Telecom – Daylight Again

16 Apr

Telecom – Daylight Again

Reliance Jio’s (RJIO) launch in FY17 had unleashed one of the most brutal price wars in India’s telecom market. Consequently, industry ARPU plunged ~38%, leading to total industry size shrinking to INR1.4tn from INR1.8tn. However, finally, there’s light at the end of the tunnel as we perceive potent catalysts on the horizon:

1) mobile broadband penetration crossing 50% has rendered monetising of existing customer base more lucrative than chasing incremental market share;

2) price hikes are imminent as RJIO approaches its 400mn subscriber goalpost; and

3) telecom operators’ massive non-core asset monetisation drive, which makes it imperative for investors to repose confidence in the telecom industry’s long-term health.

These, we envisage, to trigger pricing recovery in telecom operators from H2FY20, propelling industry ARPU to pre-RJIO level of INR 156 by end FY22 (INR98 in Q3FY19), in turn catapulting industry size 50%. We expect operating leverage to kick in for Bharti and Vodafone Idea boosting the otherwise subdued EBITDA margin. Among players, we prefer Bharti (BUY) and RJIO over Vodafone Idea (HOLD) due to the latter’s high leverage, low network investments and integration challenges. We see further value enhancement in RJIO .

Penetration reaching the tipping point

We estimate telecom operators to raise prices in H2FY20 as mobile broadband subscriber penetration reaches ~65%. Typically, in a market characterised by low penetration of services, providers’ quest for market share to gain economies of scale drives down prices, fuelling price wars. However, as investment requirements mount and relative attractiveness of balance market wanes, weaker players consolidate and participants start favouring pricing over incremental market share. We have seen this play out in India’s telecom market (FY12-17), in China & Japan post 4G launch and Netflix’s evolution in the US. We believe, while penetration of services is a vital metric, other factors such as the number of players, their leverage, market share aspirations, etc., also impact at the margin.

RJIO close to key subscriber benchmark

RJIO spearheaded the pricing disruption in India. After 10 quarters since launch and achieving 30% revenue market share (RMS), it is important to pause and take stock where the company stands now versus its objectives. RJIO management, during launch, had stated its ambition of 400mn subscribers and 50% RMS in an INR3.0tn market (by FY21 versus INR1.4tn currently) with 50% EBITDA margin. Compared to its aspiration, although the company has 30% RMS and significantly higher EBITDA margin (39% currently) than peers, its RoCE is meagre 3.3% due to high capital employed. Hence, we believe that after achieving one of its key goals—400mn subscribers in H2FY20—RJIO will hike prices to improve return ratios.

Industry deleveraging mandates pricing recovery

We believe, sale of non-core assets by all the three telecom operators will be a key trigger for industry recovery. The telecom industry is saddled with ~INR4tn net debt and 9.0x net-debt to TTM EBITDA. This has prompted massive deleveraging drive by telecom companies by equity infusion (INR500bn) as well as sale of non-core assets (pegged at a staggering INR2,270bn led by RJIO). However, weak financials of telecom operators—customers of fiber and tower assets—could weigh on investors’ appetite in buying these assets. Hence, improvement in ARPU leading to industry recovery is necessary for all operators to deleverage by selling non-core assets. Sale of non-core assets is positive for the industry as besides deleveraging operators’ balance sheets, it will boost capex productivity, thereby reducing capital requirement.

Outlook and valuation

Bharti and Vodafone Idea are trading at 9.2x and 18.1x FY20E EV/EBITDA versus 7.2x and 9.5x five-year average of one-year forward EV/EBITDA multiple, respectively. We attribute the higher–than-historical valuations to: 1) shrinkage in revenue leading to EBITDA margin compression; and 2) higher investments for future revenues leading to ballooning of debt. However, we believe, the industry is on the cusp of revival—to expand to ~INR2tn by FY22 from INR1.4tn currently. This will drive 30% and ~65% EBITDA CAGR for Bharti and Vodafone Idea, respectively.

Bharti, with a strong balance sheet and adequate network investments, is well placed to capitalise on industry recovery. We have separately valued Bharti’s Core India business and Africa business using DCF, and have incorporated the diluted value of Infratel. We maintain ‘BUY/SO’ on the stock with revised SOTP based target price of INR435 (INR 396 earlier) as we revise up revenue on account of higher ARPU.

Although Vodafone Idea has higher operating and financial leverage from India’s telecom industry revival, we maintain our cautious stance considering underwhelming capacity expansion plans and weak data volume traction. Hence, maintain ‘HOLD/SU’ with a DCF based target price of INR18, adjusting for the rights issue.

We continue to believe that RJIO will become India’s largest telecom operator led by the network’s high data capacity driving mobile broadband subscriber market share. We value RJIO at an enterprise value of INR3.0tn, as the triggers driving the value are well defined now: 1) leadership in data volume market share, 2) strong content ecosystem creating customer stickiness, and 3) low-cost structure ensuing high EBITDA margins.

Key risks to our thesis are:

1) RJIO’s much higher market share aspirations & a strong balance sheet which might result in its reluctance to increase prices,

2) early maturity of 5G ecosystem and

3) Vodafone Idea’s precarious balance sheet health could prompt other operators to wrest market share from it by keeping prices low.

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