Saturday, November 14, 2009

Indian telecom companies - invest or stay away?

Indian telecom companies have been taking a pounding recently and the reasons are well known. I am in sync with those analysts and individuals who think this negativity is only a short term one and this is the right time to invest to make money 2 years down the line. This is a test to the big players and if these companies are worth their salt then they will emerge out stronger. My strategy will put in some money regularly for next few months into airtel and rcom.

There was an interesting analysis in the business line today. I'm copying it verbatim here
Indian telecom companies have suddenly gone from being the institutional investors’ blue-eyed boys to last on the shopping list. Stocks such as Bharti Airtel are languishing close to their 52-week low even as the market is close to its yearly highs.

Telecom stocks now trade at 10-15 times forward earnings, compared to 20-25 times till end-September, and are at a substantial discount to the broader market. Fears of new players winning market share away from the entrenched players, sliding revenues and the spectre of “per second’ billing have all had a hand in battering telecom stock valuations.

However, how much of this de-rating of the likes of Bharti Airtel, Idea Cellular and Reliance Communications (RCom) is justified? Some correction in valuation may be called for, given that popular metrics such as ARPUs, subscriber additions and usage minutes have come down, hinting at lower growth for players. But the situation may not turn out as dire as markets now expect.

First, with all operators joining the per-second billing race, the loss of subscribers to new players may be temporary. Second, this offering itself may be short-lived because of its adverse impact on profitability, unless operators resign themselves to making losses on all short-duration calls.

Third, for players such as RCom and Bharti, non-cellular businesses have been contributing significantly to overall revenues and at robust margins, providing a cushion against competitive pressures in mobile services.

With Idea Cellular, entry into lucrative new circles as it becomes a pan-India GSM player offers scope for growth. This is evident from the fact that with these launches, Idea has also increased its subscriber addition run-rate in the month of October. Here’s an analysis of the concerns and the reasons why larger players may survive this phase.

Tariff war and its longevity
The new regime of per-second billing, recently launched by Tata DoCoMo (GSM arm of Tata Teleservices), has set the cat among the pigeons in the telecom space. In the few months since this billing was introduced, Tata DoCoMo became the largest incremental market-share gainer with four million subscribers added in September.

RCom joined the battle soon, offering Rs 0.5 per minute for all calls, local and STD. This led to fears of slowing subscriber growth for other top players. This assessment, though justified in the short term, may not, however, hold good in the long run.

First, with all operators now joining the ‘per-second’ bandwagon, the market share drift to one or two operators may be limited sooner than later. Witness to this is the fact that, after a lull in September, all the frontline operators have seen rapid improvement in subscriber additions for October. Overall GSM additions (excluding Tata DoCoMo and RCom) in October are up 14.2 per cent relative to September to over 10 million.

Second, the economics of the per-second itself suggests that it may not last too long.

Players such as Bharti, RCom, Idea and Vodafone derive about 50-56 paisa per minute as revenue per subscriber. The cost of providing a mobile call for Bharti works out to approximately 40-42 paisa per minute, and may be similar or marginally higher for other players.

For regional players (though many have pan-India licences), the cost of providing this service may be higher as they do not have the scale and nationwide connectivity and may have to rely on pan-India players for NLD and roaming services.

The termination charge an operator pays for a call made by its subscriber to another operator’s is about 20 paisa per minute.

This suggests that only a subscriber who speaks for at least 40 seconds would ensure break-even! For example, a person who has spoken for exactly 60 seconds would ensure realisations are above current levels for operators, while another who speaks for 20 seconds would entail a stiff loss.

The calls made between different operators (local and NLD) account for 44 per cent of the total calls, according to data released by the telecom regulator. Unless, termination charge is shifted to a per-second basis, and cost of providing calls is drastically reduced (which is impossible for a new operator), this pricing cannot continue indefinitely.

‘Failing’ in metrics
The tariff wars apart, the September quarter earnings numbers of telecom majors too were a reason for their de-rating after they came in below market expectations.

For Bharti, Idea, RCom, Vodafone and TTML, ARPU (average revenues per user) fell 7-20 per cent sequentially and about 20-25 per cent from year-ago levels. Subscriber additions for Bharti and Idea fell below their quarterly run-rates.

But how much should an investor be worried about this?

Two factors need to be kept in mind. One, revenue growth for telecom operators has not hinged on subscriber growth in recent years. Two, companies have improved margins substantially amid a slower pace of revenue growth. Revenue growth has substantially lagged subscriber growth from 2005. Between 2005 and 2008, while the annual growth in subscribers was 61-74.8 per cent for the top operators’ revenues grew by only 27.7-50.9 per cent. Though ARPUs have fallen 34-45 per cent in absolute terms over these years, all operators actually expanded their margins!

Even with the fall in tariffs, the number of minutes used by subscribers has been falling steadily over the last 4-5 quarters. The usage minutes fell 11-14 per cent, but rate per minute declined 9-10 per cent.

Though monthly subscriber additions have gone up from 5 million to over 10 million the last 3-4 years, thanks to a series of tariff cuts, innovative schemes and, finally, the disruptive ‘lifetime recharge’, this hasn’t resulted in proportionate revenue growth. This suggests that the incremental subscribers, especially from the rural areas, were not revenue accretive at all.

Subscriber additions, ARPU and minutes of usage may serve as an accurate gauge when there is a connect between subscriber adds and revenue growth. That is no longer the case, and underperformance on this count should not be the cause to de-rate stocks.

Second, there is the problem of multiple SIM cards that subscribers tend to use. So, depending on the use, and affordable tariff plans, a subscriber may use the services of multiple operators. So, subscribers would show up in different operators’ networks at different points in time, creating significant duplication. Bharti estimates such subscribers to be as much as 30 per cent of the subscriber base, while Idea pegs the number at 20 per cent.

Other businesses of telcos
Though there have been tariff cuts over the years, Bharti, RCom and Idea have EBITDA margins of 27-40 per cent. This suggests that players ensure a sufficient margin of safety before they sacrifice profits to tariff wars.

Majors such as Bharti and RCom also generate a substantial portion of their revenues from a host of non-mobile services. These revenues also sport EBITDA margins over 40 per cent for these companies, which are well-placed to take advantage of potential, both in India and overseas.

RCom derives over 30 per cent of its revenues from its global, broadband and enterprise data business, while for Bharti, this forms just over 20 per cent of revenues. Since Bharti, RCom and BSNL are the only players with a pan-India fibre-optic network, they provide NLD connectivity to a lot of incumbent players as well as new operators. This apart, Bharti and RCom are among the top players in the enterprise data connectivity market in India, estimated to be Rs 7,400 crore currently and set to go up to over Rs 13,000 crore by 2013, according to a Frost & Sullivan report.

Reliance Infratel, the tower infrastructure arm of RCom, also has been successful in increasing tenancy for its towers. It has signed several deals in recent times, prominent among them being a Rs 10,000-crore outsourcing contract with Etisalat DB.

Both these companies also have over a million DTH subscribers, suggesting another sustainable revenue stream.

With tailor-made packages, capability to deliver both free and pay channels, and ability to drive value-added services, DTH ARPU (average revenue per user), which is in the Rs 150-160 range, could grow over the next few years. A recent PwC report states that DTH households are likely to increase to 35 million(from 16 million currently) by 2013.

Idea, which acquired Spice Communications and also new licences over the last 18 months has become a pan-India player. It is in growth mode and is being fully funded for all its expansions, through infusion from Axiata and Providence.

Most of the new circles that the company has launched operations in are metros such as Mumbai, Chennai and Kolkata, apart from other profitable States. Being a partner in Indus Towers means it has been able to get operations up and running in new circles quicker than many new entrants.

Clearly, all these three players have substantial potential. Investors need to look beyond the immediate price wars and view the industry from a 2-3 year horizon. They may accumulate all the three stocks, especially Bharti Airtel.