China Unicom (NYSE:CHU), China’s second largest mobile operator, will be releasing its FY 2013 interim results on August 8. The mobile carrier is expected to post another good quarter backed by a robust increase in 3G data demand with its 3G subscriber base almost doubling to 100 million from June last year. As per our analysis, China Unicom’s stock derives more than 50% of its value from the Mobile Services & Phones division. Hence, we will be closely tracking changes in China Unicom’s mobile ARPU, especially the 3G ARPU, considering the fact that the 3G business now contributes more than 50% of the mobile division’s revenues. Moreover, China Unicom’s 3G ARPU is more than twice that of 2G, thereby making it one of the most important drivers for China Unicom’s revenue growth.
Globally as well, data demand has become an important growth driver for mobile operators as the voice business continues to stagnate. Having realized this early on, China Unicom has acquired a sizable 3G subscriber base which holds tremendous long term potential. Since China Unicom still has a long way to go before it achieves a significant 3G penetration rate among its subscribers, the overall outlook for the stock remains upbeat on account of the huge untapped potential.
Results for Q1 2013 surprised investors as net earnings increased 88.5% in comparison to Q1 2012. We expect Q2 to follow suit as the data demand from more than 100 million 3G subscribers, would likely provide a fillip to China Unicom’s earnings. 
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3G Subscriber Growth Shows No Signs Of Abating
China Unicom’s 3G subscriber growth has had a splendid run in the last few years. Monthly 3G subscriber additions have been growing and are likely to stay on course as China Unicom’s 3G penetration offers ample opportunity for growth. China Unicom’s 3G penetration as a percentage of its wireless subscribers is only about 38% currently. This shows that the operator has significant untapped potential as far as data demand is concerned. For the six months ending June 2013, China Unicom added 24 million 3G subscribers at a brisk pace of 4 million 3G subscribers a month. Comparing this with last year’s data, 3G subscriber additions have grown by an impressive 40%. 
However, despite the increase in 3G subscribers and the ensuing growth in the consumption of data, we see a worrying trend developing for China Unicom. The company’s 3G ARPU has consistently declined over the last few quarters, having fallen from RMB94 in Q1 2012 to RMB78 in Q1 2013. If this trend continues over the next few quarters, it could potentially limit the growth of China Unicom’s 3G business and consequently its mobile division as well. One of the prime reasons for the downfall in China Unicom’s 3G ARPU has been the rapid increase in sales of low-cost smartphones, which tend to be less data intensive. Moreover, the subscriber profile of a low-cost smartphone buyer is generally characterized by low data consumption. However, in the current scenario where telecom operators face stiff competition in 3G/4G data services, China Unicom’s focus on increasing its market share is a step in the right direction, even though the 3G ARPU would come under pressure with low quality subscribers.  
Has 3G Performance Translated Into Financial Gain?
China Unicom’s 3G bet has significantly impacted the company’s results. The company’s financial results took a leap in FY2012 when it reported a 70% increase in its net earnings over the previous year, bolstered by rapid growth in its 3G service revenues. However, this growth has come at a price. The company has not been generating free cash flows due to its heavy capital expenditure and the high subsidies on smartphone sales. As a consequence, it has saddled its balance sheet with a huge debt load.
Margins for the mobile division have drastically reduced from about 45% in 2008 to 21% in 2012, as per our estimates. The astronomical contraction in margins has been due to the high subsidy impact on sale of smartphones by China Unicom. In 2009, China Unicom became the first wireless carrier in China to clinch an iPhone deal with Apple. Although the deal has been one of the major contributors to China Unicom’s 3G subscriber expansion, it has put a serious dent on the company’s margins due to the high upfront subsidy costs that have to be incurred along with sale of premium smartphones. However, margins for the mobile division have stabilized at around 20% due to substantial sales of low-cost smartphones that have a lower subsidy impact in comparison with premium smartphones. As a result, China Unicom’s subsidy expense as a percentage of 3G service revenues has reduced from 17.7% in FY2011 to 10.2% in FY2012. Going forward, we see the subsidy impact largely under control as low-cost smartphones dominate the Chinese smartphone market.