Spectrum order risk for telcos; Bharti top pick: JM Fin

The cabinet on Friday had fixed a minimum base price of Rs 14,000 crore for the auction of telecom spectrum. While there has been mixed reactions from the street, Sanjay Chawla of JM Financial believes the litigation remains a real risk for the telecom sector.

According to Chawla, telecom companies can challenge the order on grounds of lack of spectrum auction. Talking about the various telecom players, Chawla said RIL may not acquire spectrum and launch Greenfield operations. It would be more logical for RIL to acquire an existing operator, he added.
Other major telecom operators like Bharti Airtel and Vodafone is likely to be impacted when their licenses are up for renewal, Chawla told CNBC-TV18. It might impact tariffs by 25-30% if a complete pass through is assumed. However, he keeps Bharti amongst his top picks in the telecom sector and recommends investors to stay away from Idea till its bidding strategy is clarified.  Below is the edited transcript of the interview on CNBC-TV18. Q: All the telecom companies are up in arm saying that they will take the government to court, do you see litigation as a real option?
A: Absolutely, because companies have been talking about taking on the government from a legal point of view ever since the Supreme Court (SC) verdict came out and their review petitions were not accepted by the SC. Now ofcourse the final proposals are out from the cabinet and the final decision has been made.
There are two-three grounds of litigations. One is the restriction in the supply of spectrum. Even though about 20 megahertz has been cancelled based on the SC verdict, government is only auctioning 10-13 megahertz of spectrum. There is a scarcity which is apparently being created.
Secondly, a high spectrum price in our view is against the public policy and also against the spirit of a free and fair auction. It is preventing market from discovering the true value of the spectrum. So on both these grounds, there is ground two challenge, there is room to challenge the cabinet decision. Q: How do you see the auction proceeding? What is your sense of how early or when the timing of the auction could be and do you think there is a realistic probability of the auction actually bombing?
A: On the timing, clearly, auction will not be completed in the next 20-30 days as per the previous deadline. I guess it is very likely that auction will now happen in the October to December quarter and government will probably ask for an extension to the existing deadline in the next week or so.
Also in terms of how successful the auction will be, a lot depends on the position taken by the potential bidders, by companies like Uninor, Idea Cellular and also Sistema. At this point of time, there seems to be an even matching of supply and potential demand.
But, if a new entrant jumps into the fray from a pure Greenfield operator, then I think the bids could go higher. Otherwise, there is a good chance that in some of the circles, not all the spectrum which is on auction will get picked up.
_PAGEBREAK_ Q: You are probably alluding to Reliance, do you think that will play a key role in how the auction pans out and what kind of prices are eventually achieved?
A: That is clearly a wild card or swing factor right now. Fundamentally, we believe that it may not make too much sense for Reliance Industries to buy 1,800 megahertz Greenfield and launch a Greenfield operation. It would probably make more sense for them to acquire an existing operator.
That would be cheaper compared to acquiring Greenfield spectrum and then rolling out a brand new network. That is clearly the swing factor. If Reliance Industries also wants to participate in the auction then there could be excess demand, which could take the prices higher than even the cabinet reserve price. Q: How do you see the large players like Bharti and Vodafone approaching the auction, can they take a stance that they will not bid and stay away or do you think they cannot afford that luxury?
A: As far as the large players like Bharti and Vodafone are concerned, their existing spectrum holdings and licenses have not been impacted by the SC verdict. They are not under any pressure or compulsion to bid for the spectrum which is on offer this year.
It is basically Idea and Tata Tele and also Uninor whose licenses have been impacted and who, we believe, are the potentially serious participants in the upcoming auction.
As far as Bharti and Vodafone are concerned, they will be impacted mostly because of the impact or the implications on the renewal pricing – their licenses are coming up for renewal in 2014, 2015 and 2016. So the auction discovered price this year is likely to be used as a benchmark for pricing spectrum at the time of renewal.
They will be impacted, so obviously they won't participate in this year's auction but, they will be impacted if the auction discovered price turns out to be much higher than the reserve price. Q: What about the impact on tariff which a lot of the players have been warning about, do you see tariffs going higher?
A: If the industry has to completely pass on this burden of higher spectrum charges to consumers, then our estimate is that at the reserve price decided by cabinet the impact on tariffs would be around 25-30% on outgoing call tariffs. But, it is very difficult for the industry to pass on the entire burden in the near-term.
If you see the schedule of payments for spectrum, it is actually spread over the next ten years because that is linked to the timing of renewal and license extension. So not everybody will have to pay a high price for the spectrum and at the same time.
That is why we won't see the entire burden being passed on immediately. That will only happen if the spectrum holdings of all the operators gets repriced and paid for simultaneously. Q: Where does this leave the listed space, given these developments how would you approach the universe of listed stocks?
A: Our view is that a lot of the downside is already in the stock price. Although from the regulatory uncertainty point of view, these are just one-two layers which have been peeled off the onion. There are a lot of other aspects which have to work through.
Things like what would be the escalation rate which should be applied on the auction discovered price because Bharti and Vodafone will have to pay for renewal after three-four years. If today's price is going to be used as a benchmark, what kind of escalation rate would be applied? Will the government go for a nominal 5-6% annual escalation rate or will they go for 10-12-13% kind of a rate? A lot depends on these variables.
If you assume 5-6% kind of a rate, then we believe that a lot of the downside is already in Bharti's stock price. Our target price is Rs 380. It will not be impacted much unless the escalation rate used is in excess of 10%. Our preference is for Bharti if the downside risk is that the government may use higher escalation rate.
In that case smaller operators like Idea would be impacted much more. At this point in time, we would want to stay away from Idea, at least till their bidding strategy becomes clear and the auction discovered price is baked into the renewal cost. Our preference is clearly for Bharti right now.
_PAGEBREAK_ Q: Where does this leave Reliance Communications because that has done quite badly from a stock perspective after the Flag Telecom IPO got pulled out?
A: They have got other operational issues and funding issues to deal with. But, I guess there is a lot of uncertainty which is hanging over Reliance Communications because there is a litigation going on against the dual technology or the GSM allocation to both Tata and RCOM. If the SC verdict were to be adverse for them, that would be very negative for the stock price.
Even Tata and RCOM would be asked to pay the auction discovered price to continue their GSM operations. So there is lot of risk which is not priced in even now in the RCOM share price.