Telecom's winners and losers

The government used to try and hold up the stock markets by getting UTI and LIC to buy shares. Next thing you knew, US-64 was brought to its knees. Then, during the Lehman crisis, the US government tried a ban on short-selling. You would have thought that regulators learn from each other. But no, the Germans tried the same thing recently when they banned short-selling of European currencies and bonds - and brought the house down.

The US actually went so far as to break up AT&T into the five Baby Bells. As far as I know, AT &T is still among the 25 largest companies in the world. Which makes the following story doubly queer…

Is the telecom Regulatory Authority of India (TRAI) trying to hammer down some self-fangled notions about anti-competitive market structures, or is this real regulation? Who benefits?

The simple principle recounted in the seminal 3,000-year-old book The Art of War (Sun Tzu): in any battle, the differential over the crowd is the most important factor in deciding the probability of victory, not the absolute power. So if there are 100 players with 10 ounces of strength each, then the 101st player with 12 ounces of strength is very valuable; but if there are 10 players with 100 ounces of strength each, then the 11th player with 120 ounces is not very valuable. Think about it: the differential has to be disproportionate to the distribution of strength, not the absolute level of strength.

If the short message that we get from the TRAI suggestions is that 'they are going after Big Telecom', then they are doing an expectedly ham-handed job of it. Look at the playing field in telecom just now: there are two giant pan-India brands (Bharti and Vodafone) which together account for 57 per cent market share, one down-market pan-India brand (Reliance), and three regional brands (Aircel, Idea and Tata, who will probably be bought out), and two dying public sector companies. There are sundry others, who are irrelevant, and need to be put out of their misery.

Now let us take up the TRAI proposals:

Wants to charge for extra spectrum and make it sharable or tradeable.
This is in favour of the biggest players, Bharti and Vodafone, because they are the ones most likely to have spectrum shortages, especially as they mop up market shares in a post-consolidation marketplace. The one-time charges for past allocations will probably be seen as unfair by the Courts; even if they are not, the total hit is a small part of the cash flows being generated by these players. Except for having a short-term effect on stock prices, they will not do any long-term damage to them, because there will be a small blip (two months in case of Bharti) in their EBIDTA streams.

Mobile Number Portability to be accelerated.
Mobile Number Portability (MNP) is expected to hit Big Telecom, because the cheaper plans of the upstarts will motivate the high-spenders to switch. But look at the reality. My (Bharti) phone bills have already dropped 84 per cent over the last two years; do I really care about the rest 16 per cent? Now I will look to maximise network quality and brand sheen. And in the Bharti 98100 customer-set (the most valuable part of Bharti's post-paid spenders, as any telemarketer will tell you), who would want to switch to the Reliance network, for example? The trade-off will be between network quality (on which Bharti and Vodafone will increasingly differentiate themselves from the rest of the pack, with their differential cash flows) and brand sheen, which the Bharti-Vodafone combination has already built.

Find anybody who spends more than Rs 2,000 per month; he is very likely to be from Bharti or Vodafone and very unlikely to change. But with falling ARPUs (average revenue per user), it is very likely that Reliance might lose its price-and-value-sensitive customers, who may find that network quality-at-a-particular-price is a far better value proposition than poor network quality plus low-end brand at-the-cheapest price that Reliance offers.

The short point: MNP will be won by brand wars, as network quality becomes a hygiene factor, with little to choose between the top three players.

Wants to link 2G spectrum to 3G prices.
This will probably not clear the courts' scrutiny. As the battle shifts to 3G, most of the real additional spend will be on data and non-voice products, where Bharti has already reached 17 per cent of total revenues, and Vodafone 11 per cent. As this goes to 50 per cent, voice-only players will be squeezed out of the market altogether.

The other things that the market is saying:

Big Telecom has overpaid for 3G.
Sure, it would have helped if they had got it cheaper, but this is not a setback relative to each other, since all the players have paid similar amounts, especially for the all-India spread that they have captured. Even if they have paid 50 per cent extra, it is only four months' EBIDTA for Bharti, with which a very significant platform for future consolidation has been obtained. So if there has been overpayment, the premium per unit of EBIDTA flows is lowest for Big Telecom.

Remember, only Bharti is going to comfortably raise the cash. Reliance is already heavily over-borrowed. That is a big differentiator. We saw the ease with which Bharti was able to raise the Zain war chest. With post-Zain EBIDTA and revenues of $13 billion, and similar Debt:EBIDTA profiles (i.e., three-four times), Bharti is now 3.5 times Reliance's size. If it is able to maintain its return on capital employed (ROCE) with no further setbacks, its yearly EBIDTA will equal the entire capital stock in Reliance. What does that say for its differential ability to invest in network quality, rural distribution, solar panels for its cell sites, more towers, and the entire product infrastructure around 3G, besides Digital TV?

With stretched balance sheets all around, Bharti is the only one with enough free cash flow to make a go of it. The returns on incremental capex will increase, because of the oldest rule of investment: in an atmosphere of 'investment famine', where Mr. Market has turned away from a sector, product profitability will rise to the point where it will be viable to get the growth debt-funded. That is, the higher risk premium plus the higher cost of debt to an out-of-favour sector will be serviced by higher product prices and profitability. If you are looking for examples, the jute industry is a good one.

The market is valuing Bharti at a point where nothing is expected from it any more, i.e., at 11 times forward earnings in an industry where subscriber growth is still 35 per cent. Even the smallest amount of 'traction' (i.e., link between customer or volume growth and revenue growth) will allow Bharti to beat market estimates.

What we know well is that when profits are in short supply, investments are well scrutinised and the money spent carefully. The money goes into places where the demand-supply mismatch is maximum; I expect the biggest investments to be made in towers, rural distribution and brand building, and the building of non-voice applications targeted at the rural markets. This will give Bharti a near-monopoly in the vast rural hinterland, with a very high-cost barrier that will secure its cash flows.

To get a good fix on what will decide the fate of this bruising battle, take a look at the field, stakeholder-by-stakeholder:

Equity investors. They have valued Bharti at 11 times forward earnings, as compared to six for Reliance. Idea is valued at 19 for its M&A potential and its regional or niche positioning, but Mr. Market does expect Bharti to outperform.

Bankers. Smarter in general than the typical marginal retail investor, who is driving stock prices just now, they have taken a long-term view on Bharti. But they don't seem to treat Reliance the same way. Idea and Vodafone are their other favoured clients.

Employees. One look at the website is enough.

Customers. Here it gets a little dangerous. Brand sheen can be created with good advertising, like Vodafone has shown spectacularly. This is the big hope for Reliance: if it can reposition its brand with some good advertising, then I will stand corrected. But I don't think advertising alone can do it; you will also need better customer experience, especially in network usage.

Suppliers. The differentiators have been created by the Bharti outsourcing model. If somebody can beat them at their own game, watch this lot carefully. But with Bharti scaling this ability up in other geographies like Africa, I would expect this broader reach to enhance its competitiveness rather than reduce it.

Government. This really is the joker in the pack. As the government's most effective backdoor rural taxation mechanism, I would have expected the government to support consolidation in the telecom sector. Moreover, as the most likely world beater coming out of India, with the potential to touch the lives of the entire planet, I would think that it would be India's most remembered brand. Alas! On the one hand, you have China using its diplomatic muscle to speak up for Huawei, while on the other, you have a campaign to systematically weaken the telecom revolution and those who made it happen.

This article was originally published on July 10, 2010.