China Unicom (NYSE:CHU) is expected to release its fourth quarter earnings on Tuesday, March 3. In the previous quarter, the second largest wireless carrier in China reported strong results with net profit rising over 26% year-over-year (y-o-y) to RMB 10.6 billion ($1.73 billion) in the nine month period ending September 2014. This was driven by consistent subscriber gains in mobile and fixed-line broadband as well as lower costs. Mobile broadband service revenue from high-speed subscribers (3G and 4G) grew by 24.3% y-o-y to about RMB 80.4 billion ($13.1 billion) driven by a net addition of over 34 million high speed subscribers in the one year period prior to September 30, 2014. Although the company registered robust bottom line gains, the government’s recent decision to impose a Value Added Tax (VAT) on telecom services negatively impacted its revenue and profit growth. ((Press Release, China Unicom, October 24, 2014))

When the company releases its fourth 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 the last few quarters compared to the same period in 2013, 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 8.3 million high speed wireless subscribers in the six-month period ending December 2014, compared to over 22.6 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 solid increase in the number of subscribers in 2014. China Unicom has around a 34.5% share of the total fixed-line broadband market (by subscribers) in China, with the largest share (53.5%) being held by China Telecom (NYSE:CHA). ^[1] ((Operating Data, China Unicom, February 2015)) ((Key Performance Indicators, China Telecom, February 2015))

Our current price estimate for China Unicom is $16, which is slightly below the market price.

See our full analysis for China Unicom’s stock here

ARPU In Focus

China Unicom added about 8.3 million high speed subscribers in the July-December period last year. This helped the carrier improve its 3G-4G mix from 47.7% at the end of June 2014 to almost 50% by the end of the year. This means that out of the carrier’s total 299 million subscribers, over 149 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 high speed users at the end of September was RMB 65.7 ($9.86), down about RMB 10 from 2013. 3G-4G ARPU declined in the previous quarter likely due to a higher proportion of low-cost smartphones in China Unicom’s overall user base and also due to reduced tariffs of 3G-4G data services. The carrier’s overall ARPU (2G, 3G and 4G) also declined by 5% to RMB 45.5 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 growth as the carrier expands its 4G coverage and encourages its 2G users to transition to its high speed networks. This will boost the carrier’s 3G-4G mix and ARPU as well.

Fixed Broadband Sales On Steady Growth Path

China Unicom has around a 34.5% share of the total fixed-line broadband market by subscribers in China, behind China Telecom’s 53.5%. China Unicom added over 4.1 million broadband subscribers in 2014, compared to about 776,000 in 2013. Therefore, we expect strong sales growth for the fourth quarter as well as full year 2014. It is also likely to be driven by improving broadband ARPU, driven by the 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 last year, coming into effect across the country in June. The VAT rate applicable to basic telecom services and value-added services was 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 had on the company’s bottom line in the fourth quarter and how China Unicom plans to control expenses amid increasing competition. ^[3]

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1. Mainland China Telecoms Statistics, Marbridge Consulting, November 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 [↩]