China Unicom (NYSE:CHU) is China’s second largest wireless carrier by subscriber base, trailing the country’s as well as the world’s largest, China Mobile (NYSE:CHL), by a country mile. While China Mobile has a dominant market share of close to 65%, China Unicom has a little over 20% of the world’s biggest wireless market which crossed a billion subscribers earlier this year. This 20% might seem like a small market share to have, but China Unicom’s over 220 million subscribers makes it twice as large as the largest U.S. wireless carrier, Verizon (NYSE:VZ). At the same time, the country is gradually transitioning from the older 2G standard to 3G, and China Unicom is moving aggressively to reap the advantages of a nascent 3G market.
However, expanding its 3G base has proven to be extremely costly for China Unicom. The carrier was the first to bring the iPhone to China three years back and the continuous effort to push 3G has had a telling effect on margins. Both marketing and 3G handset subsidies have burgeoned over the past few years, and the carrier is also spending heavily on wireless infrastructure to support the future mobile growth. While these expenses may have wrecked margins and caused the stock to lose close to a quarter of its value this year alone, the carrier’s long-term prospects look good and, with time, we expect to see its huge 3G investment start to pay dividends. Our $22 price estimate for China Unicom is about 33% ahead of the market.
Unicom Profits From An Equitable 3G Mix
With close to 700 million subscribers, China Mobile has three times as many subscribers as China Unicom. But when it comes to 3G, the difference is not nearly as wide. As of August 2012, China Mobile had 72 million 3G subscribers, only about 13% ahead of China Unicom’s 64 million 3G subscribers. Low 3G penetration of around 18% in China is giving smaller wireless carriers such as China Unicom ample opportunity to compete on an even ground with the otherwise dominant China Mobile.
Moreover, the fact that China Mobile runs its 3G network on a proprietary homegrown TD-SCDMA standard has proved to be a big deterrent for the carrier in securing smartphones compatible with its network. Even the iPhone, which is already launched on the other two carriers in China, hasn’t made its way to China Mobile yet. Moreover, due to the heavy subsidies associated with the iPhone, it looks less likely that the carrier will be carrying the smartphone anytime soon despite the fact that the iPhone 5 was launched with a TD-SCDMA compatible chipset. (see Apple Faces China Mobile-Sized Stumbling Block Limiting China Upside Potential)
Taking advantage of this, China Unicom has been closing the 3G gap with China Mobile by adding at least an equal number of 3G subscribers every month. In July, when China Mobile’s 3G net adds slowed to only 1.9 million, China Unicom’s strengthened to almost 3.1 million. In August, China Mobile’s 3G net adds improved significantly to almost 3.2 million but China Unicom still added about as many 3G subscribers as the previous month. For the first eight months of 2012, China Unicom led the 3G charts with more than 20 million 3G net adds as compared to the much larger China Mobile’s 19 million during the same period.
ARPU rises as 3G penetration grows
Leading the 3G race is proving beneficial for China Unicom because 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 first half of 2012, China Unicom’s 3G ARPU was RMB 92, almost two and a half times as much as its 2G ARPU of RMB 35. The higher speed HSPA+ network, which the carrier has recently started rolling out, will help it increase ARPU levels further as subscribers use more data-intensive applications on their phones. (see China Unicom Speeds Ahead In Smartphone Race With HPSA+ Rollout)
However, 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. The carrier is also pushing down the prices in the Android market, and was the first to launch a foreign brand RMB 1000 smartphone. Low smartphone prices decreases the subsidy China Unicom has to pay per phone and increases the demand for 3G handsets as well. With China poised to become the largest smartphone market by the year-end, China Unicom stands to benefit from the proliferation of affordable low-end smartphones in the country. Growing smartphone penetration increases the usage of 3G services, and China Unicom’s broad product portfolio will help it tap the growing demand.
In order to support the growing demand, China Unicom is also aggressively spending on network upgrades and maintenance to improve coverage and increase quality of service. This has a negative impact on cash flow, but the growing market for 3G as well as the carrier’s focus on driving 3G penetration gives us reason to believe that the carrier will be able to recoup more than its upfront investment in due time.