The Telecom Regulatory Authority of India (TRAI) has decided to reduce the interconnection usage charge (IUC) rate by a hefty 57 per cent, to Re 0.06 per minute from the previous Re 0.14 per minute. The reduction comes at an awkward time for the struggling telecom industry. Operators are already facing stress due to their debt-laden balance sheets, falling revenues, and likely employee layoffs.
Given the externalities of this vital sector, a downturn could lead to trouble in the larger economy. The telecom slowdown will impact government revenues, both directly, due to lower income from revenue share, and indirectly, if it causes stress elsewhere.
In theory, the policy decision to cut IUC rates cannot be faulted. The IUC in some mature telecom markets is low or even zero. Indeed, TRAI proposes to eliminate IUC altogether by January 2020, moving to the so-called bill-and-keep (BAK) regime. However, the timing could have been better, the calculation methodology more transparent and the reduction phased less steeply.
Industry observers make another point. A low (or zero) IUC favours newer operators. Incumbents with large subscriber bases gain net IUC revenue when more calls terminate on their networks. Conversely, a new operator with a low subscriber base has to make net IUC payouts. So, a low IUC is one way of easing the entry of new operators and thus enhancing competition.
At this time, only one operator stands to benefit from a lower IUC. Ever since the launch of services by Reliance Jio Infocomm Limited (RJIL) in September 2016, small operators have lost subscribers. As of July 2017, RJIL had a 9.1 per cent market share in terms of visitor location registers and it pays IUC on every voice call that terminates outside its network. Moreover, RJIL offers free voice calls, so it is not passing on the IUC to its customers. Hence, RJIL stands to gain from a lower IUC, while the other major players would be net losers.
Therefore, arguably, the decision to cut IUC by a substantial percentage amounts to favouring that one operator over all the others. This move could actually lead to reduced competition by placing stress on other incumbent operators.
RJIL gains, others lose
Financial analysts differ on the exact impact of the IUC cut, but they agree on one basic point: it will benefit RJIL while disadvantaging other operators. According to an estimate by India Ratings and Research (Ind-Ra), the reduction in IUC would have a 4-5 per cent impact on the earnings before interest, taxes, depreciation and amortisation (EBITDA, also called operating profits) levels of large incumbent operators such as Airtel, Idea Cellular and Vodafone India. Ind-Ra also estimates that this cut could help RJIL save Rs 35 billion-Rs 40 billion in annual IUC.
The Hongkong and Shanghai Banking Corporation (HSBC) estimates that the 57 per cent reduction will boost RJIL’s operating margins. In a sensitivity analysis, HSBC said that at the earlier IUC of Re 0.14 per minute, RJIL’s EBITDA margin would not exceed 11 per cent by its third year of operation, even assuming it achieved a subscriber base of 320 million customers with an average revenue per use (ARPU) of Rs 195 per month. However, post the reduction, the EBITDA margin would jump to 24 per cent by the third year. EBITDA margins will rise to 37 per cent if IUC is eliminated. RJIL could even approach EBITDA break-even with 270 million customers at an ARPU of Rs 170 at zero IUC.
Fitch Ratings estimates that the reduction will result in a transfer of $500 million-$600 million per year from incumbents like Bharti Airtel, Vodafone and Idea Cellular to RJIL. It concurs that the move will lead to faster EBITDA break-even for RJIL and reduce the EBITDA of Bharti Airtel, Idea Cellular and Vodafone India by 3-6 per cent in the financial year ending March 2018.
TRAI’s suggestion to eliminate IUC altogether with effect from January 2020 would impact the EBITDA levels of the industry by 7-9 per cent. It will also hit its debt servicing capacity. Ind-Ra estimates the impact of the cut on the stand-alone leverage (debt-equity ratio) of the incumbents at 0.1-0.3 times as IUC is reduced to Re 0.06 per minute, and at 0.2-0.6 times if IUC is scrapped.
Fitch says that ARPUs declined by 20-22 per cent year on year during April-June 2017, reflecting RJIL’s discounts and promotions. Most of the incumbents have lost subscriber market share to RJIL, with Bharti Airtel being the exception. But the removal of IUC in 2020 is likely to have less of an impact since RJIL’s net payment of IUC would anyhow fall as its subscriber base grows. The asymmetry may be minimal by 2020.
The big picture
Let us look at some numbers to get an idea of the bigger picture. It is not pretty. Sector revenues are dropping, consolidation is the name of the game, there are debt servicing issues, and there will be plenty of layoffs.
The Department of Telecommunications (DoT) has informed the finance ministry that it would be impossible to meet the budgeted revenue target of Rs 473 billion for 2017-18. It estimates revenues of Rs 295.24 billion, which is 38 per cent lower than the target revenue. This is a direct result of shrinking sector revenues.
The price war triggered by RJIL has led to a wave of consolidation. Two years ago, there were 10-12 operators per circle. Now, the number is down to less than six. Vodafone and Idea, and Reliance Communications (RCOM) and MTS are merging, while Telenor has sold out to Airtel.
DoT’s annual report for 2016-17 stated that around 4 million people were directly and indirectly employed by the telecom sector, which contributed around 6.5 per cent ($140 billion equivalent) directly to the GDP. Of these, around 2 million were directly employed within the sector. The industry estimates that 25,000-35,000 direct jobs may be at stake as financial stress bites. About 15,000 jobs may evaporate due to mergers. According to news reports, Idea Cellular is said to have already let go of around 1,800 employees and another 6,000 jobs could be at stake as the company readies for the merger with Vodafone. Vodafone is also believed to have “right-sized” its workforce by laying off 1,500 employees. RCOM is believed to have laid off 2,000 employees, ahead of its merger with Sistema and its abortive merger with Aircel. Aircel has also reportedly axed some 1,000 employees. Indirectly, another 100,000 jobs are estimated to be at stake.
The IUC cut could lead to a further deterioration in the credit profile and free cash flows of telecom companies. Net leverage (debt-equity ratio) has been increasing and interest cover (the ratio of earnings before interest and taxes to interest costs) has been on a downtrend since 2015.
The industry has debt servicing problems with a cumulative debt of over Rs 4 trillion owed to lenders and to the government in the form of outstanding spectrum charges.
The total bank credit deployed to the sector in 2016-17 amounted to Rs 851 billion. Credit to the sector has been declining as banks become cautious. In 2015-16, credit declined by 9.4 per cent year on year while credit declined a further 1.6 per cent in the first quarter (April-June 2017) of the current fiscal.
Financial services company Credit Suisse estimates that the share of telecom debt owed by companies with an interest coverage ratio of less than 1 has more than doubled since late 2016. An interest coverage ratio of less than 1 indicates that the company is unable to service debt from its operational earnings. More than half the companies in the sector have interest coverage ratios below 1. The associated vulnerable debt is around Rs 1.5 trillion.
The largest operator at present is Airtel, which had a net funds from operations-adjusted leverage of 1.9 in 2016-17. Projections suggest that Airtel’s revenue and EBITDA will both decline by at least 5 per cent in 2017-18. That will push the leverage to 2-2.2 times, closer to the threshold of 2.5, where it may receive a negative rating.
The government has attempted to ease the burden on operators by lengthening the tenor for the repayment of spectrum costs to 16 years from 10 years. But this may be insufficient – the wish list includes lower spectrum charges and revenue sharing fees, faster clearances for network roll-outs, mergers, etc.
Given the situation, it is not surprising that there has been a war of words with various companies having conflicting opinions and conflicting claims.
In a statement, RJIL said that it does not gain: “RJIL has always offered free voice services. There is no question of any advantage from the new IUC regulation to RJIL as it has already passed on all benefits to customers. We deny any benefits to RJIL. At a time when the world is moving towards IP-based technologies, cost of voice has come down to a fraction of a paise and customers should enjoy this advantage.” However, RJIL does gain in the sense that it has to make net IUC payouts right now, which is an expense, and that expense will be reduced.
Further, RJIL indicates that the incumbents’ argument of keeping IUC at Re 0.14 per minute implied that IUC was being treated as a subsidy.
Idea Cellular, on the other hand, has asked TRAI to release its model for calculating IUC in the public domain. The company says that IUC rates in comparable large markets like China, Indonesia, Brazil and the US were several times higher than those in India. In Indonesia, the rate is Rs 1.67 per minute and in Brazil, it is about Rs 2 per minute. Idea also argued that a zero -IUC regime is usually voluntarily put in place when there is symmetric traffic between networks, which is not the case in India.
Airtel also says that the mode of calculation is non-transparent and that the IUC should actually be between Re 0.30 and Re 0.35 per minute on the basis of costs based on audited calls. (Idea makes similar claims about the real costs of IUC.) Airtel says that it had incurred losses of Rs 68 billion over the past five years due to IUC being below the cost of Re 0.30-Re 0.35 per minute. The computation of the handling cost is indeed a methodological issue, as the cost is a function of multiple parameters.
Vodafone’s official spokesperson also indicated disappointment: “We are disappointed with this decision and are now considering our options in response. The Indian telecom industry is already experiencing the greatest period of financial stress in its history. This is yet another retrograde regulatory measure that will significantly benefit the new entrant alone, while adversely affecting the rest of the industry. Unless mitigated, this decision will have serious consequences for investment in rural coverage.”
Given the lower IUC, RJIL could get more aggressive, rolling out more discounted offers to grow its subscriber base. The other incumbents are also likely to respond with price cuts, discounts and promotions. As a result, industry-wide mobile blended ARPUs may fall to around Rs 150 by March 2018, down 5 per cent from March 2017. This situation will lead to a shake-out with only three private majors left standing: Idea-Vodafone, Airtel and RJIL.
Given that penetration of urban centres has hit saturation, there are few growth options. Operators will have to make rural roll-outs to increase penetration and garner new subscribers. They will have to claw out urban market share by offering value for money and higher quality of service. They will also have to compete to grow the data segment.