In May, 2010, I did a column (Telecom’s winners and losers, available on our website), examining the recommendations of TRAI. I laid my arguments as to how it was impossible to achieve a fragmentation of the industry without resorting to unfair means. My column predated the breakout of the 2G scam, which has hogged the headlines for the last few months. It might be useful to read that article, to understand how the industry will evolve now.
The TRAI recommendations
It is now clear that they will be watered down, one by one. In May, 2010, TRAI had suggested that telcos pay market rates (based on 3G auction prices) for 2G spectrum at the time of licence renewal. At these prices, the licence renewal would have cost the big telcos Rs20,000 crore each; the new proposals floated by TRAI have already brought the bill down to half that amount. While this itself is a relief, it remains unfair and the telcos will protest it.
The unfairness comes from the assumption that a price discovered in times of artificial scarcity (we know post the 2G scam) should be used to benchmark licence renewal fees and spectrum allocation in an environment that is now far easier.
The proposal for making spectrum tradeable is progressive. But after implementing the guideline, prices of spectrum will drop steeply, because on the selling side will be the numerous scam-tainted companies who have no customers, and on the buy side, is a set of very limited buyers with very limited purchasing power. The artificial scarcity of spectrum will have gone, and I won’t be surprised if prices even collapse. Remember, 3G spectral efficiency is 2.7X time 2G, so the spectrum needed for the same traffic will have dropped substantially. Already, one company seems to have realised that, because they have approached the Supreme Court with an offer to return the spectrum and the licences, if they can get back the licence fee they paid to DoT. And the deafening silence of DoT on this request seems to indicate that they know this to be true.
The proposal to cap spectrum seems to have been given a quiet burial. In any case, it would not have stood up to a court’s scrutiny, and is so blatantly seen as punishing the successful telcos that it would have created a public backlash.
As an aside, for those who are interested, it brings out the unfairness of the scam for the leading telcos. You fight a battle for the brand/customer and win fairly, based on superior customer service, experience, etc. Then an artificial scarcity of your most important raw material (spectrum) is created, and that now-rare commodity is siphoned away to johnny-come-latelys, who are seeking a free ride into an industry that has already been opened up, and where latent customer demand is now unhooked. Shockingly, they discover that it takes much more than free spectrum to win the customer, and after entry, they find that the rest of the battle for the customer’s pocket is still way beyond their means. They bleed white, and chastened, they are happy to be given euthanasia. Really like the burglar, who picks the lock of the tijori/treasury, only to find that he has mistakenly stumbled into a snake pit…
That leaves Mobile Number Portability (MNP), which came with a bang and went out with a whimper. The limited data coming from MNP shows that the big telcos have superior networks, so there is no ‘hoarding’ of spectrum. The same companies which are behind on rollout obligations, are anyway scam-tainted, have hoarded unnecessary spectrum and have kicked off the irrational pricing, are the biggest losers in MNP. The verification of subscriber bases has shown up these companies to be fudging numbers to corner spectrum again. If all this spectrum is taken over and released to those networks that have the subscribers, network quality will increase dramatically.
That leaves only one more renegade proposal, which could hit this beleaguered industry. TRAI wants that every MHz above 6.2 MHz be priced at Rs1,769.75 crore. This is to put the bigger telcos at a cost disadvantage, simply because they have more customers and therefore, need more spectrum. This too does not clear the test of fairness and may not see the light of day.
The investment hypothesis
After the collapse of Nazism, Germany has been defensive about its history for the last 60 years. That is human nature; the most diehard savers just now are no longer in Japan, but in the US and maybe, Greece. The cleanest, most careful policy that you will now see from this government, will be in the telecom sector, trust me!
If this is obvious to us, then we can move onto my next point. We will no longer see the hoarding of spectrum any more. Further, we will not see any policy from the government that pushes up the cost base of the entire industry, reducing it to a backdoor tax collection machine for the government. There will be some respect for the impregnably low tariffs achieved by this industry, and the fact that such a cost base fuels many other service and consumption industries.
Now let us look at the competitive scenario. To repeat, MNP has come and gone, and the results have been predictable. The 3G launches have not seen aggressive behaviour from anyone, nor are there any big expectations. Most big players will quietly use 3G to improve spectral efficiency, and absorb the licence costs within their existing profit streams. This is particularly true of Bharti, which will lead the price discounting, as it pays down the 3G and Zain debt. It is the only company that has been repaying debt, about $0.5 bn since my last update.
The PSU telcos have too many problems of their own, with branding and service quality. They were never qualified for leadership, anyway. The battle really was between Bharti, Vodafone, Reliance and Idea. Reliance is now known to be facing Balance Sheet stress and is caught in a debt trap, operating above the acceptable Debt: EBIDTA ratio with big chunks of debt maturing by end of FY2012. It will have to place equity, which looks difficult, given that it has FCCBs which are not going to be converted. Even if it places Equity, it will be hugely dilutive, making it an unattractive investment even at these valuations.
Quietly, its EBIDTA growth rate is back to its pre-Zain days, while the stock has stayed virtually at the same place. It has not faced the washout that has plagued the broader market in the last two months, because of little expectation built into the price, given the overhang of the Zain valuations, the question marks over the turnaround, plus revenue/profit growth at Zain, and the overhang of regulatory imposts embedded in the TRAI proposals.
One by one, these concerns have been dealt with. Zain is back to revenue growth, the tariff wars have abated, EBIDTA is back at Rs20,000 crore per annum (this time on a revenue base of ~Rs60,000 crore), and the company’s free cashflows of Rs10,000 crore are being used to pay down debt. While Reliance has debt:revenue of 1.5, with lower margins and much lesser free cash flow (debt: FCF = 15 years), Bharti’s debt is at one time revenue, and 5 years’ FCF. In about two years, the debt would have got very comfortable. At six times EBIDTA, the stock is among the cheapest telecom stocks in the world, with an attractive positioning in the best growth markets of the world. It is perhaps the most competitive telco in the world, with its ‘minutes factory’ model, and is available at the valuation of a cyclical sugar or textile company, which typically have Free Cashflow : EBIDTA = 20 per cent against 50-60 per cent in case of telecom.
Using Warren Buffet’s principle, Bharti, therefore, is valued at about 60 per cent of its fair value over three years, i.e. a margin of safety of 40 per cent.
Using the Rule of 72, at 20 per cent growth rate, Free Cashflow is doubling every three years. Remember, most of the capex is over, and now the improvements in network quality, tower population, solar panels for towers, etc have to be funded. Can you now imagine RCom being able to fund all that?
In the next two years, we will see this industry consolidate. Some major players may fade away (PSU telcos are prime candidates), or be restructured or merged with other firms. The Joker in the pack? Mukesh Ambani’s Reliance Industries, which could consolidate the industry, given what it already has (BWA) and an opportunistic acquisition or two, maybe even RCom.
The end of the regulatory overhang and the New Telecom Policy will clear the uncertainty over the telecom sector and will act as a trigger for re-rating. You may not have to wait for the fundamentals to play out; just a clearing of the horizon may be enough.