Reduce Bharti Airtel, Idea Cellular: Emkay

• Hyper competition to keep voice ARPM under pressure. Lower subscriber adds to impact traffic growth. Meaningful contribution of data is still far, high 3G tariffs offer room for further cuts.
• Margins and profitability to remain under pressure due to intense pricing competition and network expansion. RIL’s possible entry into voice to limit tariff hike.
• Valuations near historic lows are justified given the decline in profitability & low business returns, with no visible signs of turnaround in near term. Spectrum renewals and other regulatory payouts to further weaken the balance sheet
• Further cut earning est. for Bharti & Idea and downgrade the stocks to REDUCE with revised TP of Rs228 & 72, resp. Regulatory concerns to remain overhang on the sector.

Subscriber addition for the industry declined to 19mn in Q1FY13 v/s 21.5mn in Q4FY12 (share in net adds for Bharti increased from 20% to 40% in Q1FY13). Telecom industry is expected to report 4% qoq growth in Q1FY13, driven by 4% qoq growth from Bharti. On the back of lower subscriber addition and stable MoU/sub going forward, we estimate industry traffic growth at 10%/8% yoy in FY13E/14E v/s 13% in FY12. Slowing voice growth and muted data growth is a cause of concern in highly competitive voice market.

Competitive intensity to keep voice realizations under pressure

Industry has once again started to witness pricing pressure in Q1FY13 after two quarters of respite. Multiple factors which led to decline in ARPM during Q1FY13 were 1) Increase in service tax, 2) Trai’s recos on combo packs and 3) Bharti’s aggressive pricing strategy. We believe pricing pressure would continue to prevail in voice segment as Bharti’s aggressive pricing strategy has started to show results and operators like Uninor & Tata DocoMo are aggressively campaigning cheap voice services.

Margin contraction: The biggest worry

Increased pricing competition, higher marketing spends and continued network expansion has resulted in margin contraction. Marketing spends across the industry increased as subs addition has fallen and incumbents are aggressively trying to maintain share in net adds. Higher investments in network to boost data demand & to improve service quality, thereby increasing network opex. Going forward, we expect EBITDA margin for incumbents to remain under pressure. Muted revenue growth with increasing cost (Network opex and SG&A) would continue to impact operational performance.

Regulatory risks remain, RIL’s possible entry in voice to restrict tariff hike

High reserve price, spectrum re-farming and one-time spectrum charge will be significantly negative for the incumbents. Spectrum re-farming would be key dampener for the sector, if implemented. Regulatory overhang continues to cast shadow over the sector. RIL’s possible entry in voice segment (participation in auction or acquisition) is likely to be negative for the incumbents. Current proposal of deferred payments could be an incentive for RIL to participate in upcoming auction. RIL’s entry would not lead to further price disruption but could limit the upside in tariffs in near to medium term.

Outlook

Looking at the current state of the industry where 1) subscriber additions have fallen significantly, 2) churn rate remains high, 3) pricing pressure continues to prevail due to competition, regulator’s intervention and increase in service tax 4) regulatory uncertainties are not coming to an end and 5) operators are unable to pass the high cost to subscribers, leading to continuous fall in profitability; we believe margin and pricing pressures would continue to prevail in the industry in the near term as operators are not in a position to pass high cost to subscribers due to high elasticity towards usage.

Industry has been talking about tariff increase post 2G auction but we believe tariff hike in near term remains unlikely due to multiple factors explained above. If RIL or Uninor bid at the current price (which is still very high, in our view), it would restrict tariff hike from incumbents post 2G auction.

We believe if Uninor participates in upcoming 2G auction it would not lead to a tariff hike as it has only low end prepaid subscribers on its network, which would not welcome tariff increase at low quality of network. Secondly, incumbents would increase tariffs during the course of renewals and not at one go, unlike the last fiscal. This time, tariff hikes would be gradual and timed with spectrum renewal.

3G tariff (which still remains at significant premium to 2G data prices), high cost of 3G handsets and weak network quality would continue to be a barrier for incremental subscriber addition on network. We see further room for cut in 3G tariffs, otherwise operators would continue to lose money on spectrum and network investment.

Valuations

Post Q1FY13 results, Bharti Airtel and Idea Cellular have under-performed broader markets by 18% and 10% respectively. Both Bharti and Idea are still trading at premium to Sensex despite weak operational performance and mute outlook on margin expansion in near term. We remain cautious and downgrade Bharti and Idea to reduce from hold. Telecom stocks are trading at close to historic low valuations, which we believe is justified given the current operational performance, low business returns and muted outlook on revenue growth and margin expansion. RoE and RoCE for Bharti and Idea are currently in single digits and are expected to remain so going forward as well. Payout towards regulatory demands in future is expected to further leverage balance sheet and impact cashflows.

Bharti: Bharti has underperformed broader markets due to muted revenue growth and margin contraction in both domestic and African operations. Bharti is trading at a significant discount to its long term EV/EBITDA multiple of 8.7x, which we believe is justified on the business returns. Increased pricing pressure, lower than anticipated uptick in 3G contribution, regulatory risks and risks from RIL are expected to remain a drag on Bharti.

The concerns have increased over the operational performance in the near term. Weak KPI’s in both India and Africa are acting as a double edged word for Bharti. Muted revenue growth and EBITDA margin contraction in India and similar scenario in Africa (with additional burden of ~$9bn debt) is concerning at current juncture. We believe IPO of Bharti Infratel would take some time and proceeds from that would not reduce debt in meaningful manner.

We have revised our estimates downwards for Bharti. We cut ARPU assumption for Africa and increase costs for both India and Africa operation, leading to 2.3%/3.7% cut in EBITDA for FY13E/14E. Our revised earnings stand at Rs9.2/13.5 for FY13E/14E.

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