Did Vodafone overpay for a stake in Hutchison Essar?

Vodafone (VOD: chart), a British mobile telecom operator, has set a foot India with a purchase of 67% stake in Hutchison Essar. The bid valued the company, including $2 billion debt, at $18.8 billion. Hutch, at the end of December 2006, had little less than 24 million subscribers in India.

Deal Logic

The average monthly revenue per subscriber has been between $8 and $10 or between $100 and $120 per year for almost all the cellular carriers in India. At the top end of the annual revenue of $120 per subscriber, Vodafone is prepared to pay nearly seven times fiscal 2006 revenue. Assuming 30% growth in cellular subscriber base and no growth or decline in annual revenue per subscriber, the deal values the company at five times the revenue in fiscal 2006. Not to forget, this is multiple of revenue and not a multiple of operating earnings.

The largest cell carrier, Bharti Airtel, has a market cap of $33 billion, and Reliance Communication is valued at $22 billion. The current Vodafone deal values Hutch Essar at a roughly $800 per subscriber, similar to what market values for other cell carrier companies. But then market assumes that current subscriber growth rate of 50% will continue for many years to come.

Emerging Markets Rational

Cellular carriers around the emerging markets have found it difficult to justify the purchase price above three times trailing revenue, but then there are very few markets growing as fast as markets in India. If future growth is what is likely to help the current valuation, then investors have to ask two more questions. What is going to drive this future growth and what will stem the decline in average revenue per subscriber?

Growth Story of India

If the subscriber base increases only on cheaper cost of service and innovative price plans, then the current assumption of revenue growth may be difficult to attain. Future subscriber growth is likely to come from smaller towns and rural areas that are not likely to pay more than $60 per year for the telecom service and are going to demand handset that may cost less than $10. Of course, there is market at the bottom end of the industry, but is it as profitable as at the top end?

Frankly, at this point no one knows and only time will tell.

Previous predictions of the lack of profitability in the cellular business in emerging markets, such as India and China, have not proven to be correct. China now has 350 million subscribers, and India has 150 million. However, more than 50 million of these subscribers in India were added in the last twelve months and their behavior and loyalty is still unpredictable.

Vodafone Deals

Last year, Vodafone sold its operation in Japan to Softbank and its 25% stake in Swisscom Mobile to Swisscom. The company also bought Turkey’s second largest telecom company of 12 million subscribers for $4.6 billion. This acquisition was done at half the price paid for Hutch Essar stake, when measured on cost per subscriber.

Vodafone still has to deal with two more issues: network build-out and ever declining monthly rates. If the current optimistic economic scenario remains true for the next two years, demand for cell phone services is likely to remain high. If economy slows down, either because of poor rainfall, slower IT export revenue or political turbulence then the demand for cell phone service is likely to drop faster than estimated. One only has to look at what happened when economies slowed down in Mexico, Indonesia and the Philippines.

At the current deal price there is very little room for error and only the most optimistic scenarios are discounted. All fast growing markets eventually slow down and return to their normal growth rates. Predictors of slow down in India for two years have been wrong, but with every passing day it appears that their case is getting stronger and stronger.

Next Three Years

The Indian economy may accelerate on rising consumer spending for a year or two to 10% or more and then may experience a sharp pull back to 7%. This does not look bad when compared to what was happening in the Indian economy only seven years ago, but stock market valuation can correct sharply. Foreign investors are not known to be around when economies are slowing down, and there lies the problem for Vodafone.

Vodafone at the end of the year 2008 may have subscriber base of 30 million and substantial market share of between 15% and 20%, but profitability may be elusive. The market share growth is going to come only with an annual investment of $2 billion or more in the network expansion. The lower handset costs, innovative and cheaper telecom tariff, and lower monthly payment plans will also be needed. This price competitiveness points to a race to the bottom for five top players in India. New ways of managing business where every penny counts will be needed. Lessons learned from computer hardware makers in China and the U.S. will help Indian cell phone operators, but Indian companies have proven to be innovative.

It was not long ago when operators were charging sixteen rupees per minute of telecom call, but now rates hover near one rupee. In the coming years, operators will have to learn to live with rates below 70 paisa and struggle to generate profits, but stock market may not show any mercy. Stock market loves growth: revenue and earnings growth. But a toxic mix of lower growth in profitability, slower growth in revenue, and lower growth in subscription may kill cell carrier stocks.

Only seven years ago, Mr. Li Ka-Shing had sold Mannesman Telecom Group at the height of the telecom bubble to Vodafone. In less than three years, Vodafone had to write-down this asset significantly. While the news of this deal and foreign investments dominate headlines in India, one must not forget that not one paisa of $11.1 billion is likely to remain in India. Every paisa is destined to go to the bank account of billionaire Li Ka- Shing in Hong Kong.