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China Unicom Limited (NYSE:CHU)

Q2 2007 Earnings Call

August 23, 2007, 5:00 AM ET

Executives

Xiaobing Chang - Chairman and CEO

Bing Shang - Executive Director and President

Jilu Tong - Executive Director and CFO

Presentation

Xiaobing Chang - Chairman and Chief Executive Officer

Good afternoon ladies and gentlemen. On behalf of the management, I would like to welcome you to China Unicom's 2007 interim results announcement. First of all, let me introduce other members of the management team. Mr. Shang Bing, Executive Director and President; Mr. Tong Jilu, Executive Director and CFO. Today's presentation has three parts. First, I will share with you the main achievements of the company's first half and outlook for second half. Next Mr. Shang will review with the company's operating performance and Mr. Tong will then give you the analysis of the first half financial results. After that, we would be happy to answer questions you may have.

In the first half, with new changes in market environment, the company furthered business model transformation, strived to expand the market expansion, and make new progress in the world business development. Business and revenues showed continued growth; mobile value added service maintained a strong momentum. Costs and expenses were under effective control, resulting in continuous improved profitability and more solid balance sheet.

Total revenue reached RMB49.18 billion, up 5.1%; EBITDA RMB16.74 billion, up 8%; pre-tax profit RMB5.65 billion, up 38.9%; net profit RMB3.77 billion, up 34.6%; basic earnings per share increased RMB0.297. In the first half, the fair value change of the option part of US$1 billion convertible bonds the company issued in July 2006 was RMB1.64 billion. After considering the above fair value change, net profit reached RMB2.13 billion. Since the fair value change does not affect the company's operating performance and cash flow, the following analysis will not consider this factor.

In the first half, with the changes in tariff policy and market competition, the company emphasized on profitable growth, enhanced the marketing effort and realized continuous growth in business and revenue. Total cellular users reached to 151.63 million, up 12.2%. Total MOU reached 222.3 billion minutes, up 16.7%. Total revenue reached RMB49.18 billion, up 5.1%.

Mobile value-added service maintained a rapid growth. Compared with the same period of last year, short message service volume up 24.9%, ringback tone users up 39.5%, CDMA 1X users up 21.1%. Mobile value-added revenue reached RMB9.4 billion, up 17.4% and as a share of cellular service revenue increased to 21.1% from 18.6%.

The company has furthered business model transformation and achieved continuous control on costs and expenses through enhancing budget management and effective use of marketing expenditure. In the first half, total costs and expenses were up 1.9%, lower than growth rate in total revenue, and as a share of total revenue decreased to 88.5% from 91.3 % over the same period last year; of which marking expenses down 8.2%; as a share of total revenue decreased to 19% from 21.7% over the same period last year.

With the continuous revenue growth and effective control on cost expenses, profitability showed a continuous improvement in the first half. EBITDA year-on-year up 8%, pre-tax profit year-on-year up 38.9%, and net profit year-on-year up 34.6%. By the end of first half, the company's balance sheet became more solid. Compared with the year-end 2006, total interest-bearing debt down 29.5%, net debt down 32.7%, debt-to-cap ratio down to 18.5% from 24.4%.

Looking forward into the second half, the company will focus on following the five aspects of work -- strive to realize growth with quality through a better execution; further implement separation of GSM and CDMA marketing operations; further enhance network capacity and quality; continuously increase revenue share of non-voice business; strengthen international cooperation and further improve overall management capabilities.

Also, I'd like to take this opportunity to inform everyone that SKT noticed the company on August 20, 2007 of full conversion of US$1 billion convertible bonds at HK$8.63 per share. The company believes the conversion will consolidate a strategic alliance between SKT and the company, and deepen the cooperation of SKT and the company on mobile communication.

Now I would like to invite Mr. Shang Bing to present company's operating performance in the first half. Thank you.

Bing Shang - Executive Director and President

Thank you Chairman Chang. Now I'll present you the operating performance for the first half. In the first half, to respond to new changes in the market environment, the company adhered to its annual operative environment strategy and took serious measures. Those measures include separating marketing operations of GSM and CDMA; budgeting marketing expenditure in proportion to customer contribution; appropriately increasing CDMA handset promotion; responding rationally to changes in tariff policy and market competition. As a result, subscriber growth accelerated, subscriber acquisition quality further improved, and overall business recorded a continuous and healthy growth. Compared with the first half of 2006, GSM net adds are up 22.2%, CDMA net adds are up 41.8%. Marketing expenses per RMB100 service revenue for GSM, CDMA, and fixed line business down 6.8%, 12.9%, and 12.5% respectively.

GSM total MOU and revenue up 19.8% and 5.4%. CDMA's total MOU and revenue up 9.1% and 2.9% respectively. Fixed line total revenue and external revenue up 3.5% and 20.9% respectively.

In the first half, GSM business gross market growth opportunity proactively developed recent value-added services and recorded stated revenue growth. The implementation of CPP further lowered the GSM revenue per minute. GSM MOU moved higher, but not enough to cover loss from declining tariff, resulting in lower GSM ARPU.

In the first half, the company enhanced CDMA marketing efforts, resulting in higher subscriber growth. However, lower expenditure of existing users after contracts expired, together with low consumption of new subscribers led to further declines in CDMA MOU, ARPU and services revenue.

In the first half, the company took effective measures to further increase short message service and the ringback tone penetration, and to proactively promote such competitive applications, at internet access and stock trading and maintain mobile value added service growth momentum. Mobile value added service revenue up 17.4%, of which GSM up 17%, CDMA up 18.4%. Short message service remained the major contributor to mobile value-added-service revenue. CDMA 1X and ringback tone became the important sources for growth, with their aggregate revenue growth already exceeding that of short message service.

In the first half, the company furthered fixed business restructuring and accelerated growth of new services. Led by usage fee and rental income, external revenue of fixed line business achieved strong growth, offsetting the decline in intersegment revenue caused by lowered settlement price, leading to continuous growth in overall fixed line business.

In the second half, the company will further implement separation of GSM and CDMA marketing operations and it will take specific measures to strive to realize the growth with the quality. On GSM business, the company will improve subscriber mix through mobile branding effort, enhance acquisition and retention of mid to high-end subscribers, and promote sales of standardized service offering to lower marking expenses so as to further promote profitable growth. On CDMA business, the company will improve handset promotion, build up CDMA-specific distribution network, contribute [ph] effort to ensure handset supply and enhance customer retention.

On mobile value-added service, the company will continue to increase short message service and ringback tone penetration, take the launch of GPRS as an opportunity to promote advanced value added service such as stock trading, email, VAP MMS among GSM users; and proactively promote internet access, stock trading and a mobile IM service among CDMA users.

On fixed line business, the company will maintain voice and the rental revenue scales [ph] through effective use of the resources, increase marketing efforts towards various investors and the small to medium enterprises, and promote fixed line value added services by better leveraging internal resources.

Now I would like to invite Mr. Tong Jilu to analyze the company's financial results in first half of 2007.

Jilu Tong - Executive Director and Chief Financial Officer

Thank you President Shang. Next I would like to present you the analysis of financial results in the first half of 2007. The company's total operating revenue reached RMB49.18 billion, year-on-year up 5.1%, of which service revenue reached to RMB46.45 billion, year-on-year up 3.8%. Sales of telecom products reached RMB2.73 billion, year-on-year up 34.4%; value added service remain the major source to revenue growth, year-on-year up 19%, accounting for 63.2% of incremental revenue.

The company total costs and expenses reached RMB43.53 billion, year-on-year up 1.9%, 3.2 percentage points lower than the growth rate of total revenue. Selling and marketing, depreciation and amortization, financial income costs were the major drivers to slow down part [ph] expenses growth. Selling and marketing year-on-year down 8.2%, depreciation and amortization year-on-year up 1.5%, financial net income reached RMB139 million.

The company's EBITDA reached RMB16.74 billion, year-on-year up 8%. Overall EBITDA margin increased to 34% from 33.1% over the same period of last year. Pre-tax profit reached RMB5.65 billion, year-on-year up 38.9%.

GSM operating revenue reached RMB30.96 billion, year-on-year up 5.4%; costs and expenses RMB26.21 billion, year-on-year up 2.3%; pre-tax profit RMB4.75 billion, up 26.6%; EBITDA margin up to 45.7% from 45% over the same period of last year. The effective control of marketing expenses was the major reason behind the lower growth rate in operating costs and EBITDA margin recovery. Compared with the first half 2006, marketing expenses year-on-year down 1.7% and as a share of operating revenue down to 15.2% from 16.3%.

CDMA operating revenue reached RMB16.22 billion, year-on-year up 2.9%; costs and expenses RMB15.58 billion, year-on-year up 0.8%; pre-tax profit RMB637 million, year-on-year up 116%; adjusted EBITDA margin up to 31% from 29.9%. Continuous decline in marketing expenses drove CDMA pre-tax profit growth. Compared with the same period of last year, marketing expenses year-on-year down 14.5%, of which handset amortization costs year-on-year down 23.8%.

Fixed line operating revenue reached RMB4.06 billion, up 3.5%; costs and expenses RMB3.8 billion, year-on-year up 0.4%; pre-tax profit RMB259 billion, up 88.1%; EBITDA margin down to 43.2% from 43.9% over the same period last year.

The company continued to focus on investment return and to maintain a rational [ph] CapEx strategy and appropriate CapEx scale. In the first half, the CapEx reached RMB9.26 billion, accounting for 35.6% of the annual CapEx budget. GSM CapEx RMB4.84 billion, up 13.9%. Cash flow from operation and free cash flow maintained a relative high level, cash flow from operation amounting RMB17.57 billion, free cash flow RMB8.31 billion.

Thank you again for coming to our interim results briefing. Now we will be pleased to take your questions. Thank you.

Question And Answer

Operator

Alright. Ask the first question.

Unidentified Analyst

First question is related to the CapEx and why the level of CapEx in the first half was quite low compared to your budget for the year, is there a reason why... do you think that you're revised down or is it... what is the reason for the slow spending relative to that? My second question is regarding the overall handset subsidies for GSM, looks like the overall sales and marketing went down, if you could discuss on the CDMA side, what the subsidies look like?

Unidentified Company Representative

[Foreign Language]

All right. Regarding the first question, the total CapEx budget for 2007 is RMB21.6 billion and in the first half of 2007, the actual CapEx was RMB9.26 billion, accounting for 75.6% of the budget. And I think here the lower completion rate is due to... mainly due to the time delay of the construction. And I would say that we are going to beat the schedule by year-end.

Of the CapEx, the GSM was RMB4.84 billion in the first half 2007 and with that investment we added around 12 million new capacity in GSM network. And company... our total capacity of GSM is around 120 million and that compares with our subscriber base of about 113 million, so you can see it's close to kind of 100% utilization rate.

Looking into the second half of 2007, the company plan to increase the GSM network CapEx by adding more capacities in regions where the level of capacity is not sufficient to meet market potential, and so that probably is the one reason why we've had to add GSM CapEx. Another reason is that the implementation of calling party pay, which should result in a higher usage and also cause some impact on our network capacity. So that's another reason which we had to add more capacity to our GSM network. And the last effect [ph] is that we plan to upgrade more, just in more cities GPRS. We plan to invest probably around let's say RMB250 million to upgrade GPRS in around probably 100 sort of cities. So that's the first question about the CapEx.

Regarding second question that the CDMA handset subsidy, in 2007, first half 2007, the company continued to put some of the effective development necessary [ph] on business and strictly linked the handset subsidy to CDMA subscriber ARPU contribution. So in first half 2007, the newly added CDMA handset amortization is around RMB220 million. And amortization as a part [ph] of the CDMA handset cost was RMB182 million... sorry, RMB1.82 billion in the first half of 2007, and we add probably around, let's say, 428,000 CDMA subscribers per month, and that translate into around RMB225 per subscriber in terms of handset subsidy.

Unidentified Analyst

[Foreign Language]

All right. Just briefly translating the three questions, one is regarding the separation of the GSM and CDMA marketing operations. What do you think when we can we see some initial effect of those initiatives? The second question is about the exchange gain due to the RMB reevaluation versus how much is due to, let's see, 1 billion convertible bonds, how much due to the 500 million bank loans. The third question is about the cash flow is current decline, cash flow from operation, also free cash flow and what's the reason there?

Unidentified Company Representative

[Foreign Language].

Regarding the first question about the separation of the CDMA and GSM marketing operations, starting early this year, the company start to separate the GSM and CDMA marketing operations and by end of the first quarter, we roughly completed this transition and stand to operate from... starting from the second quarter. So far I think the separation has been pretty smooth, and the CDMA and GSM specific marketing forces and also probably distribution channels are roughly in place. If you look at the results of the first half of 2007, you can see the improvement in both our GSM business and CDMA. So I would say that's partly due to our separation of the GSM and CDMA marketing operations starting early this year.

Of course, there are probably new issues associated with this initiative. For example probably, we're spending more on, let's say, distribution channels, we are probably adding more cost, just as mentioned as the personnel cost increase. But I would say overall, I think the separation has showed some initial effects. So we believe, let's say, the effect will become more obvious in the second half of this year and we're very confirmed, very firm to further implement the separation of these two marketing operations in the second half this year. That's about the first question.

The second question is sort of regarding exchange gain due to the RMB reevaluation. I think... here I think you have looked at... first looked at, let' say, total interest bearing debt actually declined substantially in the first half, at year-end about RMB26.5 billion to RMB18 billion by the end of June this year. That resulted in much lower financial cost in the first half. And also if you... we just completed the conversion of the convertible bonds, SKT has decided to covert. So after that's complete, I think our interest bearing debt will decrease further by probably RMB10 billion. So that will help a lot in the second half our financial costs.

And specifically you asked a question about the exchange gain linked to 1 billion convertible bonds and also US$500 significant [ph] bank loan. To get [indiscernible] the gain from that is about RMB250 and plus there is another... we have a financial income from the bank deposit, which is about RMB100.03 million in the first half. So that together is about, a gain of about RMB350 million. So that's probably major reason why you can see a financial net income in the first half of 2007.

Regarding the third question about the cash flow decline in the first half, you've probably noticed that pre-tax profit in first half 2007 increased by 38.9% and the reason why cash flow from operations declined is due to two factors -- one is that in the same period of last year, the advances from customers increased by RMB1.1 billion, while in the first half this year, that amount actually just increased by RMB80 million, that's the first reason. The second reason is that the inventory and also account receivables declined by RMB750 in the first half of 2006, while in first of 2007 the inventory and account receivable actually increased by RMB280 million. So that difference created the decline in the cash flow from operations.

Unidentified Analyst

[Foreign Language] Three questions, why is that... again about separation of the GSM and CDMA marketing operations, how the company allocate resources and also probably evaluate the performance in the provincial level. Second question is about the different models of mobile business, why is that probably you have high ARPU than probably associated with high marketing expenses, and the other one is that you have relatively low [ph] ARPU, but also relatively low marketing expenses, what do you think... which mode will probably feed with [ph] income? The third question is about I noticed... as you notice that the substantial increase in the interconnection charges, so given the current settlement... interconnection settlement system, so what could be the change in the future?

Unidentified Company Representative

[Foreign Language]

Okay, alright. First question about the separation of the GSM and CMDA marketing operations, overall I would say the separation has been preceding smoothly and the transition was stable and the base marketing forces of each segment are roughly in place and specifically how we are going to, let's say, exercise; for example, in terms of distribution channels, the sales outlet for our call, sales outlet which is probably part of the dollar [ph], self-owned sales outlet. Okay, you have to sell and market both services, GSM and CDMA, but for a long call sales outlet including some part of our self owned distribution channels plus the third party distribution channels, currently we try to separate between GSM and the CDMA, but you have to see... sell, let's say, the other service, for example, if you are a GSM sales outlet but you have also the responsibility to sell CDMA, but you are defined as GSM sales outlet. This is how we conduct in the provincial level.

Covering I think the separation probably, let's see, will bring more marketing expenses. So coming back to real strengths of the management here... make very specific, the management to work each segment, less marketing expenses doors [ph], and there will be continuous... part of your performance. By doing that, we think we can control well the possible increase of marketing expenses during the separation of the marketing operations. And overall, the company is satisfied with what it's achieved within the separation of the GSM, CDMA marketing operations, and that brings us to two sides of the story, one is that we hope that we can achieve a faster business goal... operation [ph]. On the other hand, we have to carefully control the positive increase in marketing expenses due to that initiative. So in the second half of 2007, the company definitely will further implement the separation of GSM, CDMA marketing operations.

That's for the first question. Regarding the second question, imagine two pieces of models, one is that high ARPU with high marketing expenses; and the other one is obviously low APRU with low marketing expenses. I think both models probably will continue to exist in Chinese market because in a rural market, I think probably that's the model where you have a low ARPU and also with as low marketing expenses. But for the high end users, we think we probably will need spend more in order to get those users. So for China income [ph], I think probably in the near term we are going to still probably take two models together to explore different segment of the market in Chinese market.

Unidentified Company Representative

[Foreign Language]

The Chairman just proposed because of the time limit, he hope that we can give up the translation and so that you have more time to ask questions, but for those who couldn't understand Mandarin, we can arrange you a specific person to help you on that.

If you need our translator please raise your hand.

So, Okay.

[Foreign Language]

Unidentified Company Representative

Alright, okay. Hold on, one more question.

[Foreign Language]

Unidentified Company Representative

If you have questions can't understand the answer, please raise your hand. So we're not going to translate.

Unidentified Analyst

[Foreign Language]

Unidentified Company Representative

[Foreign Language]

Unidentified Analyst

Hi, thank you very much. First question is just a clarification of an earlier question on the capitalized marketing expense, just want to clarify that the incremental capitalization this quarter was around, I think, it was RMB220 million, was that correct? And also what was the end of period capitalized marketing expense for the CDMA side? Second question is regarding CDMA handsets, how many handsets were actually sold in the first half of the year and what do you think the full year target will be and how many of these will be dual-mode CDMA, GSM handsets? Finally, I'd just like to get sense as to how the C5 promotion of the low-end CMDA handsets has been progressing since its launch in Q2? If you could give us any metrics, that will be very helpful.

Unidentified Company Representative

[Foreign Language]

Unidentified Company Representative

Need to translate? You got it or indiscernible]

Unidentified Company Representative

[Foreign Language]

The carrying amount of CDMA handset cost is about RMB2.48 billion by the end of June this year. And the newly added CDMA handset cost in the first half was RMB2.2 billion.

Unidentified Analyst

[Foreign Language]

Unidentified Company Representative

[Foreign Language]

Okay, last two questions, alright?

Unidentified Analyst

[Foreign language]

Unidentified Company Representative

[Foreign Language]

Unidentified Company Representative

I think time is up. So probably if you have more questions please come to us for the details. Thank you again for coming to the announcement.

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