28 June 2011

Telecom (Mkt cap: US$42bn) Irrational competition, exuberant investments:: IIFL

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From the FY08 highs of 23%, ROEs of the Telecom sector collapsed
to 9% in FY11, on account of: 1) substantial escalation of
competition due to near-doubling of the number of competitors in
each service area and RCom’s and Tata’s entry into the GSM space;
2) surge in capital employed arising from the high price paid for
securing 3G licences; 3) US$10.7bn investment by Bharti in
acquiring Zain in Africa, an entity that’s yet to turn profitable.
Wireless subscriber growth has been the main driver of revenue
growth in India’s Telecom sector. From 2m subscribers in 2000,
subscriber population has jumped to 840m today. Until 2007, the
high growth in subscriber base was accompanied by high revenue
growth, as competition was far lower than it is today. Since end-
FY07, India’s mobile subscriber base more than quintupled, but
operating margins deteriorated sharply as the decline in ARPUs more
than negated the gains from operating leverage.
Apart from new 2G licence awardees, RCOM and Tata decided to
move from CDMA to GSM and the consequent worsening of
competition resulted in a very sharp fall in tariffs. Since FY07,
average tariffs are down 50%.
Further, the government conducted 3G and BWA (broadband
wireless) auctions in 2010, and capped the number of blocks of
spectrum at four. A 5MHz block eventually fetched US$3.7bn/block,
and BWA auctions fetched much higher prices than they were initially
expected to. All taken, the Indian Telecom sector, with annual
revenues of
auctions. 3G products are now being rolled out and returns from this
investment will perhaps take a few years before they even cover the
cost of capital.


Bharti’s US$10.7bn acquisition of Zain resulted in an immediate 25%
cut in earnings, further dragging down the sector’s ROE. We expect
the African operations to turnaround this year and this should
positively contribute to improving its ROE. In addition, sharp tariff
cuts by new competitors have proven to be unviable, and are
unlikely to be repeated. 3G is likely to improve cash earnings
beginning this year. In our view, ROEs for the sector has bottomed
and should gradually get better from here.

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