Telecom has been one of the fastest growing sectors in India, with the performance of services providers being led by mobile telephony. From around 2.8% tele-density (connection per 100 population) in March 2000, the sector now connects around 17% of India's population through a host of services, which include mobile, fixed line and Internet. Thriving Indian businesses, especially the IT and BPO industries have also helped the strong growth in another segment called 'Enterprise services', which include wholesale proviosion of data and bandwidth services.
In this write-up, we shall analyse the telecom sector in its most fundamental terms, thereby studying the basic business models of companies in the sector. We shall also outline certain key points that investors need to consider before investing into a telecom stock.
Let us begin by brief definitions of the four major sub-segments that make up the telecom sector:
- Fixed Line
We shall first take up the revenue analysis of these segments and then moving on to the cost structure for telecom services providers. Let us first understand the mobile/cellular services business in its entirety.
I. Mobile/Cellular services
The cellular mobile service providers (CMSPs) make available mobile telephone services where by a customer on possession of a handset and obtaining a connection by way of SIM (Subscriber Identification Module) card (for GSM based technology phones) is able to connect to the network of the service provider. This is a wireless service that allows the customer to connect with other wireless customers as also wire line customers.
A CMSP derives its revenues by way of tariff charges for outgoing calls made by subscribers on its network. As such, revenue for a CMSP is simply a multiple of average revenue per subscriber per month (ARPU) and number of subscribers. Let us now understand what determines the ARPUs and subscriber base.
ARPU: Average revenue per subscriber per month, or ARPU, is the amount of money that a CMSP generates per subscriber per month. It can be obtained by dividing the total wireless revenues by number of subscribers and then dividing the output by number of months in a period (i.e., 3 months for a quarter and 12 months for a year's calculation of ARPU). To even out the volatility in ARPUs, if any, it is better to arrive at the figure by averaging the wireless revenues and subscriber base for the latest two years. However, considering the rapid pace of subscriber addition for Indian CMSPs, ARPU calculated as dividing the trailing 12-months wireless revenues by latest subscriber base is also an appropriate figure. For instance, if a CMSP has earned a total of Rs 50,000 m as wireless revenues in the past 4 quarters (or trailing 12 months) and its current subscriber base stands at 20 m, its ARPU will be Rs 208 per month (Rs 50,000 m of wireless revenues divided by 20 m subscribers divided by 12 months).
Another way to arrive at ARPU is to multiply the average number of minutes of usage (MOU) per subscriber per month with the per minute tariff. Most of the Indian CMSPs generally disclose their MOUs and per minute tariff and as such, these can be used to determine the ARPU. While there might be a direct correlation between change in MOU and change in ARPU, it might not work the same in India's case as tariffs are falling at a rapid pace. As such, even if a subscriber talks for a longer time, the CMSP's ARPU might not increase at the same rate as per minute rate might decrease.
Subscribers: Growth in a CMSP's subscriber base is dependent on several factors, the key amongst them being:
Economic growth: With growth in the economy, and the consequent increase in activity, it requires people to be in touch even when on the move. This brings out a pressing need for owning mobile/cellular phones. Thus, with a growth in economic activity there will be more and more people subscribing to telecom services, thus leading to growth in subscriber base for CMSPs.
Rising income level: As the real income levels in a society rise, more and more people are able to afford usage of cellular phones. Also, with rising incomes, as personal consumption expenditure (as percentage of income) reduces, the consumer does not feel the pinch of rising telephone bill, thus having the propensity to talk more, thus leading to higher MOUs for telecom services providers.
Affordability: While there may be a need to be in constant touch as outlined by the above two factors, it is the increased affordability that really increases the demand for such services. The affordability is interplay of lower tariff charges and availability of cheaper handsets. While lower handset costs make mobile more affordable at the entry level thus allowing more people to be a part of the 'mobile community', lower tariffs allow for an increased usage of telecom services, while not having such an overbearing impact on telephone bills.
II. Fixed line services
The fixed (wireline) services are dominantly provided for by the PSUs (BSNL and MTNL) in India. A customer can obtain a connection where by a wireline provides him with the last mile connectivity on the national telecom network. Although this had been a dominant mode of telecommunication in the past, it is fast being replaced with mobile telephony, which has the advantage of connectivity on the move. The fundamental business of a fixed line operator is almost similar to that of a CMSP, in terms of ARPU and Subscriber base.
The Internet services are provided either by telecom service providers or independent Internet service providers (ISP) who deal exclusively in providing this service. There are two forms of Internet that are currently popular - the dial-up connections and the broadband connections. While both these forms are used for transmitting and receiving data, a broadband connection (Internet access that allows minimum download speed of 256 kilo bits per second from the point of presence of the service provider) allows you to transmit data at faster rate.
The Internet business also works like a generic telecom business but for the fact that here, a personal computer (PC) is used for data/voice transmission instead of a phone unit (mobile or fixed line handset). Apart from the usual - economic growth and rising income levels - the growth of the Internet business is dependent upon:
PC penetration: Internet penetration in India is currently at very low levels, as compared to its developing peers. This is set to take off with the rise in PC penetration, which will again be a consequence of affordability in terms of lower PC costs and reduced cost of data transfer. The cost of data transfer depends on whether one is using a dial-up or a broadband connection. The dial-up package entails a fixed charge for Internet access and a variable charge for the telephone connection. On the other hand, tariffs for broadband are usually designed on the basis of quantum of data transmission. As there is rationalisation of these tariffs going forward, Internet will become more affordable and this will drive growth, as the recurring expenditure will reduce.
Parental encouragement: An interesting change that has come is the way parents now look at computers. The age of a typical computer user has dropped significantly as parents increasingly realise the growing importance of computers in education in the years to come. So, unlike most products where children are targeted to drive sales of consumer durables, in the case of computers, it is the parents who are going all out to ensure that their child grows up to be a computer literate. Thus, with computers coming into homes, it will not be long before parents will wish their children to be wired to the web owing to the rich source of information.
IV. Enterprise services
Moving on from the individual, who is the major user of mobile, fixed line and Internet services, let us now briefly analyse the 'Enterprise services' business of telecom companies. These services are used by large and medium corporates for data transfer between their offices and/or their suppliers' offices, which may be spread in a city, or a country, or even across continents. The need of users to have a seamless connectivity with their associates is what drives this business for telecom companies. Considering that this business takes care of data transfer needs of corporates, who are not as 'affordability' conscious as the individuals (who use mobile, fixed line or Internet services), telecom companies generally earn higher margins on Enterprise services than they earn on any of the other three business lines. IT and BPO sectors, whose business is so data dependent, are the major users of Enterprise services.
After discussing the revenue aspects of telecom service providers, let us now understand the major cost heads for these companies. These cost heads can be broken up into regulated and non-regulated costs. Entry fee, access deficit charge and license fee are regulated. On the other hand, sales, general and administrative (SG&A) and employee expenses are non-regulated in nature.
Entry fee: The companies providing national and international long distance (NLD and ILD) services are required to pay a flat entry fee of Rs 25 m each (from earlier fees of Rs 1,000 m and Rs 250 m respectively). These fees are to be paid to the central government for obtaining a license for providing these services.
Access deficit charge: The government also collects from the cellular operators an access deficit charge. The charge payable is 1.5% percent of non-rural annual gross revenue (AGR) of the telecom service providers and the amount collected is used to subsidise the telecom service provided by BSNL in rural areas.
License fees: Telecom companies are required to pay an annual license fee of 6% of their AGR to the Government of India. Licenses offered to the telecom players are for a limited period of time and these are required to be renewed on expiry.
SG&A expenses: Telecom companies incur expenditure in the form of advertisement costs for enhancing their visibility and also to make their brand more appealing to the consumers. Expenses are also incurred on customer acquisition and on maintenance of telecom equipment and network.
Personnel expenditure: These are costs incurred for maintaining the staff for executing the telecom companies' marketing strategies, for general administrative purposes, for maintenance and repair of telecom infrastructure, and customer relationship management in call centers.
Apart from these operating costs, telecom companies also incur cost for servicing debt and tax payments. Telecom is an operating leverage play (indicates that each new subscriber will come at a higher profitability than the previously added subscriber), and, as such, the benefits of faster subscriber addition are directly seen on companies' improving operating profitability (as fixed costs are apportioned over a larger subscriber base).
Key factors for identifying telecom stocks
After analyzing the fundamental factors driving a telecom company, let us now understand certain key factors that you need to consider before investing into a telecom stock.
Management vision and depth: Apart from rollout of services into newer territories and subscriber addition, what leads to sustenance in a telecom company's growth is the management's capability to discern ongoing trends, innovate and have a vision for the future. This is of critical importance, as it helps them to formulate the right strategies keeping on track the company's performance. Owing to the fact that the management and ownership are different in a public limited company, an investor (owner of a part of the company) must ensure that the near term goals of the management are aligned with the long-term objectives of the company.
Scale of operations: Investors must look for telecom companies with a large coverage not just in terms of geographical area but also in terms of services offered. In a telecom industry, it is possible for the company to generate multiple revenue streams by utilising the network in an efficient manner. This also helps create a natural hedge against a slow down in any particular segment.
Capex plans: India is a vast country and telecom companies are required to expend huge sums in the form of capital expenditure for roll out of services. As a result, it is important to look at the company's capex plans and how is it going to fund the same. While for most companies in the initial period of rapid growth, net cash generation (after meeting operating expenses) might not be adequate to meet the funding requirements, it is pertinent for the investor to understand whether the management has been prudent enough in its funding plans. Too high a dependence on debt in times of rising interest rates might impact profitability.
Key financial metrics: Before investing in a telecom stock (or for that matter any stock), an investor must closely look at the key financial operating and profit ratios of the company. The ratios are nothing but an arithmetical representation of a company's financial data that help in gauging the health of the company. Key ratios to be look at for a telecom company are as under. It is important to look at these ratios for 3-5 years in the past, considering that most telecom companies in India do not have a history before that.
- Sales growth
- Average revenue per user
- Subscriber growth
- EBIDTA margins or Operating margins [(Sales - Operating expenditure)/Sales)]
- Interest coverage [Profit before interest and tax/Interest]
- Net profit margins [Net profits/Sales]
- Earnings per share
- EBIDTA per share
- Debt to equity
- Return on equity [PAT/Equity or Net worth]
- Return on capital employed [PBIT/Capital employed, which is Equity + Debt]
- Free cash flow [Profit after tax + Depreciation - Dividend & Dividend Tax - Capex -Working capital changes]
Apart from these, investors should also compare other key ratios like receivable days, working capital turnover and asset turnover, amongst others to arrive at a final view on the company (not the stock!).
Importantly, these ratios must not be looked at in isolation and one should look at the past data as well to arrive at a trend, which shall give a better perspective of the company's performance over the years. Also, an investor must compare ratios of the company with the industry leader and its peers to gauge a company's relative performance.
Valuations: As we have indicated above, comparing a host of financial metrics will give the investor a final view on the company, but not the stock. For arriving a final view whether to buy or sell the stock, one needs to study the key valuation ratios.
Telecom companies can be valued by using the 'Price to earnings (P/E) ratio'. Also, considering the high levels of depreciation (that is a non-cash expense), a 'Price to cash flow (P/CF)' valuation can also be considered. Investors can even use the 'Enterprise value per subscriber (EV/Subscriber)' ratio, which indicates the price at which a company can be bought over.
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