China Unicom Controls Subsidies Through Low-End Smartphones As 3G Adoption Grows

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The proliferation of low-cost smartphones is helping China Unicom (NYSE:CHU) control subsidies and improve profitability as it taps the growing demand for 3G data services. Last quarter, the second largest wireless carrier in China saw its net profits rise by over 51% year-over-year as 3G revenues grew strongly and subsidies were reined in by lower dependence on expensive smartphones such as the iPhone. While the overall 3G subsidy expenses grew by almost 43% due to the sheer volume of handset sales, it decreased as a percentage of 3G service revenues, from about 7.1% in Q3 2012 to 6.7% last quarter. Increasing competition in the smartphone industry has pushed prices down to around $150, limiting the subsidy impact to margins and and driving 3G adoption as well. The carrier managed to add about 11.6 million 3G subscribers during the quarter – 24% ahead of the same period last year.

However, the 3G subscribers it has been adding using low-end smartphones have not been of the highest quality, as evidenced by the declining 3G ARPU. The carrier has also been losing cash due to a high level of capital investment on its mobile network. Last year, China Unicom generated negative free cash flow of about RMB 30 billion, compared to negative RMB 10 billion in 2011. So far this year, Unicom has controlled its capital expenditures in a bid to conserve cash ahead of a potential 4G expansion in the coming months. The resumption of network spending once 4G licenses on the mainland are issued, possibly later this year, is likely to put pressure on cash flows once again. Keeping in view the growing 3G business and the heavy CapEx requirements required to support the data growth, we maintain our $18 price estimate for China Unicom, which is about 15% ahead of the current market price.

3G Has Been Good To China Unicom But The Equation Could Change

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China Unicom’s 270 million subscriber base may be massive relative to U.S. carriers such as Verizon and AT&T, but when it comes to China, the carrier is a distant second behind China Mobile, which has nearly three times as many subscribers. The difference, however, is not nearly as wide in the 3G market. As of Q3 2013, China Unicom had around 112 million 3G subscribers, about 34% behind the 170 million on China Mobile’s 3G network. While Unicom has managed to convert about 40% of its subscriber base to 3G so far, China Mobile’s 3G penetration is still in the low 20s.

What has helped China Unicom is that it runs its 3G network on a more widely used 3G technology than China Mobile, which uses a homegrown proprietary TD-SCDMA standard that is not compatible with many of the most popular smartphones. However, that may soon end as Qualcomm’s newly launched TD-SCDMA compatible chipsets see wider usage. China Mobile also may be close to an iPhone deal, with one of Apple’s handsets recently receiving regulatory permission to access the carrier’s network. China Mobile’s push into 4G with a TD-LTE network, which is currently being tested out in several cities, should also give it access to a much wider set of popular smartphones. This could make it tougher for China Unicom to gain high-end 3G/4G market share going forward – signs of which have started showing, with Unicom’s 3G market share declining by 3% since the start of 2013 as China Mobile exerted itself (see China Unicom Faces 3G Headwinds As China Mobile Finds Its Footing).

ARPU Rises As 3G Penetration Grows

Either way, the carrier should continue to benefit from the growing adoption of 3G services since most of the growth is coming from data rather than voice, which has reached near-saturation. Adding 3G subscribers helps China Unicom increase its ARPU levels as 3G smartphone users consume huge amounts of data. For the full year 2012, China Unicom’s 3G ARPU was RMB 86, more than twice its 2G ARPU of RMB 34. The higher speed HSPA+ network, to which the carrier has upgraded its 3G network, should help increase its ARPU levels further as subscribers use more data-intensive applications on their phones (see China Unicom Speeds Ahead In Smartphone Race With HPSA+ Rollout).

On the other hand, margins will continue to be impacted by the sale of subsidized 3G phones such as the iPhone, but China Unicom is betting on making its money back by locking in customers for the term of the contractual period. Moreover, the carrier has also been successful in pushing down prices in the Android market, with RMB 1,000 smartphones increasingly getting popular. Low smartphone prices decreases the subsidy China Unicom has to pay per phone and increases the demand for 3G handsets as well. As can be seen in the chart below, mobile EBITDA margins in the last two years have stabilized at around 20%.

However, the 3G subscribers it has been attracting with the low-end phones have not been of a very high quality, causing 3G ARPU to fall as a result. The carrier’s 3G service ARPU fell to about RMB 76.5 in the first three quarters of 2013 from around RMB 89 a year ago. The overall ARPU, however, should continue to strengthen since the carrier’s 3G ARPU is still more than twice as high as 2G.

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