China Unicom (NYSE:CHU) announced its 2012 annual results on March 21. The second largest wireless carrier in China grew strongly last year, increasing its revenues by 19% over 2011, on strong 3G adoption and growing demand for mobile data services. China Unicom’s 3G revenues last year were up by an impressive 83% y-o-y. In order to drive this growth, the company sold a lot more 3G-capable smartphones than last year as handset sales grew by 67% y-o-y, and it managed to control subsidies by focusing on cheaper $150 options. The subsidy costs as a percentage of 3G service revenues dropped from close to 18% in 2011, to about 10% last year helping China Unicom grow its net income at a faster rate (68%) than revenues.
Growing 3G adoption also helped the carrier pick up market share at the expense of dominant carrier, China Mobile (NYSE:CHL), which has lagged rivals due to the lack of the iPhone and an incompatible 3G network. More than 90% of China Telecom’s nearly 40 million net adds last year subscribed to its 3G network, helping the carrier capture almost 22% of the overall market and 33% of the 3G market.
However, the carrier continued to lose cash due to a sustained high level of capital investment on its mobile network. The carrier upgraded all of its 3G base stations to HSPA+ in order to attract high-end 3G subscribers and sustain the growing data demand. The RMB 100 billion in capital expenditures it had to incur last year was 30% higher than 2011. Consequently, the company generated negative free cash flow of about RMB 30 billion last year, triple the negative RMB 10 billion it had generated in 2011. In 2013, however, the carrier plans to slow down on network spending and conserve cash for a possible 4G expansion in the coming years. We expect network spending to resume once 4G licences on the mainland are issued possibly later this year. Keeping this in view, we have decreased our price estimate for China Unicom to $18, which is still about 35% ahead of the current market price.
China Unicom Benefits From An Equitable 3G Mix
China Unicom’s 240 million subscriber base may be a subject of envy for some of the larger U.S. carriers such as Verizon and AT&T. But when it comes to China, the carrier is a distant second behind the industry behemoth, China Mobile, which has nearly thrice as many subscribers. The difference, however, is not nearly as wide in the 3G market. As of February 2013, China Unicom had around 83 million 3G subscribers, only about 20% behind the 105 million that subscribe to China Mobile’s 3G network. While China Unicom’s overall market share is only about 22%, it has close to 33% of the 260 million strong 3G market. A low but steadily growing 3G penetration of about 22% is giving smaller wireless carriers such as China Unicom ample opportunity to compete on an even ground, with the otherwise dominant China Mobile.
China Unicom has also been helped by the fact that the dominant carrier currently runs its 3G network on a homegrown proprietary TD-SCDMA standard that is not compatible with many smartphones. However, that may soon end as Qualcomm’s newly launched TD-SCDMA compatible chipsets see wider usage. It could also be possible that Apple launches a cheaper iPhone on China Mobile’s network, in order to assuage its subsidy concerns, making it tougher for the smaller carrier to compete. (see Qualcomm Paves the Way for an Apple-China Mobile iPhone Deal) China Mobile’s push into 4G with a TD-LTE network, which is currently being tested out in several cities, is likely to give it access to a much wider set of popular smartphones so China Unicom might find it harder to gain high-end 3G/4G market share going forward.
ARPU rises as 3G penetration grows
Either way, the carrier is benefiting from the growing adoption of 3G services since most of the growth is coming from data rather than voice, which has reached near-saturation. Adding 3G subscribers helps China Unicom increase its ARPU levels as 3G smartphone users consume huge amounts of data. For the full year 2012, China Unicom’s 3G ARPU was RMB 86, almost two and a half times as much as its 2G ARPU of RMB 34. The higher speed HSPA+ network, which the carrier recently upgraded to will help increase its ARPU levels further as subscribers use more data-intensive applications on their phones. (see China Unicom Speeds Ahead In Smartphone Race With HPSA+ Rollout)
On the other hand, margins will continue to be impacted by the sale of subsidized 3G phones such as the iPhone, but China Unicom is betting on making its money back by locking in customers for the term of the contractual period. Moreover, the carrier is also pushing down the prices in the Android market, and was the first to launch a foreign brand RMB 1000 smartphone. Low smartphone prices decreases the subsidy China Unicom has to pay per phone and increases the demand for 3G handsets as well. With China having already become the largest smartphone market, China Unicom stands to benefit from the proliferation of affordable low-end smartphones in the country. Growing smartphone penetration will increase the usage of 3G services, and a broad product portfolio should help China Unicom tap that demand more effectively, while decreasing the subsidy impact.