V6 Indian Telecom Sector FAQ - Crisil

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CRISIL Insights Mobile Telecom Sector: Better Times Ahead?

FAQs The Indian telecom companies have been facing strong competitive pressures and high levels of regulatory risks for the past few years. The telecom players have accumulated significant quantum of debt in their balance sheet to roll out new services and acquire spectrum, expecting strong growth in demand in the world’s second largest populated economy. While the subscriber penetration has been a success story so far, the mobile tariffs in India are among the lowest in the world. On account of the capital intensity in the sector, the total debt in the mobile telecom sector has reached an estimated Rs.2.0 trillion as on December 31, 2011; this includes bank debt, capital market instruments and external commercial borrowings. Given that the sector has been at cross roads for more than three years, there is a keen interest from the investors to know where the sector is heading over the medium term. This FAQ is an attempt to address some common questions asked by investors and other market participants on where the sector is heading over the medium term.

Key Conclusions India’s telecom sector is in a transition phase. The large players are on the verge of bouncing back, despite the persisting regulatory uncertainty. CRISIL believes that the phase of competitive intensity that has pressurised their margins is almost over. Furthermore, the extremely high investment phase is over, and the future requirements for capital expenditure (capex) will be perceptibly lower. Both these changes in the environment will lead to an improvement in the balance sheets of large companies in the telecom sector. At the same time, the outlook for new and smaller players is different. The business continuity of the new players has been affected with the Supreme Court (SC) ruling cancelling the 2G licences issued after January 10, 2008. Even if the new players choose to bid for the licences in future, the challenges in the operating environment will continue for the new players in the industry. The operating margin of these players will remain under pressure because of their low pricing power and high operating cost. In addition, their debt levels will remain high impeding any correction in gearing.

CRISIL Insights

CRISIL believes that: n

The mobile telecom sector revenues will grow at 15 to 16 per cent over the medium term.

n

The operating margin of large CRISIL-rated players1 in this sector will improve by upto 500 basis points (bps; hundred bps equals one percentage point).

n

The capital structure of the large CRISIL-rated players is expected to improve with gearing of below 1 time as on March 31, 2014 from around 1.5 times expected as on March 31, 2012 driven by improvement in operating profitability and moderation in capex.

n

The changes in regulatory framework in the sector will remain the key rating sensitivity factor for the CRISIL-rated telecom players.

1.

How has the landscape for mobile telecom players evolved over the past decade? Mobile penetration levels in India have significantly increased over the last decade, and mobile services now reach out to a wide section of the population. Even as this growth in subscribers has taken place, the Indian mobile telephone operators have combatted intense competition, accumulated increasingly high debt levels on their balance-sheets to fund growth, and faced an uncertain regulatory environment. Competition in the sector intensified following the entry of new players in 2008-09 (refers to financial year, April 1 to March 31) and resulting in 10 players per circle compared to an average of 4 worldwide. Intensifying competition led to predatory pricing accompanied by a sharp drop in operating margins. The operators have also had to increase their capex in order to cope with inadequate spectrum allocations compared with international standards. Total bank credit to the sector increased to Rs.910 billion as on December 31, 2011 from Rs.526 billion as on December 31, 2009 following the debt funding of 3G and Broadband Wireless Access (BWA) spectrum blocks in May 2010. This stretched the balance sheets with gearing of over 1 time for most of the players. Furthermore, the ambiguity pertaining to issues such as spectrum pricing and availability, auctioning of new 2G licences, 3G roaming agreements among operators, and procedures for renewal of licences after their expiry, have all led to an uncertain regulatory environment for the telecom operators. While the issues pertaining to the regulatory environment will continue to be relevant till the time they are addressed, issues pertaining to competitive intensity and capital structures for the large CRISIL-rated telecom players are however set to change going forward.

2.

What has been the impact of competitive intensity for mobile telephony in India and what is the expectation for the medium term? CRISIL believes that the period of hyper competition is over. As the new players incurred continuing cash losses, and the large players hiked tariffs in select circles in July 2011, competitive intensity gradually started coming down. This is reflected in the fact that in the last two quarters, the average revenue per user (ARPU) declined by

1 Large CRISIL-rated companies comprise Bharti Airtel Ltd, Vodafone India Ltd, Idea Cellular Ltd, Tata Teleservices Ltd and Tata Teleservices (Maharashtra) Ltd. These players account for nearly 60 per cent of the subscriber base, 75 per cent of the revenues, and two-thirds of the debt in the sector.

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Chart 1: Reversing Trends in ARPU ARPU (Rs./user/month)

160

140

R~4 CAG

%

120

100 Dec-10

Mar-11

Jun-11

Sep-11

Dec-11 (E)

Mar-12 (E)

Mar-13 (E)

Dec-14 (E)

only 2 per cent quarter-on-quarter (q-o-q), compared with 7 per cent q-o-q degrowth a year earlier, and a steep 19 per cent degrowth in 2010-11. CRISIL expects the competitive intensity to come down further with the cancelling of 122 licenses by the SC on February 2, 2012. With expected decline in the number of operators, incumbent operators will be in a better position to hike tariffs. In addition, the new operators whose licences were revoked by the SC order are most likely to raise tariff to cover the higher price determined by the auction process. Consequently, telecom tariffs will increase significantly, resulting in improved profitability for the current operators. CRISIL expects the ARPU to grow at 4 per cent per annum in 2012-13 and 2013-14. This is in sharp contrast to the last three years when the ARPU has declined steeply. The next phase of competitive intensity may emerge over the long-term with the launch of fourth generation (4G) services. However, this phase is unlikely to materialise in the next one to two years as it will need the concomitant development of a facilitating ecosystem for 4G comprising equipment supplies, handsets, and content. Over the past three years, the increase in competitive intensity has resulted in intense pricing pressures in the telecom sector. Currently, the tariffs in India are among the lowest in the world at less than 1 cent per minute as compared to the global average of over 8 cents per minute.

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The tariffs in India fell dramatically after the entry of new players in 2009. They launched services in their circles with disruptive tariff plans and built-in free minutes. The predatory pricing was done with an objective of quickly scaling up the subscriber market share. As a result, the industry’s ARPU has been on a declining trend for the past two years; it declined to Rs.130 as on September 30, 2011 from over Rs.200 as on September 30, 2009 (refer to Chart 1). With a sharp decline in ARPU, the operating margin for the large CRISIL-rated players declined by 900 bps in 2010-11 over 2007-08. However, despite the predatory pricing, the new players have not been able to garner significant subscriber or revenue market share; CRISIL-rated players continue to control a major portion of the market (75 per cent of revenue market share and about 60 per cent of subscriber market share as on December 31, 2011).

CRISIL Insights

Table: Drivers of Revenue Growth (In per cent) Growth rate

2009-10

2010-11

2011-12 (estimate)

2012-14 (CAGR)

ARPU

-23

-19

0.1

4

Subscriber

37

40

14

12

Mobile Revenues

5

12

14

15-16

3. What are the prospects of revenue growth in the sector, given the teledensity of about 80 per cent, coupled with low tariff? CRISIL expects the mobile telecom sector revenue to grow at 15 to 16 per cent over the medium term as compared to a compound annual growth rate (CAGR) of 8 per cent over the past two years, driven by growth in ARPU and subscriber base (refer to table ). Mobile subscriber growth is expected to be 14 per cent in 2011-12, and will be about 12 per cent in 2012-13 and 2013-14. Although, the teledensity as per reported subscriber numbers is about 80 per cent, teledensity as per the visitor location register (VLR)2 norm continues to be low at 50 per cent, reflecting the multiple SIM cards held by some subscribers. However, despite the prospects in rural markets where the teledensity is 35 per cent, the overall subscriber growth rate of 12 per cent will be significantly lower compared to that in the past (40 per cent in 2010-11). This can be attributed to the emphasis on the quality of the subscribers due to stricter subscriber addition norms, and significant decrease in free minutes given out by the players earlier. Although the ARPU has declined steeply in 2009-10 and 2010-11 (refer to table), it is expected to grow marginally in 2011-12 at a CAGR of about 4 per cent between 2012-13 and 2013-14, on the back of expected increase in tariffs by the players and increasing penetration of data and value-added services.

4. What is the expected trend in operating margin? Will the operating margin improve with reducing competitive intensity? CRISIL expects the operating margin for the large CRISIL-rated players to improve by upto 500 bps by 2013-14. This will reverse the declining trend in margins – operating margin fell by 9 per cent between 2007-08 and 2010-11. There are two key reasons for this improved expectation – first, the reducing competitive intensity combined with recent cancellation of 122 2G licences (mainly for the small players) will increase the pricing power of the large CRISIL-rated players, resulting in a 300 bps increase in operating margin. Second, higher contribution of data and value-added services will lead to upto 200 bps increase in operating margin. Along with this, the quality of minutes of usage is expected to improve, and the cost per minute for the large rated players will continue to be low. Let us discuss each of these aspects in further detail: n

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Tariff increase: In July 2011, Bharti Airtel Ltd (Bharti), Vodafone India Ltd (Vodafone), Idea Cellular Ltd (Idea), Tata Teleservices Ltd (Tata Tele) and Tata Teleservices (Maharashtra) Ltd raised tariffs by 20 per cent in selective circles and services. Bharti increased its tariffs in six circles which was 45 per cent of its revenue share, while Vodafone increased it in three circles which contributed 25 per cent to its revenues. Both Idea and Tata Tele increased rates of its off-network calls, and SMS for all new subscribers. CRISIL expects the players to extend the tariff increase to circles with similar characteristics of revenue and subscriber market share.

VLR is a database which reflects the number of active subscribers. Inactive subscribers are those who are either switched-off or moved out of coverage area, not reachable, etc.

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Expected increase in contribution from data and value-added services: The uptake of data and valueadded services is expected to increase to about 18 per cent of the mobile revenues over the medium term. This is because the percentage revenue contribution from data and value-added services for mobile operators in India is low at 11 per cent as compared to the global average of 22 per cent. Furthermore, India has a large growing population in 15 to 30 years age bracket and the penetration of smartphones is increasing.

n

Levels and quality of minutes of usage: CRISIL believes that the minutes of usage for the industry will continue to remain flat at around 330 minutes per month. However, the quality of minutes of usage is set to improve on account of significant reduction in free minutes in the network and aided by the availability of 3G spectrum for the large players. This is because of the fact that the new tariff schemes are no more accompanied with bundled free minutes as was the case about three years back. Smaller players have now realised the importance of extinguishing the extent of freebies provided in order to improve their operating parameters. The focus is clearly shifting to number of active subscribers which contribute to revenues and profits.

n

The cost of operations for the large CRISIL-rated players is expected to be low driven by continued sharing of passive infrastructure (towers, fibre optics), sharing of network (both inter and intra-circle roaming), and outsourcing of other non-core network functions like call centers. These factors have resulted in marked improvement in cost per minute of incumbents over the past five years and would continue to aid them in keeping the cost of operations low.

5. What is the expected level of 3G penetration over the medium term, and how much impact it will have on the players’ operating margin? CRISIL expects the 3G penetration in India to be at least 5 per cent by 2013-14 from about 1.5 per cent currently. 3G penetration in other developing countries like China and Indonesia has steadily grown to about 10 per cent within three years. However, 3G will not have a significant impact on the operating margin. This is because 3G usage per customer is expected to remain moderate due to the high pricing of 3G services. Despite 3G not significantly pulling up the overall ARPU, it will certainly aid in achieving 18 per cent contribution from the data and value-added services to the mobile revenues.

6. What have been the trends in capex and what are the plans over the medium term? CRISIL believes that the high level of capex undertaken in the past will moderate over the medium term owing to high population coverage already achieved by CRISIL-rated players. The combined capex for the rated players for the next three years is expected to be about Rs.230 billion per annum, nearly half of the average in recent years. Majority of the capex will be towards capacity expansion in existing service areas, while about 25 per cent of the capex would be related to 3G (refer to Chart 2). CRISIL rated players paid about Rs.388 billion for 3G and BWA spectrum blocks in 2010-11. This resulted in an average capex of about Rs.4503 billion per annum for the CRISILrated players over the last three years.

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Excluding acquisition of Zain Africa at about Rs.400 billion in 2010-11.

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CRISIL Insights

Chart 2: Break up of future Capex

Future Capex

n n

n

65% - Increasing Geographical reach Capacity expansion in Tier 2 cities Enterprise services

Expansion – 90% n

Maintenance – 10%

25% -3G relaed - Transmission backend - Upgrading BTS - Back haul data capacities

*BTS refers to Base Transceiver Station

7.

What are the cashflow implications for the large CRISIL-rated telecom players in the light of these capex plans? The trend of negative free operating cashflows (FOCF) of the past five years will change over the medium term. CRISIL expects an improvement in FOCF from 2011-12 onwards, driven by a combination of lower capex and higher earnings before interest, tax, depreciation and amortisation (EBITDA). Since 2006-07, high capex and declining operating margin have resulted in negative FOCF for CRISIL-rated players. With Rs.400 billion spent for acquisition of Zain Africa by Bharti, and Rs.388 billion paid for 3G and BWA spectrum blocks in 2010-11, the aggregate FOCF for CRISIL-rated players reached an all-time low of negative Rs.828 billion. The capex for the rated players for next three years is expected to be moderate at about Rs.230 billion per annum. Along with this, the EBITDA is expected to improve to an average of over Rs.425 billion per annum over the next three years from an average of Rs.264 billion per annum over the last three years. FOCF is thus expected to be marginally positive in 2011-12 and significantly positive in 2012-13 and 2013-14 and would support debt repayments (refer to Chart 3).

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Chart 3: FOCF to Turn Positive for Large CRISIL-rated Telecom Players FOCF for rated companies

350

150

Rs. Billion

(50)

2007

2008

2009

2010

2011

2012(E)

2013(E)

2014(E)

(250)

(450)

(650) Including Rs. 400 bn spent for acqisition of Zain Africa (850)

8.

Given these trends in FOCF, how will the players’ capital structure pan out over the medium term? CRISIL believes that the improvement in FOCF and the consequent reduction in debt will result in a correction in gearing for the large CRISIL-rated players. The gearing for the rated players is expected to improve to below 1 time by March 31, 2014. The debt-funding of spectrum fees, associated capex, and intense competition have led to weakening of financial risk profiles for the players in 2010-11. This has resulted in an increase in debt levels, and consequently the gearing for rated players increased to 1.57 times (including debt taken for acquisition of Zain Africa) as on March 31, 2011 from 0.78 times as on March 31, 2010.

What is the impact of US dollar/Indian rupee (USD/INR) exchange rate on the credit profile of the players?

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The total debt in foreign currency for the CRISIL-rated players is estimated at about Rs.840 billion and forms about 60 per cent of their total debt as on December 31, 2011. In 2011-12, the USD/INR exchange rate has exhibited substantial volatility; the rupee depreciated by 21 per cent to Rs.54.3 per dollar as on December 31, 2011 from Rs.44.97 per dollar as on April 1, 2011. In the last two months, the rupee appreciated to about Rs.49 per dollar. CRISIL believes that the volatile exchange rate environment can pose significant risks for telecom players. These risks, however, will not impact cashflows immediately since the majority of the foreign currency debt (about 70 per cent) has repayments starting from 2013-14 and about 30 per cent of the debt is fully hedged.

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CRISIL Insights

10. How does the recent cancellation of 122 2G licences by the SC impact the sector dynamics? CRISIL Research believes that the SC decision compounds the regulatory challenges in an industry, which is already grappling with multiple uncertainties regarding spectrum allocation and pricing, merger and acquisition (M&A) norms, and procedures for renewal of existing licences when they expire. Nevertheless, competitive intensity in the sector will reduce, leading to improvement in pricing power for the established players. With the number of operators likely to reduce, incumbent operators will be in a better position to hike tariffs. Moreover, operators who acquire licences under the new process are likely to raise tariffs to cover the higher licence fees. Consequently, telecom tariffs will increase significantly, resulting in improved profitability for the current operators. Some operators whose licences have been cancelled may even choose to exit the business in the wake of the SC verdict, either because of deterioration in their business prospects, or limited possibility of securing additional funding. Foreign investor sentiment towards the sector and availability of funding may also be adversely impacted. (Refer to CRISIL’s press release post cancellation of 2G licences by the SC dated February 3, 2012)

11. What are the implications of the potential regulatory changes that the industry is likely to witness? The National Telecom Policy is expected to be announced in mid–2012. The draft version of the same was published in October 2011 by the Department of Telecommunications. However, the contours that would shape the industry’s future are still not clear. Some of the most critical regulatory changes and their potential impact have been highlighted below:

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Relaxation in restrictive M&A guidelines: The proposed M&A norms allow for upto 60 per cent market share of the combined entity (subject to approval from GoI) along with no restriction on the minimum number of players in a service area. In the light of the cancellation of 2G licences by the SC, the relaxation in the M&A guidelines will not have a significant impact on the sector dynamics. CRISIL believes that the key driver for M&A in the sector is the scarcity of spectrum. Post the SC verdict cancelling 122 licences, more spectrum will be available in the market. The large players may acquire this spectrum through the auction process rather than through M&A. However, it is still not clear if the other players would be allowed to participate in the auction.

n

Favoring spectrum sharing, trading and pooling: The draft telecom policy also provides for allowing spectrum sharing, trading and pooling among the players. This can result in an optimal utilisation of spectrum, leading to synergy in operations among incumbents by increasing their operating leverage (will result in change from capex to operating expense [opex] model). However, the exact framework for this aspect is still under study and is not expected to be implemented over the short term. Key factors in the draft telecom policy which can have a negative impact on the sector over the short term are:

n

One-time-charge for excess spectrum over prescribed limit of 6.2 MHz for GSM players: This will result in possible cash outflows for Bharti, Vodafone and Idea as they have a total of 32.4 MHz, 21.4 MHz and 14.2 MHz spectrum, respectively, over the prescribed limit of 6.2 MHz. Tata Tele will remain unaffected as it does not hold spectrum in excess of 6.2 MHz in any circle. The possibility of this one-time charge and the level of pricing will remain a key rating sensitivity factor.

n

Spectrum re-farming in the 900 MHz band: The telecom companies benefit from spectrally efficient 900 MHz band. Bharti has 59 per cent of its total spectrum in 900 MHZ band while Vodafone and Idea have 42 per cent and 49 per cent, respectively. Replacing the 900 MHz with the 1800 MHz band can potentially result in increase in capex and opex for these operators by 1.5 to 2.0 times than that is required in the 900 MHz. This factor will not pan out immediately as DoT does not have enough spectrum in 1800 MHz for replacement; if at all it is expected to be implemented in phases. The possibility of this factor panning out depends on the ability of the GoI to vacate the 1800 Mhz.

12. What is CRISIL’s outlook on its rated telecom companies? CRISIL expects that for its large rated mobile telecom players, the operating environment will improve, which will result in a correction in their capital structure. The key monitorable for the rated players will be correction in gearing due to improvement in operational metrics, level of capex, foreign exchange losses and any significant outflows due to regulatory changes over the medium term. Outlook on Bharti: Negative CRISIL believes that Bharti will derive significant operational benefits in Africa, but the realisation of these benefits, and reductions in cost, could take longer-than–expected. This is because the African markets are a mix of diverse geographies, socio-political landscapes, and regulatory environments. The rating may be downgraded if the cashflows of the combined business is not in line with CRISIL’s expectations leading to slower-than-expected improvement in debt protection metrics. Conversely, the outlook may be revised to ‘Stable’ if the combined business begins to yield significant and sustained benefits within the expected timeline, or if there is a large equity infusion in Bharti, resulting in a faster-than-expected improvement in the company’s capital structure. Outlook on Tata Tele and Tata Teleservices (Maharashtra) Ltd: Stable CRISIL believes that Tata Tele will continue to receive timely support from the Tata group and technological support from DoCoMo Inc. The outlook may be revised to ‘Positive’ if Tata Tele reports significantly better-thanexpected operational and financial performance, or if its capital structure improves significantly because of largerthan-expected equity infusion. Conversely, the outlook may be revised to ‘Negative’ in case Tata Tele’s capital structure and debt protection metrics deteriorate significantly, or in case of any adverse change in regulations for telecommunication operators. Outlook on Vodafone and its subsidiaries: Stable

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CRISIL’s outlook on Vodafone is partly based on Standard and Poor’s (S&P’s) rating outlook on Vodafone Group Plc (Vodafone Group; rated ‘A-/Stable/A-2’ by S&P). CRISIL believes that Vodafone will continue to receive timely business and financial support from Vodafone Group. The outlook may be revised to ‘Positive’ in case of a significant and sustained improvement in Vodafone’s cash flows and capital structure over the medium term. Conversely, the outlook may be revised to ‘Negative’ in case Vodafone’s business and financial risk profiles are adversely affected, most likely because of increase in competition or adverse regulatory changes. The outlook may also be revised to ‘Negative’ if Vodafone makes larger-than-expected debt-funded investments, or if its financial risk profile deteriorates as a result of the company sharing any income tax liability on Vodafone Group’s stake acquisition, or if there is a similar revision in S&P’s rating outlook on Vodafone Group.

CRISIL Insights

Rating drivers for Idea CRISIL’s rating on Idea reflects its strong market position in its established telecom circles, and adequate financial flexibility because of its status as a leading AV Birla group company. CRISIL believes that Idea’s strong market position along with expected increasing contribution from value added services (including data) over the medium term will help it arrest the declining trend in margins. The rating also reflects CRISIL’s expectations that Idea will post stable cash accruals over the medium term driven by its cost competitiveness and steady revenue growth. These rating strengths are partially offset by Idea’s average gearing and debt service parameters, and its exposure to competition in its established service areas. Recent rating action on Sistema Shyam Teleservices Ltd (SSTL) CRISIL placed its rating on SSTL on ‘Rating Watch with Negative Implications’ post SC’s order to cancel 122 unified access service licences (UASL) granted to mobile service operators on or after January 10, 2008. The rating decision reflects CRISIL’s belief that the verdict can potentially impact more than 80 per cent of SSTL’s revenues. CRISIL continues to be in discussions with SSTL’s management, and will remove the rating from watch and take appropriate rating action once it gains clarity on SSTL’s future course of action, with regard to fresh applications for licences, and related funding plans.

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List of Rated Mobile Telecom Players Company Name

Rating

Bharti Airtel Ltd.

CRISIL AAA/Negative/CRISIL A1+

Idea Cellular Ltd.

CRISIL A1+

Sistema Shyam Teleservices Ltd.

CRISIL B+/Rating Watch with Negative Implications

Tata Teleservices Ltd.

CRISIL A/Stable/CRISIL A1

Tata Teleservices (Maharashtra) Ltd.

CRISIL A/Stable/CRISIL A1

Vodafone Ltd.

CRISIL AA/Stable/CRISIL A1+

Vodafone Cellular Ltd.

CRISIL AA/Stable/CRISIL A1+

Vodafone Digilink Ltd.

CRISIL A1+

Vodafone East Ltd.

CRISIL A1+

Vodafone West Ltd.

CRISIL A1+

Vodafone Mobile Services Ltd.

CRISIL AA/Stable/CRISIL A1+

Vodafone South Ltd.

CRISIL AA/Stable/CRISIL A1+

Vodafone Spacetel Ltd.

CRISIL A1+

About CRISIL Limited CRISIL is a global analytical company providing ratings, research, and risk and policy advisory services. We are India's leading ratings agency. We are also the foremost provider of high-end research to the world's largest banks and leading corporations.

About CRISIL Ratings CRISIL is the largest credit rating agency in India. CRISIL pioneered ratings in India more than 20 years ago, and is today the undisputed business leader, with the largest number of rated entities and rating products: CRISIL's rating experience covers more than 46,496 entities, including 24,850 small and medium enterprises (SMEs). As on December 31, 2011, we had more than 16644 ratings (including over 8000 SMEs) outstanding. CRISIL Privacy Notice CRISIL respects your privacy. We use your contact information, such as your name, address, and email id, to fulfill your request and service your account and to provide you with additional information from CRISIL and other parts of The McGraw-Hill Companies, Inc. you may find of interest. For further information, or to let us know your preferences with respect to receiving marketing materials, please visit www.crisil.com/privacy. You can view McGraw-Hill’s Customer Privacy Policy at http://www.mcgrawhill.com/site/tools/privacy/privacy_english. Last updated: 31 March, 2011.

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