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Telecom
India
Competition, Consolidation, Regulation, Valuation. Current valuations of the
Indian telcos offer little upside even if one takes a benign view on competition and
assumes the best-possible outcome on the regulatory front. On consolidation, we are
bemused by the simplistic notion that it is a panacea for industry woes. We expect
complex challenges to meaningful, industry-structure-changing consolidation. Our
industry view remains Cautious.
Competition – improvement in industry structure critical to a benign long-term view
Two underlying factors will drive competitive action in the market over the coming quarters, in our
view – (1) drive for market share – overall market is unlikely to expand enough to support even the
seven large (in terms of capital committed) players in India today, and (2) balance sheet strength –
challengers need to supplement their price-led competitive strategy with investments in improving
network quality; this will require improvement in balance sheets through equity injection given
that their negative free cash flow situation is likely to continue. That said, even as stretched
balance sheets of challengers have kept price competition in check in past few months, the next
disruptive competitive event could be an equity injection or two away. Competition (from
challengers) is down, but not out and most importantly, industry structure will remain challenging
till a challenger or two is out, through in-sector consolidation or bankruptcy.
Consolidation - ‘M’ may not happen, ‘A’ may not be good
Potential M&A-led consolidation is oft talked about as imminent and the panacea for the current
industry woes. However, we believe that – (1) a material merger (‘M’) may not happen on account
of regulatory and valuation challenges and (2) a material acquisition (‘A’) may not be good for the
industry as it would likely replace a weak balance sheet with a stronger one. Relaxation in M&A
regulations can at best make M&A activity viable and lower the regulatory cost of a transaction.
Combination of a willing seller, a willing/capable buyer, and an agreeable price still needs to
emerge – we fail to see a viable combination that we can term ‘material’ consolidation.
Regulation – the bottom line is that the cost of raw material for the industry is set to rise
Amid all the news flow on the regulatory side, we would urge investors not to lose focus on the
fundamental change that the new regulations (NTP 2011) could bring to the sector – set a (high)
base for the industry’s raw material, i.e. spectrum. Even as the DoT is yet to decide on what the
market value of spectrum should be and whether it should be levied selectively for past spectrum
grants (excess or start-up) or not, we believe that any future spectrum allocations (fresh/renewal)
will be at market-linked prices, increasing the cost base for the industry. Benefit from lower license
fee is likely, but this may potentially be passed on to the end-consumer – industry-wide cost
benefits (for example, from tower sharing) have been passed on to the consumers in the past.
M&A regulations may also be relaxed, but consolidation has other challenges, as discussed above.
Valuation – rich despite fairly benign assumptions; downside risks to estimates exist
The stretched balance sheet situation of the challengers and the (currently) benign competitive
scenario may entice a positive view on the incumbents with a medium- to long-term view but we
believe a positive investment thesis based on that would be missing a critical point – the elevated
valuations of Indian wireless names (7.6-8.2X FY2012E EV/EBITDA, substantial premium to global
and EM telcos) demands absolute winners, not relative ones. We remain Cautious on the sector
‘Material’ consolidation looks unlikely
We define ‘material’ as an event that would change the competitive scenario in the industry
within a short timeframe of its occurrence. A material consolidation event, in our view, can
only be a merger between two of the top-7 operators in the country. Any other
consolidation event (merger between two non top-7 operators, merger between a top-7
and a non top-7 operators, or acquisition of any operator by a completely new entity) will
not improve the industry structure; it may, in fact, worsen it.
The challenge to a ‘material’ consolidation is just one – there is questionable incentive for
(and arguably little capacity with) any of the top-7 operators to buy another of the top-7
operators at a price it is willing to sell it. Here’s the trouble – the smallest of the top-7
operators (by revenues) has a balance sheet size approaching US$7 bn. The cost of spending
US$7 bn (which would imply an EV/ gross capital invested of 1, and mean zero return for
the equity shareholders) to acquire the smallest of the top-7 operators far outweighs the
benefits to the acquirer, in our view. A situation, where one of the operators is willing to sell
at a loss or in distress is possible, but unlikely. In fact, a distressed sale scenario could attract
‘new’ suitors for the asset, not the best scenario for the industry.
Dilemma of a struggling operator
As discussed above, the smallest balance sheet among the top-7 operators today stands at
~US$7 bn. Now, a struggling operator’s decision (whether to stay in the market or sell) is
made at the margin. It would have to choose between one of the following –
Sell at a loss (a profit-yielding sale is unlikely, in our view, for reasons discussed in the
previous section) and essentially, convert unrealized losses to realized ones.
Stay in the business with the hope of realizing a lower loss or a profit at a later date.
Staying in business would clearly demand finding sources of funding the business till an
EBITDA and subsequently OCF turnaround happens. For the struggling operators, hope is
the prescription and funding injection (equity/debt) is the medicine. As long as the
funding tap is open, hope will prevail, in our view.
Some of the recent news flow and channel checks on this front suggest that the funding tap
remains open for now – (1) RCOM signed a US$1.9 bn long-term debt + vendor financing
agreement with China Development Bank; the company has also been making efforts to
monetize its tower and submarine cable assets and has also indicated the possibility of
dilution at the parent company level, (2) TTSL is planning a Rs30 bn rights issues, and (3)
Aircel is working on getting quasi-equity funding from Maxis in the form on preference
capital.
The point we are making is that, at the margin, the latter of the above two options may
continue to appeal to the struggling operators as long as – (1) funding at a reasonable cost
remains available or (2) an attractive sell-out proposition does not present itself. Also,
attractive sell-out proposition is more likely to come from a ‘new’ entity than an existing top-
7 operator and this may not yield the best outcome for the industry.
TRAI’s spectrum pricing recommendations – a rehash
TRAI had made certain recommendations on 2G spectrum pricing, which if accepted by the
DoT, would be used to determine (1) the one-time levy on operators holding more than 6.2
MHz of 2G spectrum, and (2) spectrum fee on renewal for all operators, adjusted for
inflation. While noting that these are still just recommendations and are subject to DoT’s
acceptance, we estimate the total NPV hit (one-time + renewal) of Rs34/share for Bharti,
Rs27/share for Idea, and Rs20/share for RCOM.
We are not too worried about the one-time excess spectrum levy on operators – this has a
limited one-time impact; however, DoT’s decision on spectrum pricing on renewal bears a
close watch – this would signal the policy approach to the overall spectrum issue given that
the Government faces a difficult task of keeping consumer interests and Government
revenues in mind, while not jeopardizing the long-term health of the sector. This also has
implications on the direction of future spectrum-related policy decisions – 900 MHz
refarming, spectrum trading, etc.
Other potential areas of negative/ positive surprise on regulations
We note that there are a few non-spectrum, non-M&A related areas on the regulatory front
that could spring negative or positive surprises -
Partial/ complete removal of roaming charges on home network. Some press
reports in the past few months have suggested that the TRAI could consider new
recommendations on national roaming charges. These could be in the form of (1)
considering India as one geography with no extra roaming charges (on incoming as well
as outgoing calls) if a subscriber is connected to the ‘home’ network, (2) moving from a
22-circle definition for roaming to a 4-zone one – essentially, a subscriber in the North
zone would be able to roam free in the home network within the North zone. We believe
that the move has merit as there are very little incremental costs of access on roaming if
the subscriber is in the home (same operator’s) network – to put it differently, why should
the cost of providing access to an operator’s cell site be too different from the cost of
providing access to a different cell site of the same operator’s a KM away but at the other
side of the circle boundary? We note that roaming charges contributed to 7.5% of GSM
operators’ and 4.9% of CDMA operators’ revenues for the September 2010 quarter, as
per TRAI reports.
Further cut in termination rates. TRAI issued a notification on December 24, 2010
asking for comments from operators on ‘review of Interconnect Usage Charges’ which
covers areas like termination and carriage. We note that the last review of IUC charges by
the TRAI in early CY2009 resulted in a 10 paise cut in termination charges to 20 paise
from 30 paise and had a negative impact on the industry. We do note that a cut in
termination rates should theoretically be EBITDA neutral (despite being revenue-negative)
for most large operators who have broadly equal termination revenues and costs. The
trouble is that cuts in termination charges typically result in off-net call rate cuts by
smaller operators and the industry structure forces other operators to respond partially/
fully. Rough calculations suggest that a 10 paise cut in termination rate (if the savings are
passed on to the consumers) can impact EBITDA per minute by 1.5-2.5 paise – a 10-15%
wireless EBITDA hit for Bharti and a 20-25% hit for Idea.
Reduction in license fee for Metros, A and B circles. The TRAI, in its May 2010
recommendations had suggested a move to a uniform license fee structure from the
current slab-wise structure for different category of circles (6% for C, 8% for B, and 10%
for Metro/A circles). The TRAI had suggested a gradual move to 6% across circle
categories in a phase manner. Policy circles have debated on whether such a move would
be revenue neutral to the Government. Nevertheless, assuming (1) that a move to 6%
happens, and (2) all the savings on account of license fee reduction are kept by the
industry and not passed on to the end-consumer in the form of lower tariffs, we estimate
a positive NPV impact of Rs15/share for Bharti and Rs9/share for Idea.
We summarize the per share impact of various regulatory changes (without assuming any
change from what is currently proposed) on Bharti and Idea
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
Telecom
India
Competition, Consolidation, Regulation, Valuation. Current valuations of the
Indian telcos offer little upside even if one takes a benign view on competition and
assumes the best-possible outcome on the regulatory front. On consolidation, we are
bemused by the simplistic notion that it is a panacea for industry woes. We expect
complex challenges to meaningful, industry-structure-changing consolidation. Our
industry view remains Cautious.
Competition – improvement in industry structure critical to a benign long-term view
Two underlying factors will drive competitive action in the market over the coming quarters, in our
view – (1) drive for market share – overall market is unlikely to expand enough to support even the
seven large (in terms of capital committed) players in India today, and (2) balance sheet strength –
challengers need to supplement their price-led competitive strategy with investments in improving
network quality; this will require improvement in balance sheets through equity injection given
that their negative free cash flow situation is likely to continue. That said, even as stretched
balance sheets of challengers have kept price competition in check in past few months, the next
disruptive competitive event could be an equity injection or two away. Competition (from
challengers) is down, but not out and most importantly, industry structure will remain challenging
till a challenger or two is out, through in-sector consolidation or bankruptcy.
Consolidation - ‘M’ may not happen, ‘A’ may not be good
Potential M&A-led consolidation is oft talked about as imminent and the panacea for the current
industry woes. However, we believe that – (1) a material merger (‘M’) may not happen on account
of regulatory and valuation challenges and (2) a material acquisition (‘A’) may not be good for the
industry as it would likely replace a weak balance sheet with a stronger one. Relaxation in M&A
regulations can at best make M&A activity viable and lower the regulatory cost of a transaction.
Combination of a willing seller, a willing/capable buyer, and an agreeable price still needs to
emerge – we fail to see a viable combination that we can term ‘material’ consolidation.
Regulation – the bottom line is that the cost of raw material for the industry is set to rise
Amid all the news flow on the regulatory side, we would urge investors not to lose focus on the
fundamental change that the new regulations (NTP 2011) could bring to the sector – set a (high)
base for the industry’s raw material, i.e. spectrum. Even as the DoT is yet to decide on what the
market value of spectrum should be and whether it should be levied selectively for past spectrum
grants (excess or start-up) or not, we believe that any future spectrum allocations (fresh/renewal)
will be at market-linked prices, increasing the cost base for the industry. Benefit from lower license
fee is likely, but this may potentially be passed on to the end-consumer – industry-wide cost
benefits (for example, from tower sharing) have been passed on to the consumers in the past.
M&A regulations may also be relaxed, but consolidation has other challenges, as discussed above.
Valuation – rich despite fairly benign assumptions; downside risks to estimates exist
The stretched balance sheet situation of the challengers and the (currently) benign competitive
scenario may entice a positive view on the incumbents with a medium- to long-term view but we
believe a positive investment thesis based on that would be missing a critical point – the elevated
valuations of Indian wireless names (7.6-8.2X FY2012E EV/EBITDA, substantial premium to global
and EM telcos) demands absolute winners, not relative ones. We remain Cautious on the sector
‘Material’ consolidation looks unlikely
We define ‘material’ as an event that would change the competitive scenario in the industry
within a short timeframe of its occurrence. A material consolidation event, in our view, can
only be a merger between two of the top-7 operators in the country. Any other
consolidation event (merger between two non top-7 operators, merger between a top-7
and a non top-7 operators, or acquisition of any operator by a completely new entity) will
not improve the industry structure; it may, in fact, worsen it.
The challenge to a ‘material’ consolidation is just one – there is questionable incentive for
(and arguably little capacity with) any of the top-7 operators to buy another of the top-7
operators at a price it is willing to sell it. Here’s the trouble – the smallest of the top-7
operators (by revenues) has a balance sheet size approaching US$7 bn. The cost of spending
US$7 bn (which would imply an EV/ gross capital invested of 1, and mean zero return for
the equity shareholders) to acquire the smallest of the top-7 operators far outweighs the
benefits to the acquirer, in our view. A situation, where one of the operators is willing to sell
at a loss or in distress is possible, but unlikely. In fact, a distressed sale scenario could attract
‘new’ suitors for the asset, not the best scenario for the industry.
Dilemma of a struggling operator
As discussed above, the smallest balance sheet among the top-7 operators today stands at
~US$7 bn. Now, a struggling operator’s decision (whether to stay in the market or sell) is
made at the margin. It would have to choose between one of the following –
Sell at a loss (a profit-yielding sale is unlikely, in our view, for reasons discussed in the
previous section) and essentially, convert unrealized losses to realized ones.
Stay in the business with the hope of realizing a lower loss or a profit at a later date.
Staying in business would clearly demand finding sources of funding the business till an
EBITDA and subsequently OCF turnaround happens. For the struggling operators, hope is
the prescription and funding injection (equity/debt) is the medicine. As long as the
funding tap is open, hope will prevail, in our view.
Some of the recent news flow and channel checks on this front suggest that the funding tap
remains open for now – (1) RCOM signed a US$1.9 bn long-term debt + vendor financing
agreement with China Development Bank; the company has also been making efforts to
monetize its tower and submarine cable assets and has also indicated the possibility of
dilution at the parent company level, (2) TTSL is planning a Rs30 bn rights issues, and (3)
Aircel is working on getting quasi-equity funding from Maxis in the form on preference
capital.
The point we are making is that, at the margin, the latter of the above two options may
continue to appeal to the struggling operators as long as – (1) funding at a reasonable cost
remains available or (2) an attractive sell-out proposition does not present itself. Also,
attractive sell-out proposition is more likely to come from a ‘new’ entity than an existing top-
7 operator and this may not yield the best outcome for the industry.
TRAI’s spectrum pricing recommendations – a rehash
TRAI had made certain recommendations on 2G spectrum pricing, which if accepted by the
DoT, would be used to determine (1) the one-time levy on operators holding more than 6.2
MHz of 2G spectrum, and (2) spectrum fee on renewal for all operators, adjusted for
inflation. While noting that these are still just recommendations and are subject to DoT’s
acceptance, we estimate the total NPV hit (one-time + renewal) of Rs34/share for Bharti,
Rs27/share for Idea, and Rs20/share for RCOM.
We are not too worried about the one-time excess spectrum levy on operators – this has a
limited one-time impact; however, DoT’s decision on spectrum pricing on renewal bears a
close watch – this would signal the policy approach to the overall spectrum issue given that
the Government faces a difficult task of keeping consumer interests and Government
revenues in mind, while not jeopardizing the long-term health of the sector. This also has
implications on the direction of future spectrum-related policy decisions – 900 MHz
refarming, spectrum trading, etc.
Other potential areas of negative/ positive surprise on regulations
We note that there are a few non-spectrum, non-M&A related areas on the regulatory front
that could spring negative or positive surprises -
Partial/ complete removal of roaming charges on home network. Some press
reports in the past few months have suggested that the TRAI could consider new
recommendations on national roaming charges. These could be in the form of (1)
considering India as one geography with no extra roaming charges (on incoming as well
as outgoing calls) if a subscriber is connected to the ‘home’ network, (2) moving from a
22-circle definition for roaming to a 4-zone one – essentially, a subscriber in the North
zone would be able to roam free in the home network within the North zone. We believe
that the move has merit as there are very little incremental costs of access on roaming if
the subscriber is in the home (same operator’s) network – to put it differently, why should
the cost of providing access to an operator’s cell site be too different from the cost of
providing access to a different cell site of the same operator’s a KM away but at the other
side of the circle boundary? We note that roaming charges contributed to 7.5% of GSM
operators’ and 4.9% of CDMA operators’ revenues for the September 2010 quarter, as
per TRAI reports.
Further cut in termination rates. TRAI issued a notification on December 24, 2010
asking for comments from operators on ‘review of Interconnect Usage Charges’ which
covers areas like termination and carriage. We note that the last review of IUC charges by
the TRAI in early CY2009 resulted in a 10 paise cut in termination charges to 20 paise
from 30 paise and had a negative impact on the industry. We do note that a cut in
termination rates should theoretically be EBITDA neutral (despite being revenue-negative)
for most large operators who have broadly equal termination revenues and costs. The
trouble is that cuts in termination charges typically result in off-net call rate cuts by
smaller operators and the industry structure forces other operators to respond partially/
fully. Rough calculations suggest that a 10 paise cut in termination rate (if the savings are
passed on to the consumers) can impact EBITDA per minute by 1.5-2.5 paise – a 10-15%
wireless EBITDA hit for Bharti and a 20-25% hit for Idea.
Reduction in license fee for Metros, A and B circles. The TRAI, in its May 2010
recommendations had suggested a move to a uniform license fee structure from the
current slab-wise structure for different category of circles (6% for C, 8% for B, and 10%
for Metro/A circles). The TRAI had suggested a gradual move to 6% across circle
categories in a phase manner. Policy circles have debated on whether such a move would
be revenue neutral to the Government. Nevertheless, assuming (1) that a move to 6%
happens, and (2) all the savings on account of license fee reduction are kept by the
industry and not passed on to the end-consumer in the form of lower tariffs, we estimate
a positive NPV impact of Rs15/share for Bharti and Rs9/share for Idea.
We summarize the per share impact of various regulatory changes (without assuming any
change from what is currently proposed) on Bharti and Idea
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