The proliferation of low-cost smartphones is helping China Unicom (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 almost 90% year over year as 3G revenues grew strongly and subsidies were reigned in by lower dependence on expensive smartphones such as the iPhone.
While the overall 3G subsidy expense grew by almost 13% due to the sheer volume of handset sales, it decreased as a percentage of 3G service revenues from about 15.6% in Q1 2012 to 11.6% last quarter. Increasing competition in the smartphone industry has pushed prices down to the $150 levels, helping drive 3G adoption as well. The carrier managed to add over 11 million 3G subscribers during the quarter, about 29% 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 ARPUs. The carrier has also been losing cash due to a sustained high level of capital investment on its mobile network. Last year, China Unicom generated negative free cash flow of about RMB 30 billion, triple the negative RMB 10 billion it had in 2011. In the coming quarters, however, we expect capital expenditures to slow down as the carrier looks to conserve cash for a possible 4G expansion next year. The resuming of network spending once 4G licenses on the mainland are issued, possibly later this year, could put pressure on cash flows once again. Keeping the growing 3G business and heavy capex requirements required to support the data growth in view, we have a $18 price estimate for China Unicom, which is about 20% ahead of the current market price.
3G Has Been Good to China Unicom, but the Equation Could Change Soon
China Unicom's 250 million subscriber base may be the subject of envy for some of the larger U.S. carriers such as Verizon (VZ) and AT&T (T). But when it comes to China, the carrier is a distant second behind industry behemoth China Mobile (CHL), which has nearly three times as many subscribers. The difference, however, is not nearly as wide in the 3G market. As of Q1 2013, China Unicom had around 88 million 3G subscribers, only about 23% behind the 114 million that subscribe to China Mobile's 3G network. While China Unicom's overall market share is only about 22%, it has close to 31% of the 260 million strong 3G market. A low but steadily growing 3G penetration of about 25% is giving smaller wireless carriers, such as China Unicom, ample opportunity to compete on an even ground with the otherwise dominant China Mobile.
What also helps China Unicom is that it currently runs its 3G network on a homegrown proprietary TD-SCDMA standard that is not compatible with many smartphones. However, that may soon end as Qualcomm's newly launched TD-SCDMA compatible chipsets see wider usage. It could also be possible that Apple (AAPL) launches a cheaper iPhone on China Mobile's network, making it tougher for the smaller carrier to compete. (See also "Qualcomm Paves The Way For An Apple-China Mobile iPhone Deal.") China Mobile's push into 4G with a TD-LTE network, which is currently being tested out in several cities, is likely to 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.
ARPU Rises as 3G Penetration Grows
Either way, the carrier is benefiting 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, almost two-and-a-half times as much as its 2G ARPU of RMB 34. The higher speed HSPA+ network, which the carrier recently upgraded to, will 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. However, the 3G subscribers it has been attracting with the low-end phones have not been of a very high quality, causing 3G ARPUs to fall as a result. The carrier's 3G service ARPU fell to about RMB 78 in the first quarter of 2013 from around RMB 94 a year ago. The overall ARPU should, however, continue to strengthen since the carrier's 3G ARPU is more than twice as high as 2G.
Disclosure: No positions.