Do Idea and Vodafone’s merger terms need a rethink?
Idea Cellular Ltd and Vodafone India Ltd announced a neatly packaged merger deal in March 2017. The former’s promoters got the equal rights they were looking for, and Vodafone Group Plc got to deconsolidate its cash-guzzling India operations.
But with leverage at the two companies going out of whack since, and constraints on capex already impacting market share, perhaps a rethink is in order. The deal’s current structure puts limits on funding for these companies. A tweak in the merger terms can improve liquidity and leverage ratios considerably, and help in effectively staving off threats from competitors Bharti Airtel Ltd and Reliance Jio Infocomm Ltd. The catch, however, is that this may entail Vodafone ending up as a controlling shareholder.
The merger agreement signed last year is based on equal rights and equal shareholding between Idea Cellular’s promoters and Vodafone Group. To achieve this, Vodafone has kept its 42% stake in Indus Towers Ltd, valued at around $5 billion, out of the deal’s purview. It can also contribute Rs2,500 crore more as debt into the merged entity. Even after all this, it would have a 50% stake in the merged entity, while Idea’s promoters were expected to have a 21.1% stake, based on ownership patterns at the time of the merger announcement.
To bring about equal shareholding, Idea’s promoters had agreed to buy shares worth Rs3,874 crore from Vodafone at the time the deal closes. It also has the option of buying shares worth another Rs9,000 crore within a four-year time frame.
As such, the deal is structured in a way where large amounts are expected to change hands between the joint venture partners. Besides, while Vodafone may soon be flush with funds after the Indus Towers sale, none of this might find its way to the merged entity, lest it upsets the agreed shareholding pattern.
This isn’t a problem in itself. But it is certainly odd if the merged entity is constrained for funds at the same time. Already, Idea and Vodafone’s capex is trailing that of Airtel and Jio by miles, and it’s showing in subscriber addition numbers and revenue market share. Between March and October, Idea and Vodafone’s active subscriber count has declined by around 4 million, while that of Airtel and Jio has expanded by 14 million and 40 million, respectively.
Data collated by IIFL Institutional Equities shows that Idea and Vodafone’s combined capex this year is expected to be half that of Airtel and less than a fourth of what Jio is spending. In the preceding two years, their capex had matched Airtel’s spends.
It’s true that liquidity at the two companies has improved in the past few months, after the sale of their respective stand-alone tower businesses, as well as an equity issuance by Idea. It will improve further when Idea disposes of its 11.15% stake in Indus Towers. But while liquidity might improve in the interim, leverage ratios will remain elevated, simply because the tower sale results in an almost equal reduction in Ebitda. Besides, the newly raised cash will help in the near term, but constraints on capex will continue once the funds are exhausted. Ebitda stands for earnings before interest, tax, depreciation and amortization.
“High leverage would mean that Vodafone and Idea would be forced to cut capex at a time when Bharti and Jio remain in high-capex mode,” IIFL’s analysts said in a 5 January note to clients.
As this column pointed out last week, the merged entity might end up with a net debt to Ebitda ratio of around seven times by the time the deal closes, in a best-case scenario. This is higher than the agreed maximum leverage of six times the companies need to ensure by September this year.
IIFL’s analysts estimate the merged entity needs an equity fund infusion of Rs27,500 crore for ending up with a net debt to Ebitda ratio of six times. Idea’s announced fund-raise of Rs6,750 crore, in their books, falls woefully short.
Leverage ratios have gone out of whack thanks to the relentless onslaught by Reliance Jio. By forcing competitors to keep tariffs low, Jio has caused profit margins to plunge and cash burn to increase significantly. Idea is already running large losses, and things deteriorated further in the December quarter, thanks to the cut in interconnection usage charges and down-trading by customers.
And just when investors had assumed there was stability on the tariff front, Jio cut tariffs at the start of the new year . In short, there’s no relief in sight as far as profitability goes. While the merged entity will extract large savings post-merger, these are expected to be back-ended, and it will be a while before profit margins start rising.
At the same time, by encouraging large data usage plans, Jio is effectively forcing its competition to upgrade their capacity. In short, capex needs are estimated to be higher than what was earlier envisaged.
A significant cash infusion into the merged entity seems like a good solution to address these problems. If the equal shareholding constraint is off the table, Idea’s promoters can use its funds to capitalize the company further, rather than buy Vodafone’s shares. And even Vodafone can make a large infusion using proceeds from the sale of its Indus stake.
While this may upset the agreed shareholding pattern, both partners will ensure they are investing in a far more robust entity with a strong balance sheet. As such, they can get more bang for their buck when the dust settles.
With the industry headed towards an oligopolistic structure, returns can be decent once things settle; it makes sense for Idea and Vodafone to put their best foot forward in the current market share battles.
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