South Africa: Cashing in

FROM THE ECONOMIST INTELLIGENCE UNIT

The South African government looks set to get out of the telecoms business – and not before time.

Liberalisation of the telecommunications sector arrived late in South Africa. In the country's notoriously underdeveloped fixed-line sector, a second operator was only approved last year. In the mobile sector, the tardy arrival of competition allowed state-controlled Vodacom to hang on to nearly 60% of the market.

This state of affairs has been a good one for the South African government which still owns a controlling 38% of the fixed-line operator, Telkom, which in turn owns 50% of Vodacom. In the year to last March, Telkom reported revenues of R52bn (US$7.2bn) and pre-tax profits of R13.5bn, giving a healthy profit margin of 26% and return on equity of 26%.

The bulk of these profits have been provided by the mobile business, which is 50% owned by the UK-based multinational, Vodafone. Given that the mobile phone sector still has plenty of room for growth – particularly in other African economies - the recent news that Telkom aims to sell its stake in Vodacom looked distinctly odd. Surely Telkom could have sat back and enjoyed the profits of its mobile subsidiary – now the largest operator in Africa - or even invested them in better networks for the fixed line business? The latter has, indeed, been on the agenda.

The country's new and growing mobile phone sector, however, could no longer wait for Telkom to get its act together. Telkom's fixed line business has been so plagued by politics and under-investment that less than 10% of South Africans currently have access to a fixed line. This state of affairs put a fire under the mobile sector in South Africa, pushing penetration rates up to close to 75%. But getting dependable network coverage still remains difficult, expensive or both across the South Africa. For mobile operators eager to keep average revenue per user (ARPU) up, this is a problem to be tackled - not ignored.

This summer, as a result, MTN, the country's second operator, announced it would build its own fixed-line network to cut the fees it has to pay Telkom to use its pipes and to meet the growing demand for internet access in South Africa. With 36% of the local mobile phone market and large chunks of other African and Middle East markets, MTN is big enough and profitable enough to carry out these plans. If it went ahead with these plans, it would have created a new competitor to Telkom's fixed line business and enabled MTN to undercut Vodacom's prices as it would have been free from Telkom's network.

Changing places

Despite its strong hold on the market, such a move would be bad news for Vodacom. Telkom, which consolidates 50% of Vodacom's earnings, recently reported that the company's sales and profits both showed double-digit growth in the year to last March. However, churn rates were up in the period. Vodacom's other parent, Vodafone, for its part, recently reported that retention costs increased in South Africa in response to the introduction of mobile number portability during the year and the provision of 3G and data-enabled device upgrades for contract customers and a loyalty point scheme.

In addition to these pressures, Telkom already faces a new fixed-line competitor which received its license in August last year. Called Neotel, the new company is expected to grab 12-15% of the fixed-line market from Telkom by 2009, according to US-based Pyramid Research. Further, Telkom faces increasing pressure domestically and internationally to improve the country's connectivity to the internet, now a paltry 4%, according to Internet World Stats.

No wonder, then, that recent reports from South Africa also revealed that Telkom is in talks to sell its fixed-line business – and to MTN itself. Almost as soon as the talks were confirmed last week, investors sent MTN's share price down as much as 6% while Telkom's shares closed up nearly 9%. Investors were clearly delighted that Telkom could be shedding its fixed-line business and reaping a handsome price for its mobile business from Vodafone to boot.

Just how handsome is up for speculation. South African newspapers have reported that the Vodacom sale would give Telkom as much as R70bn while the fixed-line sale could bring in another R30bn. This windfall could be distributed to shareholders, used to reinvent Telkom as a media company, or perhaps used to buy a lower-tier mobile phone operator. It might be too early, however, to make such predictions. Vodafone, having spent more than US$11bn on India's fourth-largest mobile phone company, Hutchinson Essar, is still making losses and not in the strongest position to borrow a similar sum for the remaining stake in Vodacom.

It may need to convince its bankers to allow a bid for most of the shares, however, in order to maintain its controlling stake. As for the rest of the shares, these are likely to be sold to the public after at least 5% are sold to a black consortium, under the government's Black Economic Empowerment Code.

No matter who buys the shares, the South African government, with its 38% stake in Telkom, stands to make a tidy profit on the two sales. Given its distinctly patchy record to date, its best way forward would be to make sure that Telkom stays away from the telecom business. Buying up a third-place mobile operator, given that the heady days of growth in South Africa's mobile sector are now over, would merely expose Telkom to the harsh effects of market liberalisation that its been trying to avoid for years.

SOURCE: INDUSTRY BRIEFING