Lead Story

A costly recharge

India's third largest operator secured its turf for good. Can Idea make the most of its costly spectrum purchase?

Himanshu Kapania is not exactly a fitness freak but he loves his morning jog before work every day. That ritual helps the 53-year-old cope with the rigours of occupying the corner office at Aditya Birla group company Idea Cellular, the country’s third-largest wireless operator with a market cap of over ₹61,000 crore.

An old hand at Idea, Kapania’s first stint lasted between 1997 and 2003 before he moved to RCom as its CEO for northern India and he rejoined the company in 2006 as the COO of southern and western India. And then, in 2011, he took over the mantle of MD when Sanjeev Aga hung up his boots. 

Kapania has seen the telecom landscape evolve over the years, right from the introduction of the new telecom policy (NTP) in 1999 to the low point of 2012, when the telecom scam resulted in massive licence cancellations that also saw Idea lose licences for seven circles. But what really shook Kapania were the 20-odd days when Idea’s entire existence was in question.

The fifth round of spectrum licence auction, between March 4 and March 24, turned out to be the fiercest telecom battle India has witnessed since 1991, when the government first began auctioning airwaves. The current auction was this aggressive because in December 2015, the 20-year validity of 29 licenses across 18 service areas were to expire.

The top telecom players had a lot to fight for with Idea Cellular having to retain nine circles, Vodafone and RCom seven each and Airtel six. In fact, against the reserve price of ₹49,000 crore and much before the auction began, the government had already received commitments of ₹60,000 crore — a clear indication that players were desperate about saving their businesses and also keen on making inroads into new territories. 

A total of eight operators paid 20,435 crore as earnest money deposit for participating in the auction, with Reliance Jio paying the highest deposit of ₹4,500 crore, followed by Bharti Airtel’s ₹4,336 crore. Jio already has pan-India spectrum in the 2,300 MHz band and it won spectrum in 1,800 MHz in 14 telecom circles in the previous auction.

In non-metro circles, where fewer towers were available, it made sense for Jio to bid for 900 MHz, given that it is the most efficient spectrum with propagation characteristics similar to spectrums in higher bands.

“900 MHz is hugely critical, since it has the advantage of penetrating signals indoors. This is in addition to offering a big plus when it comes to going rural, where less cell sites are required. It is critical since it gives you geography and also makes money,” points out Sanjay Kapoor, former CEO of Bharti Airtel.

The build-up was clearly unnerving for incumbent players. “It was like your own house, which you have painstakingly built and been living in for 20 years, was now suddenly open for anybody and everybody to bid and own,” says Kapania, sitting at Idea’s head office in suburban Mumbai.

But what Kapania did not anticipate was the intensity with which Idea’s turf would be attacked. At the end of the fourth day of auction, the bids for 900 MHz saw an increase of 85% against its reserve price of ₹3,980 crore, even as the other three bands (800 MHz/1,800 MHz/2,100 MHz) saw a mere 2-6% jump.

“After a point, it [bidding higher] did not make sense for any player except for the original owner of the house [considering what was at stake]. We were relieved as the competition shifted to other spectrums and circles. We were just waiting for the auction to conclude,” he says.

But on the last four days, the lull turned into a storm as aggressive bidding was once again seen in the 900 MHz band.

“We were surprised by the bank guarantees given by companies with deep pockets. It was a very emotional time for us. There was a huge danger of services being discontinued for 108 million subscribers… it was a case of an existential crisis,” adds Kapania, who has an engineering degree from BIT (Mesra).

The fiercely fought auction ended after 115 rounds of bidding, yielding the government an all-time high of ₹1.09 lakh crore, surpassing the ₹62,162 crore of the previous auction in February 2014. While the exchequer will be laughing all the way to the bank, the telecom players have loaded up their balance sheets with further debt, with Idea emerging as the most aggressive bidder — paying through its nose just to retain its existing business (see: A study in contrast). 

Not surprising, then, that industry observers are a bit sceptical about its chances. Hemant Joshi, partner, consultancy firm Deloitte Haskins & Sells, says, “Whether consumers and telcos will benefit or make money remains to be seen in the new context. Post the auction, it will be challenging for the industry to service such debt. Today, India has the lowest average revenue per user in the world and servicing such humongous leverage will definitely put pressure on the cash flows and the profitability of the industry.” Concurs Sudip Sural, senior director, Crisil Ratings, “The industry will have to shell out close to ₹1.05 lakh crore and close to 75% of this will come through debt.”

But why Idea did what it did is also an outcome of what was at stake for a company that emerged as a serious contender from its chequered past, beginning with a tri-way joint venture that went by the moniker Batata.

Purple patch

It was in May 2002 that Ratan Tata announced a new name, Idea Cellular, for an equal three-way joint venture between the Tata group, Aditya Birla group and AT&T. Back then, Idea — with close to 9 lakh subscribers — was the new kid on the block. But the honeymoon was short-lived — by 2006, the Tatas and Birlas were at loggerheads, with the Birlas moving the department of telecom to force the Tatas to exit from Idea or reduce their stake to below 10%. The Birlas said the Tata group, which had also seeded Tata Teleservices, was violating licence conditions.

A series of allegations and counter allegations ensued, and the protracted four-month battle saw the Tatas slapping a notice on the Birlas for breaching the shareholders’ agreement by revealing confidential information about the then-unlisted Idea Cellular. By April, however, both the partners smoked the peace pipe, with the Birlas buying out Tatas’ 48% stake for ₹4,406 crore, thus valuing Idea at ₹9,200 crore.

A year later, the Aditya Birla group company went public, raising close to ₹2,200 crore at ₹75 a share, and there has been no looking back since. From ₹3,000 crore in FY07, revenues surged to ₹31,555 crore by FY15, while its market cap has more than doubled from around ₹30,000 crore.

The exponential growth saw Idea leapfrog from being the sixth player in the telecom business to the third position — after Bharti Airtel and Vodafone — but, more importantly, overshadowing Reliance Communications, which was at no. 2 when Idea had entered the market.

Even as the others were focusing on and fighting for urban subscribers, Idea chose to go the other way by building itself in rural pockets and then spreading to metros. It incurred huge capex to build its network and doubled its reach from 11 circles in 2007 to 22, as the company’s net block (size of assets in the balance sheet) expanded eight times.

More than the speed, what the market appreciated was Idea’s quality of growth — largely backed by moderate leverage. A simple and lean organisational structure (like allowing regional heads far more freedom) and a direct connect with customers through branding helped the company garner and maintain quality growth.

Idea’s approach to set up dedicated business units, decentralising decision-making in the hands of the managers of these units along with flexible pricing in different circles, saw it steal a march over the competition.

Over the ensuing period, its market share grew from 8% to 18% and its subscriber base surged 21X from 7.37 million to 158 million currently, with the highest chunk coming from rural markets (see: Hinterland calling). Since FY06, sales have grown 30% and profits 35% every year — setting the highest benchmark in the industry. 

While the shareholders of Idea Cellular will breathe easy with the company securing its crucial spectrum — accounting for over 70% of its subscribers and 73% of its revenue — for another two decades, the challenges are far from over. 

Led by expensive bidding, Idea not only had to shell out a hefty amount for its existing spectrum but also restricted its ability to buy new spectrum, compared with its competitors who were lapping up more.

“Nine service areas and 106 million subscribers were dependent on this auction and we simply could not afford to lose them,” points out Kapania. It was a tough choice, which came at a huge price, partly influenced by other bidders in the form of aggressive bidding when they knew that Idea couldn’t afford to lose the circles.

Against market expectations of about ₹22,000 crore-23,000 crore, the company ended up paying ₹30,300 crore (see: Coming full circle). In fact, for the first time, companies surrendered their spectrum (Rcom surrendered five out of six licenses that were up for renewal). Idea is happy that for the next 20 years, the bulk of its spectrum does not run a renewal risk. The market cheered the outcome by catapulting the stock to its all-time high of around ₹200 a share.

The debt cycle

Though Idea emerged as the highest bidder, the irony is that only 12% of the money spent on auction went towards acquiring additional spectrum or growth spectrum compared with 40% in the case of Bharti.

“Idea spent the least on buying fresh spectrum (₹6,100 crore) compared with peers such as Bharti and Vodafone, which extended their 3G spectrum footprint to 21 and 16 circles, respectively and have surpassed Idea on revenue coverage under own 3G. Bharti stole a march over both Vodafone and Idea by picking up the maximum 900-spectrum. It now has the capability to deploy premium 3G in six-seven circles within the next one or two years compared with Vodafone and Idea’s two circles each,” points out Sanjay Chawla, who tracks the company at JM Financial Institutional Securities.

Post auction, Bharti’s 98% (before auction, 73%) of revenue will be covered under the 3G footprint compared with 80% (before auction, 79%) in the case of Idea. This clearly shows that the competitors are becoming stronger. So, Idea has to not only deal with the increasing competition but also be ready for new entrants such as Reliance Jio, which is about to enter the fray very soon. 

Though the company does not have to pay the money in one go, the debt will go up gradually. Of the total amount, the up-front payment will be ₹7,700 crore, while the balance would be paid in 10 equal installments beginning April 2018. The initial payment towards the spectrum will be made through internal accruals and the recently concluded QIP proceeds of ₹3,750 crore. However, despite a moratorium of two years, analysts estimate that net debt will nearly double from the current ₹16,800 crore (FY15) to close to over ₹30,000 crore by FY16, with the balance of approximately ₹22,000 crore debt coming on to the books. 

And servicing this debt will be an issue. Today, the company makes earnings before interest and tax of close to ₹5,500 crore, which is more than enough to cover its interest cost (close to ₹583 crore in FY15). However, with the interest cost ballooning to around ₹2,500 crore, the interest coverage ratio will fall to 2.1 times (see: When it pinches). This essentially means that a large part of these earnings will be used for servicing the interest cost, leaving very little profit on the table. 

Additionally, the annual amortisation of licence fees will go up from around ₹630 crore in FY14 to close to ₹2,000 crore annually. This means that both interest and amortisation put together will eat into a large part of the earnings, keeping Idea under pressure. In fact, the consensus estimates suggest that per-share earnings will peak to around ₹9.1 in FY16 (compared with ₹8.5 in FY15) and then fall to ₹8.5 again in FY17.

Surprisingly, return on equity, which is very important to understand how much a company is making for every rupee of equity invested in the business, could drop from 16% in FY15 to as low as 10% by FY17. At this rate, one would question if it were better to keep the money in the bank instead of putting it in the business, which is relatively riskier.

The payment plan

The only positive for the company is that it generates strong cash flows — ensuring that it will not be caught in a liquidity trap. To put this in perspective, in FY15, Idea generated operating cash flows of close to ₹10,000 crore, which, with marginal 10-12% growth in operating profits, will reach close to ₹12,000 crore-13,000 crore over the next two years. Even after leaving ₹6,000 crore-7,000 crore for regular capex, the company will be able to meet its debt (equated installments towards the spectrum) and interest obligations, which estimates suggest can be in the region of ₹4,000 crore annually.

This is why, except for pressure on earnings and return ratios, the Street is not expecting pressure on cash flows. This also means that the company may not have to raise additional debt or equity, which otherwise would have sent wrong signals (of a weakening balance sheet) to the market.

“Considering our operating cash flows, we do not see any need to raise fresh bank debt and even the payment to the government can be managed through our internal accruals,” points out Kapania.

Meanwhile, it is estimated that to justify this investment, the company will need to generate an additional operating profit of close to ₹4,000 crore (that is ₹30,000 crore divided by its current EV/Ebitda multiple of 8X). Now, to generate that additional ₹4,000 crore, the company will have to raise tariffs by 7 paise per minute to cover the investment cost.

The number is arrived at by dividing the operating profit plus other expenses such as license fees, which typically amounts to 20% of total revenue, by the total number of minutes (68,000 crore in FY14). 

In other words, the existing average revenue per user (ARPU) of ₹179 needs to increase by ₹21.5 (see: Full volume). However, these are indicative figures (that only capture the pricing), which may be lower if the company is able to raise volumes through its existing subscribers or bring in new subscribers. For instance, if it increased subscribers by 5% every year, the additional revenue required to be generated through ARPU will come down by ₹1. 

From this, it is clear that to justify investments and recover money to support adequate financials and cash flows, the focus will now be on generating more money while leveraging existing assets. 

With 22 circles, Idea has constantly grown its revenue market share from 14.4% in 2012 to 17.5% in 2015 and now aims to further leverage existing networks (see: Beefing up). However, one key concern is that the competitors, too, are growing their subscriber bases, and with more muscle in the form of spectrum in the hands of Bharti and Vodafone, the gap could actually shrink.

The gap is marginal today as 48% of Bharti’s (105 million) and 53% of Vodafone’s (96 million) subscribers are based in rural markets. For instance, in March 2015, Bharti added close to 1.68 million rural subscribers — the highest in the industry.

The hope is that with the huge capex and up-front payment made for the expensive spectrum, most telecom players are now looking for a price hike so that some of these costs can be recovered, especially when the marginal players are losing on the service and cost fronts.

On the flip side, even if prices are raised by 2-3%, that will have a huge impact on Idea Cellular, given its highly sensitive earnings. The Street is expecting ARPU for voice, which accounts for close to 84% of the revenue, to go up from ₹168 in FY14 to around ₹198-200 by the end of FY17, which is an annual growth of about 5-6%. 

However, that seems quite unlikely. “The market is factoring in a price increase, which is unlikely to happen. The management has been saying that for quite some time but tariffs have remained stable or declined. No doubt, there is massive operating leverage when a price increase happens but in the context of new entrants who can cut prices and create distortion, I am not very optimistic,” says Vivekanand Subbaraman, who tracks the sector at HDFC Securities.

Agrees Sural of Crisil, “The voice segment is expected to report a moderate growth over the medium term on the back of increasing subscriber base (CAGR of 6%) as well as selective scaling back of discounts offered on voice recharge vouchers.”

The last time the company carried out a voice tariff hike, including withdrawal of offers and freebies, was in January 2013 in select circles. Voice revenue per minute has been falling for the past several years. And with the drop in termination charges and roaming charges — most players have reduced roaming charges in the range of 40-70% — there seems to be very less room for tariffs to go up, particularly with the possible price war expected with the entry of Reliance Jio. “With the entry of new large players, competition will increase and in that context, it will be challenging for existing players to raise tariffs,” points out Sural. 

Interestingly, Jio’s decision to bid aggressively in 900 MHz saw the incumbents putting their might into retaining their turf and that ensured that Jio still got the lower frequency spectrum of 800 MHz at a much cheaper rate. Jio got about 49 MHz in the 800 MHz band and another 28 MHz in the 1,800 MHz band for just over ₹10,000 crore, increasing its spectrum footprint from 597.6 MHz to 751.1 MHz. This strengthens its position as the largest spectrum holder and enables it to seamlessly offer 4G services with the multi-band LTE technology, ensuring that Jio has the upper hand if and when it chooses to aggressively price its offerings.

In the just-concluded March quarter (Q4FY15), Idea saw a 7.1% year-on-year decline in revenue per minute to 33.9 paise — the highest decline in the past 16 quarters. In FY15, the average subscriber’s minute usage per month came to 388 (about 13 minutes a day), which is close to 73,500 crore minutes annually, based on its existing subscriber base of 158 million.

On the same minutes of usage, if Idea reduces the tariff from 34 paise to 32 paise, it will impact revenue by close to ₹1,500 crore, a reduction of almost 6%.

Hence, voice tariffs have very little scope and, in fact, will drag the revenue if rates fall further. Alternatively, the tariff fall can be offset through higher usage and an addition in subscribers. If, as against 388 minutes a month, subscribers use 400 minutes (14 minutes a day), that addition will increase revenue by ₹772 crore, which is 3% higher. 

But can the company raise minutes and subscribers to increase volumes, which is again a function of economic growth and income levels? Analysts expect 6-10% growth in monthly minute usage along with growth of 6-8% in the subscriber base, so, the company should be able to partly compensate for the possible pressure on tariffs.

This is where the role of data revenue comes in. However, since it accounts for only 17% of revenue, the impact on overall basis will be limited. Also, in data, the growth is largely driven by volumes because, here as well, the pricing pressure is high. The last hike in data tariff was in October 2013 and, thereafter, prices have only fallen. In Q4FY15, the company’s average revenue per MB declined to 26 paise against 34 paise in Q1FY14 (see: Losing steam).

“Data realisations are down about 25% from FY13, pointing to a continued pressure on data pricing. Though it had stabilised in the first three quarters of FY15, Q4FY15 suggests that holding data prices at current levels might be difficult. We see continued risk of moderation in data pricing in the name of increasing data penetration (particularly due to Jio’s entry),” mentions Viju K George, telecom analyst at JP Morgan. On the other hand, traffic has been good, growing at almost 100% year-on-year in each of the last several quarters.

“Even if upside volumes do manage to partly compensate for likely data pricing erosion in FY16, the capex and profitability implications could be adverse and are not factored in by the Street. A 1% change in pricing exerts much more impact on an operator’s operating than an offsetting volume change, not to mention capex arising from the latter. Thus, the composition of data revenue growth or the price-volume mix is important to monitor over CY15 and CY16 for implications for profitability and capex,” George states in his report.

Besides, some analysts feel that if Jio gets aggressive, it will erode the data revenues of existing players, similar to what happened when the initial stages of the 3G launch hurt 2G data revenues. Further, according to Rajan Mathews, director general of the cellular operators association of India, it will not be easy for Idea to raise prices.

“Competition will certainly increase, not only with the entry of new players such as Jio but also, with cloud computing, machine-to-machine or device-to-device data transfer having their own impact. Also, if you have to reach the bottom of the pyramid in the hinterland and exploit the data opportunity, you cannot afford to raise prices,” he says. 

In India, about 54 million people use the 3G network and Idea has about 16 million subscribers. It aims to upgrade about 70% of its GSM networks to 3G in FY15 as the management expects data volumes to grow at 100% annually over the next couple of years. “Between voice and data, 80% of voice is consumed outdoors, while 20% is indoors. It is exactly the other way around in the case of data. In that context, sticking with 900 MHz and going with 3G makes perfect sense,” feels Kapoor. 

So far, Idea has been loading its 2G sites for the 3G network, but it will have to spend more to deliver services and compete to lay more networks. “While a big plus is that the data story has just about started and the subscriber’s propensity to consume it is huge, the company will have to create infrastructure for data, which is not part of the ₹30,000 crore that it will spend. Data, unlike voice, is not based on pricing but rather on customer experience. Operators can get away with [poor] voice quality but that will not work with data,” elaborates Kapoor.

Idea is cognizant about the challenge and has earmarked capex of ₹5,000 crore-5,500 crore for the current fiscal against ₹4,000 crore in FY15. “We are present in over 350,000 villages and hope to improve our services and brand name further to tap the opportunity, for which we already have infrastructure ready. A lot of new customers prefer to come to Idea because we are the only operator in some of the service areas,” points out Kapania.

While Kapania does exude the confidence of a man relieved to have retained his home, whether he lives peacefully from here on will depend on the new neighbourhood that Idea finally finds itself in.