Opportunity in telecom stocks?

In the short run, balance sheets of telecom companies will continue to bleed but there will be buying opportunities when M&As start

After many stops and starts, the next telecom spectrum auction is scheduled for early February. Eight companies have issued expressions of interest. There is political will to make this go through. The UPA would like to raise as much as it can before the general elections. It is a different matter if the policy failures that forced this situation can be sorted by the same government that caused the mess.

The sector is a classic example of how crony capitalism and greed vitiates an industry, even if there's everything going for it. Massive demand was a growth driver over the past 15 years. High levels of competition ensured consumers got basic voice services at the lowest rates in the world. In fact, India went from being one of the most expensive markets in the world in 1996 to being among the cheapest by 2003.

But as the Raja imbroglio indicates, the policy space was captured without much effort by service providers and licences were handed out ridiculously cheap to incumbents. After those were cancelled by the Supreme Court, attempts were made to re-auction at ridiculously high prices.

In between, 3G spectrum was auctioned at fairly high rates. But the 2G base re-auction rates were set higher than those for 3G. 4G was also auctioned, with few takers, under the explicit condition that 4G could not be used to deliver voice-over-internet (VOIP). Then, VOIP for 4G was apparently allowed in one of many policy changes. There was litigation galore and it continues. Some foreign investors have pulled out, while others have remained.

In the middle of this mess, a few telecom companies are making money. Bharti Airtel's drive into Sri Lanka, Africa, etc, has been prompted by an understanding that the Indian telecom market is fraught with unpredictable risks. The government has lost money in terms of opportunity costs by auctioning licences cheap. It has lost more money by just delaying processes. It has also been forced to spend money to recapitalise its own loss-making operators, MTNL and BSNL.

In the meantime, consumers have suffered because there is little incentive for operators to roll out better technology that offers a more attractive value-added experience. Fixed broadband remains a black hole, 3G remains unsatisfactory and 4G is available only in a few places. Data-based revenues remain a very small percentage of voice/SMS and the largest data revenue stream is music and ringtone downloads. All this means the positive externalities from widespread penetration have not been fully realised.

Global experience indicates some things. One is that the ill effects of crony capitalism cannot be fully reversed. There are too many subscribers to simply close the industry and reboot. At least a part of the prior excesses committed will have to be accepted. How this acceptance will come about is unclear. But it's a reasonable bet that the incumbents have enough clout to make it happen.

Another point is, as margins drop, consolidation is guaranteed. Multiple operators cannot keep dividing a pie no longer growing at great pace. This means mergers and acquisitions must occur. Thus far, policy has not been very conducive to this but it's inevitable. Again, at some inflection point, M&A norms will finally be straightened out.

In the short run, telecom operators will have to continue to make large investments to stay in business. Their balance sheets don't look pretty and they'll probably look worse by the end of 2014-15. Several brokerages have responded to this by making negative calls on the industry and there's a chance that share prices will be sold down over the next couple of months.

That's fine. It will, for one thing, force operators to look at alternative revenue streams, rather than a pure voice focus. That means a better environment for data and value-added services. At some stage, M&A possibilities will start creating buying opportunities. The operators left in play at the end of this churn will have a clearer playing field and more reliable revenue streams.