The Hindu Business Line : Is `due diligence' different for the telecom industry?

While `due diligence' is doing its rounds in the corridors of Hutch, the layperson may wonder what it is all about. Diligence, for starters, is assiduousness, industry, meticulousness, conscientiousness, thoroughness, attentiveness, and carefulness, as Word would tell you in its list of synonyms. And `due diligence' is "an internal audit of a target firm by an acquiring firm," says www.bloomberg.com, in its financial glossary. To know more about due diligence, Business Line contacted Mr Deepak Kapoor, Executive Director-Transactions and Leader, InfoComm Practice, PricewaterhouseCoopers. Here are his answers to a few quick questions.

Excerpts from the interview:

Is a due diligence exercise different in case of telecom industry?

The answer to this question is both — no and yes. No, because this exercise, by its very nature, involves ascertaining that there are no hidden liabilities that an acquirer might end up taking over. The carrying value of assets in the books is representative of their revenue generating capabilities. The historical revenues and profits are sustainable going forward.

And `yes,' because the deal drivers in this industry, many a time, are based more on operations than on finances. We have seen purchase consideration being paid on an agreed value `per subscriber' rather than the more conventional methods of a multiple of revenue or EBITDA (earnings before interest, taxes, depreciation and amortisation). This essentially means focusing the diligence exercise more on ascertaining the actual subscriber base, assessing its revenue generating capacity and probability of continuing on the network, quality of ARPU (average revenue per user), definition of ARPU, and so on. Even when the transaction is based on the multiples of financial parameters, a sound knowledge of the industry and the surrounding environment becomes imperative.

How does a due diligence exercise assume importance in the telecom M&A landscape?

This industry, one can perhaps claim, is different is many ways from most of the traditional industries. The extent of dependence and the impact of external factors such as regulatory issues, licensing guidelines, technological aspects, and market forces, is quite significant and hence a complete understanding of these factors is critical for successfully achieving the objectives of a due diligence exercise.

In what ways do the externalities affect the transaction or the valuations in a telecom deal?

The telecom industry is heavily regulated. Right from the entry stage, to the growth phase — organic as well as inorganic, and even upon exit by way of sale, joint venture, and so on.

Our experience has shown that regulatory directives, such as intra-circle M&A guidelines and licensing conditions, such as prior approval of the licensor, restriction of pledging of licence, minimum net worth criteria, prohibition on change of shareholding, compliance with FDI (foreign direct investment) norms, and so forth can prove to be potential deal breakers.

The rapidly changing enabling technology takes its toll on redundancy of assets carried in the books — be it the billing system, network, IT environment or the backbone infrastructure. In case of a strategic investor, it is very important to assess the post acquisition integration cost to be incurred by way of aligning the various underlying technological platforms such as for billing, VAS (value added services), IVR (interactive voice response), roaming devices, and accounting software.

Even softer aspects such as brand positioning, perception in the mind of customers and advertising strategy, directly impact the quality of customers, the ARPU levels and its composition, which in turn have a significant bearing on the financials and profitability of an operator.

What are the key risk areas on which the due diligence exercise, in general, should focus on when a telecom operator or business is being acquired?

While, an analysis of external drivers does help significantly in taking an informed decision about an acquisition, this can be achieved only after one has completely understood the target and the internal operating and financial issues of that entity. The `as is' scenario has to be mapped in detail to arrive at the associated risks and costs attached with those risk factors.

Even otherwise, this sector has its fair share of typical issues, which could be applicable to any industry. Historically, most telecom operators have been mired in shareholder disputes, which have in most cases, triggered off M&A activities. Being a capital-intensive industry, the lending community has been very active in this industry. The high cost of entry coupled with a long pay back period has led to significant defaults by the operators on debt servicing obligations, a lot of which have reached the court and for arbitration proceedings.

Vendor financing has been a prominent form of funding operations in this industry. It would be very hard to find an operator who would not have had a dispute, if not on financing issues, then definitely on pricing and technological front, with an equipment vendor in this industry if not on financing issues, then definitely on pricing and technological front.

Competition is inherent to any industry or market, but the level of transactions amongst competitors, inter-operator dependencies and the quantum and scale of underlying financial settlements is far greater in telecom industry compared to any other. Right from letting one's own customer generate revenue for the competitor (in a roaming scenario), to compulsory usage of competitor's assets (interconnection for servicing own customer), to voluntary usage of competitor's assets for cost economies (such as infrastructure sharing, and leasing of backbone), the quantum and complexity of inter-operator issues makes this industry unique. All such issues make a due diligence exercise even more important for ensuring that there are no un-recorded or hidden liabilities.

How has the due diligence approach evolved in this industry?

From good old days of gaining a basic understanding of the business dynamics in a pure vanilla voice market of a specific circle, we are now talking of strategic positioning of a player in a pan-India market environment. Distinction between circles is getting blurred and the focus is more on the quality of non-voice revenue and economies being drawn from infrastructure sharing. There is a fundamental change in the business model — from a capex (capital expenditure) driven approach (of creating and owning the network) to increasingly outsourcing-based growth, where critical functions such as network and IT are being left to the experts to manage, who in turn are paid on a revenue share basis. This assumes importance from an accounting perspective as well, since the capex, whose charge to the income statement is in the form of depreciation (a non-cash item and accounted below the EBITDA margin), is being replaced by opex (operating expenditure) items, such as rental for infrastructure sharing, and revenue share for outsourcing services.

The reduction in employee strength, brought about by outsourcing staff in place of retaining employees on payroll, has brought a paradigm shift in one's approach in evaluation of a transaction.

The exercise for normalisation of earnings is now driven by assessing the impact of pay-outs to various (un)related parties under various arrangements, review of capitalisation policy, etc., rather than once important factors such as proportion of now `so called' value added services — itemised billing, bill plan change charges, and roaming rentals and so on.

D. Murali

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