HONG KONG -- More than almost anywhere else, China can provide stock investors with unpleasant surprises. For anybody thinking of getting in on the giant public offering by phone company China Unicom, that's important to keep in mind.

Unicom, founded in 1994, is China's second-largest phone company and the perennial weak sibling to former monopoly

China Telecom

(CHL) - Get Report

. The company has just begun a road show in preparation for an issue of American Depositary Receipts and Hong Kong-listed stock that could raise between $4 billion and $5.3 billion. If the 2.8 billion-share offering prices at the upper end of that range, Unicom could end up the biggest Asian IPO ever outside Japan.


China Unicom





Expected proceeds:

$4 billion-$5.3 billion

Number of shares:

2.8 billion



Trading starts:

June 21

With its prospectus released Tuesday, Unicom's public offering is new enough that most fund managers are still reading the details. Finding a disinterested analyst to talk about Unicom is tough, too; no fewer than 15 different investment banks have underwriting relationships with the company. Even the analyst at a bank that is not a lead underwriter -- Rohit Sobti of

Salomon Smith Barney

-- said he was not allowed to discuss the issue until after it goes public. Unicom officials were not available for comment.

The issue will be priced on June 16 with trading to begin in New York on June 21. Hong Kong trading starts the day after. Already, conglomerate

Hutchison Whampoa

has agreed to take a stake in the company.

Playing Catch Up

What seems clear from the prospectus is that Unicom has a lot of catching up to do before it commands the same investor affection as China Telecom. That company, boosted by optimism that China's phone market was on the verge of explosive growth, briefly overtook banking group


as Hong Kong's most valuable company earlier this year.

Among its problems: Unicom has lower market penetration than its competitors, relies heavily on outmoded technology and has outstanding disputes with foreign partners.

"It's not really attractive relative to China Telecom," said Jesse Yim, who manages the

Barclays ASF China Fund

. The fund isn't available to U.S. investors but is worth following because it has outperformed its peers, according to

Standard & Poor's Micropal


Unicom has only 14% of the national mobile-phone market, even though it already operates in the high-growth, prosperous and highly populated Beijing, Shanghai and Tianjin markets. China Telecom has no presence in those places, yet it has a larger share of the country's wireless market.

Then there is Unicom's dependence on paging, an inferior technology in a world that will soon see mobile Internet access as the norm. Yim says 50% of Unicom's

comes from paging, which he calls a "sunset industry."

In addition, while it will likely come to market at a 30% discount to China Telecom's valuation based on enterprise value to EBITDA, Unicom is no bargain using traditional valuation methods: If it comes to market at the mid-point of its pricing range, it would sell for more than 160 times last year's earnings ($16.60 against last year's earnings of 10 cents an ADR).

The really big mystery surrounding Unicom, and where the biggest risk lies, is over the issue of how it has managed to settle some 40 commercial disputes with foreign investors in time to go public. Starved for capital in the mid-1990s, Unicom had come up with an ingenious way to get around China's ban on foreign ownership of telecom networks.

It devised what became known as China-China-Foreign, or CCF, financing vehicles. Under these, foreign companies would form joint ventures with Chinese firms and these joint ventures in turn would take stakes in telecom networks. It worked well for three years, until China's government decided it was illegal and shut all the operations down.

Settling the Score

As of March 1, the

Economist Intelligence Unit

reported that all but a few of the foreign investors in the CCF arrangements were still haggling with Unicom over how much they should be compensated for having their equity investments cancelled. The EIU reported that through March,

Bell Canada


CCT Telecom

of Hong Kong and



won average settlements from Unicom of $85 million.

Now, not even three months later, Unicom reports in its prospectus that all of the other CCF deals in mobile phones have been settled. It's taking a charge of $100 million off this year's earnings to account for cash paid to the foreign companies, plus another $138 million for the warrants the foreign parties are said to have accepted.

Just one problem: if the average settlement for three companies was $85 million a piece, is it believable that the entire remainder of companies settled for about $7 million a piece? It's hard to judge, because Unicom offers no breakdown of how the settlements worked. More worrisome, its profit forecast for this year (it projects a loss) and the amount of the write-off have not been examined by the company's independent auditors.

Unicom's prospectus says only that all of the CCF contracts have been terminated. The lead underwriter,

Morgan Stanley Dean Witter

, declined to comment on whether Unicom's parent company (effectively, the government of China) would make good on any future claims by angry former foreign partners of Unicom.

Investors have recently been down a road that looked somewhat like this one. Two years ago, state-owned

Guangdong International Trust and Investment

went bankrupt after borrowing too much money. Whispers in the credit market that the government would make good on the company's debts came to nothing in January 1999, when China told foreign banks they would be taking a haircut on what they had thought was quasi-sovereign debt. Chinese stocks crashed and credit lines to Chinese companies were rolled up overnight.

The provisions for settling Unicom's quarrels with its foreign partners were not subjected to independent audit but rather were prepared "in accordance with accounting principles and local market practice in Hong Kong," according to the company. Those are the same accounting practices that failed to reveal all the liabilities GITIC was carrying before it went bust.

Finally, there are the CCF arrangements Unicom entered in its paging business. These are still being dissolved and Unicom says the public company won't include these businesses. Still, it takes the trouble to mention that "the amount of compensation to terminate these arrangements cannot currently be estimated" and there is no explicit statement that Unicom's state-owned parent will pick up the tab.

The term

caveat emptor

has been around for a long time, but it might as well have been invented for this very IPO.