A regional player with national ambitions

Idea is a well managed regional operator in the fastest growing cellular market in the world, generating a 2007-09e EPS CAGR of 52%

The company has a 2-4 year growth runway before spectrum and financial constraints and a move to nationwide pricing create opportunities to scale up or merge with a larger player

We initiate coverage with an Overweight (V) rating and a fundamental DCF based target price of Rs 168, with 31% potential upside and possibility of further FDI

Scaling the growth mountain

Idea Cellular (Idea) is the strongest of the emerging regional players in the Indian wireless market and is positioning itself to play with the “big boys”, Bharti, RCOM, and VOD on the national stage. India has a fragmented wireless market structure, with licences and spectrum awarded on a circle by circle basis and little inter-circle roaming-traffic flows. Idea has a presence in 13 circles or operating regions of the 23 telecom regions in India, eight circles with mature operations, three circles that have been recently launched, and two in the pre-launch phase. In this context, Idea has the spectrum and financial resources to compete head-to-head with the national players in its existing circles, with an average market share of 18% and a 20% share of net additions. We estimate a 52% EPS CAGR FY07-09e based on its existing 13 circles and have not factored in potential consolidation. On a longer-term view, we believe India will follow the global trend of wireless consolidation into 4-6 national players and Idea is likely to participate in this process. The global experience suggests consolidation will be driven by a combination of spectrum constraints, heavy network upgrade costs to 3G, a shift to nationwide pricing, and financing constraints. We believe Idea faces scale disadvantages in the form of higher operating and financing costs. Idea’s management acknowledges that M&A is a possibility but suggests the company is likely to be a buyer rather then a seller and that the strategic shareholders, the Birla family, have a long-term commitment to the Indian telco space. However, Vodafone’s landmark purchase of Hutch India for USD18 billion and a relaxation of regulatory restrictions on M&A suggest consolidation will remain a key theme. We initiate with an Overweight weighting and a DCF-based target price of Rs168; the key downside risk is spectrum and the key upside risk is M&A catalysts.

Well managed regional operator

Idea is a well managed regional operator in the fastest growing cellular market in the world. We are structural bulls on the Indian wireless space due to a combination of significant pent up demand, low capex-opex, low revenue per minute, expanding EBITDA margins and high returns on capital. Indian wireless licences are issued on a circle by circle basis, leading to a geographically fragmented market. The competitive dynamics and competitive profile vary from circle to circle and national trends can be misleading. The company has a presence in 13 circles out of the total 23 telecom regions in India, eight circles with mature operations, three that have been recently launched, and two in the pre-launch phase. Despite its regional presence and pan India market share of 8.5%, Idea is well placed and commands a market share of 18% in its eight established circles. We think Idea will see robust subscriber growth as it is present in the GSM segment which accounts for 75-80% of net additions.

Near term looks solid

We are upbeat on Idea’s near term growth as we expect it to gain market share as it launches in five new circles. The Indian market continues to grow rapidly with 6-7 million subscriber net additions per month and Idea is well placed on account of its strong brand and execution skills to benefit from the overall India growth story. We expect the Indian market (subscribers) to expand at a CAGR of 38% over the next two years and estimate Idea’s subscriber base to increase at a CAGR of 49% during the same period. Further, we expect Idea to benefit from the delay in the expansion plans of public sector rival BSNL, a leading pan India GSM based operator.

Medium term: Spectrum and balance sheet limit growth

Idea faces significant challenges in moving up from 13 circles to 23 circles in the medium term. The company’s licences in 10 circles are pending with the Department of Telecom (DoT) on account of the spectrum queue. Given the spectrum constraints, Idea may get left behind as a regional player if it cannot achieve scale and critical mass. Wireless is a scale intensive business and smaller operators tend to have higher operating costs and lower EBITDA margins. Smaller operators also terminate a larger percentage of their outbound traffic on other networks leading to higher interconnect interconnect costs. Scale benefits also stem from a variety of sources, including lower employee costs and a more efficiently used network. Further, Idea’s limited balance sheet flexibility will also make it more difficult for it to become a national operator in the medium term even if spectrum is made available on a gradual basis.

Medium to long term: Consolidation catalyst kicks in

Indian wireless telecoms is highly competitive, with nine operators (four national and five regional/quasi national operators) fighting for market share. We do not believe the status quo can last and think consolidation is inevitable; in our view a market with 4-5 operators will work best.

Earnings outlook

On the basis that Idea is rolling out five new circles over the next 12-18 months we estimate a FY07-09e EPS CAGR at 52%. The positives built into our estimates should start to be reflected over the next 9-12 months. Our earnings estimates for Idea are high compared to Bharti and RCOM. Idea is evolving as it builds from eight circles to 13. Its 21% share of net additions in its eight established markets shows the company has a strong management and execution system in place. We believe it can continue this performance in the five new circles. However, we see a large gap on ROIC, with Idea’s FY07 ROIC at 15% compared to Bharti’s 25%. We forecast an improvement in ROIC for both Idea and Bharti but expect this gap to widen over the medium to long term from the current 9% because operations in only 13 circles will prevent Idea from earning an attractive return on capital. We believe lack of scale is an issue for Idea in the medium to long term and as a result Idea’s margins are expected to trail Bharti’s by c4-5%. We are on the higher end of consensus on sales and EBITDA as we are excited about the strong execution, overall growth and spectrum/regulatory reforms. We have factored one time write-offs for operations in new circles and hence are marginally lower than consensus on the earnings numbers.

Valuation and risks

We initiate coverage on Idea stock with an Overweight rating and a target price of Rs 168 based on DCF (WACC 8.75%, C0E 11.3%, RFR 4.8%, MRP 6.5%, Cost of debt 8%, D/(D+E) 0.43). Our target price is based on company fundamentals alone and does not factor in any premium on the back of the M&A catalyst. We expect Idea to benefit from overall mobile growth, its five new circles and delays at BSNL. The downside risks are an extended delay in release of spectrum, a rapid drop in revenue per minute, a regulation capping the number of service providers and a sharp de-rating of the Indian equities market. Based on the Vodafone/Hutch Essar and STC/Maxis deals, we believe there is a strong demand for well managed regional assets. In the event of consolidation, regional players like Idea may warrant a valuation premium to regional peers and we view this as an upside risk. Idea is trading at a premium on EV/EBITDA to its peers but we are not concerned as Idea is not comparable to the big players. Idea will take another couple of years to attain maturity and we prefer to use the EV/subscriber multiple to compare Idea with peers. On Wireless EV/Wireless subscriber, Idea is trading at USD 629, a discount of 29% to Bharti and 13% to Reliance Communication.