TELECOM ATTRACTING SUBSTANTIAL FOREIGN INVESTMENT

Growing teledensity making communication affordable

By SHABBIR H. KAZMI
June 19 - 25, 2006

Lately telecommunication sector has attracted a lot of local and foreign investment. The growth has been extra ordinary, more because of the latent demand. Teledensity has improved a lot but remains mostly confined to urban areas. The prospects for growth are phenomenal but still offer a lot of potential. Growth in cellular market clearly shows that future growth would be led by wireless technology, particularly due to enormous opportunities in the rural areas.

In one of its report released in February this year Merrill Lynch has expressed a selectively positive stance on Pakistan's telecommunication sector. With total teledensity around 18% there cannot be much argument against the potential of the sector. However, lack of listed companies and price distortion due to mergers and acquisition (M&A) stories offer limited opportunities for the investors in general and foreign investors in particular.

According to Merrill Lynch one of the key impediments for fund managers seeking exposure to Pakistan's growing telecom sector is also the availability of limited options. Cellular market exhibits the extreme case with none of the six operators listed at the local stock exchanges. The other segments are also not much different with a total of seven listings. In addition, M&A activities or at least stories often distort price levels in general making prudent choices based on fundamentals a little difficult.

The privatization story of Pakistan Telecommunication Company (PTCL) has remained in limelight for a very long time. While market participants do have an eye on fundamentals, they also remain concerned about the increasing competition being faced by PTCL. The real triggers for stock price remain sentiment and news flows. With issues between the government and Etisalat now mostly resolved, fundamentals should drive the price movement. Based on expected earnings and a bottom line, the scrip trades close to its fair value. In terms of dividend yield, the stock looks attractive but a lot depends on the policies of Etisalat. In addition, the yield is lower than that on long-term government bonds in Pakistan, which takes the sheen off the argument even further.

One of the players, Callmate Telips, is focusing LDI to date and remains the best exponent of the LDI telephony boom. Its earnings have multiplied five times and share price has increased many times within a year of launching services. However with the LDI segment fast approaching saturation, life as a specialized LDI operator would not be easy. Profit growth is likely to taper off as margins shrinks and revenue momentum slows down. Management of Callmate realizes this threat and is actively pursuing diversification policies in the Local Loop segment through acquisition and/ or joint venture. While the intent makes sense, lack of details on the proposed project restrict analysts from determining fair value.

With total teledensity at 17% (fixed and mobile), about half the regional average teledensity, opportunities in Pakistan's telecom sector are enormous. While cellular density has grown phenomenally, average addition has remained around 1.5 million new connections every month. Prospects for growth still exist due to subdued growth witnessed in the past, partly due to lackluster management and partly due to high tariffs. A look at peer markets suggests that economic prosperity and teledensity are positively correlated. With Pakistan's economy growing stronger and expected to continue on the same path is forecast to grow at an average rate of 6%, fueling further improvement in teledensity.

The sector is also expected to benefit from introduction of new technologies. One such area is WLL, which is not only cost effective but also requires less roll out time. While copper lines cost around US$ 250-275, WLL costs around US$ 100-110 and also does not require digging up of the earth to lay down lines. Reportedly only 40% of Pakistan's population has access to telephony. However, increase in population coverage is one of the key policy objectives of the government. The policy objective is fully supported by channeling of funds from the Universal Service Fund to local loop operators in order to entice operators to spread their coverage to far-flung and commercially less attractive rural areas. Cellular operators are also playing role in expanding coverage. They plan to expand their coverage area from the current 350 cities to over 600 cities throughout Pakistan.

The LDI traffic mix is expected to gradually change because growth in outgoing traffic is outpacing growth in international incoming traffic, an outcome of prosperity and reduced rates on outgoing traffic. The shift is evident from the ratio of incoming calls to outgoing calls, which stood at 12 minutes of incoming for every minute of outgoing in 2004 and is estimated to have declined to 8 during 2005. With the LDI price war at its peak, the growth in international outgoing traffic should continue due to price elasticity.

Merrill Lynch has divided Pakistan's telecom sector into four segments namely 1) fixed wire line, 2) fixed wireless, 3) LDI and 4) cellular. One can see a unique structure in different segments of the industry in terms of concentration of market shares. PTCL emerges as a dominant player in the fixed wire line segment while market shares are more dispersed in the other three segments. Similarly, competitive practices also vary, but price invariably remains the preferred tool of competition.

FDI IN TELECOM SECTOR

COMPANY

JUL-SEP 05

OCT-DEC 05

JAN-MAR 06

JUL 05 MAR 06

PTCL *

-

-

565

565

Telenor Pakistan

37.35

154.37

109.77

301.49

Warid Telecom

28.03

24.18

1.35

53.56

Pakistan Mobile Communications (Pvt) Ltd.

14.85

14.85

14.85

44.55

Wateen Telecom

6.93

1

1

8.93

Multinet Pakistan

-

2.5

3.7

6.2

Ericssion Pakistan

-

6.08

-

6.08

Redtone Telecom Pakistan

0.57

1.38

2.02

3.97

Instaphone

1.32

1.32

1.32

3.96

Transworld Associates

-

2.48

-

2.48

Nortel Networks (Asia )

-

2

-

2

Saif Telecom

-

-

1.4

1.4

Wise Communication System

-

0.74

0.64

1.38

Others

2.36

2.04

2.17

6.57

Total

91.41

212.94

703.22

1007.57

Enjoying half a century long history in the fixed line segment, PTCL remains the most dominant player. The company controls 97% of the wire line telephony market in the country with the rest distributed amongst a cluster of smaller area specific operators. The situation is not expected to change drastically. With high cost of laying copper lines, being the biggest barrier, the only dynamism in the sector could come through optic fiber networks targeting a triple play strategy, therefore slowing down the growth in connections. With PTCL also aggressively entering the domain of optic fiber through its OFAN Network in Karachi, Lahore, Islamabad and Rawalpindi, its dominance in the segment is expected to continue with an estimated 85% market share till 2010. The future of the segment will be driven by optic fiber based services, which are mostly targeted towards the upper strata of the society. Therefore, quality of services will be used as a competitive tool in addition to price wars.

According to Merrill Lynch while optic fiber will play a part, the true growth in fixed line teledensity will come through WLL telephony due its cost and time effectiveness and suitability to Pakistan's geographic domain. While WLL holds around 8% share in the six million fixed line connections, the share could increase to around 48% in the 13.3 million connections in service by 2010 on the back of its growth and slow down in fixed wire line. PTCL like most other segments dominates the field, with a market share of 57%. As against this Telecard, the first company in the private sector to explore WLL segment, enjoys a market share of 30%.

WLL is arguably one of the less intensely competed segments. With the PTCL busy with non-operational privatization related issues and the latest entrants still rolling out their networks, the competition has been subdued. Nonetheless the limited competition has again focused on price by offering low on-net calls and subsidies on handsets. Given the potential in the segment there is ample room in the market which will prevent cutthroat competition in the near future.

The segment has started off with a bang immediately following the deregulation. However, the opportunity has been short lived. With the number of operators desiring to exploit the opportunity price war has also intensified and so has the pressure on the PTCL (International Incoming revenue down by about 52% YoY in the first quarter of 2006). Rates on LDI traffic have dropped in the range of 45 to 85% but that has also translated into enhanced traffic. To sum up the segment is fast becoming a commodity business where the focus is higher volume.

In terms of structure the segment can be divided into two categories of operators: 1) Operators who view LDI as a short-term "money minting" medium and 2) operators (cellular; fixed line and WLL) who treat LDI as a complement to their core operations. With the price war to cool down, the first category of operators could find the going tough unless they diversify their revenue base.

The cellular sector has started picking up momentum, exhibiting addition of over one million subscribers every month. The subscriber base, which stood at 8 million in early 2005, exceeded 21 million at the end of the year. While it may be difficult to post the same growth rate in 2006, the cellular subscriber base could touch 30 million subscribers by end of the year 2006. The cellular teledensity is expected to touch 30% in a total subscriber base of 50 million by 2010.

The initial boost to the segment came in through the introduction of Calling Party Pays regime in 2000. The recent run up in subscriber numbers has been fueled by 1) aggressive marketing campaigns with reduced tariffs and subsidized SIMs reducing upfront cost for the cellular subscribers, 2) falling handset prices, 3) reduction in government taxes on cellular connections and 4) increased coverage area. However, the sheen is taking off the growth as ARPUs for cellular operators are on a constant decline.

Growth is coming through pre-paid connections which yield a lower ARPU yielding Rs 250-400 per month) compared to post paid connections yielding over Rs 2,000 per month. While cellular usage is increasing, costs of the services are on a continuous decline. With the cost per SIM also coming down from around Rs 2,500 in early 2004 to Rs 200 currently, affecting average revenue drastically. The inactive SIMs also results in lower ARPUs as the denominator in the ARPUs equation gets larger than warranted.

The cellular segment has long been dominated by Mobilink, at one stage holding a market share of around 65% amongst four operators in the market. However, with the entry of two new international operators in early 2005, Mobilink has faced stiff competition, which is evident from declining market share.

The market structure could be altered to a great extent once Mobile Number Portability (MNP), which allows subscribers to switch operators while retaining the same number, is introduced. Since there is a void in the market with respect to a quality leader, any operator which steps up service quality will stand to gain.

Competition in the cellular sector has been about increasing subscriber numbers at the expense of service quality. With the growth in subscribers coming predominantly via pre-paid connections, the emphasis is on reducing the cost of maintaining a connection via reduced upfront and variable costs. The post paid segment is however contested more on churn basis and revolves around headhunting post paid subscribers of other operators by offering value added services and adding a mandatory dose of tariff reductions to lure customers.

Having achieved massive growth the sector needs consolidation. This may come as 1) Merger of struggling smaller and inefficient operators. 2) In addition to mergers of companies within individual segments, the activity is likely to spread to inter segment mergers as specialized operators in specific segments chase growth in high growth segments. 3) With further licenses unlikely to be issued, foreign telecommunication operators seeking exposure in Pakistan will have to acquire existing operators. For instance, all the seven telecom companies listed at the local stock exchanges are currently surrounded by M&A stories.

The regulator of telecommunication sector, Pakistan Telecommunication Authority (PTA) has adopted a policy encouraging competition providing smaller operators an opportunity to compete with PTCL, which had enjoyed monopoly status for decades. Low barriers to entry, infrastructure sharing on reasonable rates, restrictions on pricing powers of Significant Market Players and aggressive rate cuts on international incoming, have made the industry landscape tougher for PTCL. On the other hand, channeling of funds via Access Promotion Contribution provides some cushion to PTCL but still favors the new operators.