My Best Pick 2013

Shifting gears

Improving realisation rates and margins in addition to regulatory clarity bode well for Bharti Airtel

There’s bad news and there’s good news. Let’s take the bad first. The Indian telecom sector has been growing with hyper-competitive intensity over the past three-four years and regulatory uncertainty has impacted its outlook, profitability and financial strength, no arguments. It’s easy to explain why Bharti Airtel, the leader of the pack, has seen its stock under-perform significantly over this period. But all that is set to change, I think. 

The good news is that the sector is at an inflection point and Bharti’s under-performance will be reversed in 2013. I have my reasons for this and will get to them shortly.  But first, it would be pertinent to understand a little bit of Bharti’s background. Bharti Airtel, which has 30% of market share in revenues, is the dominant player in the Indian telecom sector and is likely to benefit the most from the changing outlook. A deeper look at some of the key issues that impact the sector and the stock would not be out of place here.  

First, an improvement in the realisation rate, which has been under pressure, thanks to recent hyper-competition in Indian telecom, is now inevitable because the rates are at an inflection point and we can expect them to move up significantly over the next six-nine months. Why now? The telecom sector’s dynamics have changed irrevocably after the cancellation of the controversial new licences that were given in January 2008 and, more recently, the failure of the 1,800 MHz spectrum auction. 

Operators can improve their realisation rates in three ways — they could rationalise their free or promotional minutes, introduce activation fees to reduce churn, or increase headline tariffs. I feel they will reduce their free or promotional minutes first because it is low hanging fruit, and activation fees and headline tariffs will follow as the industry consolidates further. Our analysis shows that voice realisation per minute (RPM) can move up 20% without any increase in headline tariff, that is, mobile operators can improve the yield on minutes by significantly reducing or eliminating promotional minutes.

I expect the mobile base tariff to move up over the next three years after the headline tariffs increase as input costs — power, diesel, employee wages and so on — have been rising substantially. Moreover, the prices of most utilities or consumer staples such as power, gas, milk and soap have risen over the past five years, and I believe telecom may not be an exception. So, I have built-in a 20% improvement in Bharti’s realisation by FY16. This improvement in the realisation rate is also likely to improve the company’s operating profitability.

My estimate is ahead of what the consensus is, which, I think, will move up significantly in the coming months. This will happen when the Street sees tangible signs of RPM improvement. It follows that companies such as Bharti and Idea will witness positive earnings momentum over the coming months.

Regulatory clarity

The regulatory progress in the Indian telecom sector over the past one-and-a-half-year is a blessing. This golden period has brought clarity on a number of key issues: licensing conditions, spectrum pricing, spectrum allocation methodology, re-farming, spectrum sharing, uniform licence fee and even telecom M&As. The regulatory developments, let’s be honest, are a mixed bag. The main pluses are spectrum sharing, spectrum liberalisation, uniform licence fees, and the relaxed M&A norms. But two issues — the high reserve price for spectrum and the DoT’s decision to go ahead with re-farming — are viewed negatively. 

Overall, the news flow on spectrum pricing and re-farming have been progressively positive over the past few months. The failure of 1,800 MHz/800 MHz auction has prompted the DoT to reduce reserve price in four service areas. I still maintain that the current reserve prices are reasonable, specifically of the 900 MHz spectrum for which the government has fixed a reserve price twice that of the 1,800 MHz spectrum.

As for the question of re-farming, the government has decided on partial re-farming for incumbent operators, which will allow them to retain 2.5 MHz when their licences are renewed. Trai had recommended complete re-farming earlier in the year, which is an incrementally positive development as it takes away the uncertainty surrounding the renewal of 900 MHz licences. Nevertheless, I believe the matter is likely to get embroiled in legal battles until the government and the incumbents try to find an amicable solution for it. To sum up, Bharti Airtel leads the sector and has a strong balance sheet. That’s why, among all the operators, it is well-placed to ride over these regulatory challenges.

A misplaced threat

There’s a dark cloud, or so it’s thought, hanging over the horizon. But is there really stormy weather to be feared? Reliance Industries is expected to launch broadband wireless services based on TDD LTE (Time-Division Duplex Long-Term Evolution, a 4G telecom technology standard) in 2013. It’s believed that the launch of broadband wireless access (BWA) services by RIL will trigger another round of price wars in the sector. I think there’ll be negative sentiments around the BWA launch, especially for incumbents, but the concerns over RIL’s entry into telecom are misplaced because the target market for RIL will be fixed broadband replacement.

Moreover, the TDD LTE ecosystem is still nascent and it will take another three-four years to mature. RIL’s initial launch will be more on a trial basis and will require a 2G/3G base network to have seamless LTE services. Besides, voice services are central to any mobile operator’s business case in India and enabling them on an LTE network will remain a critical challenge for a greenfield TDD LTE operator. I would go so far as to say that there is no business case for a standalone TDD LTE operator in India and it would be best for RIL if it acquires an existing operator. RIL’s non-participation will result in allaying the immediate concerns over continued hyper-competition in the voice market, which will serve all operators, Bharti in particular, rather well.

Data: The next big growth driver

I think we are about to witness a boom in data revenue in the medium term. This will be driven by our demographics, cheaper smartphones, and the deployment of 3G services. Incidentally, HSPA+ (Evolved High-Speed Packet Access, a tech standard for wireless broadband) is capable of handling data traffic, chiefly via smartphones and tablets, over the next decade. So, I don’t see any immediate need for TDD LTE in India’s mobile market. That’s in the background. 

Pertinently, the recently-released quarterly results of Bharti, Idea and Vodafone show that non-voice revenues are reaching an inflection point. Once the prices of smartphones and tablets fall to sub-$100 levels over the next 12-18 months, the market for data services is bound to pick up significantly. Bharti, I feel, is nicely placed to ride the data boom in India, thanks to its footprint in 3G/TDD LTE spectrum and high-quality customer base.

Africa ahoy 

Ever since Bharti took over from Zain in Africa, there has been a consistent improvement in the company’s operating metrics in that continent. Its Africa revenues have grown by 12% over the past 12 months, and Ebitda margins have expanded by 2% in the same period. The region is also a highly elastic market — minutes generated on the network have grown by 26% while the realisation rates have declined by 13% over the same period.

Initially, the Bharti management focused on replicating its Indian model in Africa by outsourcing non-core functions, network operations, call centres and IT, to bring down overheads and improve network quality. Now that the restructuring is behind it, Bharti is ramping up its operations in Africa with what its management believes is the best way to do so — follow a steady approach. Indeed, I expect Bharti will continue to grow steadily in Africa.  

The long and short of it

I will admit that I am bullish about the Indian telecom sector. The industry is going to consolidate into five-six companies in the medium term. Realisation rates can improve significantly in 2013 and the margins will be better with the regulatory changes. Bharti is going to benefit from all of this and it is our top pick in the sector. We have a ‘buy’ rating on the stock with a 12-month price target of ₹425.