Spice Communications: Avoid

Investors can refrain from subscribing to the IPO of Spice Communications being made in the price band of Rs 41-46. The company is a pure-play mobile services provider in Punjab and Karnataka, with a combined subscriber base of about three million. Faced with high debt and vendor dues, Spice hopes to raise funds for the twin purposes of part-repayment of debt and future expansion. Though the asking price values Spice at a discount to competitors, such as Bharti and Idea, the company's track record, cost-structure and trends in business growth in recent years suggest that it may not be well-placed to capitalise on the growth opportunities in mobile services, amidst intensifying competition.

Of the IPO proceeds of about Rs 520 crore (at the higher end) and the pre-IPO placement of Rs 112 crore, half is to go towards part-repayment of debt (which stands at about Rs 1,200 crore), and the rest to pay licence fees for starting NLD (national long-distance) and ILD (international long distance) services and repayment of vendor dues (Rs 63.6 crore and Rs 177.6 crore respectively).

Business overview

Spice has been in operation for over 10 years now (inception 1997) and is yet to turn PAT (profit after tax)-positive. The balance-sheet shows accumulated losses of over Rs 684 crore as of December 2006. Other regional players such as Aircel and Idea fare better on the above parameters. Aircel, Bharti Airtel, and Idea, which also commenced mobile services in 1997-98, turned profitable within six-seven years and acquired a national footprint.

Spice appears to have lagged its peers in optimising its network operating costs, possibly signalling that it may not be getting the best deals from its network equipment vendors. At 40 per cent of revenues, the proportion of network operating cost for Spice is a clear 15-20 percentage points higher than that for Idea and Bharti. An increasing trend in these costs over the last three years is also of concern, for future profitability.

Second, trends in Spice's subscriber additions over the last year do not compare favourably to competition. It has only managed to add about 82,000 subscribers a month in Punjab and Karnataka, while Airtel has managed to add nearly 2.5 lakh subscribers per month. BSNL and Hutch have added more than a lakh subscribers a month over the past year in these two circles. Spice ranks fifth among the six mobile service operators in Karnataka, but is better-placed in Punjab, where it is second in terms of subscriber numbers. Aircel, which added 1.5 lakh subscribers a month in the last year, despite being a regional player, has managed to retain its leadership position in terms of subscriber base in both the Chennai and Tamil Nadu Circles. For Spice, the modest subscriber additions and a rapidly-falling ARPU (average revenue per user) over the last couple of years are threats to revenue growth.

Third, a substantial portion of this IPO is to go towards part-debt repayment, vendor payment and licence fees to commence NLD and ILD services. Though this would reduce interest costs, the company may be left with little to be deployed in a national rollout of mobile services. In any case, with only part repayment of debt, interest costs will remain at relatively high levels.

Expansion plans

The company has applied for licences for mobile services in 21 new circles. This signals a move to try and move from a two-circle operation to a 23-circle operator, which appears quite ambitious. Apart from the constraints imposed by Spice's financial position, it is also important to note that getting spectrum allocation is a difficult proposition, given the existing competition for spectrum. That apart, some circles (such as West Bengal and Haryana) already have five GSM cellular (most others have four) and two CDMA (Code Division Multiple Access) operators and, hence, the prospects of Spice acquiring fresh licence(s) and entering new circles appears difficult.

Second, the company's foray into providing NLD services would make far better sense if it were a national player — to carry its own traffic to other circles. Regional players usually lease bandwidth from other national GSM (Global System for Mobile Communications) players for roaming and inter-circle traffic carriage.

Spice plans to have NLD infrastructure in 15 locations, whereas it has operations in only two circles. This might help reduce roaming tariff for its customers in the long run, but would involve periodic capex spending on upgrade and expansion of network to accommodate the increased traffic. Considering the paucity of funds that the company already faces, it could find it difficult to bankroll expansion over the long run.

Third, it will face stiff competition in existing as well as any new circles from national players. In the light of the multi-billion dollar nation-wide network expansion announced by each of these players, aggressive subscriber additions, and falling ARPUs, Spice may not have the wherewithal to withstand the competition. These factors indicate the possible high execution risks.

Valuation

At the upper end of the price band, the offer values Spice at a substantial discount (40-45 per cent) to Idea Cellular on an Enterprise Value/subscriber basis. On other metrics such as EV/EBITDA and EV/Sales, the offer does not build in a significant discount to Idea or Airtel, despite the latters' much larger scale of operations and superior cost structure. Spice's EBITDA (earnings before interest, depreciation and amortisation) margin, at 24 per cent, is lower than the others players (the industry average is around 34 per cent). Recent reports also indicate that the Idea-Spice merger has been called off on account of disagreement over higher valuations.

Offer details: The company proposes to offer 131,111,111 shares amounting to a 16.39 per cent stake in the price band of Rs 41-46 per share. Enam Financial Consultants and UBS Securities India are the book-running lead managers, and Karvy Computershare Private Limited is the registrar to the issue.