India Telecommunications : ARPMs, voice/ data traffic, margins trend up: Morgan Stanley

Higher ARPMs, voice traffic and data growth, as
well as margin improvement, should lead to robust
revenue and EBITDA growth, and higher ROCE. The
companies are operationally free cash flow positive.
Idea’s sensitivity to traffic, ARPMs and strong
execution make it our favourite.

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Traffic growth is strong. Bharti and Idea have had the
highest growth in incremental minutes, at 11-12bn in
F4Q13, partly due to migration of traffic from smaller
players that are ceasing operations in certain areas.
Data volumes have picked up sequentially, by
20-25% in the last three quarters. We estimate that
non-voice will contribute ~18-24% of the companies’
revenues by F2016. Fall in data tariffs and cheaper
handsets have been the key triggers.
Promotional tariffs are increasing, with incremental
players focusing on smaller footprints in India; this
should improve industry profitability and ARPMs as well
as traffic growth for the incumbents
Incremental revenues coming in at almost 45%
margins, implying margin improvement in F2014. With
peak capex behind the operators, the industry is
finally operationally FCF positive; we estimate ROCE
will improve by ~600 bps for the operators by F2016.
Our top pick is Idea, based on its execution: Idea’s
revenue market share has increased by 200bps in the
last three years. Its F2013-16E EBITDA CAGR at 18% is
the highest in the group. We prefer Bharti next, based on
its strong FCF and relatively strong balance sheet.
Key risk remains spectrum-related payments: We
have factored excess spectrum and renewal charges
into our cash flows. The failure of 900 Mhz renewal
spectrum implies lower spectrum-related payouts.

Investment Case
Summary & Conclusions
The Indian Telecom industry in 2008 was a key favorite
amongst foreign portfolio investors, who, we estimate, had
over 10% of their holdings in Indian telcos. This exposure
has now declined by almost three-fourths, to about 2.5%,
primarily due to the expected fall in margins because of
tariff wars and heightened competition, accompanied by
ongoing regulatory challenges. The industry has
underperformed the Sensex by 40-90% since 2008, with
OnMobile and RCOM being the worst performers at -91%
and -84%, respectively, followed by Bharti at -40%, while
Idea has performed in line with the market. We believe that
most of the concerns in the last five years have been
addressed and are reflected in the stock prices, as
absolute valuations are well below average levels
historically. With these concerns largely addressed, we
believe 2013 could be the year of the Indian telcos. In this
note, we focus on two key issues and two key investment
themes, reiterating our bullish stance on the telecom
space.

Key Issue #1: Will traffic decline for the incumbents?
Foreign investors have wound up their sizable overweight
positions in this industry, seemingly believing that traffic
would decline for the incumbents, and EBITDA as well. In
F4Q13, however, we witnessed migration of traffic growth
for the incumbents as Bharti and Idea posted the highest
growth in incremental minutes in the last 12 quarters at
11-12bn. We believe this is partly due to migration of traffic
from the new operators, some of which are ceding
business to the incumbents; the rest of this growth reflects
incrementally stabilizing to rising tariffs. The four
incumbents – Bharti, Vodafone, Idea and RCOM – have a
combined revenue market share of 76.1% and only 71.7%
of traffic volumes; hence, we expect this trend to continue.
We estimate 8-10% CAGR in traffic for the incumbents in
F2013-16.

Idea has been the maximum gainer in traffic growth in
the last three years, adding ~440 bps of traffic market
share and close to 200bps of revenue market share.
Most of the new operators have either closed shop or
reduced overall coverage. Etisalat and STel have
completely wound up their operations following the
Supreme Court announcement of cancellation of licenses
in February 2012. Aircel has stopped operations in five
circles in the last six months, Uninor in 15 circles and
Sistema in 12 circles. This enabled the incumbents to gain
traffic last quarter. Also, as the new operators start
focusing on smaller footprints, their long-distance calls that
previously used their own networks should migrate to
long-distance operators that are the incumbents.
Key Issue #2: 3G spectrum fees paid by the operators
have been a drag on their ROCEs
Our analysis suggests that purely 3G revenues have
negative incremental returns. However, the silver lining is
that data volumes have picked up sequentially, by 20-25%
in the last three quarters. We estimate that non-voice will
contribute ~18-24% of the companies’ revenues by F2016.
The fall in data tariffs and cheaper handsets have been the
key triggers for the growth. Operators have been inching
up their 2G data tariffs, while 3G data tariffs have remained
largely stable over the last six months but have come down
by ~7x since the beginning of 2012.
We estimate that Idea’s non-voice revenue will increase
the fastest amongst its peers at a 21.6% CAGR in
F2103-16 and will contribute 18.2% of sales.

Key Investment Theme #1: Incremental revenues are
coming in at higher margins of almost 40-50%, implying
margin improvement in F2014. In F4Q13, Bharti and Idea’s
incremental revenue growth rates were at 32% and 55%
EDITDA margins (adjusted for one-offs). Our analysis
suggests variable costs account for 44% of overall
revenues for Bharti and 51% for Idea.
A one paise hike in ARPM would raise Bharti, Idea and
RCom’s net profits by 7%, 11% and 15%, respectively, we
estimate. More importantly, with promotional tariffs on the
rise, we expect ARPM to increase by 6-7% in the next four
quarters.

Key Investment Theme #2: Peak capex is behind the
operators, and the industry is finally operationally FCF
positive. Overall capex to sales for the industry has fallen
from over 25% in F2010 to 14% in F4Q13. We also expect
net debt to EBITDA to improve despite spectrum
payments.