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A Straight Call
Potential for robust data growth and a stronger cash flow more than offsets the African negatives that have cast a shadow on Bharti Airtel

It’s not exactly a hot favourite on the Street, but telecom major Bharti Airtel has got all the ingredients that make it a sound bet in the new year. Of late, the stock has taken a drubbing from its high of Rs 420 to Rs 342 (Jan 16), down by a sizeable 18%. The adverse reaction by the market was mainly driven by the Nigerian naira devaluation of around 8% from 155 against the dollar to 168. Analysts perceive the development negatively since Nigeria is Bharti’s biggest market in Africa and contributes 12% to consolidated revenue as per FY14 data.

However, in our opinion, this is simply a notional factor. Since Bharti’s revenue earned and costs incurred are in the same currency, the telecom giant does not face any impact on cash flow. But it impacts the numbers when the figures are converted on a dollar or rupee basis for financial reporting. Thus, it is purely a reporting impact and does not influence cash flow.

The other concern for the company has been around spectrum. Bharti’s cumulative spectrum renewal costs could be about Rs 100 billion, assuming a 50% upside to the current reserve price, with Andhra Pradesh and Karnataka being the only two top-tier circles. On the other hand, Idea Cellular could potentially require about Rs 200 billion for a majority of the bigger circles. Bharti is comfortably placed given its robust free cash flow of Rs 100 billion in FY15 compared with Rs 62 billion for Idea Cellular. Thus, in conclusion, Bharti’s sizeable balance sheet/free cash flow and lower spectrum renewal payouts give little cause for concern when compared to its rival from the Aditya Birla camp.

Also, Bharti is well-placed to increase its capex intensity. The current capex-to-sales ratio of about 12% for both Bharti and Idea is well below the required capex. Our analysis shows that if incumbents were to reach data coverage comparable to 2G coverage over the next five years, they would have to double capex, leading to nearly an 18% capex to sales, thus affecting free cash flows. Bharti with a sizeable balance sheet is, therefore, better placed than Idea to absorb spectrum as well as capex costs over the next few years.

Data Upgrade

There are three factors driving data growth — handset ecosystem, coverage and affordability. The handset ecosystem is still at a nascent stage with a less than 10% penetration. However, what is satisfying is that smartphones, which accounted for 6% of the total handset sale, now account for 25%, highlighting a significant shift towards the smartphone ecosystem.

Second, data coverage, which is at 25-30% compared with 2G coverage, is still low, but the improving regulatory environment is increasing 3G capex intensity and majority of the telcom capex is going towards data capex, highlighting the data coverage growth.

Third, 3G affordability has reduced significantly riding on the back of a 90% price cut in 3G data prices from its peak that works out to 1.5X of 2G pricing, which was over 3-4 times the price three years back. Bharti’s data contribution to revenues has witnessed a hike from 5% two years ago to about 15% now and is growing at nearly 100% annually. This explains the growth trend. With an improving handset ecosystem and lower price differentials, we could see accelerated data growth for a long period driving the overall revenue growth.

We believe incumbents market share will increase following an improvement in data growth and revenue per minute. Smaller firms with weak coverage, an inability to invest heavily in network ramp-up and lack of sufficient spectrum will be negatively affected.

As such, Indian operations hold little execution risk for Bharti. Competition from marginal players has waded except in a few circles and we have seen a calibrated approach from the top three telecom companies to improve earnings. If data growth continues, it will offer enough support to improve earnings without much dependence on voice revenue per minute (RPM) improvements.

African Safari

For now, there is nothing much to be bullish about the African Safari. Bharti’s Africa Ebitda margin has dropped to Q4FY11 levels of about 23-24% with RPM down over 40%. We believe that there is little scope for improvement in terms of revenue and Ebitda growth. However, we see a limited downside risk considering two factors. First, the company’s Africa capex outlay is capped, and second, our channel checks with competition indicate that operationally, price-led competition may be limited as the focus has shifted towards customer experience such as mobile banking and cellular network quality.

While Africa offers low visibility, India’s wireless business should see a 5% RPM increase till FY16, a flat minutes of usage (MoU) and 76% data revenue CAGR over FY14-16, a rise from 66%. We raise our Ebitda margin for FY15 by 30 bps and by 90 bps for FY16 on account of a healthy data growth outlook and an improving overall India margin profile. We have cut our Africa Ebitda by 2.5% as we expect a flat 0.7% Ebitda CAGR over FY14-16.

Still Attractive

The stock is valued at 6.3 times estimated FY16 EV/Ebitda and after factoring in spectrum payouts, it trades at 7 times, with a net debt-Ebitda ratio of 2.6 times. The industry has been threatened by regulatory and spectrum concerns. We believe that issues such as spectrum renewal should not be a major deterrent in Bharti’s growth plans. With higher earnings and return ratios quarter on quarter, the stock will see a lower weightage of regulatory/spectrum premium on cost of capital, allowing a better valuation multiple. A well-planned India execution, led by data growth and RPM improvement, should offset Africa risks. We raise our DCF-based TP by 10% to Rs 425, after factoring in an 11.5% weighted average cost of capital and a 3% terminal growth.

However, our key concern in telecom stems from an increased capex intensity towards data network rollout. Major southeast nations spend 18-20% capex to sales, while Indian operators spend 10-11%, despite being far behind on coverage. With 20% 3G coverage, Reliance JIO Infocomm’s network launch could turn out to be a trigger for an increase in capex spend, which could cap free cash flows.

The writer is managing director, institutional equities, at Elara Capital. The writer does not hold a position in the stock

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