Will Vodafone's new Idea work?

Image: Shailesh Andrade / Reuters

Talk of consolidation in the Indian telecom space has been brewing for a while. But the biggest announcement came on January 30 when UK-based Vodafone Group Plc confirmed its Indian business was contemplating a merger with Idea Cellular, the mobile telephony arm of the Aditya Birla Group.

The deal, if consummated, promises to be the mother of all mergers. Vodafone India is the country’s second largest telco, and Idea the third largest. Together, they are likely to create India’s largest telecom firm, overtaking Sunil Mittal-led Bharti Airtel, with the combine looking at a close to 42 percent revenue market share, a 36 percent subscriber market share, and revenue of around Rs 74,500 crore, according to a Motilal Oswal research report.

The rationale behind why Idea may want to join forces with a bigger competitor isn’t hard to fathom, given the strain on its balance sheet caused by the current turf war in the Indian telecom space. Reliance Jio, the new 4G broadband wireless and telephony services arm of the Mukesh Ambani-led conglomerate Reliance Industries Ltd has rolled out operations aggressively in a bid to rapidly capture subscriber market share. Under a promotional scheme, Jio’s voice and data services are being offered free to consumers till March 31.

For the quarter ended December 31, 2016, Idea posted a standalone turnover of Rs 8,662 crore, up by 3.3 percent year-on-year, but down by a massive 7 percent over the preceding quarter. From a profit of Rs 22.5 crore in the December 2015 quarter (and Rs 4 crore in the September 2016 quarter), Idea plunged to a loss of Rs 479 crore in the third quarter of fiscal 2016-17. The telco’s Ebitda (earnings before interest, tax, depreciation and amortisation) fell by a massive 24 percent sequentially to Rs 2,165.5 crore in the same period.

Despite dropping voice and data services rates significantly, Idea lost 55 lakh data customers during the October-December period.   
 
An Ambit Insight research report called Idea’s operating metrics for the December quarter “disastrous” and said the Aditya Birla Group company fared worse than other incumbents, including Vodafone and Airtel.

Apart from falling revenues, the sharp dip in Idea’s profitability was exacerbated by higher depreciation and amortisation charges due to the high capex investments that the company has been putting in place over the last two years, including purchase of expensive, additional spectrum, to retain the telecom circles it operates. Owing to this acquisition of additional airwaves, the company’s interest and finance costs jumped by 170.5 percent year-on-year to Rs 923 crore in the December quarter.

The Ambit report noted that the loss reported by Idea in the last quarter was the first ever quarterly loss reported by the company since its listing in 2007.   
 
While analysts agree that the Vodafone-Idea entity will have the requisite muscle power to withstand competition, it is unlikely to ease competition in the sector. “A planned merger should help them (Vodafone India and Idea) withstand intense price competition, but it is unlikely to lead to increased pricing power for operators in the short term,” said a research note by credit ratings agency Fitch Ratings.

“The consolidation may not result in reduction in competitive intensity for the sector. We believe Reliance Jio will continue to disrupt the market till it gains volume market share proportionate to its capacity market share,” an Edelweiss Securities research report said.

But Fitch expects the proposed merger to improve the combined entity’s Ebitda (earnings before interest, tax, depreciation and amortisation) margin by 250-350 basis points due to “cost savings —mainly on network and marketing expenses”.

According to Edelweiss, network cost rationalisation will be the biggest benefit since the average spectrum holding of the combine will be 32 percent higher than what Idea has at present, leading to proportionately higher capacity per tower that will help keep network operating expenses under control.

However, there are certain unknowns with respect to the proposed transaction, including the structure of the deal. Though Vodafone is a larger entity, Idea has said the premise of preliminary discussions to explore a merger was equal rights over the business. “If the Aditya Birla Group is working towards equal rights, it could imply fresh equity infusion from the group in the combined entity,” says a report by ICICI Securities. A Credit Suisse research report estimates that to bridge the valuation gap, the required equity infusion in the merged entity, such that Vodafone and Idea get an equal stake, could be in the region of $2.39-$3.72 billion (Rs 16,000-24,900 crore, based on Monday’s rupee-dollar exchange rate).

According to the Fitch report, the merger plan may also face some regulatory hurdles as the combine will end up holding more spectrum in a few circles than telecom regulations allow, which would need to be sold to other telcos or surrendered to the government. The forced sale may benefit other telcos in need of such spectrum. And considering the new company can fetch as much as Rs 7,500 crore from such a sale, it can use this to beef up its own operations, the Motilal Oswal report said.

Meanwhile, analysts say Bharti Infratel, the listed telecom tower arm of Bharti Enterprises, of which Bharti Airtel is also a part, will definitely bear the collateral damage of the proposed merger considering it is likely the combine will surrender some telecom tower tenancies. Around 39.5 percent of Infratel’s revenue comes from Idea and Vodafone at present, said the Edelweiss report, and a 15 percent tenancy rationalisation could lead Infratel’s turnover (Rs 5,595 crore in FY16) to contract by as much as six percent. 

(Reliance Industries is the owner of Network 18, publisher of Forbes India)