The Indian telecom sector has come a long way since it was opened up in 995-96. With a strength of 190 million subscribers, it has emerged as the fastest growing telecom market in the world today. A capital-intensive industry, it is constantly raising funds for network expansion, rural connectivity and technical research.

"The total capital investment in the telecom sector stood at $47 billion at the end of financial year 2005-06, with private companies accounting for around 58 per cent," says Amit Goel, research manager, Zinnove.

Surprisingly though, foreign direct investment in the sector has been very low at only $2.7 billion or 5.74 per cent of the total investment. According to the research company, this is primarily due to the fact that most of the FDI has been only in the wireless segment.

Today, there are basic economies of scale working at different levels in the telecom industry. And perhaps the best news of all is that telecommunications is now recognised as a good business to invest in.Hence, given the right regulatory environment, current and potential telecom network operators and service providers have little trouble in attracting investment.

Financing options

The telecom financing life cycle has evolved over the years. Operators started out with the traditional route to fund the rollout of their networks. This was a combination of promoters' funds and longterm rupee loans from banks and financial institutions with back-ended repayment structures, primarily to match the cash flow of the project.

Over the last few years, telecom companies have frequently tapped the international market in a variety of ways including external commercial borrowings (ECBs), foreign currency convertible bonds (FCCBs) and finance of import equipment through support from external credit agencies (ECAs). For instance, Bharti Airtel raised $354 million through ECA funding from Swedish ECA, EKN, and Finlandbased FinnFund in 2005 to fund its network expansion. Likewise, Reliance Communications has recently approved a proposal to raise $1 billion via the FCCB route.

Given the growth potential of the Indian telecom sector, bank credit is another important source of finance. According to Romal Shetty, director, Telecom Risk Advisory Services, KPMG India: "A number of leading European banks have already committed over Rs 20 billion to the sector.Bank credit is a key competitor to private equity players as the large funding requirements of the industry can be easily met by using this method." The Essar Group, for instance, managed to raise over $8 billion in bid financing through banks, including Morgan Stanley and Standard Chartered.

Moreover, as telecom companies start generating profits, they develop a fairly steadfast hold over self-financing in the short run or even in the medium term, thereby reducing the reliance on external funding. However, according to Shetty, "Indian telecom financing needs are not exactly affordable –­ be it basic infrastructural costs, licensing or buy-out of players, the funds required are huge."

Operators are now moving towards outsourcing network infrastructure in a big way. There has been a fundamental change in the business model of the telecom operators –­ from a capex-driven approach of creating and owning the network to an outsourcing-based approach."This results in transferring the capex component of the total expenditure of a telecom operator to companies like Nokia and Ericsson as well as larger offbalance-sheet financing and improved cash flows. This helps operators expand rapidly without significant capital investment," says Krishna Ramachandran, manager, risk and business solutions, Ernst & Young India. According to him, companies no longer need to take the FCCB or ECB route to fund their network expansion, given the outsourcing trend that has resulted in lowering the capex requirement and hence, the longterm financing requirements drastically.

Meanwhile, thanks to a booming equity market, fresh infusion of equity by dilution of shareholding in favour of private equity players and international telecom companies has become the preferred option.

Says Shetty: "The majority of private equity funding comes from FDI by overseas telecom operators. An example of this is the Vodafone and SingTel stake in Bharti. In addition, there are equity funding groups like Blackstone, which is looking at teaming up with Reliance Communications for a stake in Hutchison." Improved valuations are compelling promoters to invite overseas strategic partners for funding future growth. "Private equity placement is a more lucrative form of raising money vis-àvis the overseas borrowing route, particularly since a number of operators already have strong joint venture partners," says Ramachandran. However, the company will have to relinquish ownership and a share of its profits to other equity investors.

Global telecom companies including Vodafone, TM International, Orascom and China Telecom have all evinced interest in the Indian telecom market. Some deals in the recent past include Vodafone's investment in Bharti, Temasek's investment in Tata Teleservices and Telekom Malaysia's buyout of Spice Telecom.

The telecom industry recently witnessed the biggest takeover battle in the history of Indian telecom with the Vodafone Group finally winning the race for Hutchison Telecom International Limited's (HTIL's) 67 per cent stake in Hutchison Essar Limited (HEL). Vodaphone will pay about $11.72 billion, discounting $1.5 billion debt for HTIL's stake. With this acquisition, the company will gain a firm foothold in the Indian cellular market. The other major contenders in the race included Reliance Communications and the Hindujas.

Public offerings also seem to have become a preferred route for raising capital for future growth among companies with an established track record, reasonable subscriber base and a sound business plan. "In 2005, India witnessed over $4.5 billion changing hands by way of investments and buyouts," says Ramachandran. Of late, many Indian telecom companies are taking the initial public offering (IPO) route. Bharti Airtel, Reliance Communications and Tata Teleservices (Maharashtra) have already raised money from the capital market. Idea Cellular has filed a prospectus with the Securities and Exchange Board of India and is expected to get listed by March 2007. Spice Telecom is also contemplating visiting the capital market.

Looking at trends in the recent past, another option is raising finances in the debt market. "However, only telecom companies that are financially stable and have good earning capacity can raise funds from the credit/debt market," says Shetty.

Clearly, there are many financing options available in the market today."The actual mix of debt and equity, however, depends upon the company as do the means of financing," says Amit Hire, research analyst, CRISIL.

Return on investment

Most of the telecom players have wellestablished infrastructure in place and have passed the break-even phase. Over the last few years, mobile operators have seen significant improvement in margins.The economies of scale that operators have achieved on account of the growing subscriber base, supplemented by a reduction in licence fees and declining cost of capital have resulted in improved profitability. In the future, the cost of equipment is expected to decline. This, along with the expected reduction in licence fees and increase in subscriber base, will ensure the profitability of the telecom sector.

Revenues can be increased by increasing volumes and offering innovative value-added services like ringtones and wallpapers. Also, revenues will be enhanced as the sector moves towards 3G, convergence and triple play.

Some issues...

At this stage, there are not many factors that can inhibit the growth of the sector.Hence, financing should not be an issue.However, the next level of growth will come primarily from low-end users with low-cost handsets. "From a marginal profitability analysis point of view, profits are not likely to be higher than what they are today. Therefore, if a company wants to set up a large operation across the country today, getting returns will be more of a challenge for it vis-à-vis existing operators. That is one of the key reasons that Vodafone is willing to pay a high premium to buy out an existing business," points out Ramachandran.

The financial viability is also gauged by the technical research and technologies deployed by the company. For instance, the financier is likely to consider the new products that the company is launching, or whether it is moving towards Wi-Max or IP convergence. The more proactive companies are likely to raise funds more easily as they will generate more revenue, given that there cannot be any innovation in voice and the low data penetration.

Moreover, some rules of the FDI policy, such as those pertaining to the nationality of the top management and remote access, are deterrents to foreign investment. Greater regulatory certainty, fewer bureaucratic hurdles and removal of restrictions pertaining to ownership issues would give greater comfort to foreign investors.

Competition is inherent in any industry or market, but the level of transactions amongst competitors, inter-operator dependencies, and the quantum of underlying financial settlements are far greater in telecom compared to any other. Right from letting one's own customer generate revenue for the competitor (in a roaming scenario), to compulsory usage of a competitor's assets (interconnection for servicing own customer), and voluntary usage of a competitor's assets for cost economies (such as infrastructure sharing and leasing of backbone), the quantum and complexity of inter-operator issues make this industry unique.

As the sector moves forward, most of the large players will continue further geographical expansion. Meanwhile, the consolidation phase will continue with the acquisition of smaller players, who have less than 15 per cent market share. According to a study by a global deal advisory firm, Grant Thornton, India recorded 343 M&A deals in 2005, totalling $18.2 billion, of which the telecom sector accounted for 14 deals valued at $5.4 billion. With this trend likely to continue, bankers can expect a busy year ahead.