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Mobile Telecoms Big and Small are Dialing Emerging Markets for Growth

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Every day in emerging markets, more and more people are hearing the sound of cell phones ringing. Indeed, as mobile telecommunications markets in Western Europe become more commoditized and subscriber growth slows, established players from there and North America are increasingly moving into emerging markets to maintain their growth momentum. At the same time, local and regional companies are also gearing up, betting that being smaller and nimbler will help them garner market share despite competition from the global telecoms giants.

The jousting among mobile providers in emerging markets is understandable because the rewards may be substantial. Standard & Poor's Ratings Services sees strong upside potential in terms of gaining new subscribers and generating cash flow in a number of markets. That's largely the result of demographic trends and macroeconomic forces that are encouraging more people to acquire cell phones and use the many services that come with them. Also, network rollouts are generally well advanced from a coverage perspective, with capital spending devoted to improving capacity.

As a result, many mobile operators have been able to enhance their credit profiles through adequately funded and successfully executed business plans and reasonably conservative financial policies. Standard & Poor's upgrades reflect these trends.

However, the road to success in emerging market mobile isn't always smooth because many risks can offset the robust growth potential. Among these are risks related to economic volatility, foreign exchange, political and institutional instability and corruption, inflation and high interest rates, and the minimal depth of local capital markets. In addition, many emerging markets still suffer from relatively inefficient information flow from companies to investors.

Growth Prospects And Market Specifics Determine Our Assessment Of Emerging Market Mobile Operators

When analyzing emerging market mobile operators, Standard & Poor's bases its assessment on several factors. On the business risk side, these include an evaluation of growth opportunity and market maturity, demographics, macroeconomic conditions, and country risk. We also review the competitive and regulatory environments that affect the growth prospects and security of an investment. And we consider trends in use, average revenue per user (ARPU), customer churn, and revenue contributions from data services. These factors provide good clues about the quality of the customer base. Network technology, geographic coverage, and capacity, and the related capital requirements are additional key elements. Choice of technology can also be important.

For example, some operators in the past badly handled their network upgrades to GSM from TDMA --and lost a lot of customers.

When we consider the financial risk profile of an emerging market mobile operator, corporate governance and financial policy are particularly important. And business plan execution and market characteristics have a strong influence on prospects for profitability and cash flow generation. Business plan funding and liquidity are essential in the start-up phase, and they need backup from an adequate long-term capital structure. A robust mechanism for the parent to move cash from an operating unit located in an emerging market to the parent company outside an emerging market country when necessary is an important element of a company's credit quality, enabling it to cover interest payments or repay debt at the parent company level.

Low market penetration supports demand

Mobile operators naturally look to areas with large populations and low wireless penetration for subscriber growth. Countries like India, China, Brazil, and across Africa fit the bill (see table 2). In many such markets, the limited availability of fixed-line services has made mobile telephony the only source of telecoms service. And that has created plenty of pent-up demand that people often satisfy as soon as mobile service becomes available. Falling network equipment costs have created financial scenarios that provide better returns for operators than historically, enabling them to invest in more remote areas or expand coverage.

Instant access and cheaper handsets boost subscriber numbers

Most people in emerging markets use mobile telephony on a prepaid basis, which gives them instant access to services. This reduces operators' exposure to the risk that customers won't pay their bills, which can occur with postpaid contracts.

As personal income increases in emerging markets more people can afford the cost of a handset. Adding to affordability is the production of cheaper handsets. In India, for example, a mobile handset now costs about the same as a bicycle. National economies with sufficient personal income levels to get over the barrier of handset ownership offer more near-term attractive investment prospects for operators, but decent returns can be made in poorer economies despite low ARPU in nominal U.S. dollar terms. Some countries have experienced low ARPUs from the outset, while we are seeing higher ARPUs in service areas with low penetration declining incrementally as lower use subscribers are added to the network.

Nevertheless, the mobile phone is increasingly becoming an enabler of personal income generation and livelihood improvement in emerging markets. In some countries, we are seeing a growing viral marketing effect and scale impact, contributing to meaningful operating cash flow increases for operators. At the same time, scale achievements and learning from experience have helped improve distribution channels and handset distribution. This leads to operating efficiencies that can translate into higher profit margins for operators.

Competitive and regulatory environments can be critical to successful operations

Air-time rates have gone down on a per-minute basis due to growing competition and, in some instances, regulation. In certain South American countries, for example, regulators have mandated per-second billing (which carriers in very competitive markets normally use) to improve affordability. Although this may cause an initial drop in revenues for operators, the price elasticity effect of per-second billing could eventually lead to higher usage and revenues.

Although there are variations across markets, a reduction in regulatory levies can have a positive effect on operators. A balanced approach to license fees gives more financially constrained operators a chance to expand their businesses past the critical point of reaching positive free operating cash flow (FOCF) generation. This is also positive for an emerging market country's national budget, as a profitable and cash flow generative operator will start contributing higher taxes from a stronger operating base. In many cases, a mobile phone operator will be one of the major corporations in a given country. In countries where businesses collect value-added taxes or other levies, mobile phone operators can act as relatively efficient tax collectors. As a result, governments might be less inclined to stifle operators that represent large chunks of foreign direct investment in poorer countries and are an important source of employment.

Minimal pension burdens back operators' risk profiles

Credit quality is also supported by the absence of significant employee pension obligations for mobile operators in emerging markets compared with long-established fixed-line telecoms companies in Western Europe and North America, for example. The minimal pension obligations result from a younger workforce and the companies' comparatively short tenure.

Technological, Security, And Corporate Governance Issues Cloud Visibility

Although growth opportunities in rural areas provide potential upside, providing basic coverage can be difficult. Some countries also present security problems. In Iraq, for example, high security costs burden the operations of Orascom Telecom Holdings S.A.E. (B+/Stable/--), through its subsidiary Iraqna. Elsewhere, the electricity supply needed to operate networks may not be reliable, and illiteracy can handicap the current and future uptake of data services.

Having local partners can occasionally increase operating risk

Corporate governance and the activities of any third-party minority shareholders at the country operating level can have a serious impact on operating efficiency and control. The situation at Ukrainian market-leading mobile operator CJSC Kyivstar GSM provides an example of this. As a result of a dispute between 56.52% shareholder Telenor and 43.48% shareholder Storm LLC (controlled by Altimo, an affiliate of Russia-based Alfa Group), a court injunction has prevented Kyivstar from disseminating financial or operating information. This required a waiver on Kyivstar's bond indentures to avoid triggering an event of default, leaving investors with no financial information on the company until April 30, 2008. The dispute also raises questions as to whether the board procedures can be followed properly and whether it can make decisions effectively.

Local minority investors can provide substantial on-the-ground knowledge, political and regulatory contacts, and local financial market brokering when a telecom first enters an emerging market. However, the local partner's interests may not always be aligned with those of the foreign strategic investor. Between 2001 and 2003, for example, the minority local partner of Millicom International prevented management from gaining access to its operations in El Salvador and forced a temporary deconsolidation of the operating subsidiary's results. Following the partner's subsequent exit, the operation is now one of the most important for Millicom and is performing well.

Across the range of companies we rate that have a local equity partner, working relations with the strategic investor are varied. As a result, a multinational operator's approach may differ according to each market. Players that can adjust to the political and governance context in a given jurisdiction will generally be the most successful. This is perhaps a reason to consider that success is achievable not only through the financial firepower of a company like Vodafone Group PLC (A-/Stable/A-2) or Telefonica S.A. (BBB+/Stable/A-2) as it enters an emerging market, but also the entrepreneurial flair or operating and strategic flexibility that can be seen at smaller operators that don't have immediate access to as significant capital resources.

Convertibility risk is present, albeit with limited negative effects to date

Convertibility risk (that is, the ability to move cash out of a country when necessary) can be an important consideration for emerging market players that need to service foreign currency-denominated debt or pay suppliers abroad. To date, there are relatively few examples of the mobile phone companies we rate suffering from the inability to move cash out of a country due to convertibility risk or factors linked to political and institutional risk (which is high in certain jurisdictions). Payments can be made out of a given country once the central bank approves the convertibility, assuming all legal issues and covenant compliances (if applicable) are in order.

Operators need to mitigate the impact of foreign exchange risk

Billing in local currencies while purchasing equipment and repaying certain obligations in hard currencies can expose operators to currency fluctuations if sufficient hedging is not in place. This also applies to variable interest rates on hard currency debt. In many cases, the smaller size or profile of emerging market operators may render hedging prohibitively expensive or impractical.

Operators can attempt to mitigate the impact of foreign exchange risk by pegging the price of their services to a hard currency such as the U.S. dollar. The flip side of this is that revenues may be impaired at times of negative local currency volatility, as pegging reduces the affordability of services and, consequently, causes a drop in mobile phone use. Russian mobile operators, for example, after pegging their services to the U.S. dollar for many years, have now started billing and pricing in Russian rubles given the relative stability of the ruble against the dollar and euro. This has been accompanied by an increase in the depth of the Russian ruble bank and bond markets, with companies increasingly sourcing funds locally.

Players face high churn in competitive markets

Competition between operators can be intense in emerging markets--despite the fact that penetration levels are lower than in Western Europe--particularly in the race to acquire subscribers. There are a number of pressure points: first, network availability and coverage to satisfy and service pent-up demand; second, tariff competition to continue driving penetration and usage; and third, customer service and innovative products to provide both product and brand differentiation. One example of innovative products for emerging market players is Millicom's "e-pin," which enables subscribers to charge their prepaid accounts wirelessly in very small denominations.

Although these markets are very heavily weighted toward prepaid telephony, which eliminates customer-related credit risk, emerging market operators are generally more exposed to churn than their counterparts in Europe and the U.S.

Churn results from several factors, including competing operators' zeal to attract customers through innovative product offerings. Tariff plans that do not give customers an incentive to remain on a given network also contribute to high churn. In many markets, new connections are represented by SIM cards: when bonus introductory minutes are depleted, users will buy a new SIM card from the same provider or a competing operator. Assessing an issuer's creditworthiness by subscriber number statistics becomes meaningless in these circumstances; revenue and EBITDA growth are more effective indicators of the sustainability of a company's performance.

Regulatory risk and enforcement of legal agreements can be challenging

Regulatory risk, including license and spectrum risk, can be unpredictable. Typical emerging market problems arising in this area emanate from political and institutional instability and corruption. Issuers frequently insist that such risks are of a theoretical nature, but there are instances in which they materialize. For example, until recently in Iraq, three operators provided service nationally according to temporary permits. The Iraqi government had not awarded any licenses. When full licenses were issued, Orascom, which had already made substantial investments in infrastructure in the country, was outbid by another entity that did not yet provide service in Iraq and lost the right to operate--a risk that had originally been considered unlikely to materialize. Orascom signaled a possible sale of the business and subsequent potential exit from the Iraqi market after it dropped out of the bidding process. It is only now in the process of organizing the continuity of its business in Iraq through a joint venture with one of the bid winners.

Other examples include the expiry of Millicom's joint venture in Vietnam in 2005, leaving it without a business in that country. Spectrum confiscation risk surfaced for Vimpel-Communications (JSC) (VimpelCom; BB+/Stable/--) in Russia at the beginning of the decade, which caused some concern for the development of its business. For its part, Mobile TeleSystems (OJSC) (MTS; BB-/Positive/--), which operates in Russia and the Commonwealth of Independent States (CIS), ran into problems in Kyrgyzstan in 2005 when it failed to take control of its $150 million cash acquisition of a 51% indirect stake in Kyrgyz mobile operator BiTel. This reflected problems regarding the validity and legal recognition of an agreement to acquire the mobile operator and resulted in MTS losing control of the operation and writing off $320 million in its 2006 accounts. Generally, disputes that arise over transaction validity, including ownership transfers and control of assets, can be difficult to resolve if a country's judicial system does not function properly.

High Profitability Is Achievable In Emerging Markets

Emerging market mobile operators can achieve high levels of profitability and operating efficiency due to lower labor costs per employee, generally lower marketing and advertising costs, and an ability to maintain relatively high but affordable tariffs in growing markets. Mobile margins vary greatly from below 30% to above 60% depending on economic, regulatory, and competition factors (see table 3). An important consideration is the level of traffic that it is "on-net" and that does not require an operator to pay call termination to another network in the same market. First entrants to a market or players with a large subscriber market share (greater than 50%, for example, as seen in a number of markets) can significantly boost margins by paying a lower proportion of mobile termination fees. Operators in countries such as Brazil, Pakistan, and Argentina are, however, feeling the effects of margin pressure owing to intensifying competition.

Emerging Market Mobile Operators Show Financial Policy Restraint Relative To Western Markets

Given the business risk considerations for emerging market companies linked specifically to the jurisdiction in which they operate, leverage ratios have typically been lower than those seen in more mature markets that provide greater operational visibility from a regulatory and country risk perspective. Leverage levels are not generally significantly higher than 2x for the more established emerging market operators, although EBITDA at the start of operations may negatively skew leverage ratios relative to the long-term capital structure in place (see table 4).

Operators that have passed their initial development state in terms of network rollout and peak capital expenditures, and that have achieved sustainable market positions, can ramp up free operating cash flow generation meaningfully. The excess cash allows companies to further enhance their network if necessary, undertake M&A, or start paying dividends. Operators rarely use free cash flow to lower nominal gross debt levels, as this would not necessarily be desirable for an efficient capital structure.

Cash flow growth key to assessing emerging market mobile operators

Mobile players that demonstrate strong visibility on FOCF generation will generally have higher ratings or will have been upgraded over time in line with a visible derisking of the business. Positive free cash flow break-even is supported in most cases by economies of scale, assisted by strong subscriber growth and a good operating performance track record in a predominantly stable sovereign environment. Operators most likely to achieve positive FOCF at an early stage are those that have successfully managed their business development, taking advantage of explosive subscriber growth to self fund. This is an advantage in relation to other telecoms players. FOCF at alternative fixed-line operators, for example, saw slower growth given immediate competition from former state-owned incumbent operators at the beginning of the decade.

Credit fundamentals set to remain stable in the medium term, although funding sources could fluctuate

Notwithstanding variations between markets, we expect positive organic growth fundamentals to remain broadly in place for the remainder of 2007 and into 2008. What may change is the pace of growth in different markets, which influences the pace of investment and, consequently, the level of funding and additional debt needed by operators that have not yet achieved sustainable positive FOCF generation. In addition, access to capital essential for business plan execution may be dictated by overall global credit market conditions. The recent capital market liquidity squeeze should prompt emerging market treasurers to plan financing actions as early as possible to avoid market fluctuations and liquidity pressures.

Ability to upstream cash can be key in sensitive capital markets

In countries with thin capital markets, operating subsidiaries need to receive funding through equity injections or downstream loans. Similarly, parent companies need to be able to upstream cash from their main cash-generative operating subsidiaries. The inability to do so can significantly limit financial flexibility, although the maintenance of significant cash balances at the parent company level can provide comfort to bondholders. Careful use of reasonably priced loans available at the operating company level is therefore viewed positively by Standard & Poor's, as it limits recourse to the parent company and avoids the need to upstream cash, which may be subject to sovereign and foreign exchange risks.

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