China Unicom (NYSE:CHU) announced a solid set of results for the first half of 2013, as 3G growth continued to impress amid robust sales of low-cost smartphones, which helped mitigate subsidy concerns as well. The second largest Chinese wireless carrier benefited tremendously from its 100 million plus 3G subscriber base as strong data demand boosted overall revenues. Half yearly revenues grew by 18.6% from last year, bolstered by a 52.1% increase in the operator’s 3G service revenues over the same period.
China Unicom’s 3G business continues to be its mainstay as 3G subscribers increase every month while a low 3G penetration rate of 38% offers large room for growth. However, considering the capital intensive nature of the telecommunication industry and the fast changing technological landscape for mobile telephony, China Unicom will have to carefully devise its 4G strategy in light of the steps being taken by its mighty competitor -- China Mobile (NYSE:CHL) (see China Mobile Readies For A Massive 4G Launch). Heavy CapEx for 3G has so far thwarted China Unicom’s efforts in generating free cash flows. However, the company managed to generate free cash flows in H1 2013 by scaling back its CapEx spend, in preparation for a potential 4G LTE launch in the coming months.
In our previous analysis (see China Unicom’s Earnings: 3G Push Driven By Data Demand And Low Cost Smartphones), we had raised concern over China Unicom’s declining 3G ARPU. However, as per the latest interim results, the 3G ARPU seems to have stabilized at RMB 77.6, which is a good sign for the long-term growth of the company. Another positive development is that the impact of handset subsidies has largely been mitigated as low cost smartphones now represent a bulk of Chinese smartphones sales.
We reiterate our price estimate of $18 for China Unicom’s stock. Buoyed by strong results, the stock price rose more than 6% post earnings on August 8th.
3G Revenue Growth Is Here To Stay
China Unicom’s 3G business represents more than 50% of the mobile division’s revenues. More importantly, China Unicom’s 3G ARPU is more than twice that of 2G. Therefore, increase in 3G subscribers with simultaneous higher 3G penetration translates into higher revenue and earnings growth for China Unicom.
China Unicom’s strong half yearly performance can be attributed to the growth of its 3G subscribers from last year. For the six months ending June 2013, China Unicom added 24 million 3G subscribers, a 40% improvement over the same period last year. As a result, the company’s 3G service revenue grew 52.1% to RMB 40.91 billion in the first half of 2013. Consequently, overall revenues grew 18.6% to RMB 144.31 billion. Going forward, we expect the 3G business to continue its strong performance as China Unicom adds 3G subscribers at a brisk pace of 4 million per month.
Focus On Free Cash Flows
China Unicom has invested huge sums on its HSPA+ 3G network. As a consequence, it has not been able to generate positive free cash flow (operating cash flow – CapEx) in the last couple of years. However, the recent results show a change in this trend.
In the first half of 2013, China Unicom generated a positive free cash flow of RMB 19.6 billion as CapEx declined by almost 50% from the same period last year. The decline in CapEx is as per the company’s guidance as it seeks to conserve cash for its 4G foray. The onset of 4G would require large capital investments from China Unicom. Thus, the upcoming transition in the Chinese telecommunication space is likely to curtail free cash flow generation for China Unicom.
It will be interesting to see how China Unicom adapts to 4G as licenses are expected to be issued later this year. China Mobile, the largest of the three Chinese telcos, has been the front-runner in 4G as it plans to build more than 200,000 4G base stations in 2013. If 4G services were to trickle down quickly to China’s mobile subscribers, China Mobile will certainly get an edge considering its large scale preparation for a 4G launch.
Low Cost Smartphones Have a Neutralizing Effect
In the last couple of years, low cost smartphones have become increasingly popular in the Chinese market. This has impacted China Unicom in two ways. On one hand, it has led to lower 3G ARPU while on the other it has helped in controlling the subsidy impact, which has enabled the company to arrest the fall in margins. China Unicom’s 3G ARPU has declined from RMB 91 in H1 2012 to RMB 77.6 in H1 2013. But the fall hasn’t impacted China Unicom much as the company has expanded its 3G subscriber base rapidly. Moreover, the decline in the 3G ARPU seems to have stabilized at the current level and we expect it to rise over the long term, considering the explosive demand for data consumption.
On the margins front, the onset of 3G proved to be tough for China Unicom as the mobile division’s margins declined from about 45% in 2008 to around 21% in 2012, as per our analysis. Handsets subsidies on premium smartphones like the iPhone have been responsible for the large contraction in margins. However, low cost smartphones have helped China Unicom control the subsidy impact and the subsequent fall in margins.
Recent data confirms this trend. For the first half of 2013, 3G terminal subsidy cost as a percentage of 3G service revenue declined to 10.3% from 13.1% in the previous year. EBITDA margins for the mobile division have also stabilized at around 21% in the last 2 years. Therefore, on a broader perspective, low cost smartphones have certainly helped China Unicom emerge as a healthier company.
Disclosure: No positions.