Buy Spice Communications target Rs 70

Investment Rationale

M&A Prospects Add Flavor to Wireless Growth Target Rs70

Spice’s leverage to Indian wireless has, to a large extent, been restored. Moreover, we believe its suitability as an M&A target provides icing on the cake. Ramping up coverage in Punjab and on its weaker Karnataka circle should yield robust EBITDA growth (approx 45% CAGR over CY06-09E). We rate the stock a Buy (1M) with a target of Rs70 based on a 15% M&A premium to DCF.

Coverage increase key

Presence in fast growing markets – Punjab (33% penetration) and Karnataka (22%) – offers potential, especially as Spice moves to augment its market share in the latter (approx 9%). The recent pick-up in share of net adds in Karnataka bodes well. Reducing capital constraints will help further.

Tower outsourcing depresses margins, factoring moderate improvement

About 50% of Spice’s cell sites are on independent towers (70% of CY07 BTS adds). Sliding scale pricing, coupled with single tenancy on 80% of the external towers depresses reported EBITDA margin (21.5% in CY07E) by 6%. Increasing tenancy and scale benefits should lead to margin gain of 600bps in CY06-09E.

Visible upside possibilities

Access to 900 MHz and its small footprint make it an attractive and probably the only M&A candidate, in our view. New spectrum rules may dilute M&A prospects a bit, but on the flip side provides a chance to enter new circles, though constrained by size and management bandwidth.

SCL enjoys the Support of Telekom Malaysia.
TM is a leading telecom player in Malaysia and is having a established presence in Asiapacific
region and has 49% stake in Spice. Thus TM’s experience and its track record in
expanding its business throughout the region will help SCL in implementing its Pan-India
expansion strategy and their relation with TM would help them in getting an access to
additional technical and marketing expertise and economies of scale. TM’s investment will
enhance the operational and strategic expertise of the company

SCL takes constant efforts to expand its operations in other circles of India.
SCL has applied for licences to provide cellular services in an additional 21 circles
throughout India. By providing these services it could provide an additional revenue
stream at a relatively low marginal cost to the company. SCL’s pan-India expansion
strategy includes a gradual build out of a nation wide cellular network of our own or by
means of Acquisition / Merger / Amalgamation subject to necessary regulatory approvals.

SCL operates in the circle of Punjab and Karnataka. These circles offer huge
growth potential.
Spice provides service to 2.4mn wireless subscriber as on December 2006. It operates in
the key area of Punjab and Karnataka where it enjoys a market share of 23.2% and 6.9%
respectively. The Punjab and Karnataka circle accounted for 11.95% of India’stelecommunication market share as on March 2007. Both these states are recognized as
a major Economic Hub of India where Punjab is enjoying the highest Per Capita income in
the country and Karnataka (whose major city is Bangalore) is known as “Silicon Valley” of
India. Thus SCL’s presence in these two circles offers a significant growth potential to it.

SCL focuses on Value-added services.
SCL focus on value added services like Information, Ring tones, Games, etc which would
help the company to attract the subscriber across the broad spectrum of market
segment. Thus SCL’s operational performance will improve significantly due to its focus
on providing Value-added services to its subscribers, efficient operations and economies
of scale.

Risks

Lower than expected tenancy on third-party towers and lower operating leverage in current circles pose risks. Involvement of an intermediate affiliate company for capex lacks adequate clarity and carries transfer pricing risks.