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China Unicom Limited (0762.HK) Potential leading player of 3G

Friday, October 10, 2008

6089

China Unicom Limited(762)

Recommendation on 10 October 2008
Recommendation	Buy
Price on Recommendation Date	$9.900
Target Price	$12.100

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We upgrade China Unicom Limited (0762.HK; CU) rating as Buy, but lowering our target price to HK$12.1, due to its weaker than expected net add of subscribers in the recent months. Nevertheless, it has the greatest potential to be the leading player in the 3G market in the coming years.

Also, it is expected that the synergies after combining with China Netcom (0906.HK; CNC) will also be experienced in the coming years, which help the company to reduce its operating cost because of economy of scale, thus enabling CU to escalate its profitability. Asymmetric regulation set towards the dominant player in the market would also a bonus for it to recapture the market share.

Our target price is based on our target price-to-earning ratio, which is equivalent to a 2008E P/E at 16.2x, and 2009E P/E at 13.9x, which is approximately at the mid to end of the P/E range of its global peers. We believe it is conservative for a growing telecom company in a market with relative low penetration rate. Our target price suggests potential 22.2% upside. Recommend Buy.

Result of CU in 1H08

Since the CDMA network of CU is sold to China Telecom (0728.HK; CT) because of the restructuring of the telecom sector, the profit from the network was therefore classified as result from discontinued operations. The result in below table mainly focuses on the result of CU from continuing operations (i.e. from GSM network).

The result of CU in 1H08 showed a rapid growth in its net profit. Its revenue only went up 4.03% from 33.77 billion (RMB, same in the date below unless otherwise stated) in 1H07 to 35.14 billion in 1H08. However, its net profit attributable to equity holder skyrocketed 102.97% from 2.18 billion in 1H07 to 4.42 billion in 1H08.

However, when we exclude the effect of the one-off item in 1H07, where there was a reported loss for change of fair value of convertible bond, approximately 1.61 billion, the net profit of CU only rose 8.9%. Furthermore, what we would like to pinpoint is that, the pre-tax profit in the 1H08 of CU would be a better indicator to analyze the growth of the company, because of the change of corporate tax rate in 2008. After excluding the one-off reported loss for convertible bond mentioned above, the pre-tax profit of CU slightly rose 1.2% from 5.07 billion in 1H07 to 5.13 billion in 1H08. The result is not satisfactory for a mobile operator in the PRC market where the penetration rate is still relatively low.

Lack of growth in subscribers

In the first 8 month of 2008, CU only had in total 8.90 million of net add of subscribers in its GSM network, which was much lower than its peers China Mobile (0941.HK; CM), which had totally 59.53 million of net add in the such period. Due to such reason, the market share of CU kept shrinking, and its GSM network only accounted for 11% of net add of subscribers in the market in recent month, which is lower than expected.

Why we still optimistic on CU

Although the growth of subscriber is significantly less than its peers CM, its monthly average revenue per user (ARPU) got support from growing usage of value-added services (VAS). The VAS revenue rose 21.6%, which is comparable to CM (at 26.4% year-over-year (yoy) growth). The flat monthly average minutes of usage (MOU) also helped the sliding ARPU.

Besides that, the most significant reason that makes us feel optimistic on CU is that CU will have the greatest potential to be the leading player in the 3G market in coming years.

It is expected that, upon the completion of restructuring of the telecom sector, the operators will be granted with 3G licenses in order to provide 3G service to the subscribers. As the 3G version of GSM network is WCDMA, which is the most commonly used network of 3G, therefore, it is expected that CU will get best positioned in 3G market because it will certainly be granted with such license. (CM will get license for TD-SCDMA; CT will get license for CDMA2000). Because of the mature technology of WCDMA, CU is expected to operate such network efficient, with a lower cost for the products of the network.

Expect synergies after merge with CNC

After merging with CNC, CU is expected not to operate both the CDMA network and GSM network at the same time, where they used to complete among themselves, so that resources can be saved as expected.

Also, there will be synergies between operating the GSM network along with the fixed line businesses (of CNC) by CU in the future, not only by launching “full services” to customers as package products to boost businesses, but also the cost saved, expected mostly in, selling and marketing expenses, general and administrative expenses, as well as the employee expenses. The profit margin of the merged company will be able to improve about 1.5% to 2% if there would be synergies of cost saving of 5%, or enlarge to approximately 3.5% if such synergies would help to reduce cost of 10% in those items.

Asymmetric regulation towards CM

The regulator has already set 2 cities: Tianjin and Shenzhen to be trial cities for the mobile number portability (MNP), starting in October. Also, in line with such policy, the regulator also confirmed to implement the network resource sharing among the operators, in order not to let operators duplicate investment and help to save resource.

Since the aim of those asymmetric regulations towards is to lower the dominance of CM in the market, despite that we expect the policy will be implemented part by part and will not cause sharp change to the dominance of CM in the market, it is still reasonable to believe that those policies would be favorable towards CU.

Peers comparison

We believe CU was oversold due to the sliding market. Although the growth of CU is not satisfactory, the potential of the company in the 3G market will be great because of its favorable position and mature technology of WCDMA. Also, the asymmetric regulation towards CM set by the regulator in order to make CM less dominant would also be positive to CU. So we upgrade our rating to Buy and set our target PE based target price to be $12.1, which is equivalent to a 2008E P/E at 16.2x and 2009E P/E at 13.9x, suggests potential 22.2% upside. Recommend Buy.

Statement of risk

We believe the major risks of China Unicom are as follows: (i) Delay of 3G licensing; (ii) strongly competitive market reducing its market share; (iii) faster than expected decline of ARPU and (iv) less than expected synergies experienced after combining with China Netcom.

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