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Telecom: All in the scale!
Dec 14, 2006

The Indian telecom sector has repeatedly been throwing up strong numbers over the past few years. This is a product of a well-crafted telecom policy and its timely execution. Also, the deregulation of the sector has lead to its exponential growth in the past. We have been witness to how mobile phones, from being luxuries during the initial years of their launch, have changed to being a necessity in the urban and semi urban areas. As a consequence, Indian telecom companies have been rapidly growing in size, with market leaders like Bharti and Reliance gobbling up a greater number of subscribers with each passing month. That said, although domestic telecom service providers are at the forefront in terms of growing the subscriber base, they are still a long way from attaining the kind of profitability that the global mobile players earn. Investors should remember that operating profits (or EBIDTA), apart from helping to assess the company’s profitability vis-à-vis competitors, are also crucial for telecom companies in meeting their growth requirements, as these aid the growth in internal accruals. In this backdrop, let us understand the factors that will help these companies in improving their profitability levels in the future, so as to match their global counterparts and create an internal capital base.

Benefits of plenty…
Common sense dictates that, not just in telecom but also across all sectors, volumes when spread over a larger base of fixed costs, lead to a relatively higher growth in profitability. This relationship between volume growth and growth in operating cash flows is evident more prominently in expanding markets like India, which are witnessing rapid expansion in the mobile subscriber base. The country recently crossed the 100 m GSM subscriber landmark, to become the third largest GSM base in the world, after China and the US.

Deriving the benefits of economies of scale, Chinese telecom service providers earn EBIDTA margins of nearly 50% on an average. Compared to this, the average EBIDTA margins for Indian mobile service providers is under 32% (Source: TRAI). Bharti, for instance, earns EBIDTA margins of 36.7% from its mobile business (as per 1HFY07 numbers). We believe that as the company grows its subscriber base in the future, the benefits of operating leverage will be seen in its profitability numbers, as operating expenditure (OPEX) will be apportioned amongst a large number of subscribers. We have already seen some of the benefits of this leverage in the past few quarters, as the company has maintained its mobile EBIDTA margins despite making large investments in the semi-urban and rural markets. Against US$ 6.5 of OPEX per subscriber per month during FY06, we expect the cost to decline to US$ 5.9 by FY09. Consequently, EBIDTA margins are estimated to increase from 35.7% in FY06 to 36.3% in FY09. A faster than estimated growth in the subscriber base shall only perk up the same.

The years gone by have seen telecom tariffs in the country falling significantly. From the times when it used to cost nearly Rs 16/minute for outgoing calls and Rs 8/minute for incoming calls, we currently pay nearly a rupee per minute for an outgoing call while incomings are free. Mobile service providers are, however, not too worried about the fall in tariffs as volume growth has more than made up for this fall. Volume here represents not only ‘more people talking’ but also ‘people talking more’!

The following table is representative of the minutes of usage pattern seen in India. The effect of cheaper call rates is clearly visible, with people in circle “C” talking the most, for both GSM and CDMA users, in the prepaid category. Also the usage was most in the post paid category, in circle “C” for CDMA users, and for GSM users maximum usage was seen in the circle “A” cities. It is encouraging to know that the usage is high in circle “C”, as this is where most of the growth is likely to come from in the future.

Minutes of usage per month
GSM
  Postpaid Prepaid
Circle Outgoing MoU Incoming MoU Total MoU Outgoing MoU Incoming MoU Total MoU
Circle A 381 428 809 120 196 316
Circle B 279 309 588 126 182 308
Circle C 283 287 570 149 231 380
Metro 330 415 745 94 193 287
CDMA
  Postpaid Prepaid
Circle Outgoing MoU Incoming MoU Total MoU Outgoing MoU Incoming MoU Total MoU
Circle A 519 331 850 205 235 440
Circle B 520 309 829 248 247 495
Circle C 744 460 1204 336 293 629
Metro 501 317 818 205 270 475
Source: TRAI

Apart from the growth in subscriber base, mobile service players are also offering (relatively more profitable) a number of value added services to existing customers (largely corporate clients). These include services like broadband, virtual private networks (VPN) and leased lines. The segment is set to grow faster due to the IT and ITES boom in the country. Also, with the advent of newer technologies like EDGE, WIMAX, and 3G all set to hit the Indian markets soon, the market for value added services will see a huge growth going forward, thus aiding the overall expansion in margins.

Companies like Bharti are also entering into innovative deals with technology and networking companies for outsourcing their non-core requirements and rather focusing on their core competency of branding and marketing of telecom services. Finally, the government’s recent notification on sharing of infrastructure among telecom players shall stand in good stead for companies who plan to penetrate deeper into the semi-urban and rural markets.

Conclusion
The volume game is set to be one of the most important determinants of operating performance telecom companies in the future. According to estimates by COAI (the GSM mobile association in India), mobile subscriber base is expected to form 80% of the 250 m phone connections (including fixed line) by the end of FY08. While reduction in tariffs and cost of handsets has supplemented the growth of the Indian telecom sector, we believe that future growth is likely to be aided by companies’ entry into the large and relatively untapped rural market. Also, in a high growth and intensely competitive model that the Indian telecom sector is, ARPUs are likely to fall further in the future. While the strong growth in volumes might not fully filter into the bottomline on the back of initial costs of expansion, we expect Indian mobile service providers to match their global counterparts in terms of profitability in the long run, while continuing to grow at record pace.

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