Idea Cellular (Idea) and Vodafone India boards approved the merger of operations on 20th March. Deal is expected to be closed in FY18-19 after regulatory approvals.
Rationale for the deal:
In our note on 2nd September 2016, we had said,
“As opposed to Airtel, Idea is in losing position given its negative cash flows, highly leveraged balance sheet and lack of capital defend its market share. The company will need more debt to participate in spectrum bidding but its lack funds from shareholders or bankers. The company may have to go for rights issue thereby diluting equity holdings. Or they may consider consolidating with other players to fight back Reliance Jio Infocomm.”
We had mentioned quite early that Idea would have to raise cash or merge with competitor to survive. Of all the telecom players, Idea was lagging in term of 4G capex and spectrum. The very existence of Idea was questioned since free cash flow ex growth capex was negative for Idea.
Vodafone was facing similar problems in ramping up internet services. With access to higher spectrum the company could have delivered better services and with large customer base it could lower prices to make it attractive to fight Airtel and Reliance Jio.
Combining both the entities would reduce duplication of resources and costs. It would have led to better marketing, support and optimum use of spectrum. While Vodafone leads in Urban area coverage while Idea Cellular leads in Rural areas. Hence, the merger deal went through which would result in reduction of operational costs and also improve sales on total investment.
All telecom companies should be valued based on EV/Earnings Power. However, the deal was signed based on EV/EBITDA. On EV/EBITDA basis, both the companies got valued at 6X EBITDA. Additionally, Indus tower stake of Idea is ascribed another Rs. 6700 Cr. or Rs 18/share.
Based on management’s assessment of potential synergies, Idea Cellular and Vodafone together would accrue 67,000 Cr in net present value. Total benefit of synergies would result only in FY21/FY22. We believe that the estimates of synergies are too optimistic.
Previously, we had estimated over five years Idea would earn Rs. 18,000 Cr. in operating cash flows & Maintenance capex would be around Rs. 8000 Cr. Assuming, last 2 years of free cash flow of Rs. 12,500 Cr, debt at the end of fifth year would reduce to Rs. 39,500 Cr. Assigning 13X Earnings power of Rs. 10,000 Cr, it would give us Enterprise value of Rs. 1,30,000 Cr. Deducting debt and present value would have resulted in Rs. 137 per share, and hence our MRP is Rs. 151/share assuming Idea’s stake in Indus Tower.
However, due high spectrum charges one side and fall in EBITDA in near term due to pricing pressure, the company would have earned lower than expected free cash flows. In that case, the company would otherwise had raised capital from the market or the promoters. In near future, due to lower EBITDA margin and higher interest cost, the company may report accounting losses. To avoid equity dilution, the management found it wise to merge with Vodafone. This will give the company muscle to sustain competition as well as reduce stress on Balance Sheet.
We always had concerns about Telecom industry hence we refrained from given any BUY signal in any of the three telecom companies, i.e. Reliance, Bharti Airtel and Idea. Near term is challenging due to entry of new player with strong financial footing. Airtel though has stronger balance sheet, near term pricing pressure would result in slower sales growth and fall EBITDA. While long term prospects are good, we need to buy the stocks only when long term conservative value would give us more than reasonable 15-17% CAGR on our capital. Since this is highly uncertain and leveraged play, we can’t ignore slippage in execution by any of the players.
We always liked Bharti Airtel over other players due to capable management, Leader in technology ramp up, stronger balance sheet, sticky corporate post-paid customer base. However, it hasn’t yet come to a price where we would get returns to an extent of risk taken investing in an Indian telecom venture.
