simplistic.
Figure 1: CHL Price History13
It is a general axiom in value investing that the price of a stock is not always equal to its intrinsic value and that the price generally fluctuates above and below that intrinsic value. Table 1 near the beginning of this report shows that the P/E of China Mobile has been as high as about 30 and as low as about 10.30 – its current P/E. The period during 2007 where the price rose briefly to about $100 in response to a year of high reported earnings growth was probably an overvaluation. The stock price later tumbled in response to the recession (although China was not affected by the recession, its shares are listed on the NYSE) and has stagnated in response to very low growth rates for the years 2009 and 2010. The overvaluation retreated to an undervaluation.
The price of $65, based on this logic of the price fluctuating around a central value, is taken as just the average of the historic prices. The price during late 2007 and early 2008 was about $80 and that price represented probably an overvaluation. The price during 2009 to now has been about $50 and represents a period of undervaluation. The price has recently retreated to as far as $44 in response, probably, to the general dislike and perception of riskiness of Chinese stocks in general. The central value, therefore, is calculated as $65 as the proper lower limit intrinsic value. Keep in mind that this is not a “target price” for next year or any time in the future. I do not know what the price will be in the future. Value investing supposes that over the long-term, stock prices will eventually reach their calculated value and it is hoped for, though not guaranteed, that CHL and any other stock will eventually reach that value.
In any case, it seems odd that a company with stability and future prospects like China Mobile would sell for a P/E of less than the average stock, as shown by the S&P 500 index’s P/E of 14, and even less than the average major Chinese corporation, as shown by the “iShares FTSE China 25 Index Fund” with a P/E of 11, of which China Mobile is a constituent. I believe this degree of discounting is unwarranted.
13 From Yahoo! Finance.
Catalysts for a Valuation Reversal
As stated above, a fundamental principle of value investing is that there is an element of emotion or irrationality in decision making by investors. The necessary corollary is that stock prices deviate from their intrinsic value. There are also many whose investing decisions are logical, but are independent of stock values – technical traders, selling to pay for retirement, and so on. It is known that stocks generally fluctuate above and below a stock’s intrinsic value. These undervaluations and overvaluations may last as long as a few days to a few years. The point is that one major assumption of a “value investor” is that at some point his or her diversified portfolio of undervalued securities will reverse at some point in the future, although the exact time frame for this revaluation is uncertain.
There are many investors and portfolio managers, though, who are not satisfied with this “wait and pray” approach. Many demand a “catalyst” – a reason for a security to be revalued by the market within a specific time frame. As for CHL, there are three catalysts I know of that could cause a reversal of the current valuation. These are: (1) a great bull market, (2) a strong reported growth in earnings or some other fundamental measure, and (3) CHL being given rights to sell AAPL products in China. I won’t discuss the first catalyst, but the latter two have a strong probability of occurring.
Any growth in earnings beyond that shown in 2009 and 2010 can possibly lead to a higher valuation by the market. As discussed above, I believe the growth in 2009 and 2010 is temporary. The second catalyst is AAPL selling products through CHL, which it currently does not because CHL uses the incompatible TD-SCDMA as its 3G technology. This situation, however, may change in the future.
According to the news site M2M, China Mobile is rumored to have reached an agreement with AAPL over iPhone 5, which is supposed to be released sometime in the second half of 2011. This rumor’s basis is founded in Tim Cook, COO of AAPL, having visited the company on June 23rd of 2011. In addition, the site reports that an agreement has been reached on TD-LTE (4G) iPhones. TD-LTE is one of two 4G standards in the world and is gaining some international acceptance.
Further, a state-run paper, People’s Daily, reports that China Mobile had 5.6MM iPhone users with access to its wireless network by the end of May 2011. In addition, 700,000 iPhone 4 users were added to CHL’s network in May. This fact along with competitive pressure from CHA means that CHU’s toll-bridge status for owning an iPhone in China will not last forever. As a result, as People’s Daily reports, CHU has recently been promoting multiple smart phones, rather than promoting primarily the iPhone as before. This could mean that the valuation attributed to CHU is no longer warranted, if it ever was.14 More importantly, some of the enthusiasm for Google, Apple, and others could rub off on CHL.
14 People’s Daily. July 8, 2011. “China Mobile puts more pressure on Unicom.” Accessed July 14, 2011. http://english.people.com.cn/90001/90778/90860/7434076.html
Appendix I: China Mobile Financial Statements
Presentation of financial statement data:
The statements presented are adjusted where possible to represent a truer picture of the company. For example, “deposits with banks” have been consolidated with “cash and equivalents.” The “other current assets” account actually includes amounts that are due after 1 year, but the company does not give enough information to make an adjustment to non-current assets. Certain other immaterial items have just been consolidated under the most relevant account.
The company also uses strange terminology for some accounts that I’ve adjusted to something more typical (e.g. “current taxation” to “taxes payable”). The account “reserves” has been broken down into its component parts. Various esoteric reserves – the reserve required by PRC law, a reserve for unused stock options are consolidated under “other reserves.” A minute accounting standard was adopted during 2009 by the company that changed certain balance sheet accounts. There is inadequate data to adjust 2006 in a similar fashion and that is the reason why there is a sudden increase in certain accounts. Deferred tax assets, deferred revenue, and accrued expenses and other payables were affected by the changed. Operating leases have also been added to both assets and liabilities.
The income statement has been similarly adjusted to be more descriptive and to represent the true situation better. One annoying factor, from an analysis point of view, of IFRS is that it desires financial statements to have “minimum information.” For example, about 50% of all operating expenses were placed in an ambiguous account called “other operating expenses”. The average analyst obviously would want to know what such a significant account includes, so the statements have been readjusted to show the major components.
China Mobile Balance Sheet (December 31)
China Mobile Income Statement (December 31)
China Mobile Statement of Cash Flows (December 31)
China Mobile Balance Sheet (December 31) – Annual Percentage Change
China Mobile Income (December 31) – Annual Percentage Change
China Mobile Statement of Cash Flows (December 31) – Annual Percentage Change
China Mobile Balance Sheet (December 31) – Percentage of Assets
China Mobile Income Statement (December 31) – Percentage of Total Revenues
China Mobile Statement of Cash Flows (December 31) – Percentage of Operating Cash Flows
Appendix II: Table II Formulae
Appendix III: Additional CHL Customer Data
CHL Historic Number of Customers
CHL Historic Customer Usage
Based on information in CHL’s 20-F, prepaid customers seem to be mostly from rural areas. In part for making profits and in part for adhering to PRC philosophy, one of CHL’s and the PRC’s objectives is to minimize the growing “digital divide” between the country’s urban and rural dwellers. Thus, CHL has made great efforts to make mobile phone services available to rural communities. The 20-F for 2010 notes that about half of new customers in 2010 were from rural areas.
It is questionable to me, given my limited data, how profitable these rural customers are at the moment. My knowledge of Chinese civilization is limited to articles and figures showing that men have moved off to cities “in droves,” leaving the women and old men working in the countryside in very poor conditions. At the very least, they may be a decent investment as they will hopefully be wealthier one day and be capable of paying more to CHL for additional and better services.
It is also interesting to note the explosion of billions of minutes usage during the recession years while at the same time the company had less earnings growth. The company’s 20-F for 2010 complains of strain on the network from an increase in communications as an explanation for additional capital expenditures upgrading and expanding the physical network. Increases in ARPU as the country becomes wealthier will almost certainly provide growth for years to come.
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