China Unicom (NYSE:CHU) is expected to release its second quarter earnings on Thursday, August 7. The second-largest wireless carrier in China reported strong results last quarter with net profit growing 74% year-over-year (y-o-y) to RMB 3.3 billion ($536 million) on solid sales growth in the mobile and broadband businesses. Mobile service revenue grew by over 15% y-o-y to RMB 40.7 billion ($6.62 billion) driven by net additions of 45 million high speed (3G and 4G) subscribers in the one year period prior to March 31. On the cost side, interconnection charges paid by the carrier to its peers China Mobile (NYSE:CHL) and China Telecom(NYSE:CHA) declined by over 22% to RMB 3.72 billion, owing to a favorable revision in interconnection fees at the start of the year. In the fixed-line business, it reported consistent mid-single-digit growth in revenues with the expansion of its high speed fiber network across the country. ((Press Release, China Unicom, April 17, 2014))

When the company releases its second quarter results, we expect its wireless business to continue to show strong growth on account of an expanding subscriber base and an improving 3G-4G mix. However, it is likely to be impacted by the company’s comparatively lackluster performance in adding new wireless subscribers in Q2 2014 compared to the same period last year. In the wake of aggressive expansion in the 3G/4G space by market leader China Mobile, China Unicom reported an increase of 8.5  million wireless subscribers in the three-month period ending June 30, compared to about 12.2 million in the same period in 2013. We also expect the company’s average revenue per user (ARPU) in wireless services to be slightly lower y-o-y on account of the company’s focus on low-cost smartphones in recent quarters.

In the fixed-line broadband business, we expect China Unicom to report robust revenue growth on the back of a steady increase in the number of subscribers in the second quarter. China Unicom has around a 34% share of the total fixed-line broadband market (by subscribers) in China, with the largest share (52.6%) being held by China Telecom. ^[1] ((Operating Data, China Unicom, July 2014)) ((Key Performance Indicators, China Telecom, July 2014))

Our current price estimate for China Unicom is $17, which is slightly below the market price.

See our full analysis for China Unicom’s stock here

Expanding 3G, 4G Subscriber Base to Drive Revenues

China Unicom added about 8.5 million high speed subscribers in the April-June period this year. This helped the carrier improve its 3G-4G mix from 45.7% at the end of Q1 2014 to 47.7% at the end of the second quarter. This means that out of the carrier’s total 295 million subscribers, 141 million are on the faster 3G and 4G networks.

Gaining 3G and 4G users directly helps the company’s top line growth, as they tend to use more data-intensive applications than 2G users because of the network’s higher speed, which helps generate more data revenue per user. The carrier’s ARPU from 3G and 4G users in Q1 2014 was RMB 70.3 ($11.43), down about RMB 1.2 from the prior quarter. However, owing to an improvement in the carrier’s 3G-4G mix, its overall mobile ARPU improved to RMB 47.6 from RMB 47.1. Going forward, we expect China Unicom’s mobile service revenues to continue their double-digit growth as the carrier encourages its 2G users to transition to its high speed networks and further improve its ARPU.

VAT Could Impact Profits

As part of its tax and fiscal reforms for the country, the Chinese government decided to impose a value added tax (VAT) on telecom services earlier this year, coming into effect across the country on June 1. The VAT rate applicable to basic telecom services and value-added services has been fixed at 11% and 6%, respectively. While the earlier Business Tax (BT) was calculated based on net sales, the VAT is calculated on the difference between net sales and cost of goods sold (COGS). This change is likely to increase the carriers’ tax burden and hurt profits, as the VAT is significantly higher than the currently applicable BT of 3%. ^[2]

The VAT is likely to hurt China Unicom’s profitability in the near term even as tax experts argue in its favor, citing the need to plug loopholes in the existing Chinese taxation system. However, the new system does allow companies certain cost deductions in the form of input VAT credits, which could offset some of the increase in taxes. It will be interesting to see how much impact this makes on the company’s bottom line in the second quarter and how China Unicom plans to control expenses amid increasing competition. ^[3]

Fixed Broadband Sales Likely to Continue Steady Growth

China Unicom has around a 34% share of the total fixed-line broadband market (by subscribers) in China, behind China Telecom’s 52.6%. China Unicom added about 1 million broadband subscribers in Q2 2014, compared to about 1.8 million in the previous quarter. However, we still expect sales to continue to grow in mid single digits on account of the company’s large user base and an improving broadband ARPU, driven by expansion of the high speed fiber network (FTTH/FTTB).

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1. Mainland China Telecoms Statistics, Marbridge Consulting, June 2014 [↩]
2. China to Levy VAT on the Telecom Sector Starting June 1, China Briefing, May 28 2014 [↩]
3. China Tax Alert, KPMG, Dec 2013 [↩]