Stronger signals from telecom

It was only a couple of years ago that telecom companies were hogging the airwaves. For all the wrong reasons. Having signed up a large number of new subscribers at a frenetic pace, they were grappling with many inactive accounts. Tariffs were tumbling due to hyper-competition, putting revenues and profits under pressure.

Some players, anxious to ramp up operations, had over-invested and run up a mountain of debt. On top of all this was the looming shadow of the spectrum scam, with multiple agencies investigating the players embroiled in it.

Cut to the present. Leading telecom companies seem to be in a much better shape than before. Stock prices of Idea Cellular and Reliance Communications (RCom) have more than doubled from their levels in 2012, while Bharti Airtel is up 47 per cent over this period.

The top three listed players in the space — Airtel, Idea and RCom — trade at a price-earnings multiple of 20-35 times, against 13-37 times three years ago.

But while these signals are promising, can the telecom sector regain its status as the poster boy of Indian reforms? Can investors take a new look at stocks from this consumption theme, which has been neglected?

They can, but must restrict their buys to the top players, according to our analysis. Here’s why.

In recent years, top mobile operators have stopped focusing on growing the number of subscribers and instead turned their focus to keeping their users signed on to the network.

This has paid off. Today, the active users for Airtel, Idea, Vodafone and RCom make up 95-100 per cent of their subscriber base, much higher than the 80-90 per cent a few years ago.

These operators have churned out irregular or dormant subscribers from their networks with even smaller and regional operators looking to make their subscriber base more lucrative. Simultaneously, they have reduced or even done away with discounts and inordinate free talk time on their networks.

As a result, call rates have gone up by 20-30 per cent across operators.

The proportion of high-end 3G users has also risen significantly. From being a relatively insignificant part of their business, 3G subscribers now account for 6-7 per cent of mobile operators’ user base.

By pricing data and voice at moderate levels, Idea and Vodafone have doubled their 3G subscriber base, while Airtel and RCom saw 72-80 per cent rise.

This has meant that data revenues for operators have steadily increased in the past one year. From accounting for 6-9 per cent of overall revenues, data as a proportion is now 10-13 per cent. Idea Cellular and Bharti Airtel have seen the sharpest increase in data revenues.

With the increasing penetration of smartphones and their availability with 3G compatibility at low costs, data usage is expected to explode in the coming years.

While messaging applications such as WhatsApp have cut into the SMS revenues for operators, it still brings in money as the user depends on the operator’s network.

The top three operators signed a pact that would allow them to offer 3G services even in areas where any one of them does not hold spectrum. This ran into a legal hurdle.

The move was opposed by the Telecom Department, but has now been allowed by the telecom tribunal.

So, a pan-India footprint for all the top operators in offering 3G services can only aid realisations. Some similar pacts have also been signed by a few other operators.

Of course, telecom companies continue to add 2G subscribers as well, but the focus has been to tap lucrative users.

After a long period of decline, the average revenue per user (ARPU) has, therefore, started to look up again. For the top operators, FY14 ended with an ARPU of ₹173-193, with Airtel even crossing the ₹200 mark in the recent June quarter. This comes after flat APRUs from 2010 to 2013, indicating that pricing power has returned to key mobile operators.

The average realisation per minute has also been quite healthy at 43-45 paise. Thus, a player such as Idea would be able to make an EBIT/minute of 7.3 paise, up from 4-5 paise some 1.5-2 years ago. The EBITDA/minute for RCom, too, is slowly improving.

While tariffs have been improving, bolstering the realisations of players, the much awaited consolidation in the sector also seems to be taking off. After the Supreme Court cancelled the licences of several new mobile operators in 2012, top players have seen consolidation of shares.

Today, Bharti, Vodafone and Idea together account for over 70 per cent of the market share in the country. The other six-seven operators are slugging it out with the rest of the market.

Tata Teleservices, Bharat Sanchar Nigam Ltd (BSNL) and RCom are among the other players who are slugging it out for the balance, with low single digit revenue shares.

Improving performance parameters and the thrust on data over the past one year have seen operators show significant improvement in profit margins.

The EBITDA margin for Bharti, Idea and Vodafone was 31-35 per cent in FY14, a good 3-5 percentage points higher than the previous fiscal.

Though both these players do have high levels of debt on their books, interest cover has improved for Idea and Airtel and is now at a healthy 7.5-10 times for these two companies.

Of course, RCom is still faced with considerably high debt (over ₹40,000 crore) and an interest cover of less than two.

The net debt to equity ratio was 1.48 as of March 2014, which needs to be brought down.

But in recent months, it has managed to raise ₹6,100 crore through the qualified institutional placement (QIP) route and warrants issued to promoters. The QIP book was oversubscribed, indicating reasonable level of investor interest. A sale of real estate worth ₹2,000 crore is also reportedly on the cards.

The likelihood of stake sale in its undersea cable division (Globalcom) and the tower sharing agreements with Reliance Jio are expected to bring in another ₹12,000 crore over the next few years.

These moves may ease the burden on the company, which hopes to bring the net debt to a manageable ₹25,000 crore in three years. This would bring the net debt to equity ratio closer to 1-1.1 levels.

As the company faces a scaledown in its CDMA business, its GSM operations continue to look up, given the overwhelming subscriber preference for the latter.

Idea and RCom have guided for relatively lower capex for FY15 and Airtel, too, is only slightly increasing such expenditure for domestic operations, while setting aside a large portion for its African business.

The top four operators will have four to nine circles coming up for licence renewal over the next one year. This means that they will have to surrender the existing spectrum and rebid for them in the auction slated for February next year. Some of them may have to give up on the spectrum that they held so far in the highly efficient 900 MHz band. This may entail a significant payout, if they make a rebid for airwaves in this band. But Idea, Airtel and Vodafone have already bid for the spectrum auction in the 1800 MHz band. Though the band is less efficient, it would ensure continuity of operations for the mainstay – 2G, subscriber base of operators.

Besides, they still have spectrum already won in the 3G auctions of 2010, which can be used for shoring up high-value subscribers.

Most other operators would bid only if their subscriber additions require them to, so that operations would continue unhindered.

Also, once spectrum trading comes into force in a full-fledged manner, operators would be able to share airwaves with others depending on their requirement.

It appears that the days of mindless bidding and hoarding airwaves seem to be over and operators will make strategic bids to fill gaps in operations alone.

Even payment terms for spectrum wins during recent auctions have been relaxed with just a fourth to a third of the total bid amount to be paid upfront. After a moratorium period of two years, the balance may be paid over 10 years.

But are the stocks undervalued?

While there has been a strong improvement in the financials of operators, the share prices of these companies have hardly budged over the past one year. Of course, all these stocks trade at fairly rich valuations, at 20-35 times estimated FY14 earnings.

But given the room for growth in the data segment and the vast scope for adding 3G subscribers, premium valuations may be here to stay. For investors looking to play the sector, Idea and Airtel are the top picks given their better financial position and business positives.

For investors who already hold RCom, it may make sense to retain the holdings. Fresh exposure would have to be only linked to broader market declines, given the rich valuation that it trades at present. While its debt paring process has started, the sale of Globalcom and real estate assets needs to take off smoothly before investors take further exposure.