indian telecom worst yet to be seen - sell, sell & sell

Vinit Tulsyan http://vinittulsyan.wordpress.com

1 Indian Telecom Space ‐ Worst yet to be seen – SELL – A different perspective

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Summary

Telecom stocks have been plunging since last few days, but this has come as little surprise to me. Even before the debate over telecom growth story hitting a road block started, I was convinced that the dynamics in telecom industry has started to change and will worsen going forward, though I was bullish on telecom companies on two counts, which I still am but the problem is that none of these have shown signs that they will be a significant contributor to the top line. We are still few years away for these factors to starts contributing significantly to the top-line (refer page no 14). I in one of my articles dated 30th Sep’09, titled ‘BHARTI – MTN; No Cross Border Connection – A DIFFERENT TAKE’ wrote:

• The reasons for my bullish stand on telecom sector at large are the opportunities to scale up other services such as Data carrying/transfer, IPTV, enterprises services, broadband penetration, and cross-borders data transfer apart from opportunities in value added services offered by telecom companies. The penetrations of these services are almost negligible.

• The voice business does not really excite me too much; within voice what encourages

me is the opportunity which is at hand for large exiting telecom companies, who have already spent billions and billions of dollars for putting up pan-India or pan-world infrastructure. More than the margins earned by large existing telecom players for voice business, which in my opinion will be under pressure going forward, due to fight over market share at the expense of margins by both exiting and the new players, leveraging through sharing the huge exiting infrastructure set up by large telecom companies will be the one which will compensate for the margins lost due to competition”.

• Click on the link to access the file http://www.box.net/shared/k92nffooq6) The plunge in the stock price had to happen (reasons explained in next page), though it happened sooner than later. The govt. through 3G auctions has now realized the importance



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and potential of telecom sector w.r.t. revenue generation; helping it bringing the fiscal situation under control or finance its borrowing. The stocks might bounce back in near term due to this huge selloff witnessed recently, but in the medium to longer term, due to a complete structural change taking place in the industry, the likelihood of telecom becoming either a growth or defensive play is extremely remote, at-least from a three year perspective.

• Not a growth play, because, the dynamics of telecom industry will continue to see major structural changes over next few years, which will be extremely negative for Telecom stocks in the longer term.

• Not a defensive play, rather even defensive is a strong word for Telecom sector, because Defensives mainly are dividend and safe (providing cushioning to the portfolio during tough times) plays, but given the huge expenditure to be incurred by Telecom players on various accounts (detailed below), it will just not leave enough balances on their balance sheet to give it back to shareholders, rather the situation might arise that they will have to over-leverage themselves.

• Telecom going forward (in my opinion after 3 years) would become defensive play, if few things are achieved. 1) Most of the major telecom companies are done with larger capital expenditure, 2) If there is a possibility of India witnessing at the max. 5 Pan India Player (which even in next three years, I see as a distant dream), 3) Non-Voice services (Data carrying/transfer, IPTV, enterprises services, broadband penetration, and cross-borders data transfer and VAS) starts to contribute a good amount to the top line, 4) there is a steady consistent growth in revenue similar to GDP growth, 5) companies are not over leveraged, which is the name of the game in today’s times and finally 5) rather than Individual companies going ahead and setting up their own Infrastructure, players try to leverage and share their own strength with each other.

In my opinion, telecom story in India is no more about PE or EV/EBITDA, but one has to look beyond the numbers. The numbers/multiples might look attractive but even they cannot provide any cushion to the stock prices in the longer term (at-least for the next 3 years) due to a complete structural change, which the sector is witnessing and will continue to witness going forward.



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Here, in the report, I look at 4 broad factors i.e. Government/Regulation, Expenditures, Newer Customer Acquisition, M&A/Consolidation, leading to this structural change within telecom industry, which in turn convinces me that Telecom Sector is not the sector to own, from a medium (1-2 years) or long term (3 years) perspective. I try and look at, what is the present scenario, and what these present scenarios can lead to in future. I am not all negative on Telecom story but the factors I am positive about (Page No. 14) are still few years away from yielding fruitful results. I have tried to present a perspective, which is different, practical and makes sense (at-least to me) by putting myself in the customers and service provider’s shoes, on what holds for Telecom Industry in near future. I might be wrong, but hope you enjoy the perspective.



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4 broad reasons to SELL Telecom Sector in the both medium and long term

1. Government / Regulation – Uncertain minister with uncertain policies

• Growth in controversies outpacing the phenomenal growth story witnessed by

the Telecom Industry:

o The growth in controversies surrounding the sector has outpaced the phenomenal growth story witnessed by the Telecom Industry. And as more and more companies come in (now 19 of them) and each having their own vested interest, the growth of controversies will continue to outpace the growth of telecom sector. This might lead to further deterioration in already deteriorating dynamics of telecom Industry.

• Expect more bombshell from the Minister or the regulator going forward:

o Like yesterday’s bombshell dropped by the regulator (in form of recommendation) over 2G spectrum fees, an attempt to generate revenue from various other forms, licensing norms and M&A guidelines etc. are something, the industry will have to live with, in coming years (at-least till the time Mr. Raja is Mr. Telecom Minister).

• Minister under huge pressure – not good for Telecom sector either today or for

next few years: but I firmly believe that he is not going anywhere

o The minister any way is under huge pressure from everyone i.e. Media, Public, Telecom Companies, Own Party, the ruling party, colleagues over the way he has handled the ministry, since the time he became Telecom minister. Now with the most serious allegation that the due to minister’s approach, the govt. has lost Billions and Billions of US Dollars. This debate will only gain momentum till the time 3G spectrum auctions are over and players are finally allotted their quota of spectrum; putting more pressure on minster that if the minister would have gone the PM’s way, where he directed/suggested telecom minister to allot 2G spectrum



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through Auction process, the govt. would have made billions of dollars. So, now with that opportunity gone, the yesterday’s bombshell was not a surprise. Rather, I will not be surprised, that there are more bombshells, which could be thrown at the telecom industry, with Mr. Telecom Minister trying to prove a point that if we could not generate as much revenue due to earlier 2G allocation process, we can still do so, in some form or the other.

• The 2G Bombshell

o Today’s proposal by TRAI leading to a much higher outlay for existing players

Payment of one-time-fee or OTF for ‘excess’ spectrum (>6.2MHz) based on 3G auction prices

Increase in spectrum usage fee for spectrum above 6.2MHz

Payment of auction-linked price for spectrum reassignment at the time of license renewal

Levy of license fee on infrastructure (tower) and ISP businesses at 6% of Adjusted Gross Revenue (AGR) versus NIL currently

Reversing regulators/ministry earlier stance of creating a level field for new and old players, the recommendation now discriminates in-between the existing and the new players for Spectrum allocation; this might lead to another explosion within the Industry.

• Had to come, since the telecom minister was under huge pressure, expect more

• Compared with 3G phenomenal response (set to give govt. ~Rs. 60,000 crores against expectation of Rs. 25,000 crores), Mr. Telecom minister is said to have defied PM (who wanted to have an auction for 2G as well); leading to govt. losing billions of $



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• Despite this bombshell by the regulator, I believe these recommendations might not be accepted in totality and will face extensive debates and opposition from players negatively impacted by these recommendations.

• The regulators and the govt. will continue to try having domination over the way Spectrum, Licensing and M&A norms are dealt with, which will continue to bring huge amount of uncertainty in the market place and expect more uncertainty till the time Mr. Raja is there, and my belief says he is not going where.



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2. Expenditures (HUGE)

o The Spectrum Poison

2G and 3G spectrum fees – The biggest of all

• One just cannot calculate how much Telecom companies need to shell out in order to get either 2G or 3G, every day there is new policy, there is uncertainty in the market place

• This uncertainty and a war to acquire more spectrum (as during consolidation, availability of spectrum is going to be one of the major driver for valuation) will lead companies to leverage themselves

The 3G dilemma - The story goes as follows – Only huge expenditure and Risk with little return in foreseeable future (at-least in next 3 years)

• A compulsion for the companies to have 3G spectrum in order to remain competitive

o If you have 3G, alright, nothing much to cheer about

o If you do not have 3G, then everything to lose for (because the competitors have it)

• 3G spectrum would be used to augment 2G voice capacity (especially in metros) rather than high data usage (so effectively one is acquiring 2G network at a sky high price)

• Additional Capital expenditure to be incurred for 3G Infrastructure

• Where are the handset for 3G (for example, 10% of Metro customers having 3G enabled handsets are just not going to help telecom companies)

o We have already seen the fate of 3G services offered by state owned telecom companies i.e. BSNL & MTNL

o I am sure that very few of Metro customers having 3G enabled handsets have even looked at the plans offered by BSNL & MTNL



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• Talks of telecom companies passing on the increased cost of 3G spectrum to customers is just ruled out, if any company does that, it will be in more of a problematic situation.

o The problem is that the telecom industry is boasting so many service providers, that formation of ‘cartel’ in order to have a better pricing power is just ruled out.

o The future over Spectrum costs

Telecom sector pain – Govt. gain – Good for India at large but not so good for Telecom Companies - Am sure in all likelihood, any future spectrum allocation would be done through Auction process as govt. has realized that Telecom could be the cash cow for generating revenues, which could further be used towards bringing the fiscal situation in place and the more revenue govt. is able to have, the less they will have to borrow from market place – One way positive for India but not so good news for Telecom Companies.

Availability of spectrum with newer entrants, will be one of the key factors for commanding premium during Consolidation, so any future spectrum allocation will be seen as a war zone (as currently visible in 3G) with almost every players fighting to get some share of spectrum

o Other expenditures

2G Infrastructure expansion,

Network Rollout

3G Infrastructure rollout expenditure

Maintenance of both 2G and 3G infrastructure

Debt servicing - huge outlay as most of the companies will have to over leverage themselves on account of:

• Huge 3G spectrum charges,



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• 2G bombshell by the govt.,

• Higher prices to be paid for future spectrum acquisition, either of them (as am sure future spectrum allocation would be done through Auction process)



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3. Newer Customers

o Competition

Increase in competitive activity in the market (have now forgot the count on the number of existing and upcoming players within Indian telecom space)

Increased competition will continue to keep prices under check as now onwards:

• The customers acquired by any operators will be highly sensitive to price.

• In other words, the loyalty from these customers towards the brand would be negligible and

• Any company offering cheap services will be able to acquire the other operators customer

o Given this will not be surprised to see that one operator gains at the expense of others

o Huge newer customer acquisition cost

Competition leading to newer customer acquisition cost being higher than the actual revenue generated,

o Inferior quality of newly acquired customers

The quality of new customers being acquired is extremely inferior w.r.t. revenue generation (given that fact that majority of India is still below poverty line earning only $2 or little more a day, this is the only segment which is now left out as the left out customer segment and they are the ones looking for telecom services after current subscriber base of ~600 million)

o Newer Customer - Not loyal – huge Churning to happen



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Data points out that most of the new customers acquired are from Tier-3 and beyond

Mostly pre-paid customer acquired

Fast churning will be the name of the game within industry. Uninor disclosure was an eye opener and substantiate this theory:

• Management was cautious on the India business (Uninor) and referred to a “more challenging outlook” and “need to increase usage”.

• Active subs low proportion, usage/ARPU even lower

• Uninor disclosed 2.1m active subs i.e. just 50% of the reported 4.3m as of Mar-10

• Even on active subs, ARPU at ~Rs90

o The Active subscriber theory

Many of the new mobile connections bought by customers already having existing connection

Taking connection only temporarily to capitalize on lucrative offerings by telecom companies

Once he has exhausted his balance, he starts looking for more lucrative offering either from the same operator or the other

Once he gets a better deal from some other operators, the subscriber gets into this category of ‘Non Active’

o Rural India Customer

Telecom companies keep on talking about the huge growth potential presented by the Rural India but:

• Rural India customers are more price sensitive; they will easily change numbers, if another operator is offering cheap services



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• New players to do anything to acquire customers (as this will drive their valuation upwards in case of Consolidation)

• This will lead to continuation of lower tariffs for a much longer period of time

o Acquisition of new High Value Customer – Leading to non-payment

Service providers are extremely wary of giving out post paid connection to newer customers (due to customer profiling) due to high probability of non-receipt of payment



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4. M&A or the Consolidation debate

o Inevitable but:

Still a long time before consolidation starts taking place (at-least 2 years away)

Not expected to provide any respite to the acquiring companies

Expected to be an extremely costly affair with little value addition even after consolidation due to customer profiling

The cost of M&A will be huge as the valuation of these companies (acquisition targets) will be based more on:

• Spectrum availability,

• Subscriber base;

o Logically leading them to aggressively bid for spectrum (both 2G and 3G) and

o Acquire customers at throw away prices in order to command a higher premium as and when they become acquisition targets;

Further leading in continuation of lower tariffs for a much longer period of time,

o Ultimately not helping the acquiring companies (the bigger ones) in any way



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I am not all negative on Telecom story but the factors I am positive about are still few years away from yielding fruitful results

• Other Services

o I am extremely bullish on opportunities, which are scalable in nature such as Data carrying/transfer, IPTV, enterprises services, broadband penetration, and cross-borders data transfer apart from opportunities in value added services (VAS) offered by telecom companies. The penetrations of these services are almost negligible. The problem is that they presently contribute little to telecom companies top line and huge infrastructure roll out will have to take place in order for these services to start generating revenues. Unfortunately, in my opinion, the favorable results from these opportunities are still few years away.

• Leveraging by sharing the existing Infrastructure

o The voice business does not really excite me too much; but within voice what encourages me is the opportunity which is at hand for large exiting telecom companies, who have already spent billions and billions of dollars for putting up pan-India or pan-world infrastructure. More than the margins earned by large existing telecom players for voice business, which in my opinion will be under pressure going forward, due to fight over market share at the expense of margins by both the exiting and the new players, leveraging through sharing the huge exiting infrastructure set up by large telecom companies will be the one which will compensate for the margins lost due to competition. Unfortunately, this trend is yet to be seen.

• Consolidation – only 5 players at the max

o When India has 5 players at the max (against 19 today), I will start looking at telecom as a defensive play. The defensive would not turn as growth play until the above two pointers starts contributing significantly to the top line. My wish for witnessing 5 telecom players within Indian Telecom Industry in my opinion is still 5 years away.



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Given below are the reports and articles I have come up with till date.

Date Titled Copy and paste the link to browser to download

10‐May‐10

Greece has helped open the Pandora Box...Yet for the time being it's just a catalyst for Market Re‐pricing ‐ as Dubai was.

http://www.box.net/shared/b1iznlfx0g

5‐May‐10 Fear and Panic: Unwarranted & Imaginary at‐least for now

http://www.box.net/shared/sxitjk3m6b

10‐Jan‐10

India Entering into Long Term Secular Growth zone across regions and sectors due to on the back of a truly ‘all inclusive growth'

http://www.box.net/shared/qhy1r5smdt

28‐Nov‐09 “Dubai jitter across countries and investment avenues –what, why, how and what’s next???”

http://www.box.net/shared/pbuxoffjue

5‐Nov‐09 Where are financial markets headed? http://www.box.net/shared/ch8dlgis5d

28‐Oct‐09 The rally returns across all investment avenues barring USD

http://www.box.net/shared/nau4vh1yaz

21‐Oct‐09 The Chinese (GDP) and Brazilian (2% tax) effect in financial markets across the globe

http://www.box.net/shared/4c1ayxl0ii

12‐Oct‐09 October to continue lending its support to equities & oil, a choppier, volatile and sideways November in the store

http://www.box.net/shared/02ovo7v7ii

6‐Oct‐09

Rally across all investment avenues to make markets more volatile and move sideways: a take on gold, currencies, interest rates, inflation, equities

http://www.box.net/shared/nvtufrst9n

30‐Sep‐09 Bharti – MTN; no cross border connection – a different take

http://www.box.net/shared/k92nffooq6



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29‐Sep‐09 Earning season, movement in interest rates and inflation to make markets move sideways and volatile in near to medium term

http://www.box.net/shared/l6imflvj1k

28‐Sep‐09

New theories emerge as the markets heads higher. Do M&A activities signal something? Will currencies play the spoilsport for this rally in medium to longer term?

http://www.box.net/shared/2kqtpbg60a

13‐Aug‐09

Confusion persists with conflicting data points but in my view this confusion will take this market even higher in medium to long term

http://www.box.net/shared/kuuskr1otz

18‐May‐09

Election 2009: game changer for India, change in paradigm for Indian politics, corporate world, economy, people or India at large

http://www.box.net/shared/bjrh73287n

8‐May‐09 Stress test: Cat out of bag: US financial industry report card: more positive than negative

http://vinittulsyan.wordpress.com/2009/05/08/stress‐test‐cat‐out‐of‐bag‐us‐financial‐industry‐report‐card‐more‐positive‐than‐negative/

23‐Mar‐09 The 7us$ and 6:1 (again 7) d/e ratio push for a 7% rally on wall street; but where from now; is it a sign of changing times?

http://www.box.net/shared/o4t539v3rg

22‐Mar‐09 India & China: “love us, hate us but can’t ignore us”

http://www.box.net/shared/7rjebptyqa

19‐Mar‐09 FOMC shocker… unprecedented campaign…massive quantitative easing…

http://www.box.net/shared/bnuibjt2zh

16‐Mar‐09 Fading dark clouds…but…its’ still not bright enough…

http://www.box.net/shared/6avihiseib

12‐Mar‐09 Hope: the rally lives on…but…they still are bear market rallies

http://www.box.net/shared/5mstt5jvho

10‐Mar‐09 Optimism play: bulls are back at‐least for now with markets trying to find a bottom on the back of hope

http://www.box.net/shared/1vxpxr5et5



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8‐Mar‐09 Gold: Golden fortune: long gold / short INR: buoyant long term outlook

http://vinittulsyan.wordpress.com/2009/03/08/gold‐fortune‐long‐gold‐short‐inr‐buoyant‐long‐term‐outlook/

3‐Mar‐09 Getting back to reality: is there any investment avenues left for investors in today’s world?

http://vinittulsyan.wordpress.com/2009/03/03/getting‐back‐to‐realities‐are‐there‐any‐avenuesoptions‐left‐for‐investments‐in‐today’s‐world/

2‐Mar‐09 More bad news in store than good

http://vinittulsyan.wordpress.com/2009/03/02/more‐“bad‐news”‐in‐store‐than‐“good‐news”‐–‐vinit‐tulsyan’s‐views/

26‐Oct‐08 Things will get worse before they get better – part I continued…

http://vinittulsyan.wordpress.com/2008/10/26/things‐will‐get‐worse‐before‐they‐get‐better‐continuation‐to‐part‐i/

24‐Oct‐08 The worst is not over yet? Yet to be seen!! (part: II)

http://vinittulsyan.wordpress.com/2008/10/24/the‐worst‐is‐not‐over‐yetyet‐to‐be‐seen‐part‐–‐i/

31‐Mar‐08 What is happening to property market – mar’08

http://vinittulsyan.wordpress.com/2008/03/31/what‐is‐happening‐to‐property‐market‐–‐our‐perspective‐my‐views‐while‐at‐centrum‐capital/

Links to my few reports while I was at Centrum

21‐May‐07 ESCORTS: Reploughing for a Rich Harvest (part of Investment banking assignment)

http://www.box.net/shared/2hngilv1i7

1‐Feb‐08 EMMAR MGF AVOID IPO NOTE http://www.box.net/shared/4lgi0xfyln



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2‐Apr‐08

DLF – Bigger Aspiration (a detailed 60 page comprehensive report with city wise focus and co‐relation with Infrastructural development

http://www.box.net/shared/v08knhonzo

Feb’08 Stock Picking Presentation http://www.box.net/shared/kgp3g1aehu

Thaking You, Personal Regards, Vinit Tulsyan http://vinittulsyan.wordpress.com/



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Disclaimer

This report is for the personal information of the recipient and can also be used to distribute publically. This report is for the general information and entirely represents the views of the author and should not be construed as an offer or solicitation of an offer to buy/sell any securities.

The information contained in this report has been obtained from sources that are considered to be reliable. However, I have not independently verified the accuracy or completeness of the same.

This report expresses my opinion on the structural changes taking place in the telecom sector and is not specific to any companies within the sector. I have exercised due diligence in checking the correctness and authenticity of the information contained herein, so far as it relates to current and historical information, but do not guarantee its accuracy or completeness.

There might be some forward looking statement, which is entirely based on my understanding of telecom sector, and I do not accept any liability arising from the use of this document. The recipients of this material should rely on their own judgment and take their own professional advice before acting on this information.

I am in no way responsible for any loss or damage that may arise to any person from any inadvertent error in the information contained, views and opinions expressed in this report.

I have used the logos of Telecom service providers, which is just for informational purpose and have been taken from publically available website(s). I by no means intend to gain from this report in any form.

indian telecom worst yet to be seen - sell, sell & sell

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