Even at $20 billion Hutch is worth it for Reliance Communications

The best thing about Anil Ambani is not that he is one of the best negotiators and a financial wizard but the fact that he knows his strengths. Anil know that if he has to grow really big he has to leverage his core competence of cracking deals and Hutch deal should be the epitome of his skills.

Takeover of Hutch makes great sense for Anil Ambani. It not only provides an opportunity to enter GSM in a big way and become the biggest telecom operator in the country but it also has lot of synergies which is not available to other suitors.

Hutch has GSM operations in 16 circles where Reliance Communications (RelCom) doesnot have operations and only West Bengal and Kolkata is the over-lapping circles. Hutch has high revenue per minute and ARPUs are also better. Hutch has the advantage of operating in 800-900 Hz band in most circles, advantage which only initial operates have as all new operators are given spectrum in 1800-1900 Hz band. Hutch has around 2.2 crore high end GSM customers which added with 2.8 crore customers of RelCom will increase RelCom customer base to 5 crores.

Apart from this Hutch has premium brand image (and in all probability the successful bidder would have the rights to use the Hutch brand for around 3 years). RelCom on the other hand has Webworlds (now Reliance phone shops) spread all over the country which can act as a good retail touch point for all Hutch customers too. And above all RelCom has 80,000 kms of optic fiber infrastructure which can be utilized by Hutch to cut substantial part of the carriage cost, having direct impact on the bottom-line.

The two companies can also share each others towers and other passive infrastructure. RelCom has invited GSM equipment bid which is estimated to cost around $ 7-8 billion. RelCom by taking over Hutch would be saved this expenditure apart from getting revenues from day one. RelCom would also save on advertisement and marketing expenditure and exit of one major competitor from the market would reduce the pricing pressure. The deal would also shift the telecom market from the price war mode to consolidation mode. Having both CDMA and GSM operations would also provide opportunity to provide other value added services like dual service (CDMA & GSM) on single phone, mobile stock trading etc. RelCom can also extend the free calling to own network scheme to Hutch customers leading to increased customer pull.

The Numbers

At relative realistic Rs 35,000 per subscriber value of Hutch come to Rs. 77000 crores or $17.1 billion. Today Airtel is valued at around Rs. 40,000 per subscriber. At Rs. 40,000 per subscriber the enterprise value of Hutch is $ 19.6 billion. Hutch has a debt of around $ 1.6 billion on its balance sheet which means net equity valuation of $ 18 billion. Considering the synergy and premium for becoming the biggest player in the market $ 18 billion would be an amazing deal for Anil Ambani and even at $ 20 billion (which is little stretched) he would come out winner.

I don’t want to bore the readers hence I would not go into too much details. But I would like to state that Rs. 35,000 – 40,000 per subscriber valuation although might look steep (100x of ARPU per month) but is fair considering the growth rate of the telecom sector which is around 40% per annum. And I would like to reiterate what I have stated in many of my blogs earlier – in 5 years time voice would contribute only 10% of the total revenue and rest 90% would come from data & other value added services. Hence today the focus should be on tying up as many customers as possible. And hence I have based my total valuations on number of subscribers rather than EBITDA etc.

Competition

Others players who are being named as probable candidates are Vodafone, Maxis, Airtel and Essar. Vodafone appears to the next best candidate for the deal after RelCom.

Essar: Essar does not have that kind of money and I can bet they can’t arrange that kind of money. Infact they have stop considering takeover as an option. The option in front of them is to retain their current share or sell it out at substantial premium. Their expected strategy would be as follows:

• In case RelCom is the front runner – Ask for substantial premium to sell out. They may ask for 10-20% premium per share over what RelCom pay to Hutchison for their share.
• In case Vodafone is the front runner – They may dilute their stake to 26% by selling the rest 7 % at substantial premium and hope of getting even better deal later. In case they don’t get a premium over the Hutch selling price they may retain 33% which would make Vodafone uncomfortable. Vodafone to reduce the nuisance value may like to buy out Essar completely and park the mandatory 26% with some other Indian company for the time being. However, it would be difficult to find a promoter who can shell out that kind of cash. And regulator would not allow eye wash deal where the Indian promoter is just a sham.

Vodafone: Vodafone is the second best candidate in the race after RelCom. Vodafone is very keen to enter Indian market and therefore invested in Airtel. But substantial stake of Singtel in Airtel has restricted them till date. Vodafone will have to get Airtel’s no-objection as they have non-compete agreement with Airtel. However, it is not expected to be a big problem. Airtel may give no-objection in return of some financial gain or might just give it for free to increase RelCom’s problems. Vodafone on the other hand might reduce the stake only to 9.9% from the current 10% to meet the regulatory requirement. It would also keep the option alive for merger between Hutch and Airtel in future.

Maxis: Maxis donot appear to be a serious candidate right now. Secondly there is not enough synergy benefits as Hutch and Aircel has many circles in common.

Airtel: Airtel also is not serious contender. Firstly, Sunil Mittal being a first generation entrepreneur do not has the financial resources as required in this bidding battle. Secondly he has other new businesses like retail to focus his resources on. And above all as Airtel is present in all the circles there is not much synergy benefit. Infact merger would entail surrender of scare spectrum which would make merger value destroyer.


Funding the LBO

For Reliance funding the Leveraged Buy-out (LBO) should not be a problem. Reliance brand name and Anil Ambani fund raising skills is something few doubt in the financial markets. As per media reports he has already tied by with 5 banks for $ 5 billion each for this deal. And with private equity funds like Blackstone and KKR on his side Anil Ambani has little to worry on this end. (Please note – Blackstone India head Akhil Gupta was part of senior management team in Reliance Infocomm during Mukesh Ambani’s time and is a close friend of Anil Ambani).

Considering the foreign borrowing option (especially from Japan) and unlevereged RelCom balance sheet Anil Ambani might be able to raise funds as low as 6%. At 6% interest (and $20 billion loan), cash outgo annually would be Rs. 5400 crores. Cash profit for the combined entity for the year ended 2007 is expected to be 1.5x of this amount.

He might also dilute his personal stake in RelCom from 66% to 51% to fund this takeover. His 15% stake in RelCom can easily fetch him around Rs. 15,000 crores or $ 3.3 billion. I doubt that he would join hand with Maxis for the bid.

Management

Anil Ambani unlike most other entrepreneurs’ do not fancy having day to day management control over businesses and he has too many things on his plate to work full time on one business. He might retain Mr. Ashim Ghosh and his team for the day to day management however ultimate power would always lie with him and his close circle.

Roadblocks

The two major road blocks Anil Ambani need to look out for is:

• Essar group might act pricy: Essar group might ask substantial premium per share over and above what is paid to Hutchison. As per the TRAI guideline no company can hold more than 10% stake in two different operators in the same circle. Hence the only option in front of Anil Ambani is the merge the two entities which would make 33% stake of Essar critical. Essar knows this very well and they know until unless they sell out this deal can’t go through. Essar may also demand 15% stake in the final entity, which going by Essar’s track record Anil might not be willing to oblige.
• Regulatory hurdle: As everybody knows Anil Ambani is not in good books of Sonia Gandhi and has missed major business opportunities in the recent past due to this reason. Regulation provides enough ammunition to stall the deal if they want to. Another critical factor would be the amount of spectrum the combined entity would be allowed to retain after the merger. If Rel Com is made to surrender substantial part of the spectrum this deal might not make sense.
  

I wish RelCom best of luck. This deal can push RelCom to the big league and it deserves to be there. I would like to reiterate here – in 5 year time voice would contribute only 10% of the total revenue and 90% would come from data and other value added services. RelCom optic fiber infrastructure is major sustainable competitive advantage which it can leverage better once it has higher number of subscribers. Hence even at $ 20 billion Hutch is worth it for RelCom.

Just watch out for RelCom!!

New Twist(25 Dec 2006): As expected Essar is trying to get premium of 10-15% per share from Anil Ambani (ADA) as they know until unless they sell out Anil can’t go ahead with the deal under current regulatory environment.

Hence great negotiator that Anil is has come up with a new plan. The 66% stakes of Hutchison Woampoa maybe bought by the Private Equity firms combine which include – Blackstone, KKR etc. This would help ADA avoid Essar stalling the deal. Later with 66% voting right it won’t be difficult to teach Essar a lesson and force them to move out. Blackstone and KKR will ofcourse get its pound of flesh for the same and may take 16% stake in the resulting company after merger.

Essar's Bluff (Jan 3, 2007): There are news reports that Essar has managed to tie-up with I-Banks for $20-25 billion. As I mentioned before I can bet Essar cannot manage that kind of amount.
And if I-banks are really ready to lend then I request them to please read this - Essar has all its assets already pledged to lenders and their track record in loan repayment is well known. However, the biggest problem is the intent shown by the promoters. They were the first Indian company to default on foreign loan and their problems are far from over. Due to upturn in steel cycle it might not appear so but please note they have not used the opportunity to clean the house. They have restructured the old loans just to avoid being classified as NPAs.
Most important thing worth noting is - they are managing to pledge the same asset to lenders many times over and surprisingly the lenders are not noticing it. (This is glaring example of hollowness of MBA (Finance)'s course curriculum). Essar is pledging the shares of telecom holding company (Essar Teleholding Limited - ETHL) to one lender and shares of the holding's holding company (Essar Telecom Limited) to another apart from pledging shares in Hutchison Essar Limited. Ultimately underlying asset is the same and the same asset can’t be pledged twice. But somehow target oriented mindset of today’s bankers are ignoring this fact. If any bank lends money to Essar for acquiring Hutch shares it would be digging its own grave.