3G - Will the Gamble Pay Off?

One Hot Morning the news came that the incoming calls were made free by the government. I remember it was the summer of 2003. It was the turning point for cell phones in India as it was embraced by the masses, whether they actually required it or not was not a question to be asked. Since then, there have been rapid developments in the mobile phone industry. With low call rates and reduction of handset prices, it became affordable for any average man who comfortably earned his living. Another breakthrough in the mobile telephone space has been the emergence of Reliance Communications. With their tag line “Kar lo duniya muthi mein” cell phones became an integral part of the Indian lifestyle.
If the economic boom has enabled people to buy cell phones, the latter have also made people lead better lives. Many small businessman, artisans and workers have really benefited with cell phones and there are plenty of examples all around us. The one that amazes me the most is my cook. She is a single mother and runs a small business apart from cooking for us. Every day when I open the door for her I find her listening to FM on her phone. A decade ago, it would have been a wild fantasy. Today, cell phones have become a way of life. Some use them for their business, some to gossip, and some just to make style statements. The truth is that cell phones have become an intrinsic way of life. Few years down the line it would be unimaginable to live a life without cell phones.
Coming down to facts, India has over 600 million users and almost 8 million are added every month, thus making it the second largest cell phone market in the world after China.

The Genesis
The means of communication was revolutionized in the past century, a result of unprecedented progress in science and technology. What started as a support system for the US Army to communicate ultimately became a way of life for millions across the world. The emergence of mobile phones is indeed fascinating and more so in the manner in which it has caught on in India. Here, mobile operations for the general public began in the mid-90s, though it was a luxury affordable by the rich only. The reasons were several. Primarily, the call rate was very high and the sets were expensive. There were fewer service providers and they mostly operated only in the big metros.
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Another important reason was that our country was in a state of transition. After the post-independence failure of the socialist model, the country had just opened up its economy and its middle-class, who generally form the bulk of consumers in any country, were yet to rise. By the turn of the new millennium, the change was visible. With the growth rate shooting high, we were experiencing a new change in our lives. The working class had finally made its presence felt in the country with all sorts of consumer goods taking a leap in sales. The sales of cell phones also started rising as they began to make their presence felt among the new confident Indians who entered the new century with high ambition levels. Since there was a charge on incoming calls, cell phones were mainly used by those who had business related to it. Meanwhile, the status symbol that it represented kept on diluting day by day.
First Generation (1G): The Analog Networks
The main technological development that distinguished the first generation (1G) mobile phones from the previous generation was the use of multiple cell sites, and the ability to transfer calls from one site to the next as the user travelled between cells during a conversation. The first fully automatic first generation cellular system was the Nordic Mobile Telephone (NMT) system, simultaneously launched in 1981 in Denmark, Finland, Norway and Sweden. NMT was the first mobile phone network featuring international roaming.
Second Generation (2G): The Digital Networks
In the 1990s, the second generation (2G) mobile phone systems emerged, primarily using the GSM standard. These 2G phone systems differed from the previous generation in their use of digital transmission instead of analog transmission, and also by the introduction of advanced and fast phone-to-network signaling. Coinciding with the introduction of 2G systems was a trend away from the larger ‘brickle’ phones towards tiny 100–200 gm hand-held devices, which soon became the norm. The second generation introduced a new variant to communication as SMS text messaging became possible, initially on GSM networks and eventually on all digital networks. The first machine-generated SMS message was sent in the UK in 1991. The first person-to-person SMS text message was sent in Finland in 1993. 2G also introduced the ability to access media content on mobile phones when Radiolinja (now Elisa) in Finland introduced the down-loadable ring tone as paid content.
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Third Generation: High Speed Data Networks
The main technological difference that distinguishes 3G technology from 2G technology is the use of packet-switching rather than

circuit-switching for data transmission. In addition to this, the meaning of 3G has been standardized in the IMT-2000 standardization processing. This process did not standardize a technology, but rather a set of requirements (for example, 2 Mbit/s maximum data rate indoors, 384 kbit/s outdoors). Inevitably there were many different standards with different contenders pushing their own technologies, and the vision of a single unified worldwide standard broke down and several different standards have been introduced. The first pre-commercial trial net-work with 3G was launched by NTT DoCoMo in Japan in the Tokyo region in May 2001. During the development of 3G systems, 2.5G systems such as CDMA2000 1x and GPRS were developed as extensions to existing 2G networks. The 3G telecom services generated over 120 billion dollars of revenues during 2007 and at many markets the majority of new phones activated were 3G phones.

What Is 3G?
Undoubtedly, the name refers to many unique capabilities. It possesses the potential of keeping people connected at all times and places in a more advanced manner, much closer to reality. It offers enhanced multimedia applications, something that has become a priority feature for every person when buying a new phone. This 3G technology makes a cellular phone work like a smart phone with its superior multimedia features. 3G is the next generation of mobile communications systems.

The high cost of a 3G compatible handset could also prove to be deter-rent. The enthusiasm of the existing players to procure 3G licenses can only be to pick up spectrum that is scarce for their existing 2G voice services. Instead of providing premium data ser-vices which currently do not have a big market anyway, they could well use the spectrum for the plain old voice communication, the demand for which continues to expand quickly. Sanjay Sinha, CEO, L&T Mutual Fund, says, “The next paradigm shift in the industry will come from the expansion of value-added services (VAS) and this will take some time to establish itself and stabilise. The outcome of the 3G auctions will set the tone in terms of the cost levels at which these VAS will be rolled out for the customers”.

Aggressive Bidding
We feel that the fear of value loss from not winning the 3G auction is likely to put pressure on the existing players to bid aggressively out of their comfort zone. Also, this may lead to certain operators fighting tooth and nail to win 3G spectrum in specific circles like Aircel in Chennai/Tamil Nadu where it has a steady and high ARPU subscriber base. The base would be at risk if they do not win the 3G spectrum. We believe that state-run firms (BSNL/MTNL) will hurt the most financially, as they cannot opt out of the auction, but will be required to match the clearing price.
We feel that the 3G bids by the incumbents to be driven by need of additional spectrum. Most of the 3G spectrum to be allocated will be utilized for augmenting existing capacity to carry voice traffic. Post launch of GSM networks by Tata Tele and RCOM, there is overcapacity at an industry level but at the individual company level, particularly Bharti, Vodafone and Idea, networks are rapidly reaching capacity limits. Because of this, the need for additional spectrum is the highest for Bharti, Vodafone and Idea  for Vodafone and Idea in their 16 and 11 incumbency circles, respectively. Hence, these three operators should be ready to pay a premium price for spectrum in these incumbency circles in this round of auction, thus driving bids higher.
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Another scenario that may come into play is the entry of new players who have qualified for the bidding process. The entry of new players who do not have presence in 2G is likely to lead to aggressive bidding in the 3G auction and may take it to irrational levels. The main winner to emerge from the auction is the Government of India (GOI). According to industry estimates, GOI is likely to net 3x the reserve price that has been set for pan-India. The circles that are likely see the most aggressive bidding are Maharashtra, Tamil Nadu and Mumbai. It can also be possible that all the slots in the smaller circles are not taken up as the operators may find the cost of rolling out the 3G network in these areas prohibitive as compared to potential pay-off
License Fee Amortisation
The bidders may witness some earnings’ dilution owing to the following points.:

1. Amortisation Of Spectrum Price: The payment made for 3G spectrum will be amortised over 20 years (USD 100 million per annum assuming a pan-India clearing price of USD 2 billion).
2. Increased Spectrum Usage Charges On 2G + 3G AGR: The upward revision in spectrum charge slab will be applicable to 2G AGR as well.
3. Increased depreciation and interest cost without commensurate EBITDA from 3G rollout in initial years of rollout. Some of these earnings-dilutive factors will likely be mitigated in the later years as 3G services start generating revenues/EBITDA, and capex intensity of the business goes down (3G as a technology entails lower capacity capex as compared to 2G).
4. There would be no tax benefits on 3G auction fee and rollout capex under Sec 80 IA of the Income Tax Act.
Major Challenges For 3G Bidders
The 2G + 3G operators would pay spectrum usage charges on total 2G + 3G AGR. Standalone 3G operators would attract the bottom slab rates, i.e. 3 per cent of AGR. The proposed spectrum usage charges are higher than the current slabs applicable to 2G operators and this would mean increased incidence of regulatory levy on the existing base of revenues as well, especially in circles where a winning operator holds a spectrum of more than 8.2 MHz. Bharti will get impacted in seven circles.
BWA spectrum would attract a spectrum charge equal to 1 per cent of AGR from BWA services. 3G/BWA spectrum assigned in the auction will not to be counted towards calculation of spectrum charge slab. Annual spectrum charges shall be applicable from the date of award of right-to-use allotted spectrum commercially (September 1, 2010). However, there shall be a moratorium of one year from this date on the payment of spectrum charges for the standalone 3G as well as standalone 3G + BWA operators (i.e. winners of 3G/ BWA spectrum who do not hold 2G spectrum). The moratorium of one year shall not be applicable to operators holding 2G + 3G spectrum.

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Conclusions & Recommendations
We are holding a cautious out-look about the auction process as the track record of the GOI in the last two years has not been that attractive when it comes to the auction of the 3G spectrum. We believe that any road ahead can be perfectly viewed after the 3G and BWA auction is successfully completed. “In the present telecom space the service providers are passing through a tough time because the telecom sector and the players are witnessing a trend of declining ARPU.