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China Unicom's Valuation Raised By 10% Due To Interconnection Fee Revision
China's Ministry of Industry and Information Technology (MIIT) has revised the network interconnection fees for Chinese carriers in the new year. Interconnection fees, or settlement charges, are what carriers on the calling side of a voice call pay those on the receiving side to cover the costs of interconnecting the two networks. The MIIT has lowered these fees for calls from China Unicom ( CHU ) or China Telecom ( CHA ) to a China Mobile ( CHL ) number (excluding those on its 3G TD-SCDMA network) from 0.06 yuan per minute to 0.04 yuan per minute. However, China Mobile will still have to pay the earlier rate of 0.06 yuan per minute for all calls made from its network (except 3G) to a Unicom or Telecom number. The revision is most likely an effort by the Chinese government to level the playing field for China Unicom and China Telecom in the China Mobile-dominated Chinese telecom market.
On account of the revision, China Unicom will be paying 33% lower interconnection fees for calls made from its network to a China Mobile number (excluding TD-SCDMA 3G) but all its other calls will incur the same fees as earlier. We believe this can reduce Unicom's operating costs by over $500 million for the current year, which should increase EBITDA by a similar figure as revenues are likely to remain unaffected. This can potentially increase Unicom's valuation by as much as 20%. However, considering that the impact of interconnection fees is likely to decline in the medium to long-term as subscribers move away from 2G to 3G and 4G, we have increased our price estimate by 10% to about $20.
Skewed Chinese Telecom Market
China Unicom is the second largest carrier in the 1.2 billion telecom subscriber market in China. However, its 280 million subscribers pale in comparison to the 760 million subscribers of market leader China Mobile, which has historically maintained over two-thirds of the market share. For perspective, Verizon, which is the largest telecom carrier in the US, has only about 100 million subscribers.
Although Unicom falls far behind China Mobile in terms of total subscribers, its performance in 2G to 3G transitions has been much better. Unicom has over 42% of its subscribers using 3G as compared to about 23% for China Mobile. China Unicom, along with China Telecom, were able to gain share in the Chinese 3G telecom market because China Mobile couldn't capitalize on its position as market leader to attract 3G subscribers. China Mobile's TD-SCDMA 3G technology was incompatible with many of the popular smartphones available in China and thus its 3G transition was relatively slower than Unicom and Telecom initially. However, this trend changed in 2013, as net 3G additions for China Mobile far exceeded those of Unicom and Telecom combined. Going forward, China Unicom and Telecom could find it increasingly tough to compete as 4G mitigates many of the incompatibility issues with China Mobile's network and makes it an even bigger force to reckon with in the future (see China Unicom Faces 3G Headwinds As China Mobile Finds Its Footing ).
To avoid this scenario and provide conditions for fair competition to the smaller carriers, the government could be looking to cross-subsidize them by this revision of interconnection fees. Such a move is bound to boost Unicom's finances at China Mobile's expense, and provide it with some support in rolling out its 4G network.
How Interconnection Fee Affects China Unicom's Valuation
Any China Unicom subscriber can make a domestic call either to the carrier's own network, China Mobile's network or China Telecom's network. Calls on its own network do not attract any interconnection fee and thus we can exclude them for the sake of our calculation here. For calls from a China Unicom number to China Mobile's 3G network or to China Telecom's network, the interconnection fees have not been revised and thus their effect on Unicom's operating costs would be the same as last year. However, China Unicom will pay a revised interconnection fee for calls to China Mobile's 2G network, which is 33% lower than the earlier fee of 0.06 yuan per minute. Considering China Mobile's 2G subscriber base is about 580 million, it makes about 60% of the total subscriber market for which China Unicom will have to pay interconnection fees. Assuming that about 60% of China Unicom's interconnection fees will be impacted (by 33%) as a result of this regulatory change, and that Unicom's wireless interconnection costs have increased by about 10% over the $2.5 billion incurred in 2012, we arrive at a cost savings estimate of about $500 million.
This will correspondingly improve EBITDA by about $500 million in 2014, improving margins by about 1%. This is because revenues are unlikely to change, as interconnection rates payable to Unicom by other carriers remain unchanged. Such an increase in margins over the long term could potentially increase Unicom's valuation by about 20%. However, considering that the impact of interconnection fees will decline in the medium to long term as subscribers shift from 2G towards 3G and 4G, we have increased our price estimate by only 10%.