Much as Ulysses endured the enchanting music of sirens trying to lure him to shipwreck, South African carrier MTN has been threatening to succumb to the sirens of consolidation. As the chants mount –the latest from Reliance- and MTN itself stays on the prowl for opportunities, we remain somewhat skeptical of the promise of the proposed deals. We review some of the proposed combinations.

THE ORASCOM SIREN: an African born company like MTN, Orascom Telecom is the most attractive opportunity of the bunch. It operates in two of the largest North African Markets (Algeria and Egypt), has a presence in a few small but high growth sub-Saharan African markets and features EBITDA levels well above the African average. But an Orascom deal may also be the toughest to pull off, with uncertainty looming over key assets. First, the company is embroiled in a geo-political tussle in Algeria where the government has rejected a possible buyout of Orascom unit Djezzy by MTN. Further, Orascom’s second most profitable operation, Egypt’s Mobinil, is partly owned by one MTN’s main competitors, France Telecom, who has negotiated an option to purchase Orascom’s remaining share by 2013. As for the remaining Orascom Telecom assets, they accounted for 44% of group revenues in 2009 but only 30% of the EBITDA. In other words, an Orascom without Algeria and/or Egypt is only remotely attractive.

THE RELIANCE SIREN: The Reliance siren resumed its singing last week when the Ambani brothers announced a truce in their longstanding feud by agreeing to do away with their “non-competing” agreements. This allows Anil Ambani to sell Reliance Communications without prior consent from his brother Mukesh; it also means that MTN, who had looked to purchase Reliance Communication through a share swap mechanism, can now go back to the negotiations table. Nonetheless, the asset looks a little less attractive than it did a couple of years ago. Reliance is facing substantial pressure on profitability as a result of stiff competition at home. Its revenues and earnings have dropped significantly over the past year. In addition, MTN may have a rival in Etisalat, which is also said to be interested in the Indian carrier.

THE LITTLE MERMAIDS: We believe MTN should go for smaller and sweeter assets providing both consolidation at home and a beachhead outside its current geographic footprint. Millicom would be a compelling option. The Luxemburg based operator provides some consolidation opportunities in key African markets such as Ghana and Rwanda and fills key African gaps for MTN. In addition, it would open the doors to new markets in Central and South America where the operator holds a strong position.

On March 11, MTN reported its results for the year ended on the December 31, 2009. With group revenues up by 9.2%, organic customer growth at 28% and group EBITDA margin above the 40% landmark, MTN shows notable resiliency in the face of a global economic slowdown and an operating environment that has become much tougher.

• Revenues:  MTN’s revenue growth has decelerated markedly; for the first time, group revenue growth has slipped into single digits.  African revenue rose 6% only to about $13.5bn (vs. 20% in South East Africa and 55% in West Africa in 2008). This evolution owes as much to  a tougher competitive environment, lower ARPUs and slower growth in volumes as it does to the negative impact of foreign exchange depreciation across African markets. At constant FX, revenue growth was a solid 20%.  
• EBITDA: The EBITDA picture is also challenging. Group EBITDA rose by 7% only, a sharp decline from the average of 27% experienced over the three years to 2008. EBITDA margin dropped three percentage points to 41%, with most markets feeling the pressure. The operations in WECA (West, East and Central Africa) and Nigeria showed EBITDA growth in line with group figures at around 7-8% while SEA (South and East Africa) were hurt by bad results in South Africa. The mother operation witnessed a -2% decrease in EBITDA as a result of regulatory pressures and an EBITDA margin down by 4%.The foreign exchange impact was notable here as well, with EBITDA growing at close to 20% prior to the exchange effect.     
• Data & CapEx: Data revenues in South Africa are in strong progression representing 14% of revenue at YE2009; a year on year growth of 22% vs. 11% in 2008. Most importantly non-messaging data is in strong progression representing 55% of total data revenues at YE2009 against 50% a year earlier. The evolution to data is ongoing at group level. In Nigeria the operator reported 78k active mobile internet users via data modems. MTN now operates WiMAX networks in 7 African markets and is rolling out 3G across operations.  Also notable is the fact that MTN’s 2009 CapEx actually rose, in a year when many operators cut CapEx in the face of the global credit crunch. CapEx level reached 28% of revenues, up 31% from 2007 levels (21% to revenues). These efforts reflect MTN’s investment efforts in terms of 3G roll out as well as network expansion to Greenfield areas.

As more governments move to mandate the registration of all active mobile subscriptions, concerns are rising over the impact of this new obligation on operator performance. Late last year, Vodacom indicated that South Africa’s implementation of the regulation mandating subscriber registration (known as RICA) had had a negative impact on its gross subscriber acquisition numbers. In early January, UBS removed MTN South Africa from its Top Telecoms List, amidst concerns that subscriber registration would lead to lower revenues and earnings in 2010. We believe this is an overreaction; we do not expect subscriber registration to have a materially negative impact on the earnings of African mobile operators, and see a more threatening cost impact in other factors. [Click title to read full analysis]

Subscriber registration is a painfully painstaking exercise. Logistical challenges abound, rural areas are difficult to cover, there is deep mistrust of government usage of the data, subscribers and operators just don’t like the process. But few would argue that it’s an unnecessary exercise, as a check against wanton, faceless crime. More African countries have moved ahead with plans, including Tanzania, Kenya, Botswana, Cameroon, and Ghana, and more are bound to follow.

Subscriber registration will have a negative impact, at least in the short term. This stands to reason, for registration introduces enough incremental friction into the subscription process to slash the volumes of spontaneous purchases. Subscriber registration will also likely lead to a drop in overall subscriber numbers as operators are forced to deactivate SIM cards that have not been identified. In one of the most prominent examples, Algeria compelled operators to deactivate close to 3m subscriptions in 2008; gross acquisition numbers subsequently dropped by about 50% year-on-year and the overall user base rose by a mere 3% (vs. 30% the previous year).

Overall however, we find the impact of SIM registration on operator earnings to be negligible at best in the long term (under the critical assumption that the process is not overly complicated), and at worst, a function of established gross additions and churn volume levels. The limited evidence available suggests that gross additions return to near pre-registration levels within 6 months to a year as subscribers learn to adjust to the new rules.  In Bangladesh, where the regulator deactivated 1m unaccounted lines in 2008, the impact on gross adds was marginal.

The argument for a materially negative impact on operator earnings is similarly unconvincing, in our view; in the case of Algeria and Bangladesh, operators experienced short term revenue blips (of one quarter or two) before revenue growth started anew, if from a slightly lower base.  To be sure, this is also a function of the level of penetration. The higher the penetration level, the less marginal revenue is a function of marginal subscriber additions. In Nigeria, for example, net additions are already in decline, and will likely be less than half 2008 levels, independent of any impact from SIM card registrations. Operators may still blame SIM registration, but we are not certain its impact will be any more prejudicial than a natural attrition in the number of acquisitions.

Further, we simply see bigger concerns to earnings elsewhere. The widespread decline in interconnect rates will have a more perceptible impact on earnings than SIM registration, as will across-the-board competition. Nonetheless, we believe first tier players that have moved fast enough to insulate themselves from the volatility of the voice business (as MTN has) are in a better position to withstand the one-time shock of SIM card registration.

 In an aggressive step, the South African parliament’s Portfolio Committee on Communications has announced its intention to push for a major cut in South African mobile termination rates. South African mobile networks currently pay each other ZAR1.25 ($0.17) per peak time minute for terminating calls on their networks. The Committee has indicated that it would like telcos to reduce this rate to ZAR 0.60 by November this year, and by a further ZAR0.15 annually over the next three years. [Click title to read full analysis]

 The net impact of a sharp MTR cut on operators will be materially negative in our view; from a consumer and regulatory standpoint, however, this move may be too little too late.

 - South African MTRs are among the highest in Africa. They are at the same level as rates in such markets as Gabon and Congo-Brazzaville (hardly examples of progressive economies) and 2x-3x higher than at least a dozen other African markets. Regulators in other countries have been more aggressive in cutting MTRs; to say that South African MTRs are due for a downward correction is a hard form of euphemism.

- From a regulatory standpoint, and welcome though this measure would be, there are reasons to be skeptical of its medium term impact on headline retail prices. For one, South Africa is a mature market, with mobile penetration rates around 110%. Competition has settled into a comfortable triopoly, while most other African markets now have four to six operators. The optimal time to make this move would have been prior to the licensing of a third operator in 2001. South Africa’s high prices are the direct result of its policy approximations over the past 15 years, which have created a Gordian knot that will not be easily undone.

- MTRs are merely the tip of the iceberg underneath South Africa’s mobile cost structure. Peak time on-net prepaid rates are 70% higher than the African median. The differential between peak on-net and off-net airtime prices is less than 20%; in other words, on-net calls (which do not include any form of termination fee) are nearly as high as off-net calls. A cut in termination fees would not in itself impact on-net calls, which account for more than half of all voice traffic for the main operators.

- There are other issues; according to the AfricaNext Research report The Future of African Mobile Profitability, South Africa’s network costs are high, at about $4,500-$5,000 per site per month, higher than at least a third of African markets, though increased self-provisioning should start alleviating the burden of this item. Average per employee costs are 2x-3x higher than in most other African markets.

- Strategically, we expect MTR cuts to impact the South African market in a number of ways:

      -Push operators to offer better on-net deals, so as to increase the amount of traffic they control

      -Increase the differentials in prices between on-net and off-net calls

      -Increase overall average usage

 Slashing termination rates may not make much of a difference on a stand-alone basis, but should provide enough of a threat that operators will move to cut on net calls without additional regulatory prodding; moderate on-net price cuts would provide some arguments against deep MTR cuts, with increased usage making up for the decline in revenue.

 -We expect the overall impact of an MTR cut to be a net positive for mobile operator Cell C and fixed operator Telkom, both net interconnect payers. For MTN and Vodacom, the proposed interconnect cut would have a material impact if implemented within the next three to six months. Net interconnect margins typically account for 15%-20% of EBITDA; a 50% cut in termination rates, for example, would slash 3-4 percentage points in EBITDA margin, assuming no change in prices and traffic patterns. As a result, the optimal approach for the operators would be three-pronged:

(1) slow the process somewhat until alternative sources of revenue and cost-savings processes make MTR cuts inconsequential

(2) move in front of the public relations issue, ideally by slashing on-net prices before MTRs are cut

(3) accelerate network self-provisioning.