At first glance, China Unicom looks to be in an enviable position. It is one of only two mobile operators – the other, of course, being China Mobile – that covers the world’s largest cell phone market. In August, there were 437.5 million cell phone users in China and growth remains robust at 5.5 million a month.

However, China Unicom’s role in this booming market is waning, despite being part of a government - protected duopoly and having a supposedly superior CDMA technology.

Let’s take a closer look. By June 2006, 73 percent of total operator revenue (including fixed and mobile) was contributed by China Mobile alone, which is nearly triple the amount of the other three major operators in China put together: China Telecom had a 12 percent revenue share, China Unicom another 12 percent and China Netcom three percent.

As for profit, China Mobile is far more successful than China Unicom. Last year, China Mobile made 30.2 billion yuan (U$3.8 billion) in profit, which is more than ten times the amount achieved by China Unicom.

And in terms of customer acquisition, China Mobile is stealing a march on China Unicom. It is adding an average of 4.3 million customers a month compared to less than 1.2 million for China Unicom during the January-June 2006 period.

The disparity between the two companies is also increasing. Since 2001, China Mobile’s profit margin has been consistently above 20 percent, while China Unicom has been under ten percent (on course for seven percent this year). If the trend continues, Unicom’s position will deteriorate, not only in the current cellphone market but also for future 3G services.

The persistent price war in China has attributed to the pressure on margins. When China Unicom was created in 1994, the government allowed its pricing to be ten percent below rival China Mobile in order to shore up the new contender. The policy still holds, but its real effect has diminished due to relentless price war. Since 2001, China Mobile has cut charges by 50-70 percent; in some cases, it has gone way below Unicom’s offers, making the arbitrary ten percent difference irrelevant and forcing Unicom to follow suit, which in turn bloats its capex and cuts deep into its bottom line.

The rationale of a duopoly has largely failed because it did not create real competition but rather ‘vicious’ competition with down spiral price wars and all sorts of sneaky tactics. China Unicom has never become a full-fledged competitor despite government protection and its PR efforts.

In fact, Unicom has been on a rollercoaster ride for the better part of last 12 years, trying to maintain normal operations while fending off internal and external interference, as well as being forced to adopt CDMA as a bargaining chip for China’s membership in the WTO.

Many in China criticize Unicom’s operation of two parallel networks, which hamper a coherent strategy and its ability to compete. Unicom launched CDMA service in 2002 based almost entirely on the belief that the new technology would lure new customers. It did not happen. Initial growth was painfully slow after spending US$2.5 billion in massive network construction. The main obstacles were expensive handsets, limited selection and poor service coverage. Unicom then turned to free handsets and free minutes to create a critical mass. The strategy worked as new customers began to surge, but all this came with a heavy price. Unicom lost hundreds of millions of dollars in CDMA despite rising customer count.

To cut loss and appease investors, Unicom halted handset subsidies in 2005 and has since turned it attention to the less glamorous GSM, which has maintained steady growth.

Disappointments in CDMA have stoked speculation that Unicom may spin off CDMA assets and focus only on GSM and its migration to 3G. Unicom is a relatively small company with slow revenue growth and a hefty debt load (18.3 billion yuan, or US$2.3 billion). After all, CDMA does not compete effectively with China Mobile and cannot generate substantial gains for Unicom either. Market reports show revenue from CDMA service fell 1.3 percent during the first half of 2006 and that profit margin was down 3.3 percent. There appears to be no clue as to how CDMA can exceed GSM and ignite new momentum.

Chang Xiaobing, chairman and CEO of Unicom, insists CDMA will see stronger growth for the rest of 2006 with tighter cost control and an ‘active foray’ into rural markets with budget handsets. However, this does not mean CDMA can make it on the same scale of GSM given its weakness in price, quality of service and coverage. Besides, China Mobile has already made inroads as rural residents account for 50 percent of new customers.

Duopoly, at least in the mobile industry, is virtually dead in China which, from the government’s point of view, is not only a setback in market reform, but is affecting the health of the telecom industry in general. Many believe Unicom has become a drag for the mobile sector and some kind of surgical change is needed.

China Telecom, a strong candidate for 3G, has made repeated motions to purchase one of Unicom’s networks. Insiders say the two companies are in ‘consultation’ on the transaction. Another unconfirmed report says Unicom is considering a ‘stock swap’ with China Netcom for its CDMA assets.

Unicom vehemently denies contacts of any third parties and insists the management has ‘full confidence’ in the future of CDMA.

It seems that some kind of restructuring is inevitable if the Chinese government wants real benefits of telecom reform. For China Unicom, it needs to focus on its best resources and dump other ‘face-value’ assets. Moreover, size does matter. Unicom must increase its power base through mergers in order to compete more effectively. However, the change presents a serious dilemma for the government. If China Unicom is split or to merge with another company, it can take years for the new entity to work out synergy. But a laissez- faire policy could make Unicom more vulnerable in the future and eventually beyond repair.

Can 3G save Unicom? Hard to say. In addition to uncertainties in incremental growth, pricey handsets and undifferentiated apps, Unicom will likely face more ferocious attacks not only from the old foe, but new competitors that have every intention to beat Unicom and grab market share.

Lin Sun is a telecom consultant specializing in China. Contact him at lsun@chinanex.com