China Unicom (NYSE:CHU) received a positive boost from rumors last week that the Chinese government is mulling regulatory changes which would make it easier for the smaller carriers to compete with the behemoth China Mobile (NYSE:CHL). According to local Chinese reports, the country’s telecom regulator may lower the mobile interconnection fees that China Unicom and China Telecom (NYSE:CHA) currently pay China Mobile by a half from RMB 0.06 per minute to RMB 0.03 per minute.  China Mobile will however continue to pay the existing RMB 0.06 per minute rate to its smaller rivals. Interconnection fees are the cost of voice calls that the carriers on the calling side have to pay those on the receiving side. By implementing this rule, the government could be aiming to level the playing field which currently seems very lopsided in favor of China Mobile.
These revisions, while unconfirmed, could have a very significant positive impact on China Unicom’s valuation given its cash flow concerns and that its interconnection fees account for the highest percentage of mobile revenues among all carriers. The markets have responded likewise, moving China Unicom’s stock up by close to 10% since the news broke. It is currently trading at $17, about 5% below our price estimate.
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China Unicom’s cash flow problem
China Unicom is the second largest wireless carrier in China with almost 270 million subscribers currently. Just to add perspective, Verizon which is the largest wireless carrier in the U.S. has a little over 100 million. Despite the huge subscriber base, the clout of China Mobile’s 750 million subscribers is such that China Unicom has been burning cash every year. While China Mobile boasts of mobile EBITDA margins in the 45% range, China Unicom’s is less than half at about 20% by our estimates. Such low margins mean that the carrier burns through cash when its CapEx spend surges. Last year, for example, Unicom generated negative free cash flows of almost $3 billion. So far this year, the carrier has managed to control its capital expenses to generate cash but with the transition to 4G looming, this may not last.
Partly, the reason for Unicom’s cash flow problem is its early 3G focus which caused subsidies for expensive smartphones such as the iPhone to eat away at its margins but allowed it to compete on an even keel with China Mobile. This was brief as China Mobile has been reasserting its dominance this year with its 3G net adds far exceeding those of China Unicom every month. Going forward, Unicom could find it increasingly tough to compete with China Mobile which is getting ready to launch a 4G network that will mitigate concerns associated with its incompatible 3G TD-SCDMA network and make it an even bigger force to reckon with. (see China Unicom Faces 3G Headwinds As China Mobile Finds Its Footing)
Reducing charges would free up cash for 4G
It is in this context that lower interconnection fees could provide China Unicom with some relief. While the revenues that Unicom generates from these fees will remain unaffected, its interconnection costs could come down by as much as a half. Last year, Unicom’s mobile interconnection costs accounted for almost 10% of its wireless revenues – the highest among all the carriers. Reducing this by a quarter (assuming that China Mobile accounts for only a half of its interconnection fees) could increase Unicom’s mobile EBITDA margins by a little over 200 basis points and overall margins by about 1.5%. This could boost Unicom’s EBITDA by almost 6%, or over $600 million, and increase the management’s flexibility while allocating cash for its upcoming 4G network buildout.
Due to its highly leveraged capital structure (debt accounts for almost 50% of its market capitalization), Unicom’s valuation is very sensitive to margin changes. Even a 1% increase in Unicom’s mobile EBITDA margins can add 20% upside to its valuation by our estimates. The actual impact will however depend on how much of Unicom’s costs are driven by its interconnection fees to China Mobile. Given China Mobile’s much wider coverage than China Telecom, it is likely to account for a bulk of Unicom’s interconnection costs. You can move the trend line in the forecast chart below to make your own estimate and check the impact that this has on Unicom’s price estimate.Notes: