It is snowballing into a bidding war of epic proportions. The list of potential contenders for India's fourth largest mobile operator, Hutchison Essar, controlled by its Hong Kong-based holding company, Hutchison Telecommunications International, is swelling by the day. In the past week alone, Hindujas and Verizon Communications were the names tagged to the long list of suitors that now includes Reliance Communications, UK's Vodafone, Malaysia's Maxis, Egypt's Orascom and a clutch of high profile private equity players (KKR, Blackstone or Texas Pacific) willing to ally with any of them.
However, a big "if" is built into this complex equation: the Ruias of the Essar group, who control 33 per cent of the equity in Hutchison Essar, retain the right of first refusal. And they are not willing to give up control over the company without a fight, legal or otherwise.
As this mega deal heads towards a climax over the next few weeks, we focus on three key elements. One, how do Hutchison Essar's performance metrics stack up relative to its two key private sector peers, Bharti Airtel and Reliance Communications. Two, what is the kind of `control premium' that is likely to be built into the deal consideration. Three, among the contenders (leaving Essar aside), which are the ones that stand to gain the most from the dynamics of this deal.
Performance metrics
Getting down to brass tacks, the best place to start is the financial and operational metrics of Hutchison Essar vis-à-vis Bharti Airtel and Reliance Communications:
Operating profit margins: Bharti Airtel is on top, with EBITDA margins (earnings before interest, tax, depreciation and amortisation) consistently in the 35-37 per cent bracket the past six quarters. It is obvious that Bharti has been using its scale, market share and operating leverage to emerge as the most efficient among mobile players. Reliance Communications is fast catching up with Bharti on the operating margin front, logging margins in the 34-36 per cent bracket the past three quarters. Hutchison Essar, the only player without a nationwide footprint, is a laggard on the margin front. Its margins at 31-33 per cent are at least three-four percentage points lower than its peers.
Usage metrics: A year ago (July-September 2005), Bharti's blended average revenue per user (ARPU) at Rs 476 was 7-8 per cent lower than Hutchison Essar's. But if one goes by the latest July-September 2006 quarter figures, while Bharti's ARPU has slipped by 8 per cent to Rs 438, Hutch's ARPU has tumbled 18 per cent to settle at Rs 420. Reliance Communications has had the lowest ARPU among the three players, attributable probably to higher bundled minutes in its packages and lower roaming revenues, as its network is not compatible with GSM operators.
The valuation dilemma
Over the past couple of weeks, there has been a flurry of media reports on the deal consideration that different players may be willing to pay to stay in the Hutch Essar race. For instance, reports have speculated that Hutchison Telecommunications International has set $14 billion as the minimum consideration for its 67 per cent equity stake. This works out to an enterprise value (equity plus debt) of $21 billion for 100 per cent equity for Hutchison Essar.
While there is no doubt that a fancy control premium ranging anywhere from 10-20 per cent will be paid to gain controlling interest in Hutchison Essar, but an enterprise value of $21 billion and beyond may lead to stretched valuations, bordering on overpayment, with payback extending way beyond 2012. A reality check on valuations throws up two key elements:
In June 2006, HTIL had bought a 5.11 per cent equity stake from the Hindujas at $450 million. This translated into an equity value of $8.8 billion (or a conservative enterprise value of $10-11 billion). This clearly is a far cry from the enterprise value of $21 billion that is being contemplated as a part of this deal.
Even at the current market price of HTIL (factoring in the recent run-up), the valuations of Hutchison Essar (at $15-16 billion) are running ahead of Bharti's or Reliance's based on some of the key metrics such as EV/EBITDA or EV/Subscriber or EV/Revenues. If a control premium of over 20 per cent becomes payable, these metrics are likely to get stretched even further.
However, given the huge interest in Hutchison Essar, there is a possibility of control premium trending much higher than expected. There is likely to be a scarcity premium attached to this deal as Hutchison Essar may be the only company among the top five players that may be up for grabs in the foreseeable future. And since Essar enjoys the right of first refusal and may be willing to match any of these bids, there may be a premium to this element also.
Aggressive bidding
Of all the bidders (excluding Essar), the tussle for control is likely to be between Reliance Communications and Vodafone. On a comparative scale, Reliance may be far more aggressive in its bidding war, as it stands to gain much more on a relative basis. For instance, the Hutchison Essar deal fulfils Reliance Communications' aspirations of switching to GSM, given its existing constraints in CDMA technology. In a build versus buy kind of situation, it is likely to prefer a buy as it gets them quality access to spectrum, especially in 900 MHz and this deal also entails a minimum overlap in circles (restricted primarily to West Bengal) that both the players operate in currently.
Second, as an Indian company, Reliance Communications may also be able to buy out a 100 per cent equity stake in Hutchison Essar, unlike Vodafone, which may have to restrict its exposure to 74 per cent under the FDI guidelines and also shed the 10 per cent effective equity stake it had acquired in Bharti Airtel last year.
Finally, if Reliance Communications succeeds in the buyout, it will comfortably march past Bharti in market share, creating adequate scope for capitalising on scale economies in future.