CHU China Unicom Ltd

We are downgrading our recommendation to Underperform from Neutral on China Unicom (CHU) based on the disappointing first quarter profit level as well as higher cost expectations.

China Unicom, China's second largest mobile operator, missed the Zacks Consensus earnings estimate by 4 cents. Net income plunged more than 80% year over year due to higher handset subsidies as well as increased costs related to 3G service deployments and network expansion.

The companyis aggressively involved in marketing and promotional activities since the launch of its 3G services, resulting in higher marketing expenses. Selling and marketing expenses rose 19.3% year over year in the recently concluded first quarter.

China Unicom’s 3G and fixed-line broadband business have been increasing at a faster pace since last year. These businesses are expected to be under pressure due to increasing depreciation and amortization expenses; networks, operations and support expenses; as well as selling expenses for the remainder of this year. We believe these expenses will have an adverse effect on the company’s future profitability, free cash flow and margins.

China Unicom is offering handsets at subsidized rates with lower 3G service plans for multi-year contracts to retain existing customers and add new ones. This will weigh on the company’s future overall average revenue per user.In addition, China Unicom’s GSM average revenue per user remains under pressure due to aggressive price competition and a high monthly average churn.

Further, we remain concerned about the precipitous decline in the landline business. Revenue from fixed-line business continues to face downward pressure due to the ongoing fixed-to-mobile substitution effect and intense competition. China Unicom remains significantly challenged by aggressive nationwide 3G service rollouts by its peers, China Mobile (CHL) and China Telecom Corp. (CHA).

However, for the short term (1-3 months), the stock retains a Neutral rating with a Zacks #3 Rank. We believe China Unicom will continue to make significant progress in expanding economies of scale in 3G, broadband and other businesses that will likely improve its overall revenue and profitability.

3G remains a compelling opportunity and represents the single biggest driver of the company’s long-term growth. Additionally, the company has the exclusive right to distribute the Apple Inc.’s (AAPL) iPhone in China and is in talks with Apple to sell the iPad tablet by the end of 2011.

 
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