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China Unicom in Neutral Lane

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We are maintaining our long-term Neutral recommendation on China's second largest mobile operator China Unicom (CHU - Free Report) following the second quarter results. The stock retains a Zacks #3 (Hold) Rank for the short term (1–3 months).

Despite higher network expansion costs, the company’s first half earnings increased 27.3% from the year-ago period. Revenue also improved due to rapid growth of the 3G and fixed-line broadband businesses as well as strong sales of Apple Inc.’s (AAPL - Free Report) iPhones despite losing its exclusive right on the iPhones to China Telecom Corp. (CHA - Free Report) .

China Unicom will continue to benefit from the ongoing development strategy that aims to enhance its growth and profitability. The company expects to generate higher revenues by accelerating large-scale developments of 3G and fixed-line broadband services. 3G remains a compelling opportunity and represents the single biggest driver of the company’s long-term growth.

The company is focusing more on improving its 3G data surfing service, and offering cheaper handsets and low cost services to woo new customers. These efforts are drawing more 3G subscribers, eventually leading to higher average revenue per user. In the fixed-line business, the company is poised to benefit from expansion and speed enhancement of fiber optic service in its broadband business.

Nevertheless, high levels of marketing and promotional expenditures would continue to hurt future profitability. The company’s businesses are expected to remain under pressure due to increasing depreciation and amortization expenses, network, operations and support expenses, as well as selling expenses for this year and beyond. We believe these expenses will have an adverse effect on the company’s future profitability, free cash flow and margins.

Further, we remain concerned about the precipitous decline in the landline business as well as intense competition in the domestic wireless market, in particular from China Mobile (CHL - Free Report) and China Telecom.

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