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Morningstar | China Unicom Driving Strong Revenue Growth but Wage Increases Eating into Profit

China Unicom's first-half result showed a continuation of the recovery in its key mobile business revenue that began in early 2017. After many years of inexplicably underperforming its competitors, the company appears to be back on track. Concerns about government pricing edicts on mobile data and upcoming 5G capital expenditures remain but with a vastly improved balance sheet and improved financial performance, it now looks much better placed to address those challenges. First-half services revenue was up 8.3% and EBITDA was up by 4.7%. This services revenue growth would normally lead to teens EBITDA growth for a telecom company, but China Unicom's EBITDA growth was hindered by employee benefits up 21% driven by the more flexible approach to employee pay afforded with the Mixed Ownership reform. Concerns surrounding the Government's mandate to eliminate mobile data roaming fees from July 1, 2018 were confirmed with management commenting that July mobile services revenue was 4%-5% below June. We downgrade our forecasts slightly given the higher costs and clearer impact of the pricing reform near term but retain our longer-term forecasts and our HKD 11.40 (USD 14.50 per ADR) fair value. China Unicom remains narrow-moat-rated based on cost advantages with a negative moat trend due to the company's declining technology advantage as the market moves away from 3G mobile. At these price levels, the company is mildly undervalued.

China Unicom’s balance sheet has been transformed with net debt/EBITDA falling from 1.9 times in 2016 to around 0.1 times now, leaving the company in a much better position to tackle the upcoming 5G network rollout and the opportunities that it will bring for future services. The key drivers of this balance sheet transformation were the RMB 75 billion raised from the share place in the second half of 2017, the RMB 22 billion payment from the sale of Towers to China Tower received in the second half of 2017, and the strong free cash flow generated over the past year and a half from the underlying business. The company has a trial 5G network running in 17 cities with 10 research centres on 5G applications and five co-operation centres with different strategic investors.

Although a full cash flow statement wasn't provided, we estimate operating cash flow increased by around 7%, a nice contrast with competitor, China Mobile, which reported similar EBITDA growth but an operating cash flow decline in the first half. China Unicom also did an excellent job of reducing its capital expenditures to RMB 42 billion in 2017 and is forecasting another low capital expenditures year of RMB 50 billion this year. With 5G licenses likely to be issued in 2019, a potential capital expenditures rise in the longer term is also a concern. Management is not giving too much away on 5G and it still seems too early to tell which applications will be the key demand drivers for the technology, but most telecom management teams insist that 5G rollouts will be incremental with high demand and profitability areas such as big cities, education campuses, and factories likely to be upgraded first. We forecast another relatively low RMB 57 billion in capital expenditures in 2019, before this level increases to an average of RMB 85 billion over the following four years as 5G network and new services are rolled out. We then forecast capital expenditures to decline to 17% of sales in the terminal year of our forecasts.