Book profits in Spice Comm beyond Rs 60: I-sec

ICICI Securities has come out with report on Spice Communications, which is expected to list in this week. They suggest investors to book profits beyond Rs 60, given the low long-term growth potential and better investment opportunities in the market.

ICICI Securities report on Spice Communications

Spice Communications, one of the smaller players in the Indian telecom sector, has GSM operations in two circles (Punjab and Karnataka) and a subscriber base of 3mn; the company has applied for licenses in rest of the 21 circles. The company has received national & international long distance (N&ILD) licenses for which it is raising Rs5.2bn through its IPO. Spice’s high D/E at 2x (without factoring in off-balance sheet financing of Rs1.8bn) limits access to funds in future and would result in further equity dilution on expanding footprint.

Implied valuation of USD 201/subscriber at the issue price for Spice’s CY08E subscriber base is at 60% discount to that reflected in current valuations for Bharti Airtel, which seems justified with: i) 30% differential in ARPU, ii) limited presence, iii) absence of fixed line & long distance operations, and iv) 1,500bps difference in wireless operating margins.

Targeted pan India presence unlikely; growth to be restricted to existing circles

Spice has presence in only two circles at present and is yet to receive licenses in rest of the 21 circles. Given the present spectrum crunch and uncertainty in the spectrum policy (which would likely favour incumbents), we believe Spice would lag behind other larger players. Increasing market share in Punjab and Karnataka, where penetration is expected to improve from 30% and 20% in FY07 to 49% and 37% in FY09E respectively, would be the key growth driver. We expect subscriber base to increase at 41% CAGR through CY06-08E.

Captive long distance infrastructure and increasing scale to support margins

Spice currently routes its long distance traffic via other operators’ networks on per minute basis, shelling out substantial sums every year. We expect Spice to report savings up to ~3.5-4% of sales (Rs 400-500 million annually in the next two years), once it develops its own long distance infrastructure. Further leverage is expected from G&A on the back of increasing business scale. Overall, we expect margins to improve 580bps through H2CY06-CY08E.

Yet, restricted scope of business to keep margins lower than larger peers

Spice’s presence limited to two circles, where penetration is likely to reach 40-50% in the next two years, implies restricted growth options in the long run. Further, operating margins would be significantly lower than larger peers’ based on: i) lower proportion of on-net calls, ii) insufficient leverage of long distance infrastructure, iii) bargaining power for inter-connects, and iv) roaming with other operators.

Long term growth through expansion to new circles unlikely; probable acquisition to keep valuations high

Given presence in just two circles, long-term growth would only happen with Spice expanding its footprint, which would require strong funding (likely through equity dilution; debt would be too costly with CY07E D/E of 2x). In the present state of fierce competition and spectrum crunch, synergies from Spice’s operations make it a compelling acquisition target. This suggests ~25% premium over the company’s fair value of Rs 48/share through:
i) savings in capex, ii) higher operating leverage on the back of larger subscriber base, and iii) ready access to 3mn subscribers. Also, there would be a premium for management control. We recommend booking profits beyond stock price of Rs 60.