Now sensational price plans are nothing new for the telecom industry, which has seen more than its fair share of subscriber-seeking, cut-rate tariff plans by newcomers.

Normally, these would be benignly ignored by the larger, more established companies.  
That wasn’t the case this time. The per-second billing plan announced by Tata DoCoMo was followed by the announcement of a sharp 50 per cent tariff cut from Reliance Communications (RCom), the country’s second-largest telecom network operator. Not to be left behind, Idea Cellular came up with its own set of tariff cuts.

On the face of it, it feels like another round of mercenary price gouging, but analysts sense something more radical happening behind the scenes. They believe the new rate wars suggest that companies can no longer ignore the pressure of tariff cuts from rivals, no matter how small they may be -- and that it points to an industry wilting under the increasing pressure to show subscriber growth and profits. Even as the price wars look set to scale new heights, the profitability of companies may be set to plumb new lows, say analysts.

Not surprisingly, the markets have taken a dim view of all these developments and punished telecom stocks. Since the start of the month (when the price cuts began), telecom stocks have plunged by more than 25 per cent even as analysts rushed to downgrade the sector. Clearly, the investors’ love affair with telecom stocks has turned cold for now. Do investors no longer believe in the telecom growth story anymore? Or is this just a temporary lover’s tiff?

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Robust additions

Total wireless subscriber base has grown at a very healthy CAGR of 64 per cent over FY06-09

Source: Trai

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Analysts believe that it’s best that investors learn some hard truths about the telecom industry before rekindling the affair again.
 
Bring it on

Without doubt, the new tariff plans have disrupted -- and how -- the way telecom companies price their services. Call them game-changers if you want. It started with Tata DoCoMo’s launch of per second billing plan on the GSM platform (the more widely used platform in India) and a fixed price per call plan (unlimited talk time per call) for users on the CDMA platform in July. That was  swiftly matched by Reliance Communications announcement that it would slash tariffs across the board to a flat 50 paise per minute on all local and STD (inter-state) calls (a whopping 50 per cent discount).In the past, larger players such as Bharti and Vodafone chose to ignore promotional tactics implemented by new entrants in a telecom circle.

This time apparently the reaction seems to have been different, and analysts believe that the rest of the telecom clan may have little option but to retaliate to Tata’s and Reliance’s price plans, even at the expense of hurting the average revenues they earn from the existing subscriber base. “We see competitor responses as inevitable in a matter of days, in different shapes and forms from Bharti Airtel, Vodafone Essar and Idea Cellular,” predicts Shubham Majumder, associate director - India TMT research at Macquarie Capital Securities. Already, Idea Cellular has cut its tariff to 40 paise per minute besides introducing pay per second pricing plans in some of the circles where it operates, in its attempt to capture consumer attention.

It’s a strange situation companies find themselves in. While subscribers will embrace these plans with open arms, companies will endure some self-inflicted pain because of their grand pronouncements. That’s because not only are they losing market share to new players, they are also losing money on their existing subscriber base. But as the saying goes, there is no gain without pain. Analysts say the price cuts are essential for telecom companies if they want to hold on to subscribers, especially the high-end ones. That’s because retaining market share is important for companies to maximise the use of their networks and maintain low-cost structures.

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Bad signal

MoUs are no longer showing sensitivity to tariffs and revenue per minute too is falling sharply

Source: IDFC SSKI; KPIs – Key performance indicators; MOU – minutes of usage

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As any telecom expert will tell you, all subscribers are not created equal. Take Bharti, for instance - about 15 per cent of subscribers account for around 35 per cent of its revenues. The Ebitda margin on this segment is estimated at around 40-45 per cent compared with the average wireless Ebitda margin of about 30 per cent. However, retaining these high-end subscribers will be Bharti’s biggest challenge and it is unlikely to win it without some kind of price inducements.

No surprise then, that analysts have factored in steep falls in the average realisations companies earn from their subscribers. Bharti, for instance, is forecast to see a 30 per cent drop in average realisations in the coming quarters, while Idea’s will fall by 33 per cent, according to some analysts.  And if that’s not enough, analysts say the adoption of per-second billing could become an incremental negative for almost every telecom player. “A switch to per second billing will be negative in the longer term,” says Rajiv Sharma, analyst with HSBC Securities. “We estimate it would lower sector revenues by another 10-15 per cent.”

In the past, price cuts typically resulted in more traffic on the networks as users increased talk time. So despite lower tariffs, telecom companies managed to protect profitability as the number of minutes of talk time rose. This time around, even that may become difficult as many telecom companies are struggling with spectrum-constrained networks, which may be close to exhausting their limits of taking on additional traffic.

Also, it seems unlikely to analysts that consumers will keep on increasing their telecom spend just to take advantage of lower tariffs. “It is unlikely that Indian wireless consumers will expand their voice usage (talk time) in the near term to make use of such steep tariff cuts (thereby keeping the wallet share of telecom spend the same),” says Macquarie’s Majumder.

Take them all together and you get an industry that is finding it increasingly difficult to live up to its scorching performance of the past few years. Subscriber additions rose by 60 per cent over the past three years, driven by network expansion that led to improved coverage, favourable demographics and rock-bottom mobile phone prices. The government also did its bit by easing regulations, and the benefits were passed on as lower tariffs to subscribers. While subscriber additions may still be strong in the medium term, the rate of growth will be lower. Analysts project additions at 27 per cent in the next three years (2009-2012).
 
Growth, but at what price?

There is room to grow: telecom penetration is about 34 per cent and the next round of growth is likely to come from a drive to enlist rural subscribers. According to an SSKI-IDFC report, telecom penetration is likely to increase to 49 per cent in 2011 with urban penetration at 100 per cent and rural penetration at 27 per cent (currently at 12 per cent). Rural subscribers are expected to make up more than 60 per cent of incremental additions.

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Rural push

The share of rural market in cumulative additions from FY09 to FY12 is expected to be 63 per cent

Source: Trai, NCAER, IDFC-SSKI Research

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That may be music to the ears of telecom company officials, but keep in mind that the revenues from these new subscribers will most likely be at steep discounts to the industry average, given that rural subscribers are unlikely to spend as much as their urban counterparts on mobile phone usage. This aspect is clearly demonstrated by the revenue trends of the last entrant in any circle. When Aircel launched services in Kolkata in May last year, its average revenues from subscribers were 73 per cent lower than those of existing players, indicating that early movers often snapped up the high-end subscribers while the later ones had to contend with the low-hanging fruit, that is, low-end consumers.

That’s why analysts say subscriber additions are not the best indicator of growth, and investors need to study the quality of earnings to judge how well a telecom company is doing. A focus on revenue market share and revenue-generating subscribers, rather than subscriber additions and subscriber market share, helps. Revenue-earning customers are defined as subscribers who are active and contribute to revenues. Since the Indian regulator has no standard for reporting subscribers, each operator makes up its own definition for subscriber churn and reporting subscriber numbers. Unfortunately, increasing competition and the lack of subscriber reporting norms leads to double-counting of subscribers occasionally. As things stand now, Bharti is on top with 30 per cent of the revenue market share. It has a 24 per cent share in the subscriber market, and highlights the company’s focus on improving profitability. On the other hand, RCom boasts a revenue market share of nearly 18 per cent and a slightly higher (18.5 per cent) subscriber market share, suggesting that its focus right now is adding subscribers rather than improving profitability.

Despite the increasing challenges presented by the Indian telecom industry, the fact is that it still holds much allure for the outside world. Even today, foreign telecom companies are scrambling for a toehold in this market. And why not? Most of them are staring at few or little growth opportunities in the mostly mature markets they operate in, so a 27 per cent growth in subscribers over the next few years still seems like a worthwhile bet. 

With 457 million subscribers, India is the largest telecom market in the world after China, and in that sense, hard for a foreign player to ignore. According to a Moody’s report, in the past 12 months, India overtook China as the fastest growing market in Asia. It seems that foreign companies knew this would happen, because in the past 18 months, four large telecom companies have made their debut – NTT DoCoMo (Japan), Sistema (MTS, Russia), Telenor (Norway) and Etihad Etisalat (UAE). With existing players increasing their national footprint – Idea Cellular, for instance, has upped its presence to seven circles while Aircel Maxis is present in five - and the entry of new players, the number of operators per circle will jump to nearly 12  from 7-8 in each of the 22 telecom circles in the country, making it one of the most fiercely competitive markets in the world.

To survive, most new entrants have adopted a pre-dominantly shared infrastructure model, which is aimed at lowering their capex needs and the time to hit the market. Key functions like network planning and management, IT services, back office, billing, are being outsourced.

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Dialing India

With the backing of experienced global players, the wireless industry is set to witness a rush of even more new entrants

Source: Analysts reports

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To attract subscribers, new operators need to build a reliable brand. So a successful market roll out of services is crucial for success. That entails huge initial investments.  Being a late entrant also has some disadvantages since average realisations come at a steep discount to existing players, keeping their equity returns modest (10 per cent assuming a six-year break-even period for operating profit). As the battle for subscribers grows more intense, analysts say that even more cut-throat tariff cuts could be imminent, and this could threaten the economic viability of the operations of the new entrants. In fact, RCom’s tariff cut is viewed as a strategic move to discourage more entrants by making their operations a bad economic proposition. “ Existing players want to shut the door on the new entrants even before they get their foot in the door,” says Abhinav Goel, director, Fitch Ratings.

Crossing lines

As if all the current challenges weren’t enough, there are more up ahead. Early next year, mobile number portability (MNP) is set to be introduced. It’s a move that could help newcomers grab market share faster than what would have been possible without, say analysts. Even existing players such as Idea and Reliance could gain market share in new/ traditionally weak circles. MNP allows customers to retain their phone numbers even if they switch network operators.

For sure, subscriber churn and marketing costs for telecom companies will surge after MNP comes into effect. But how much of a churn MNP can cause remains open to debate. Some say that the Indian telecom market is predominantly pre-paid (92 per cent of total subscribers) and witnesses high churn rates (45-50 per cent annually), and there isn’t much customer loyalty in the first place. More importantly, the impact of number portability will depend on the time it takes and the cost involved in switching between operators. Expect another possible round of tariff cuts in some high-decibel marketing campaigns as companies try to remind consumers to stick with their operators just before MNP is launched.

While in the short term, a flurry of cheap tariff plans and MNP could cause subscribers to jump from one operator to another, analysts believe better service levels will emerge as the key differentiator in the long run as ridiculously cheap tariffs are not a sustainable way to amass market share.

The next wave of growth?

Many companies are slowly realising that. As a first step, they are investing considerable amounts in setting up 3G networks. The 3G system represents the next step in the evolution of mobile communication. The 2G system (the industry’s current system) focuses on voice communication, while 3G allows high-speed data transfers, mobile internet access and entertainment, while having a markedly greater capacity and spectrum efficiency than 2G systems. The focus now is on quality of service. With 3G networks in place, players will be able to offer better quality of service and use it to garner market share with new subscribers as well as retaining their high-end subscribers by migrating them from the existing 2G network,” says Manoj Mohta, head- research, Crisil. Because 3G offers a better suite of services compared with 2G, the service is priced higher.

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All fall down

Telecom stocks have got de-rated, following which their shares prices have also tanked

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Experts say the average revenue for every 3G customer can be almost three times higher than those using 2G networks (where the average revenue per user is about Rs 250 a month). 3G services will also help telecom firms retain high-end consumers, who are the key group for such services.

However, the ramp-up in 3G revenues is expected to be gradual as telecom companies roll out their service plans in the first half of next year. Analysts reckon that it could take up to 18 months before 3G revenues contribute significantly to operator revenues.

Everyone hurts

In the meantime, there is no escaping pain in the near term. With little room to cut on costs, falling tariffs are likely to have significant impact on the margins and the profitability of the telecom companies. JP Morgan expects declining tariffs to lead to a margin drop of about 600 basis points for RCom. Earnings are predicted to decline by 22 per cent in FY10 and by 25 per cent in FY11 before turning positive in FY12. The fall is estimated to be even steeper for Idea Cellular. Macquarie Securities forecasts the company’s earnings per share (adjusted) to fall by 20 per cent in FY10 and a massive 76 per cent in FY11 before turning positive in FY12.

Bharti Airtel appears to be least affected on the earnings growth front. According to Macquarie, Bharti’s earnings per share (adjusted) are likely to see a modest growth of 15.5 cent in FY10 and a marginal decline of 3 per cent in FY11. Nevertheless, the deteriorating quality of earnings will have an impact on the return ratios of all telecom companies.  The least hit will be Bharti, whose return on equity is expected to decline to about 23 per cent in FY11 from 32 per cent in FY09. For Idea, the fall is more significant as RoE is expected to plunge to a meagre 1.3 per cent in FY11 from 10.4 per cent in FY10. RCom is also in the same boat: RoE is forecast to more than halve to about 8 per cent from nearly 19 per cent during the same period.

Analysts also say that the disruptive pricing policies will affect smaller, regional and startup operators and possibly speed up the industry consolidation, which with 10-12 operators in one circle, seems inevitable. “When the shakeout happens in the telecom industry, only companies with strong balance sheets will survive. The disruptive pricing strategy is more like a gamble. There is no guarantee that the company will survive just because it followed disruptive pricing,” says Manish Sonthalia, fund manager, Motilal Oswal Securities.

To facilitate consolidation in India’s crowded and intensely competitive mobile phone market, the Telecom Regulatory Authority of India (Trai) is contemplating changes that will allow mobile phone firms to buy each other out and trade in wireless spectrum. The roadmap is likely to be drawn up by December and the policy is likely to be in place before the end of the fiscal year in March 2010.

Analysts reckon companies with strong balance sheets like Bharti will benefit the most from any moves towards consolidation. No guesses on when that will happen though. For now, the sheen has definitely come off telecom stocks. Analysts have been quick to downgrade the sector and are recommending that investors stay away from telecom stocks barring Bharti, which they still believe is a good long-term bet at Rs 300 levels. “We recommend that investors avoid Indian telecoms, as a dynamic game of price positioning plays out over at least the next two to three quarters,” says Macquarie’s Majumder. “While longer-term value may well emerge, the likely barrage of competitor responses and associated negative noise will likely cap any meaningful near-term re-rating,” he adds.

With no meaningful improvement in the fundamentals of these stocks in the near term, you’re better off being a subscriber than an investor. Right now, the customer is definitely king for the telecom industry.