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What Vodafone will collect from the Hutch call

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Krishnan Thiagarajan

Vodafone Plc, the world's largest mobile operator, has landed a prize catch in Hutchison Essar, marking the British telecom major's full-fledged foray into the Indian mobile market. In a bidding war that lasted over two months, Vodafone clinched the deal (subject to formalities), pipping Reliance Communications and the Hindujas at the post. At an equity value of $11.1 billion for a 67 per cent equity stake (implied enterprise value of $18.8 billion), Vodafone will be paying a steep control premium.

Clearly, for Vodafone, the control premium is linked to entry into the "largest growth market in which we can acquire control" and 67 per cent will give the company a controlling stake in Hutchison Essar. As Mr Arun Sarin, CEO of Vodafone Plc, said at a press conference immediately after the deal: "It is fundamentally at the heart of our emerging market strategy of extracting growth. India is only 13 per cent penetrated, China is 40 per cent penetrated and Europe is 100 per cent."

Strategic intent

For the world's largest mobile service provider, the rationale for this deal springs from:

Emerging market focus

: Vodafone has lacked a cohesive emerging market strategy, especially in India, the fastest growing mobile market. Considering that the monthly mobile subscriber addition in India, at over 6 million, overtook China's in September 2006 and is likely to stay that way for the next few years, there was no choice for Vodafone but to place India as the centre-piece of its emerging market strategy.

In outlining Vodafone's strategic priorities in May 2006, Mr Sarin had highlighted that it would pursue "selective opportunities to extend footprint" in the emerging markets. Following up on this strategy, Vodafone has snapped up Hutchison Essar, which opens the gateway into the Indian market.

Fourth largest player

: The acquisition of Hutchison Essar will make Vodafone the fourth largest operator in the Indian mobile sweepstakes. Since mobile penetration in India, at 13 per cent , is likely to exceed 50 per cent (at 500 million subscribers) by 2012, the sector is probably at the starting block of a serious battle for mobile market share.

Hutchison Essar's subscriber base, at 24 million, is only 1.5-2 million lower than the state-owned Bharat Sanchar Nigam (BSNL) and 7-9 million lower than Bharti Airtel and Reliance Communications. Considering the four-fold rise in market opportunity and 6-7 million subscribers expected to be added every month, the competition, which will ride on scale economies and innovative value-added services, will be keenly watched.

Bharti Airtel, in which Vodafone had acquired a 10 per cent effective equity stake in late 2005, did not meet its objective. SingTel, which is Bharti's existing and dominant foreign partner, with over 30 per cent equity stake, has remained firmly in the saddle, with no intention of selling out. For that matter, it recently stated that it is willing to buy what Vodafone will have to offload in Bharti if it succeeded in buying Hutchison Essar.

Aggressive deal dynamics

Considering that Hutchison Essar was the only asset available for acquisition, the price tag and valuation attached to this deal are stiff, with a sizeable control premium. Taking three commonly employed valuation yardsticks to compare the Vodafone-Hutch Essar deal with its key mobile peers, Bharti and Reliance Communications, reveals the following:

EV/Subscriber

: On an enterprise value (market capitalisation plus debt) per subscriber basis, the Hutch-Essar deal is at a 15-20 per cent premium to its peers, Bharti and Reliance. For instance, based on Hutch Essar's implied enterprise value of Rs 85,000 crore, applied on a mobile subscriber base of 23.3 million as of December 31, 2006, the EV/subscriber works out to Rs 36,300

vis-à-vis

Rs 31,800 for Bharti's mobile segment. EV/subscriber is a popular metric for valuation in high growth markets as it reflects the potential for cash-flows.

EV/EBITDA

: From an EV/EBITDA (earnings before interest, depreciation, tax and amortisation) standpoint too, the deal works out to a premium of 25-35 per cent to Bharti and Reliance. Compared to the EV/EBITDA of Bharti's mobile business, at 21 times, Hutch Essar's works out to 28 times. This metric reflects the operational cash flows that can be reinvested for growth.

EV/ Revenues

: Based on this metric too, the Hutch-Essar deal works out to a 20-30 per cent premium over its peers.

Why control premium?

Vodafone's willingness to pay the control premium stems from some key advantages that it perceives from this deal. It is encouraging to note that the deal meets the investment criteria set by Vodafone in the interest of its shareholders.

The two criteria Vodafone provided are ROIC (return on invested capital) to exceed local adjusted cost of capital within three to five years and IRR (internal rate of return) to exceed cost of capital by 200 basis points. This acquisition meets the Vodafone ROIC criteria only in the fifth year and the IRR is expected to be 14 per cent.

The key elements of the deal that are likely to play to its strengths are:

Infrastructure sharing with Bharti

: Concurrent with the Hutchison Essar deal, Vodafone has entered into a memorandum of understanding for infrastructure sharing with Bharti Airtel. This will include sharing towers, shelter, civil works and back-haul transmission. And Vodafone expects savings in capital expenditure and operating expenditure (opex) for Hutch Essar to the tune of $1 billion over the next five years; the opex savings are likely to improve the EBITDA margin by 1.5 per cent.

These are the tangible savings this MOU can extract on an ongoing basis. Essars, however, are threatening to play spoilsport, having indicated their unhappiness at not being consulted on this issue. How this relationship with the Essar group plays out will have to be watched closely.

Value-added services

: In terms of value-add, Vodafone can plug Hutch Essar into its global procurement chain, especially in the area of ultra-low-cost handsets. Moreover, as the world's largest mobile service provider, with 200 million subscribers, Vodafone can contribute significantly to Hutch Essar's economies of scale in procurement or operations.

As Hutch Essar commences operations in six new licensed circles (through Spacetel) in 2007, efficiencies in network build-outs, low-cost handsets and bundled packages can play a key role in new subscriber additions. In saturated markets such as the metros, it can launch its popular Vodafone Live! services, which give value added access to entertainment, sports and pictures.

3G foray

: Since the telecom regulator is likely to announce the policy for 3G (third generation mobile telephony) in India, Vodafone's 3G experience in Europe will come in handy for growth initiatives. This is expected to help Hutch Essar get a competitive advantage in the 3G market place. Though the benefits from these variables cannot be quantified now, they are likely to pay off in a big way in the long run.

(This article was published in the Business Line print edition dated February 18, 2007)
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