Poor outlook for telecom sector

Stay away or remain underweight in it to outperform the indices.

Like other industries, Indian telecom suffers from doubtful statistics. There are over 850 million registered mobile numbers. But the way spectrum allocation is structured makes it convenient for service providers to inflate subscribers. A third of these numbers are inactive. Many others are multiple accounts registered to the same user, who finds it convenient to have numbers registered in different circles, or with different service providers, or office and personal accounts. Average revenue per user ( that is, ARPU per registered number) has fallen continuously for years. As a result, margins for service providers have also fallen. There are a dozen players or more in every circle. Very few make money and the newer entrants have not yet recovered massive capex.

The normal expectation in such circumstances would be consolidation. Weaker players would be bought out by service providers with stronger balance sheets. But this is not easy under the current policy regime, which has huge barriers to takeovers, restrictions on FDI stakes, etc.

At the same time, the industry has been plagued by scandals and litigation. This has slowed down rollouts and added to costs. It has also meant slower technology adoption. India has achieved token 3G coverage at a time when most modern networks are moving to 4G. Given what happened with 2G and 3G, it's unlikely that 4G auctions would be expedited or indeed, that there would be bidders for 4G licenses in the current cash-strapped conditions.

Service providers are on the horns of a dilemma. On one hand, they need money to make the vast investments required to continue rollouts. On the other, they face a scenario of continuously falling margins and unrelenting competition. Urban markets are saturated. Rural networks cost much more to build and operate, primarily due to the excessive cost of power in areas where the grid is not reliable.

Rural subscribers are very low ARPU, as well. So growth simply by adding subscriber numbers is no longer a solution.

Raising the ARPU of the current subscriber base is also tough. Most customers are voice-driven and uninterested in most high-end value added services, or fast data access. Due to multiple service providers competing for every subscriber, pricing power is nil. If a subscriber is unhappy, he will port the number to another service provider. Monthly churn in number porting is now at around the same levels as growth in new subscribers so, a lot of customers are indeed unhappy.

The new telecom policy 2011 (NTP) promises to change some things. It could bring some relief, if the draft is any indication. It promises to release more spectrum and allow pooling and sharing of spectrum. It also promises to ease the problems in consolidation and network sharing.

However, it could also create more pressure on margins since it proposes to remove the circle concept and hence, eliminate roaming charges by making India a single market. This would make it possible to port say, a Delhi number to a Bangalore network, if the subscriber so desires.

But it will take another six months perhaps, for NTP to be finalised. It will then take several rounds of negotiation and possibly litigation, to be fine-tuned before implementation. By then, India will be in election mode. So it could actually be 2013 or 2014, or even later, before things move on the ground with respect to NTP 2011.

In the circumstances, every telecom service provider must be fundamentally over-valued. It doesn't matter what happens to the overall equity market. Valuations for the telecom sector are very likely to fall. This could also happen for ancillaries like tower companies. The only thing that could sustain current valuations would be a drastic change in merger & acquisition norms that leads to a series of takeovers and consolidations. Again, such policy changes are unlikely precisely because the industry is so mired in scandal.

If this sounds depressing, it is. But there have been long periods when telecom stocks outperformed the market.

We could now be headed into an indefinite period when the sector underperforms. A portfolio that excludes, or is underweight in telecom, is very likely to outperform the indices until such time as visible change takes place in telecom policy.

One way to exploit this situation would be to simply not buy telecom stocks. If you are a passive index-based investor, another strategy exists. Continue to buy the index and simultaneously sell futures in listed telecom stocks. You must be prepared to roll over those positions. So this is not exactly a safe strategy. But if the logic outlined above is correct, you will make excess returns.