Telecom M&A – ‘M’ may not happen, ‘A’ may not be good.:: Kotak Sec

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Telecom
India
M&A – ‘M’ may not happen, ‘A’ may not be good. Potential M&A-led consolidation
is oft talked about as imminent and the panacea for the current industry woes. We take
a closer look at possible scenarios and conclude that – (1) a material merger (‘M’) may
not happen on account of regulatory and valuation challenges and (2) a material
acquisition (‘A’) may not be good for the industry as it would likely replace a weak
balance sheet with a stronger one. We remain Cautious.




The ‘M’ and ‘A’ of M&A – a closer look
At the outset, we spell out the definitions we use for ‘M’ and ‘A’ – it is important to distinguish
between the two. We define merger (‘M’) as a business combination involving two current players
in the industry; these could be the larger incumbents or the new licensees and the combination
could be a result of one acquiring another or two deciding to merge operations. Mode of
transaction could be cash or a share swap or a mixture – this is largely immaterial to our analysis.
We define acquisition (‘A’) as a new entity buying 100% or majority stake in one of the existing
players. The new entity could be a foreign telco, a domestic/foreign strategic player, or a financial
investor. We also note that we define ‘material’ as an event that would change the competitive
scenario in the industry within a short timeframe of its occurrence.

Material ‘M’ – may not happen
We see two key challenges to a potential merger –
􀁠 Regulatory – the current regulations do not allow two licensees to merge in a circle if the
subscriber or revenue market share of the combined entity exceeds 40%. However, the TRAI
recommendations (May 11, 2010 draft) suggest reducing this threshold further to 30%, which
would reduce further the possible merger scenarios. In addition, the TRAI has suggested
spectrum transfer charges and made other M&A-related recommendations that could render
most possible material M&A scenarios either not possible or not economic.
􀁠 Valuations and other commercial considerations – even in the possible merger scenarios that
pass the regulatory filter, we see certain issues – (1) potential valuation expectation mismatch,
(2) ability of the acquirer to pay, and (3) the burden (penalty clauses) of onerous long-term
contracts with towercos, IT service providers, network service providers and the likes.

Immaterial ‘M’ will be just that – immaterial in the short term; potentially negative long term
As defined above, an immaterial merger would not alter meaningfully the industry structure in the
short run. Such a merger could be a new licensee being bought by a larger incumbent or two new
licensees merging operations. While immaterial in the short term, such a merger will likely be
potentially negative for the industry in the long term as it would mean a disproportionate increase
in industry capacity. Essentially, when two players with 4.4 MHz GSM spectrum and capacity ‘X’
each combine, the resultant capacity with the combined 8.8 MHz of spectrum is significantly >2X.

Material ‘A’ may not be good
First things first – an acquisition, where a new entity buys majority stake in an existing player,
would just mean change of ownership and do little to alter the competitive structure of the
industry. If anything, such an acquisition would likely mean a weak player selling its stake to a
possibly stronger strategic/financial investor. This would improve the competitiveness of the weak
player and increase further the competitive challenges for the industry.


Silver lining – a fold-up led consolidation or change in regulations
The only consolidation scenario that could be positive for the industry, in our view, would be
if a meaningful player folds up – decides to shut operations or is forced into bankruptcy.
However, we believe such a player would get acquired before getting into such a state –
Indian telecom story continues to be of interest to several large telcos globally and an asset
available at distressed valuations would attract many suitors, in our view.
Another potential, though unlikely in our view, positive on this front could be a change in
the maximum subs/rev share cap recommendations. This could make more ‘material’
mergers possible.