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Morningstar | China Unicom Recovering Well but Data Roaming Removal (Hopefully) a Speed Bump

China Unicom’s 2018 result was positive with a recovery in profitability although mobile revenue growth slowed drastically in the second half due to the government’s mandated removal of data roaming fees in July 2018. Concerns about potential future government pricing edicts and upcoming 5G capital expenditure remain but with a vastly improved balance sheet and improved financial performance China Unicom now looks much better placed to address those challenges. Full-year services revenue growth of 5.9% drove EBITDA growth of 4.3%. Given the high fixed cost base 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 13% driven by the more flexible approach to employee pay afforded with the Mixed Ownership reform. We make only minor changes to our forecasts and retain our HKD 13 (USD 16.60 per ADR) fair value. This fair value implies a forward P/E of 29 times and a dividend yield of 1.4% making China Unicom’s shares attractive at current levels. We expect the company to grow operating earnings at an average of 17% per year over the next five years as its operating margin recovers from a low 3.1% in 2018 to 5.9% by 2023.

China Unicom’s balance sheet has been transformed with the company now in a slight net cash position after reporting net debt/EBITDA of 1.9 times in 2016, 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 CNY 75 billion raised from the share place in the second half of 2017, the CNY 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 two years from the core underlying telecom business.

The improved balance sheet and profitability have allowed the company to raise its dividend from zero in 2016 to CNY 5.2 cents in 2017 to CNY 13.4 cents in 2018, implying a 40% payout ratio. Maintaining that 40% payout ratio we expect the dividend to grow to CNY 26 cents by 2023.

Operating cash flow increased by around 8.6%. China Unicom has also done an excellent job of reducing its capital expenditures over the past few years, spending CNY 44.9 billion in 2018 after spending CNY 42 billion in 2017. Average capital expenditure over the previous five years was over CNY 80 billion. The company is forecasting a slight increase in capital expenditures in 2019 to CNY 58 billion, in line with our estimates, and which includes only CNY 6 to 8 billion of 5G capital expenditures. The company has 5G network trials in 17 cities and will select three or four cities for comprehensive coverage and trials in 2019. According to MIIT, overall 5G telecom capital investment in China is estimated to be CNY 1.2 trillion which is 1.5 times higher than that of 4G. The 5G infrastructure rollout is estimated to take more than eight years to complete. China Unicom management indicated that it believed the total spend level may be a moving target and it would only commit to large investments where it saw business cases. We forecast in increase in China Unicom’s capital expenditures over the five-year period from 2020-2024 to an average of CNY 83 billion per year as 5G network and new services are rolled out. We then forecast capital expenditures to decline to 16% of sales in the terminal year of our 10-year forecasts.