The Hindu Business Line : Due diligence comes calling

Hutch in India has been busy opening its books for teams of due diligence from different prospective buyers. The stake of contention is the 67 per cent that Hutchison Telecommunications International Ltd and its associates hold in Hutchison Essar Ltd.

First, it was the UK-based Vodafone, the world leader in mobile telecom, which sent its team to pore over the innards of Hutchison-Essar, as a prelude to a possible buy of the stake in question. And, at the time of writing, there are reports that Essar Group's bankers, including Citibank and Morgan Stanley, are to start a confirmatory diligence. Meanwhile, the Hinduja group began to crunch the target's financials, as a precursor to launching a full-scale due diligence. The final offer will surely be the next newsmaker for the sector.

Even as the telecom industry comes to terms with `due diligence', eWorld networked with Romal Shetty, Director (Telecommunications), KPMG, to know more about the exercise that appears to have become as popular as a ringtone favourite. Here are his answers to a few `diligent' questions on the subject of due diligence reviews in the telecom domain.

First, what is due diligence?

Due diligence reviews are conducted by proposed buyers before acquisition of a company. As the name suggests, buyers exercise diligence and undertake to verify the facts placed before it by the seller, in order to value the proposed investment. The process involves a high level review of the books of account, business plans, important covenants in major contracts, liability exposure and efficiency of operations. This also becomes a key input prior to placing the final bid based on the valuation of the company.

Why the sudden buzz of due diligence in telecom?

Indian telecom sector is rapidly becoming the Mecca of telecom world attracting foreign investors from across the globe. It is one of the fastest growing telecom market projected to have 500 million subscribers in the next five years. What has been capturing the imagination of sector analysts and common man alike is the ability of Indian operators to come up with offerings like lower tariffs bundled with subsidised handsets on a day-to-day basis and still remain a vastly profitable institution. Aggressive nature of Indian operators poses questions on the vision, profitability and sustainability of operations in the long term. In this scenario, to attract foreign players, service providers have to prove their worth through an independent perspective. This is when due diligence becomes of prime importance.

So what would Vodafone, Maxis, RCom and the Ruias be looking for when they undertake their due diligence exercise to place their formal bids for Hutchinson Essar?

The factors under study can be broadly grouped as financial, tax, pensions, IT (information technology) and operations. Financial due diligence will involve a review of historical income statements and MIS (management information system) reports to validate information about subscriber base, minutes of usage (MOU), average revenue per subscriber (ARPU) on the revenue side.

Won't it be necessary to look into the composition of subscribers?

Subscribers are generally classified as active and inactive. It is prudent to verify the figure of active subscribers and evaluate their demographic profile. The quality of the subscriber base acquired and the value placed on it affects the profitability of the venture from a long-term perspective. Similarly, a clear understanding of the ARPU trend shows the usage behaviour of the active subscribers.

How is MoU important?

MoUs should display a healthy growth. Because a high MOU results in increased network utilisation thus lowering the per customer cost of network expansion. Further, high MoU also means a better return on investment (ROI) made on capacity expansions. The most important analysis which the due diligence team will perform is jointly analysing the MoU and ARPU.

Both MoU and ARPU grow or fall together, don't they?

Growth in MoU does not necessarily increase the ARPU. Most of such growth is due to reduction in cost per unit thereby encouraging usage but as the revenue per minute is lowered, the ARPU does not grow at the same pace. In fact it has been observed that ARPUs have been consistently falling in spite of double-digit growth in MOU.

Will the due diligence team study costs too?

Yes. On the cost front subscriber acquisition costs, interconnect costs, expansion plan, network operations cost, and employee costs will be under the scanner. It should be ensured that subscriber acquisition cost is not more than the expected revenue over the lifecycle of customer. Focus should be on acquisition of platinum customer and conversion of gold customers to platinum. Interconnect cost is an operator to operator settlement for terminating calls on each others networks and directly affect the margins on a per call basis. The expected cost of expansions would give the buyer a good indication as to the fund requirements of the venture in the short to medium term. Operations of a telco primarily consist of sales and marketing, networks, billing, customer care, credit and collections and human resource functions. Effectiveness and efficiency of processes across these functions should be considered. Health of the revenue assurance department and its effectiveness in reducing revenue leakage will be an important evaluation factor.

Is revenue leakage a matter of concern for telecom companies?

It is a known fact that revenue leakages worldwide result in a revenue loss of up to 5-7 per cent. Absence of strong revenue assurance procedures will result in a dramatic increase in this percentage, seriously jeopardising the profitability of such a venture. Another important process closely related with revenue assurance is `fraud management'.

Fraud?

Due to the complexity of systems involved in a telco, it is possible for a customer with fraudulent intentions to dupe the operator. Amount of loss due to fraud and the capability of personnel in the department to detect fraud on a timely basis will be considered in a due diligence report.

Any other factors that a due diligence exercise covers in a telecom company?

Further factors include state of network elements (switches, cell sites, etc.), call drop and block rates, disaster recovery plans and QoS (quality of service) parameters, which are reviewed to evaluate network operations. Good network capacity planning can reduce the overall investment into the network, resulting in a shorter payback period and increase in ROI. Besides the above, evaluation of legal covenants/ exposure, and IT systems in place should be undertaken. Different buyers will assign varying degrees of importance to the above factors and thus would arrive at a valuation for their investment.

ComingToTerms@TheHindu.co.in

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