China Unicom Earnings Preview: 3G, 4G Adds, VAT In Focus

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China Unicom (NYSE:CHU) is expected to release its third quarter earnings on Friday, October 24. The second-largest wireless carrier in China reported strong interim 2014 results last quarter, as its profits rose about 26% year-over-year (y-o-y) to RMB 6.7 billion ($1.1 billion) on solid sales growth in the mobile and broadband businesses. Mobile service revenue grew by about 12% y-o-y to RMB 81.3 billion ($13.2 billion) driven by the net addition of over 40 million 3G and 4G subscribers in the one year period ended June 30. In the fixed-line business, China Unicom’s service revenue grew by about 4.5% y-o-y to RMB 45.1 billion ($7.32 billion), driven by double-digit sales growth in broadband services.

When the company releases its third 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 Q3 2014 compared to the same period last year as well as the introduction of value added tax (VAT) on telecom services by the government. In the wake of aggressive expansion in the 3G/4G space by market leader China Mobile (NYSE:CHL), China Unicom reported an increase of just 3.7  million wireless subscribers in the two-month period ending August 2014, compared to over 7.7 million in the same period in 2013. We also expect the company’s average revenue per user (ARPU) for 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 July and August. China Unicom has around a 34% share of the total fixed-line broadband market (by subscribers) in China, with the largest share (53%) being held by China Telecom. [1] ((Operating Data, China Unicom, September 2014)) ((Key Performance Indicators, China Telecom, September 2014))

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Our current price estimate for China Unicom is $17, which is about 10% above the market price.

See our full analysis for China Unicom’s stock here

3G, 4G Subscriber Adds to Drive Revenues

China Unicom has added about 3.7 million high speed subscribers in the July-August period this year. This helped the carrier improve its 3G-4G mix from 47.7% at the end of June 2014 to 48.8% at the end of August. This means that out of the carrier’s total 296.5 million subscribers, about 145 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 networks’ higher speeds, which helps generate more data revenue per user. The carrier’s ARPU from 3G and 4G users in Q2 2014 was RMB 68.70 ($11.15), down about RMB 6.40 from 2013 and about RMB 1.20 from the prior quarter. The carrier’s overall ARPU (2G, 3G and 4G) also declined by RMB 1.20 to RMB 47 ($7.67) in the same period, as the impact of an improved 3G-4G mix was offset by the decline in 3G-4G ARPU. 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.

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 53%. China Unicom added about 670,000 broadband subscribers in the July-August period this year, compared to about 1.1 million in the same period last year. 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 its high speed fiber network (FTTH/FTTB).

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 has on the company’s bottom line in the third quarter and how China Unicom plans to control expenses amid increasing competition. [3]

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Notes:
  1. Mainland China Telecoms Statistics, Marbridge Consulting, August 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 []