India Telecom Still Ringing Strong PhillipCapital (India) Pvt. Ltd.

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1 India Telecom Still Ringing Strong PhillipCapital (India) Pvt. Ltd. 19 July 2013 We find that the Indian Telecom sector is breaking away from an EBIDTA margin dilutive and diminishing capital efficiency trend of FY08 FY12/13 to a margin accretive trend backed by improving capital efficiency. The improvement in EBIDTA margins and capital efficiency will translate to a significant re rating of the sector over the medium term. We rate Bharti Airtel and Idea Cellular as our Conviction Buys with price targets of Rs 430 and Rs 190 respectively implying upsides of 32% and 26% respectively. Our key reasons are as follows: Sustainable minutes growth at a lower cost: The consolidation in the sector and penetration in rural areas will help the incumbent telecom operators to register robust minutes growth over FY13 15E. Sector consolidation while reducing the multi SIM usage phenomenon will not only help the incumbent operators to grow minutes at a rapid pace, but will also help in reducing churn. We note that the sector has a very high sensitivity of cost savings due to reduced churn. Thus, while the sector will continue to register robust minutes growth but the growth will be at a significantly lower cost and will be margin accretive. The return of pricing power: Pricing power is clearly returning to the sector. We note that the discount between the card rates (headline tariffs) and market operating rates is 38% and market consolidation is reducing the gap rapidly. In our recent channel checks we have noted that 3 rounds of tariff hikes have been effected in certain circles and more hikes are expected in the near to medium term. The operating leverage benefits for Bharti and Idea cellular are immense and each Rs 0.01 improvement in RPM translates to an increase of 3.6% and 6.6% in EBIDTA for Bharti Airtel (India & SA) and Idea Cellular respectively. Strong growth in 3G services augur well for margins: 3G services in India are at an inflection point. The proliferation of smart phones is increasing at a rapid pace as internet based applications like Facebook, Whatsapp, Linkedin and others are fast gaining traction. Operators, handset vendors, retail outlets and even application providers are encouraging proliferation of data. We expect the sector 3G revenues to grow by 4x over FY13 15E and contribute to 5% of the sector revenues. Improving capital efficiency and imminent re rating: The sector is now at unique positioning where EBIDTA growth will be faster than revenue growth while capex will not increase substantially. Historical data clearly shows that telecom stocks outperform during the periods of rising EBIDTA margins and improving capital efficiency. Thus, the sector will now see a virtuous cycle of profitability growth > (exceeding) EBITDA growth > revenue growth > minutes growth; resulting in continued improvement of valuations. Valuation and Conviction Buy Rating: Bharti Airtel and Idea Cellular currently trade at 5.1x and 7.1x FY14E EBIDTA. We believe that as the sector beats consensus revenue and earnings expectations on account of pricing power and cost benefits; re rating will occur. Bharti and Idea are our conviction Buys for the sector. We rate Reliance Communications as Neutral on account of corporate developments and market expectations of the company being acquired at a significantly higher price helping the stock trade at elevated levels. Companies Covered Idea Cellular CMP Reco Target Price Bharti Airtel CMP Reco Target Price Reliance Communications CMP Reco Target Price Report Priced as of 18 th July 2013 Naveen Kulkarni, CFA, FRM ( ) nkulkarni@phillipcapital.in Vivekanand Subbaraman ( ) vsubbaraman@phillipcapital.in Rs151 BUY Rs190 Rs323 BUY Rs430 Rs147 NEUTRAL Rs160 1 of 84

2 19 July 2013 / INDIA EQUITY RESEARCH / TELECOM SECTOR UPDATE Contents Focus Charts 3 Sustainable minutes growth at lower cost 4 Incremental minutes will be at a lower cost as industry churn is declining at a rapid pace 6 Reduced commissions and tigher subscriber norms imply that lower churn is sustainable 8 Rural subscriber penetration + normal monsoon are tailwinds for subscriber growth 13 Reduced competitive intensity Industry consolidation 15 The return of pricing power 18 Rate Cutters waning discounting 20 First Recharge Coupons reduction in benefits 22 Rate increases rather public and also taken by new entrants 23 Data now at a critical mass rapid growth to continue 25 Quality 3G smartphones available at US$ 100 spot 36 Relative valuation 40 Companies Section Idea Cellular 42 Bharti Airtel 60 Reliance Communication 80 2 of 84

3 19 July 2013 / INDIA EQUITY RESEARCH / TELECOM SECTOR UPDATE Focus Charts EBITDA/min (paisa/min) set to improve as incremental EBITDA/incremental min (paisa/min) picks up FY10 FY11 FY12 FY13 FY14E FY15E FY10 FY11 FY12 FY13 FY14E FY15E Estimates Estimates As both RPM and voice RPM (Rs/min) improve.and the contribution of data to overall revenue increases Voice RPM RPM FY08 FY09 FY10 FY11 FY12 FY13 FY14E FY15E % 18.3% 15.0% 11.6% 8.8% 7.0% FY13 FY14E FY15E FY16E FY17E FY18E Data as a % of revenue RHS Data revenue Sector LHS 25% 20% 15% 10% 5% 0% Estimates Estimates 3 of 84

4 19 July 2013 / INDIA EQUITY RESEARCH / TELECOM SECTOR UPDATE Sustainable minutes growth at lower cost The Indian Telecom sector minutes growth over the last 5 years (FY08 13E) was 26% CAGR. The high growth rate was driven by multiple factors which included: Sharp reduction in tariffs on account of heightened competitive activity Aggressive subscriber acquisition schemes by operators which resulted in multi SIM usage Network coverage and enhancement of reach in rural areas All the above factors resulted in sharp minutes growth but the effect of margins has largely been dilutive. Reduction in tariff results in lower gross margins and thus the growth driven by lower tariffs has largely been margin dilutive in the last five years (growth on account of lower tariffs from FY2003 FY2008 was margin accretive on account of very high elasticity). Similar to reduction in tariffs, multi SIM usage leads to lower margins as significant increase in churn translates to sharp increase in subscriber acquisition costs. While network traffic (minutes) growth has continued to remain robust, recently we have started witnessing a reversal in industry trends of Multi SIM usage on account of stringent subscriber acquisition norms, decrease in channel commissions and stable headline tariffs. Correspondingly the sector growth minutes rate has come down from 37% CAGR over FY08 11 to 12% CAGR over FY11 13E. Minutes growth has moderated but is more sustainable Expect 7% minutes CAGR over FY13 16, with incumbents growing faster at 8% CAGR during the same period. Minute growth for the telecom sector Operator (bn mins) FY08 FY09 FY10 FY11 FY12 FY13 FY14E FY15E FY16E Bharti ,064 1,128 1,185 Growth (%) 67% 28% 30% 12% 9% 10% 6% 5% Minutes market share 24.8% 27.3% 26.6% 26.9% 26.2% 26.1% 26.3% 26.3% 26.3% RCOM Growth (%) 35% 27% 7% 6% 4% 4% 4% 3% Minutes market share 17.8% 15.9% 15.3% 12.7% 11.8% 11.2% 10.7% 10.6% 10.4% Idea Growth (%) 72% 41% 47% 25% 17% 11% 10% 8% Minutes market share 8.9% 10.0% 10.8% 12.3% 13.4% 14.3% 14.7% 15.2% 15.7% Vodafone Growth (%) 52% 38% 35% 21% 13% 11% 7% 5% Minutes market share 14.2% 14.2% 14.8% 15.6% 16.4% 17.0% 17.3% 17.4% 17.4% Others ,095 1,166 1,254 1,306 1,358 Growth (%) 44% 32% 27% 15% 6% 8% 4% 4% Minutes market share 34.4% 32.6% 32.6% 32.4% 32.3% 31.4% 31.0% 30.5% 30.2% Total sector 1,147 1,741 2,297 2,941 3,393 3,711 4,045 4,288 4,502 Growth (%) 52% 32% 28% 15% 9% 9% 6% 5% Estimates Although the minutes growth rate has declined, we believe the addition of minutes in the recent past is more sustainable in nature as the usage is driven by actual addition of customers and not so much by scheme based multi SIM usage trends. We also believe that the penetration and network coverage led growth will continue to remain robust as scope for expansion in the rural markets continues to remain high. The current teledensity in the rural market is around 41% as compared to a teledensity of 139% in the urban markets. We expect the sector minutes to grow at 7% CAGR over FY13 16E but we expect the incumbent operators Bharti, Idea and Vodafone to grow ahead of the market on account of consolidation activity in the market. 4 of 84

5 19 July 2013 / INDIA EQUITY RESEARCH / TELECOM SECTOR UPDATE Minute market share movement for telcos We expect Bharti Airtel to maintain its minute market share. For Idea and Vodafone, we expect minute market share gains to continue from FY % 35% 30% 25% 20% 15% 10% 5% 0% Bharti Vodafone Idea RCOM Others FY08 FY09 FY10 FY11 FY12 FY13 FY14E FY15E FY16E Estimates Market consolidation will help the incumbents in registering minutes growth ahead of the sector. Amongst the operators which have exited wireless business Uninor had developed significant scale of operations with a sizable share of minutes market share of 3.5%. The scale down of operations by Uninor will help the incumbents to register robust minutes growth over the medium term while reducing the competitive intensity will help the incumbents in managing costs. Rationalization of Gross additions is reducing acquisition costs 1,200 1, ,141 Gross adds Net adds FY09 FY10 FY11 FY12 FY13 FY14E FY15E FY16E Estimates It is important to note that the industry is now seeing a structural improvement in subscriber additions which is also accompanied by reduction in costs. Subscriber churn has a profound impact on the profitability of telecom companies. Subscriber churn results in both direct and indirect costs which tend to bloat the cost structure of a telecom company. 5 of 84

6 19 July 2013 / INDIA EQUITY RESEARCH / TELECOM SECTOR UPDATE Monthly subscriber churn has returned and will remain at pre hyper competitive intensity levels 16% Bharti Vodafone Idea Rcom Others Total sector 14% 12% 10% 8% 6% 4% 2% 0% FY09 FY10 FY11 FY12 FY13 FY14E FY15E FY16E Estimates Industry consolidation and stringent customer acquisition norms have resulted in a significant reduction in customer churn. We believe the industry will see significant longterm benefits because reduction in churn on EBIDTA margin and earnings accretion. Incremental minutes will be at a lower cost as industry churn is declining at a rapid pace We believe that the telcos are likely to witness a trend of improving EBITDA/min on account of declining churn leading to stable cost structure and increased contribution of data revenue. EBITDA/minute for the telecom industry to pick up Bharti Airtel Idea Cellular Vodafone India FY09 FY10 FY11 FY12 FY13 FY14E FY15E We expect a significant pickup in incremental EBITDA/min in FY14 as the industry will see reduced churn play out on a full year basis. Also, we expect the incremental EBITDA/min to continue to improve on account of strong growth in data services. 6 of 84

7 19 July 2013 / INDIA EQUITY RESEARCH / TELECOM SECTOR UPDATE as FY14 will see a sharp pickup in incremental EBITDA/min (paise/min) Incremental minutes to come from (1) continued addition of active subscribers, largely from rural areas, and (2) higher usage by existing customers (5.0) Idea Cellular Bharti Airtel Vodafone India FY10 FY11 FY12 FY13 FY14E FY15E Incremental minutes growth for telecom operators will be driven by two major factors. Addition of VLR subscribers driven by additions in rural parts which continue to remain under penetrated Increase in usage by existing subscribers We believe scheme based minutes growth and daily shopper phenomenon will decline over the medium to long term which will improve the predictability of minutes growth. While we expect minutes growth trend to continue to remain robust we also expect a decline in the cost of acquisition of additional subscribers due to the following reasons: Reduction in channel commissions Reduction in churn means lower gross additions and the subscriber stays on the network longer Reduction in promotional offers on customer acquisitions Increase in prices on First recharge vouchers All the above mentioned initiatives are translating to lower customer acquisition costs and addition of minutes at significantly lower costs. Apart from addition of minutes by new subscribers, minutes are also added by existing subscribers and it can generally be assumed that the additional minutes consumed by mature subscribers grow in line or marginally lower than the real GDP growth rate. While minutes added by existing and mature subscribers grow slower than the market growth rate but it is important to note that the profitability from such additional minutes is significantly higher than the company s margins. Hence, considering the above mentioned factors, we believe that the minutes growth while continuing to remain robust are moving away from a long term trend of margin dilutive growth to a margin accretive trend over the medium term to long term. 7 of 84

8 19 July 2013 / INDIA EQUITY RESEARCH / TELECOM SECTOR UPDATE Reduced commissions and tigher subscriber norms imply that lower churn is sustainable We believe that the reduced industry churn on account of the actions taken by the telecom industry and the regulator is sustainable. Below, we highlight these changes and explain why the reduced churn trend is sustainable. Idea s management mentioned in their results conference calls that the recent changes have been made to ensure that (1) new SIM discounting is curbed dummy activations curbed as retail commissions rationalised, (2) attractiveness of recharge vis àvis new connections thus ensuring that customers who go for a recharge don t end up buy a new SIM (rotational churn) Telcos have cut both OTF as well as scheme commissions Also, slab based commissions (volume linked) have been replaced by a flat per connection incentive Activation retailer commissions are down by ~30% From our interactions with retailers across various circles, we find that commissions on activation of new connections are down by ~30%. This change was initiated by operators in Q2FY13 (August September 2012) and was implemented on a pan India basis by Q3FY13. The results of this exercise were seen in a sharp decline in gross adds, negative net adds and sharply lower commission spends by telcos. Earlier retailer commissions were volume linked and were offered in a slab wise manner, now telcos have largely substituted the same with a flat incentive structure. For new SIM cards retailer commissions are two fold An on the fly commission (OTF) offered to retailers immediately on the sale of SIM cards A month end scheme commission which takes into account SIM card activation targets for retailers. For example, in the earlier structure, for a new SIM card bundled with a First Recharge Coupon (FRC) having an MRP of Rs 39, the OTF would be Rs 25 and the scheme commission would be say Rs 15. Telcos use a term landing cost, which equals the MRP net of OTF and scheme commissions to the retailer. A negative landing regime existed earlier as explained in the example below: a negative landing of Rs 1 (which the case discusses) implies that the retailer makes money (Rs 1 in this case) even if he/she doesn t recover the MRP of the SIM and the FRC. Talk time for available for customers is additional and in this case is Rs 24, which has also been revised downwards to Rs 10. Illustration of on the ground changes as highlighted by channel partners In Rs, unless mentioned Prior scenario Current scenario SIM card MRP (Rs 10) + Rs 29 FRC (a) One the fly commission to retailer (b) Scheme commission (c) 15 8 Landed cost of SIM (d) = (a) (b) (c) 1 11 Landing with free SIM 11 1 Commission payout Drop in commission 30% Talk time available (over and above commission) 24* 10* Source: PhillipCapital Research, Company * Discounted rate benefit of local calls at 35p/min for 30 days available; earlier this benefit was 30p/min for 30 days Now, we find that there have been commission reductions at both levels the OTF and the scheme commission. Scheme commission structure too has been altered from a slab based system to a flat commission structure. For the above FRC bundled SIM card with MRP of Rs 29, the OTF has been reduced to Rs 10 and scheme commission flat at Rs 15. This implies a positive landing of Rs 4. The talk time available for the customer has been reduced to Rs 10 along with a reduction in benefits (as we discuss in the changes in the First Recharge Coupon). Below are case studies explaining the new landing regime. We highlight that the final landing, i.e. minimum landing considering the SIM card to be free, is the highest for the dominant operator in the circle; Vodafone in Gujarat circle. 8 of 84

9 19 July 2013 / INDIA EQUITY RESEARCH / TELECOM SECTOR UPDATE Case study 1 Vodafone s FRC and landed cost computations in Gujarat FRC* MRP > (1) OTF > (2) Plan voucher (including SIM cost)# > (3) Landing cost > (4) = (1) (2) + (3) Slab scheme (commissions) > (5) 2 to Landing after slab scheme > (6) = (4) (5) 2 to Final landing > (minimum landing) Landing limit Talk time Customer payment for SIM + FRC + plan voucher > (1) + (3) Source: PhillipCapital Research, Company Case study 2 Airtel s FRC and landed cost computations in Gujarat FRC MRP > (1) OTF > (2) Plan voucher (including SIM cost) > (3) Landing cost > (4) = (1) (2) + (3) Slab scheme (commissions) > (5) 2 to Landing after slab scheme > (6) = (4) (5) 2 to Final landing > (minimum landing) Talk time Customer payment for SIM + FRC + plan voucher > (1) + (3) Source: PhillipCapital Research, Company Case study 3 Idea s FRC and landed cost computations in Gujarat FRC MRP > (1) OTF > (2) Plan voucher (including SIM cost) > (3) Landing cost > (4) = (1) (2) + (3) Slab scheme (commissions) > (5) 2 to Landing after slab scheme > (6) = (4) (5) 2 to Final landing > (minimum landing) Talk time Customer payment for SIM + FRC + plan voucher > (1) + (3) Source: PhillipCapital Research, Company 9 of 84

10 19 July 2013 / INDIA EQUITY RESEARCH / TELECOM SECTOR UPDATE Volume based commissions replaced by a flat fee We also note that the prior model of volume based retailer incentives has largely been replaced by a flat fee. The earlier commission per gross add was resulting in significant wasteful gross adds as retailers would attempt to fulfill their targets to earn commissions as per the highest slab. Example of a prior slab based commission structure Commission per Gross add (Rs) other incentives/schemes Over 100 Source: PhillipCapital Research, Company Number of SIMs sold in the month The new scheme commission structure implies a flat Rs commission per gross add, which is significantly lower than the earlier slab Regulatory developments have made customer acquisition process far more stringent Customer acquisition process is now far more stringent The Department of Telecom (DoT) had revised the verification guidelines for new mobile connections. The changes mentioned are as under: New connections require a detailed Customer Acquistion Form (CAF) along with Proof of Identity and Proof of Address. Connections to be activated only after CAF and identity/address proof verfied by an employee of the telco. These details have to necessarily be part of the databases maintained by telcos. After SIM activation, the subscriber needs to tele verify details of the CAF and the same needs to be compared with the records in the database. SIM use is possible only after tele verification of subscriber details. Individual customers can only be sold 9 connections; beyond this the customer will be treated as a bulk consumer. The DoT had mandated levy of hefty penalties on telcos in cases of non compliance of the above norms and has also specified several other operational details making the customer acquisition process far more thorough (Details of regulatory interventions are mentioned in the Appendix). We believe that this regulatory intervention has played a key role in curbing rotational churn and now a significant proportion of new connections added by telcos is for genuine users rather than rate shoppers or bargain hunters. leading to decline in subscriber base, while active subscribers continue to grow The commission cuts and stringent subscriber verification norms for new connections resulted in a decline in net adds industry net adds were negative from July 2012 to Feb 2013 while March 2013 saw a bounce back and saw a positive net subscriber addition. While net adds declined marginally in April 2013, we note incumbents continue to add subscribers. Between July 2012 and now, the industry continued to add active subscribers, with active subscriber count falling only in November 2012 (the month when the new verification guidelines were implemented). 10 of 84

11 19 July 2013 / INDIA EQUITY RESEARCH / TELECOM SECTOR UPDATE Industry Subs and VLR proportion 1, Industry subs (mn) Industry VLR proportion (%) Source: TRAI, PhillipCapital India Research May 12 Jun 12 Jul 12 Aug 12 Sep 12 Oct 12 Nov 12 Dec 12 Jan 13 Feb 13 Mar 13 VLR subs (mn) Apr 13 86% 84% 82% 80% 78% 76% 74% 72% 70% 68% Net adds and VLR subs. additions (5.0) (10.0) (15.0) (20.0) (25.0) (30.0) May 12 Jul 12 Net adds (mn) Sep 12 Nov 12 Active subs. net adds (mn) In FY13, while the industry total subscriber count is lower by 50mn, active subscribers increased by 41mn. We note that after a two month adjustment period for the new subscriber verification guidelines, the net subscriber addition and active subscribers addition trends have converged. Additionally, barring seasonal weaknesses, the industry continues to add active subscribers on a monthly basis. Jan 13 Mar 13 Industry churn has already declined and the same is expected to remain at these levels As highlighted earlier, across the board, the result trends clearly indicate that the industry s corrective actions in reducing retailer commissions, customer benefits as well as the regulatory intervention have resulted in an industry wide decline in churn. Hence, incumbents as well as new entrants have seen a sharp decline in churn, as shown below. Telcos have seen churn nosedive 14% 12% 10% 8% 6% 4% 2% Q2FY13 Q3FY13 Q4FY % 8.5% 5.9% 6.9% 6.3% 5.3% 4.3% 3.2% 3.9% 13.0% 12.0% 10.0% 7.3% 5.0% 4.8% 0% Bharti Idea Vodafone Uninor Rcom in keeping with trends witnessed in global markets We analysed churn trends of telcos in various developing markets which are largely prepaid and found that the mean churn level is less than 5%. This implies that the current industry churn levels of ~5% are sustainable and are in keeping with global peers. 11 of 84

12 19 July 2013 / INDIA EQUITY RESEARCH / TELECOM SECTOR UPDATE Globally monthly churn levels are < 5% for prepaid markets 7.0% 6.0% 5.0% 4.8% 4.0% 3.0% 2.0% 1.0% 0.0% Bangladesh Algeria Africa Phillipines Average Kenya Pakistan Turkey Thailand Incumbents accounted for the lions share of industry growth in FY13 Advantage incumbents as the business model becomes less reliant on net adds Owing to the changes witnessed in the sector, we note the industry has already seen a consolidation of sorts. Incumbents garnered 67% & 109% of annual incremental industry minutes in Q3FY13 and Q4FY13 and 185% and 142% of Q3FY13 and Q4FY13 annual incremental revenue. As a result of the increasing customer acquisition cost and declining churn, along with exit of new entrants in Q3FY13 and Q4FY13, we believe that the industry is increasingly becoming favourable for the incumbents. For FY13, incumbents added 97% of industry s active subscribers, 69% of industry minutes and 104% of industry revenue. YoY incremental industry market share of incumbents in FY13 200% 180% 160% 140% 120% 100% 80% 60% 40% 20% 0% Minutes Revenue Active subscribers 104% 97% 69% Q1FY13 Q2FY13 Q3FY13 Q4FY13 FY13 12 of 84

13 19 July 2013 / INDIA EQUITY RESEARCH / TELECOM SECTOR UPDATE Rural subscriber penetration + normal monsoon are tailwinds for subscriber growth While questions are being asked about subscriber growth for the telecom sector, we highlight that there are also underlying tailwinds which can potentially boost revenue growth. Rural telecom penetration continues to languish We observe that telecom penetration in rural areas continues to languish and stood at 39% in Q3FY13. Even this metric may be over stated as the telecom penetration level isn t adjusted for (1) inactive subscribers current industry active subscriber proportion is 83% of industry subscribers, (2) dual SIM behavior. Adjusting for these effects, we believe that actual rural penetration would be ~29% (assuming rural active subscriber proportion similar to that of overall subscribers and 10% of users on dual SIM phones). This clearly indicates that there is significant scope for rural subscriber base to expand and is seen in the annual net adds in CY In CY 2012, while net industry subscriber declined by 62mn subscribers owing to tightening of customer acquisition norms, we note that the industry added 24mn rural subscribers during this period; with a majority of the subscribers getting added by incumbents. Rural telecom penetration remains low Incumbents continue to add rural subs. (yearly adds as of Dec 12) 180% 160% 140% 120% 100% 161% 163% 162% Rural 155% Urban 143% Rural net adds (mn) Total net adds (mn) 80% 60% 40% 20% 37% 38% 40% 40% 39% (5) (10) (15) (20) (25) 0% Q4FY12 Q1FY13 Q2FY13 Q3FY13 Q4FY13 Voda Idea Bharti Uninor Aircel BSNL HFCL Tata Tele Rcom Others Source: TRAI, PhillipCapital India Research Normal monsoon this year also makes the case for resumption of strong growth As observed from past trends, the telecom sector is affected by seasonality and is also reliant on good monsoons for continuing growth. We highlight that this year, monsoons have been bountiful till now and the India Meteorological Department (IMD), has projected a normal monsoon for this year. This is likely to subside inflation, improve growth and facilitate the telecom sector s growth prospects. 13 of 84

14 19 July 2013 / INDIA EQUITY RESEARCH / TELECOM SECTOR UPDATE A normal monsoon is a potential tailwind for the telecom sector Source: IMD, PhillipCapital India Research 14 of 84

15 19 July 2013 / INDIA EQUITY RESEARCH / TELECOM SECTOR UPDATE Reduced competitive intensity Industry consolidation We note that new entrants have scaled down operations in several circles and have also closed down operations in some circles. Recent commentary also indicates that some of the bigger new entrants, viz. Aircel and Tata Docomo are also contemplating closing operations in several circles. ~30% of FY14 incremental minutes of incumbents will come from exits Aircel has scaled down its operations in five circles, while Sistema and Uninor have exited several circles. Below we compute the minutes freed up by the exit of these operators. We estimate freeing up of ~65bn minutes in FY14 due to operator shutdowns Circle Exiting operator Subscribers (mn) Minutes (bn) Expected MOU Comment AP Sistema Exit post Mar'13 auctions Assam Sistema Exit post Mar'13 auctions Bihar Sistema Exit post Mar'13 auctions Gujarat Aircel Operations scale down from Nov'12 Haryana Aircel, Sistema Aircel scaled down ops in Nov'12 & Sistema exited post Mar'13 HP Sistema Exit post Mar'13 auctions J&K Sistema Exit post Mar'13 auctions Karnataka Uninor Scale down in Q3FY13 Tamil Nadu Uninor Scale down in Q3FY13 Kerala Aircel, Uninor Operations scale down from Nov'12 (Aircel) & Uninor in Q3FY13 Kolkata Uninor Exit in Jan'13 Maharashtra Sistema Exit post Mar'13 auctions MP & CG Aircel, Sistema Aircel scaled down ops in Nov'12 & Sistema exited post Mar'13 Mumbai Sistema, Uninor Sistema exited post Mar'13 & Uninor in Feb'13 North East Sistema Sistema exited post Mar'13 Orissa Sistema, Uninor Sistema exited post Mar'13 & Uninor in Q3FY13 Punjab Sistema Sistema exited post Mar'13 UP (E) Sistema Sistema exited post Mar'13 UP(W) Aircel Operations scale down from Nov'12 West Bengal Uninor Exit in Jan'13 Total minutes Source: Company, Media Reports, PhillipCapital India We estimate that ~65bn minutes have been freed up annually on account of the exit of these operators. Incumbents already saw benefits of the closure of operations of new entrants in Q4FY13 and we expect that on a year on year basis, incumbents should continue to benefit from the freed up minutes. As outlined in our minutes model, we expect incumbents to add 245bn minutes in FY14 thus, consolidation activity will result in 27% of minutes addition for incumbents. 15 of 84

16 19 July 2013 / INDIA EQUITY RESEARCH / TELECOM SECTOR UPDATE Assessment of circle wise market share data indicates that consolidation is meaningful across all circles We analyse subscriber and revenue market share data of all 22 circles and find evidence of meaningful industry consolidation. Herfindahl Hirschman Index of subscriber market share and heat map (FY08 13) HHI movement (subs)* FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 Change in FY13 Delhi Mumbai Kolkata Maharashtra Gujarat AP Karnataka TN Kerala Punjab Haryana UP(W) U.P.(E) (0.002) Rajasthan (0.001) MP WB HP Bihar Odisha Assam NE J&K PAN INDIA Source: TRAI, Company, PhillipCapital India Research * Heat map for subscriber HHI is from FY08 FY13. Green indicates higher HHI and red the lowest as shown below Lowest Highest As seen in the heat map of subscriber market share Herfindahl Hirschman Index for the telecom industry, competitive intensity has reduced in all but two circles. In several circles the HHI index indicates that the competitive intensity in FY13 is similar to that witnessed in FY10. This trend is also confirmed from the pan India HHI which is reverting to FY10 levels. The heat map also shows the worst of competitive intensity for the telecom industry was witnessed in FY10 and FY11 and we are now past the peak of competition. In addition, we note that going ahead market concentration is likely to increase, as recent data of industry net additions indicates that incumbents continue to add subscribers while new entrants lose subscribers. Analysis of circle level adjusted gross revenue data reported by the TRAI also confirms and corroborates the above findings. Below, we present time series data of circle wise HHI measured on the share of adjusted gross revenue of various operators. 16 of 84

17 19 July 2013 / INDIA EQUITY RESEARCH / TELECOM SECTOR UPDATE Herfindahl Hirschman Index of gross revenue and heat map (FY08 13) HHI movement + heat map (revenue) FY08 FY09 FY10 FY11 FY12 FY13 Change in FY13 Delhi Mumbai Kolkata Maharashtra Gujarat AP (1.95) Karnataka TN Kerala Punjab Haryana UP(W) (0.27) U.P.(E) (9.16) Rajasthan (0.48) MP WB (3.05) HP Bihar Odisha Assam NE J&K (7.12) PAN INDIA Source: TRAI, Company, PhillipCapital India Research * Heat map for subscriber HHI is from FY08 FY13. Green indicates higher HHI and red the lowest as shown below Lowest Highest As seen in the heat map of subscriber market share Herfindahl Hirschman Index for the telecom industry, competitive intensity has reduced in all but two circles. In several circles the HHI index indicates that the competitive intensity in FY13 is similar to that witnessed in FY10. This trend is also confirmed from the pan India HHI which is reverting to FY10 levels. The heat map also shows the worst of competitive intensity for the telecom industry was witnessed in FY11 and FY12 and we are now past the peak of competition. In addition, we note that going ahead market concentration is likely to increase, as recent data of industry net additions indicates that incumbents continue to add subscribers while new entrants lose subscribers. 17 of 84

18 19 July 2013 / INDIA EQUITY RESEARCH / TELECOM SECTOR UPDATE The return of pricing power Our channel checks indicate that pricing power is clearly returning back to the sector. Analyzing the current tariff structure and the realisations per minute for the telecom operators we have noted that the operators offer steep discount to woo customers and increase usage. We believe that RPM can rise much faster than the market expectations on account of industry consolidation. Gauging the industry wide impact of minutes discounting Voice spending Industry MOU 321 O/w: Outgoing mins. 166 VLR 77.1 GSM prepaid ARPU (Rs) 81.0 Adjusted ARPU (Rs) MOU adjusted 416 O/w: Outgoing mins. (adj.) 215 Local calls on net 85 % of outgoing calls 40% Local calls off net 85 % of outgoing calls 40% Local calls to landlines 4 % of outgoing calls 2% STD calls Mobile 40 % of outgoing calls 19% STD calls Landline 1 % of outgoing calls 1% Discounted has resulted in realised rates being 38% lower than potential at headline tariffs rack rate Calls to mobiles 1.2p/s Calls to landlines 1.5p/s 3.8 Voice rack rate Termination rate of 20p/min on incoming mins Total income from voice Voice RPM (assuming 5% channel commission) Add: Non voice spend (assumed as 10% of revenue) 24.0 Roaming spend (assumed as 5% of rack spends) 8.1 Telecom spend incl. non voice revenue RPM (assuming 5% channel commission) Current industry RPM prepaid (ex interconnect) Current industry RPM prepaid (adjusted for interconnect) Reduction in RPM due to STV's 38% Consumer spend (incl. service tax) Non voice spend (% of revenue) 10.0% Source: TRAI, PhillipCapital India Research According to our channel we have noted that there have been already 3 rounds price hikes and Q1FY14 results are likely to surprise on the realized minutes growth. The first one was undertaken in Jan 2013, followed by one in March 2013 and then a tariff hike as recent as May We have studied the changes in tariffs in various circles and have noted that tariffs have moved by a significantly over the last 6 months. 18 of 84

19 19 July 2013 / INDIA EQUITY RESEARCH / TELECOM SECTOR UPDATE The industry has seen three rounds of tariff hikes, in Jan 2013, March 2013 and another one as recent as May Below, we summarise the best tariffs of popular STV s for the incumbents. While the headline tariffs have remained unchanged but discounting is reducing at a significant pace in the industry. Discounting is a widespread phenomenon in the Indian Telecom Industry. The discounting of tariffs occurs by Special Tariffs Vouchers or by First Recharge Vouchers which allow subscribers to access discounted tariff plans as compared to the headline tariff plans. Special Tariff Vouchers are also commonly known as Rate Cutters in the market place. Rate cutters fall under the purview of usage and retention domain for Telecom operators while First Recharge Vouchers (FRC) are part of acquisition schemes. We believe that the industry will start seeing the impact of these changes from Q1FY14. While there has been a varied increase in publicly available rate cutters, we note that information on customized personal offers is difficult to ascertain. Thus the positive RPM impact of the three rounds of rate cutter tariff changes is difficult to quantify. 19 of 84

20 19 July 2013 / INDIA EQUITY RESEARCH / TELECOM SECTOR UPDATE Rate Cutters waning discounting Rate cutters help the subscribers in availing discounted tariff rates as compared to the headline tariffs. The Rate cutters also aid the Telecom operators in increasing usage and retaining subscribers but the sharp discount in the reported RPM versus the implied RPM (on rack rate basis) is on account of rate cutters and First Recharge vouchers. There are three components to a Rate Cutter: Price of the Rate cutter Validity of the Rate cutter Base tariff plan of the Rate cutter We have noted that all the three components have been changed recently which could result in an increase in Revenue per Minute for the telecom operators. As indicated earlier there have been three rounds of changes for rate cutters which have led to hike in base tariffs, reduction in validity and increase in price of the voucher. Snapshot of rate hikes undertaken by Bharti Airtel Bharti Airtel rate hikes RATE HIKE 1 RATE HIKE 2 RATE HIKE 3 AP Circle (#1; RMS 41.3%) Rate in Dec 2012 (pre rate Rate in Jan 2013 (after rate Rate in March 2013 (after rate Rate in June 2013 (after May hike) hike during the month) hike during the month) 2013 rate hike) Minutes/seconds packs Rs 199 voucher gives Local secs; validity 30 days STD rate cutter Rate cutter (local/std) Rs. 18 STV mobile STD Rs. 0.25/min (First 2 min will be Rs. 0.02/sec) validity 60 day(s) Rs 35 STV giving call rates of 1p/2sec. 30 day validity Rs 199 voucher now gives Local secs; validity 28 days Rs. 18 STV mobile STD Rs. 0.25/min (First 2 min will be Rs. 0.02/sec) validity 8 weeks Rs 35 STV giving call rates of 1.2p/2sec. 28 day validity Rs 199 voucher now gives Local secs; validity 28 days Rs. 18 STV mobile STD Rs. 0.30/min (First 2 min will be Rs. 0.02/sec) validity 8 weeks Rs 53 STV giving call rates of 1.2p/2sec. Landlines at 2.5p/s. 28 day validity Rs 199 voucher now gives Local secs; validity 28 days Rs. 18 STV mobile STD Rs. 0.35/min (First 2 min will be Rs. 0.02/sec) validity 8 weeks Rs 67 STV now gives local calls at 1.2p/2s and STD at 1.4p/2s ( first 2mins of the day at 1.5p/s ). Landlines at 2.5p/s. Validity 28 days UP(W) Circle (#3; RMS 18.8%) Minutes/seconds packs STD rate cutter Rate cutter (local/std) Rate in Dec 2012 Rs28 STV giving 60 free local mins valid for 15 days Rs 6 STV giving all STD calls at Rs0.25min; valid for 30 days Rs33 STV local mobile Rs. 0.30/min, 10 mins free to local minutes each day; validity 28 days Note: The portion in red indicates affected tariff Rate in Jan 2013 (after rate hike during the month) Rs28 STV giving 60 free local mins valid for 10 days Rs 12 STV giving all STD calls at Rs0.30/min; valid for 30 days Rs33 STV gives local mobile Rs. 0.30/min; Validity 28 days (not additional free minutes) Rate in March 2013 (after rate hike during the month) Rs28 STV giving 55 free local mins valid for 4 days Rs 12 STV giving all STD calls at Rs0.35/min; valid for 28 days Rs 33 STV all local mobile Rs 30p/m (between 10 Pm to 5 Pm) & (5 Pm To 10 Rate in June 2013 (after May 2013 rate hike) Rs28 STV giving 50 local mins valid for 4 days Rs 12 STV giving all STD calls at Rs1/3min; valid for 28 days Rs 33 STV all local mobile Rs 30p/m (between 10 Pm to 5 Pm) & (5 Pm To of 84

21 19 July 2013 / INDIA EQUITY RESEARCH / TELECOM SECTOR UPDATE Snapshot of rate hikes undertaken by Idea Cellular Idea Cellular RATE HIKE 1 RATE HIKE 2 RATE HIKE 3 Maharashtra Circle (#1; RMS 34.1%) Minutes/seconds packs STD rate cutter Rate cutter (local/std) Rate in Dec 2012 (pre rate hike) Rs44 STV giving 12,000 local on net seconds free; validity 15 days Rs29 STV giving STD calls at Rs 0.35/min validity 45 days STV of Rs72, local calls at 1.2p/2s; validity 90 days Rate in Jan 2013 (after rate hike during the month) Rs44 STV giving 12,000 local on net seconds free; validity 7 days Rs29 STV giving STD calls at Rs 0.35/min with the first 60 secs daily Rs 2p/s; validity 45 days STV of Rs72, local calls at 1.2p/2s; validity 60 days Rate in March 2013 (after rate hike during the month) Rs44 STV giving 10,000 local on net seconds free; validity 7 days Rs29 STV giving STD calls at Rs 0.35/min with the first 60 secs daily Rs 2p/s; validity 30 days STV of Rs72, local calls at 1.5p/2s; validity 60 days Rate in June 2013 (after May 2013 rate hike) Rs44 STV giving 8,400 local onnet seconds free; validity 7 days Rs29 STV giving STD calls to mobiles at Rs 0.35/min with the first 60 secs daily Rs 2p/s; validity 30 days STV of Rs72, local calls at 1.6p/2s; validity 60 days Bihar Circle (#3; RMS 10.0%) Rate in Dec 2012 Rate in Jan 2013 (after rate hike during the month) Minutes/seconds packs STD rate cutter Rate cutter (local/std) Rs 10 STV giving 20 free local and STD mins; validity 10 days Rs17 STV giving STD calls at Rs 0.3/min; validity 30 days Note: The portion in red indicates affected tariff Rs17 STV giving local calls at Rs 0.4/min (first 60 secs will be charged at 1.2p/s); validity 60 days Rs 10 STV giving 20 free local and STD mins; validity 3 days Rs17 STV giving STD calls at Rs 0.35/min; validity 30 days Rs17 STV giving local calls at Rs 0.4/min (first 60 secs will be charged at 1.2p/s); validity 56 days Rate in March 2013 (after rate hike during the month) Rs 11 STV giving 20 free local and STD mins; validity 3 days Rs17 STV giving STD calls at Rs 0.4/min; validity 30 days Rs17 STV giving local calls at Rs 0.4/min (first 60 secs will be charged at 1.3p/s); validity 56 days Rate in June 2013 (after May 2013 rate hike) Rs 11 STV giving 20 free local and STD mins; validity 2 days Rs17 STV giving STD mobile calls at Rs 0.4/min; validity 30 days Rs17 STV giving local calls at Rs 0.4/min (first 60 secs will be charged at 1.3p/s); validity 50 days Snapshot of rate hikes undertaken by Vodafone India Vodafone RATE HIKE 1 RATE HIKE 2 RATE HIKE 3 Gujarat Circle (#1; RMS 47.0%) Minutes/seconds packs STD rate cutter Rate cutter (local/std) Rate in Dec 2012 (pre rate hike) Minutes pack of Rs250 gave 650 free local and STD mins over 30 days STV Rs31, STD Rs0.30/min; validity 30 days STV Rs39, giving local mobile Rs 0.3/min (First min Rs0.60/day); validity 30 days, Rate in Jan 2013 (after rate hike during the month) Minutes pack of Rs250 gave 600 free local and STD mins over 30 days STV Rs31, STD Rs0.30/min; validity 30 days STV Rs39, giving local mobile Rs 0.3/min (First min Rs0.65/day); validity 30 days, Rate in March 2013 (after rate hike during the month) Minutes pack of Rs255 gives 600 free local and STD mins over 30 days STV Rs31, mobile STD Rs0.30/min; validity 30 days STV Rs39, giving local mobile Rs 0.3/min (First min Rs0.70/day); validity 30 days, Rate in June 2013 (after May 2013 rate hike) Minutes pack of Rs255 gives 500 free local and STD mins over 30 days STV Rs31, mobile STD Rs0.35/min; validity 30 days STV Rs39, giving local mobile Rs 0.4/min; validity 30 days MP Circle (#6; RMS 10.0%) Rate in Dec 2012 Rate in Jan 2013 (after rate hike during the month) Minutes/seconds packs STD rate cutter Rate cutter (local/std) STV Rs119 gives 850 Local onnet mins ; validity 30 days STV of Rs 23, STD Rs0.30/min; validity 45 days STV of Rs31, local on net calls at Rs 0.1/min; validity 45 days, local calls to Vodafone Rs0.10/min Note: The portion in red indicates affected tariff STV Rs119 gives 850 Local onnet mins ; validity 28 days STV of Rs 23, STD Rs0.30/min; validity 30 days STV of Rs31, local on net calls at Rs 0.1/min; validity 30 days, local calls to Vodafone Rs0.10/min Rate in March 2013 (after rate hike during the month) STV Rs119 gives 850 Local onnet mins ; validity 14 days STV of Rs 23, STD Rs0.33/min; validity 30 days STV of Rs31, local on net calls at Rs 0.1/min; validity 19 days, local calls to Vodafone Rs0.10/min Rate in June 2013 (after May 2013 rate hike) STV Rs119 gives 650 Local onnet mins ; validity 14 days STV of Rs 23, STD Rs0.35/min; validity 30 days STV of Rs31, local on net calls at Rs 0.1/min; validity 19 days, local calls to Vodafone Rs0.20/min 21 of 84

22 19 July 2013 / INDIA EQUITY RESEARCH / TELECOM SECTOR UPDATE Changes in First Recharge Coupons Gujarat First Recharge Coupons reduction in benefits First Recharge Coupons are plan vouchers which allow a consumer to avail a discounted tariff on purchase of a new SIM card. These vouchers are applicable only for new customers and they too have seen a reduction in benefits in Q4FY13. Generally, these vouchers are sold along with SIM cards for consumers to enroll to an attractive tariff plan. After rationalizing the process of customer acquisition, in keeping with the November 2012 guidelines of the DoT and reduction of retailer commissions, the telecom industry also reduced the benefits available on first recharge coupons. We note that this change has been made on a pan India basis and to better understand the same, below we highlight the case study of operators in Gujarat FRC Vodafone Idea Airtel Earlier Now Earlier Now Earlier Now 13 Local 30p/min and STD mob at 35p/min for 30 days; talktime (TT) Rs FR 203: Talktime (TT) Rs 0, 600 Local mobile minutes for 30 days Local 35p/min and STD mob at 40p/min for 30 days; TT Rs 0 FR 203: TT Rs 0, 515 Local mobile minutes for 30 days All mob 30p/min for 30 days; TT Rs 10 FR 196: TT Rs 10, 600 Local mobile minutes for 30 days; Loc 30 p/min; Loc off net 35p/min & STD 35ps/mins. Loc I2I 30 p/min ; Loc I2O Mob 40p/min & 35ps/min for 30 Days; TT Rs 10 FR 203: TT Rs 0, 500 Local mobile minutes for 30 days; Loc 30 p/min; Loc off net 40p/min & STD 35ps/mins. TT 9; Loc 1.2p/2sec for 30 days FR 199: TT 9; 600 Local mobile minutes for 30 days TT9, On net Loc 1.2p/2sec; Off net Loc 1.5p/2sec for 30 days FR 199: TT 9; 450 Local mobile minutes for 30 days We note that there have been changes in the several legs of the customer acquisition tariffs For normal acquisition, i.e. in the plan vouchers without the FRC, the tariff is now 1.5p/s instead of 1.2p/s earlier. In FRC s too, several tariffs have changed o o Floor rates of FRC s have increased across operators. Benefits in various schemes, such as STD benefits, local call benefits and per second pricing too have been reduced. These changes are summarized in the below table, where we summarise our FRC & acquisition tariff comparison. Changes in plans Case study: Gujarat Earlier Now Comment Normal acquisition 1.2p/s 1.5p/s Without FRC, plan vouchers provide this call rate Minimum scheme value for 30p/min FRC Rs Rs Dominant operator (Vodafone) has the highest rate Local call rates (minutes scheme) 20p/min & 30p/min 30p/min & 40p/min STD call rate (minutes scheme) 30p/min & 35p/min 30p/min, 35p/min & 40p/min Rates for 30p/min schemes increased & for same FRC Value 35p/min or 40p/min scheme available Per second pricing 1.2p/s 1.2p/s, 1.5p/s & 1.6p/s Off net rates typically higher at 1.5p/s & 1.6p/s 22 of 84

23 19 July 2013 / INDIA EQUITY RESEARCH / TELECOM SECTOR UPDATE Rate increases rather public and also taken by new entrants While we have discussed the rate increases taken by incumbents in the earlier sections, we note that the trend isn t limited to incumbents. Reliance Communciations has been vocal about tariff increases and the below is a timeline for tariff hikes that were publicly announced by the company. 21 st September 2012: 25% tariff increase from 1.2p/s to 1.5p/s RCom mentioned in media reports that the rate increase was for both the CDMA and GSM platforms and the same was implemented in four states including Bihar, MP, Gujarat & HP first (in September 2012) and then rolled out on a pan India basis by the end of October RCom 25% tariff increase from 1.2p/s 1.5p/s mentioned in Q2FY13 results release Base tariff hiked to 1.5p/s even by RCom. The company has also reduced benefits on promotional and concessional offers During the Q2FY13 results conference call, RCom had highlighted that the 1.2p/s to 1.5p/s price increase would be effected on its user base by mid Feb 2013, and had also guided for atleast 2 3 tariff increases in the next months. The company also commented in subsequent quarters that the trend of price increases is less likely to be derailed by smaller players by creating skirmishes on the street (Q3FY13 concall). 6 th May 2013: 20% further tariff increase RCom announced 20 30% increase in tariffs of all commitment plans while cutting promotional and concessional offers by as much as 65%. The company added that there has been no fall in consumer demand in the previous tariff increase. Below are excerpts from the press release. RCom 20% further tariff increase 23 of 84

24 19 July 2013 / INDIA EQUITY RESEARCH / TELECOM SECTOR UPDATE Even other new entrants such as Tata Teleserives too have mentioned that price hikes are likely. Tata Teleservices Maharashtra Limited (TTML) in its annual investor deck presented that they believe that voice RPM increase will occur from strengthening of tariffs and the same has already started happening in leading players. Below, we highlight the company s observations. Tata Teleservices observations on tariff increases March 2013 Even Aircel and Tata Teleservices have made their intentions clear about increasing rates and have also followed incumbents in tariff increases Additionally, even Aircel in a recent media interview commented that it is looking to increase voice rate per minute by 12% over the next one year. 24 of 84

25 19 July 2013 / INDIA EQUITY RESEARCH / TELECOM SECTOR UPDATE Data now at a critical mass rapid growth to continue Industry estimates for data services We estimate that the industry s 3G subscribers will be ~96mn by FY15 from ~28mn in FY13. The sharp growth in 3G subscriber base will be driven by affordable 3G handsets and smartphones, decline in 3G tariffs and increase in consumer awareness. Forecast of 3G subscribers 3G subscribers (mn) FY13 FY14E FY15E Bharti Airtel Idea Cellular Vodafone India Reliance Communications Aircel Tata Teleservices BSNL/MTNL Total subscribers The contribution of 3G revenues will increase significantly over the next 5 years and we expect Bharti with most 3G circles will be the market leader in the space. Bharti will also benefit from 4G revenue growth as the company has spectrum in 2.3GHz in 8 circles. ADD industry data revenue growth estimates 3G rev. as a % of total revenue FY13 FY14E FY15E FY16E FY17E FY18E Bharti Airtel 1.2% 2.6% 5.9% 9.0% 12.7% 15.5% Idea Cellular 1.9% 3.0% 5.2% 7.7% 9.1% 10.7% Vodafone 0.8% 1.5% 3.3% 5.9% 8.4% 11.6% Others 2.4% 3.9% 5.5% 6.9% 9.7% 14.2% 3G revenue as % of total revenue RHS 1.6% 2.6% 5.9% 9.0% 12.7% 15.5% 3G revenue growth will be very sharp for the industry and we believe FY15 will the year of data and 3G services. 3G revenue growth 3G revenue (Rs mn) FY13 FY14E FY15E FY16E FY17E FY18E Bharti Airtel 5,258 12,472 31,887 52,800 82, ,250 Idea Cellular 4,224 7,775 15,808 26,468 34,898 45,047 Vodafone 2,888 6,381 15,567 31,277 49,487 76,654 Others 12,034 21,662 34,700 51,092 83, ,853 3G revenue Sector (Rs bn) YoY (%) 97% 96% 65% 55% 50% 25 of 84

26 19 July 2013 / INDIA EQUITY RESEARCH / TELECOM SECTOR UPDATE 3G economics Increasing data business will improve sector profitability The Increasing data revenue contribution (in particular 3G revenue) is also margin accretive as revealed by a brief comparison of business margins for 2G and 3G. We note that the key to higher 3G/data business margins is the fact that bulk of the 3G revenue is incremental in nature. Network opex of 3G sites are much lower than those needed for the 2G business, as 3G deployments are largely based on co located Node B s which do not even attract incremental tenancy hence network costs for 3G only include active electronics maintenance charges (which might even be volume/revenue linked) and incremental power charges. The sales, distribution and advertising expenses too are much lower for 3G, given that most of the new 3G subscribers are largely existing 2G subscribers who possess smartphones and uptrade. Advertising expenses for 3G are however higher given the need of telcos to educate consumers on the benefits for 3G and various applications. Data business economics favourable % of revenue 2G 3G/Data Comments Roaming & Access charges 16 18% Access charges for 3G applicable only on 3G ICR circles. Network and operating charges 20 25% 10 15% Network costs far lower for 3G as most Node B's are co located with 2G BTS' Sales, distribution & advertising expenses 5 10% 4 7% Incremental SG&A for 3G is purely linked to advertising/product placement Personnel expenses 4 6% 4 6% License fees and Spectrum 10 12% 10 12% Total operating expenses 55 70% 28 40% EBIDTA 30 45% 60 72% Depreciation 10 15% 10 15% EBIT operating profit 20 30% 45 60% Illustration Of The Costs And Benefits Direct And Indirect Associated With The Provision Of 3G Services We are here Service Launch Cash flow Incremental 3G revenues Initial coverage Spectrum Incremental 3G capex+opex Lessening total capex +opex (courtesy of efficiency gains) Source: Company reports; PhillipCapital India Research We estimate that the telecom industry s data revenue grew at 9% compounded quarterly growth rate (CQGR) in FY13 to Rs 30bn. This was driven by rapid proliferation of internet applications and user awareness campaigns by telcos. 26 of 84

27 19 July 2013 / INDIA EQUITY RESEARCH / TELECOM SECTOR UPDATE Data revenue (Rs bn) grew at 9% CQGR in FY % % % % Q4FY12 Q1FY13 Q2FY13 Q3FY13 Q4FY13 12% 10% 8% 6% 4% 2% 0% Data revenue (Rs bn) growth to continue in FY % % 48% % % % 46% 46% % 45% FY13 FY14E FY15E Data revenue Sector QoQ (%) RHS Data revenue Sector QoQ (%) RHS Source: TRAI, Company, PhillipCapital India Research Estimates Source: TRAI, Company, PhillipCapital India Research Estimates Global comps reveal significant headroom for data revenue growth We believe that data proliferation is at its infancy in India and expect rapid data revenue growth from FY Globally, we find that the contribution of data revenues to telecom revenue, even in developing markets such as Brazil and China, are substantially higher than that in India, indicating that there is ample headroom for growth. India lags behind in contribution of data to wireless revenue Expect data contribution to increase from 7% in FY13 to 12% in FY15 We believe that the key factors underpinning data revenue growth are in place and the contribution of data revenue to overall wireless revenue can grow at a fast clip. Already in FY13, we estimate that the contribution of data to wireless revenue in the telecom sector has increased from 6% to 8%. We estimate that this to increase to ~12% in FY15 a conservative estimate in the context of the data revenue contribution in developing market peers. 27 of 84

28 19 July 2013 / INDIA EQUITY RESEARCH / TELECOM SECTOR UPDATE Data revenue contribution grew rapidly FY13 9.0% 7.8% 8.0% 7.1% 7.0% 6.8% 6.3% 6.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% Q4FY12 Q1FY13 Q2FY13 Q3FY13 Q4FY13 Source: TRAI, Company, PhillipCapital India Research Estimates and is set to continue from FY % 11.9% 12.0% 10.0% 9.1% 8.0% 7.0% 6.0% 4.0% 2.0% 0.0% FY13 FY14E FY15E Source: TRAI, Company, PhillipCapital India Research Estimates led by rapid 3G revenue growth The key driver of data revenue growth in our view is going to be 3G. Already in FY13, the sector s 3G revenue grew at a fast clip (> 20% CQGR) and now stands at ~Rs 8bn/quarter. We expect the sector s 3G revenue to grow at ~100% CAGR from FY13 15 led by increased proliferation of affordable smart devices and aggressive promotions by operators. 3G revenue (Rs bn) has grown at a fast clip % % % Q4FY12 Q1FY13 Q2FY13 Q3FY13 3G revenue Sector (Rs bn) Estimates 30% 25% 20% 15% 10% 5% 0% QoQ (%) RHS and we expect the same to continue from FY % % % 20.0 FY13 FY14E FY15E 3G revenue Sector (Rs bn) 3G revenue as % of total revenue RHS Source: TRAI, Company, PhillipCapital India Research Estimates 6% 5% 4% 3% 2% 1% 0% 28 of 84

29 19 July 2013 / INDIA EQUITY RESEARCH / TELECOM SECTOR UPDATE Aggressive push for data usage by several industry participants Operators are aggressively pushing data plans and 3G As highlighted earlier, our lofty expectations of 3G and data revenue growth are predicated on operators aggressively pushing data plans and improvements in the overall Smartphone ecosystem. Following are snapshots of a few of company advertisements observed recently: Vodafone India Internet advertisement Not just incumbents, but even new entrants are doing their bit to promote data usage. The below advertisement of Aircel gives free 3G in the mornings to existing and new consumers Aircel 3G promotional advertisement Source: Company, Media reports, PhillipCapital India Research 29 of 84

30 19 July 2013 / INDIA EQUITY RESEARCH / TELECOM SECTOR UPDATE Tata Docomo s advertisement in Karnataka circle offering 1GB for Rs 250. We found this hoarding while travelling in Karnataka. Tata Docomo 3G advertisement Source: Company, Media reports, PhillipCapital India Research Data promotions are also visible in points of presence at the retail level. We observed the below data offers by Idea Cellular and Tata Docomo in Maharashtra and Gujarat Idea and Tata Docomo data walls Retail point of presence Source: Company, Media reports, PhillipCapital India Research Airtel data offers advertised at a store in Karnataka; offering 200MB of data for Rs 25, valid for 7 days. 30 of 84

31 19 July 2013 / INDIA EQUITY RESEARCH / TELECOM SECTOR UPDATE Airtel Karnataka Data offer Source: Company, Media reports, PhillipCapital India Research with the focus on applications In addition, we find that, in addition to advertising data packs, companies are encouraging customers to use various data applications, viz. Facebook, videos on demand etc. Below is Idea Cellular s free Facebook messenger access offer. Idea is providing free access to Facebook messenger to its prepaid users allowing a data download of upto 200MB and the offer is valid for 3 months. We believe that such trial packs can encourage sampling among consumers, eventually leading to increase in regular data users for telcos. Idea Cellular Facebook offer Below is Airtel s Facebook pack for Rs 31, which gives Facebook usage of 150MB, free data of 50MB and is valid for 15 days. The company has also introduced daily variants of this pack, which cost Rs 3 4 while offering 40MB/day of Facebook browsing in AP, Delhi, Maharashtra, UP(E) and UP(W). 31 of 84

32 19 July 2013 / INDIA EQUITY RESEARCH / TELECOM SECTOR UPDATE Bharti Airtel Facebook offer Below is Bharti Airtel s out of home media advertisement for on demand video downloads. The company aims to simplify internet video downloads by getting consumers to call on a phone number, while charging Rs 1/video. We believe that such advertisements can encourage data usage as most users aren t aware of the value proposition of data for instance, a user browsing 1 hour of youtube might end up consuming far more than one who browses news/ s/facebook/twitter for a similar time. We believe that such ad campaigns encourage users to use data without fearing exhorbitant usage rates while clearly defining the price for a specific benefit, i.e. one video for one rupee. Bharti Airtel Videos on demand for Rs 1 32 of 84

33 19 July 2013 / INDIA EQUITY RESEARCH / TELECOM SECTOR UPDATE Data usage monitoring has been simplified In addition, companies are also making it easy for users to monitor their data usage and contain bill shock. Users are educated of options to top up their existing data commitment plans, when they near the limit so that they are saved from bill shocks which could arise if usage is continued at pay as you go rates. Note that pay as you go 3G rates, even after the rate cut are 1 3p/10KB (i.e. Rs 1 3/MB), while commitment plans offer rates as low as 20 30p/MB. Data use can be gauged by sending a simple text Users notified when they near their their data quota Estimates Estimates 33 of 84

34 19 July 2013 / INDIA EQUITY RESEARCH / TELECOM SECTOR UPDATE Additionally, telcos have also provided tools for choosing data packs We also note that telcos have created data usage calculators helping consumers decide their data packages based on their estimated usage. Below are snapshots of the same Idea Cellular Data usage calculator Vodafone India Data usage calculator 34 of 84

35 19 July 2013 / INDIA EQUITY RESEARCH / TELECOM SECTOR UPDATE And have entered into tie ups for internet proliferation Below is Bharti Airtel and Google have partnered to provide free internet access to Airtel s consumers. Through this arrangement, even Airtel users who currently don t consume data, can (1) search on Google and browse the internet for free, (2) send and read s on Gmail for free, and (3) connect with the contacts on Google Plus. The data limit for free usage per customer is 1GB/month. Bharti Airtel tieup with Google providing free internet access 35 of 84

36 19 July 2013 / INDIA EQUITY RESEARCH / TELECOM SECTOR UPDATE Quality 3G smartphones available at US$ 100 spot Telcos have time and again highlighted that the sweet spot for handset offtake appears to be the sub US$ 100 price point. We note that there are several handset companies that have jumped in the fray, which aggressively target the first time smartphone user. Smartphones are being aggressively pushed by (1) Indian and MNC Smartphone manufacturers, (2) telcos, on their own and through reverse bundling offerings, (3) retail stores I Ball Kareena Kapoor (leading Indian actor) advertisement Micromax Smartphone advertisemen Indian vendors such as Karbonn, Micromax, iball etc, are aggressively pushing budget and mid end smartphones. Byond Bipasha Basu (leading Indian actor) smartphone endorsement Intex smartphones endorsed by Farhan Akhtar (Renowned Indian Film maker and actor) Additionally, even global handset makers such as Apple, Samsung etc, have come out with innovative pricing models allowing consumers to possess handsets through equated monthly installments and give good value on exchange of old handsets. Players like Sony are banking on celebrity endorsements to promote their smartphones. 36 of 84

37 19 July 2013 / INDIA EQUITY RESEARCH / TELECOM SECTOR UPDATE Sony Smartphones endorsed by Kartina Kaif (leading Indian actor) Airtel data bundling offer Apple iphone EMI ads Samsung Cash back advertisement Apple iphone Reverse bundling of data offers Airtel, Vodafone and Idea Cellular. Idea also promotes its smartphones through celebs. 37 of 84

38 19 July 2013 / INDIA EQUITY RESEARCH / TELECOM SECTOR UPDATE Data bundling Karbonn mobile with Airtel mobiles Vodafone Samsung S4 All in one plan Idea branded smartphones endorsed by Mahesh Babu (leading Telugu cinema actor) 38 of 84

39 19 July 2013 / INDIA EQUITY RESEARCH / TELECOM SECTOR UPDATE Offer by The Mobile Store (a mobile retailer) on Samsung mobiles Smartphone offers by Indiatimes Shopping (an online & teleshopping venture) Smartphone offers by Spice Hotspot (a mobile retailer) 39 of 84