What does Reliance Jio see that NTT Docomo doesn't?

Japan’s cash-rich, $67 billion telecom firm NTT Docomo Inc. is exiting the Indian telecom market. Despite its financial muscle and the backing of the Tata group, a large and influential Indian business house, it doesn’t see a future in the Indian telecom sector.

A little over two years ago, Emirates Telecommunications Corp., also known as Etisalat, shut operations in the country. Other large companies such as Telenor have curtailed operations owing to continued losses. Fringe operators such as Loop Mobile are being acquired by large companies such as Bharti Airtel Ltd. About six years after the government opened up the sector for more competition, new entrants have more or less fallen by the wayside. The writing is on the wall—there isn’t enough room for more than a handful of telecom operators.

Given this increasingly oligopolistic scenario, one would have imagined that valuations of incumbents such as Bharti Airtel and Idea Cellular Ltd would have gone through the roof. They haven’t. Investors are still being cautious, largely because of the looming entry of Reliance Jio Infocomm Ltd.

What does Reliance see in the market that has caused it to invest an estimated $7.5 billion in the sector? This estimate is according to an oil and gas analyst at an institutional brokerage. Clearly, given the experience of the past few years, it will be foolhardy to expect the company to unleash a price war and gain market share despite its deep pockets.

“We doubt Reliance can afford to be an irrational player in the telecom segment, given it probably wants to earn a decent return on its investment,” analysts at Kotak Institutional Equities said in a 24 March note to clients. Although the company generates a lot of cash from its oil and gas business, its returns on capital from its core businesses are close to the cost of capital, giving it hardly any leeway to splurge on other business. As it is, Reliance’s non-core businesses have been cash-guzzlers, with little to show for the large amount of investment.

As far as the telecom investment goes, Kotak’s analysts say, “Reliance’s investment in the telecom business will generate very poor returns, given that it acquired 2.3 GHz (gigahertz) spectrum in May 2010 for $2.1 billion and then spent a meaningful amount of money on trials and preparations for the commercial launch, apart from interest payment on debt. Four years have passed since… its acquisition of 1.8 GHz spectrum this year raises questions about the use of the earlier spectrum and limitations of the platform and ecosystem.”

According to an analyst at another domestic institutional brokerage, it appears that Reliance will look to tap demand for differentiated services involving data usage. While these may not look like big volume drivers in the near term, they would be in the long term. As far as voice services go, Bharti, Idea and Vodafone India Ltd have a share of around 70% and are unlikely to cede any of their share easily.

Of course, given the inherent advantage incumbents have with benefits of scale, the task for new entrants becomes increasingly difficult. In fact, because of the scale disadvantage, smaller operators need to generate higher revenue per minute of traffic to achieve break-even. This is why price wars in the past have resulted in severe damage to the balance sheets of smaller telecom operators. As Kotak’s analysts put it, in this backdrop, a pertinent question is whether investors should be so worried about Reliance’s entry in the telecom sector.

Coming back to Docomo’s exit, the Tata group will be left to largely pick up the pieces. Docomo has the option of selling back its shares in Tata Teleservices Ltd to the Tata group and recover 50% of the amount ( ₹ 14,500 crore) it invested. The remaining shareholders will be left with a firm heavily laden with debt, and one that generates little profit. Few investors will be interested in paying even a nominal value for equity. According to Kotak’s estimates, Tata Teleservices has a net debt of ₹ 28,000 crore and earnings before interest, tax, depreciation and amortization of only around ₹ 200 crore. Even if some company agreed to acquire it for zero equity value, it would mean an outlandish valuation of 140 times profit.

News reports have suggested for some time now that Vodafone Plc might be interested in the company’s assets. Considering that Vodafone hasn’t exactly been prudent in the past while investing in India (about four years ago it wrote down the book value of its Indian investment by £2.3 billion), Tata Teleservices’ valuation shouldn’t be an insurmountable hurdle. But there are other complications.

The new mergers and acquisitions guidelines for the sector haven’t yet been notified, and given Vodafone’s bitter experience with the central government on taxation issues, it can be expected to play it safe. Especially so because buying Tata Teleservices out will be a complicated and long-drawn deal. One of the company’s arms is listed and will entail an open offer. Waiting a bit longer may well result in a better bargain. It will be better still if Vodafone decides to pick and choose assets in Tata’s portfolio that suits it best.

If Vodafone settles for this path rather than a complete buyout, it will be a clear sign that the days of mindless competition are coming to an end.