Hutchison-Essar: Inflated Ambitions

A battle is set to break out for Hutchison's up-for-sale
Indian telecom business with blue chips-be it service providers or equity
firms scrambling to finance a $22 bn bid for the business. At present Reliance
Communications and Vodafone appear to be leaning toward a buyout offer from
Hutch, with Vodafone targeting to buy Hutch's stake in an all cash deal while
Reliance has lined-up banking firms to finance a rival offer. Essar, which is
the second largest holder in the Hutch JV, has also thrown its hat in the ring
with $11 bn for the remaining stake. The other strong bidder in the fray is the
Hinduja group, which had a long association with the Hutchison Essar initiatives
in India.

But with the bid reaching $22 bn, isn't it a simple case of
money chasing for this asset?

Valuation Thrill

Hutchison Essar was pegged at $9-9.5 bn in June 2005 and at that
time if Hutch had made its intentions clear, of selling its stake, it would have
been the most sought after buying target. But since then it has come a long way
and is now valued at $22 bn, which is undoubtedly on the higher side. Though
buying Hutchison Essar would provide a much-needed fillip to Reliance
Communications and Vodafone's businesses, as the former is keen to ramp-up its
GSM operations while the latter would get a smooth entry in the Indian telecom
market-but the unrealistic bid-up is likely to result in low value, even over
the long run.

The market capitalization of HTIL is around $11 bn, whereas
Hutchison Essar is estimated around $5 bn.

In an ideal scenario, Hutchison Essar value should be pegged at
around $18-19 bn, with a $12.1-12.7 bn price for the 67% stake. This is based on
multiple valuation methodologies and after including a premium to be paid for
the prized asset.

"We would peg the Hutchison Essar value at close to $17 bn,
with a $11-12 bn price for the 67% stake," said Sameer Walia, MD, The Smart
Cube.

Equity analysts suggest for a lower valuation as compared with
the current level of $22 bn. Lehman Brothers, in its January 11, 2007 equity
research report, said that Hutchison Essar acquisition by Reliance
Communications makes sense as it provides a ready GSM platform for Reliance
rather than waiting for the consistently delayed new GSM spectrum to roll-out
its own network. However, Lehman Brothers think the indicated valuations of $20
bn for Hutchison Essar is expensive. In case any other entity buys into
Hutchison Essar, Lehman Brothers believe that both Bharti and Reliance
Communications stand to gain significantly from the post-buyout transition at
Hutchison Essar.

A bid of $13.5-14 bn could value Hutchison Essar at a 24%
premium to Bharti, which has a market capitalization of $25.7 bn, according to
CLSA.

At $14 bn, analysts estimate Hutchison Essar's enterprise
value/EBITDA at 20.6 times year-to-March 2007 earnings, well above Bharti's
16.2 times.

For Essar, buying or selling in Hutch is more of a compulsion
rather than any value addition. In the present scenario, it will definitely be
valued at a higher price, somewhere near $7 bn for its 33% stake in Hutchison
Essar. In an ideal situation, it won't be able to fetch $5.9-6.3 bn and in
case it buys the remaining 67%, it will have to cough-up $13 bn. Also, if it
decides to sell-off the entire stake at a later stage, it might not be able to
make much profit in this venture, as it is very unlikely that the bid would be
raised further from the current level of $22 bn. At this level, shelling out $15
bn to sell at $22 bn is not a good business proposition for any operator,
especially when it can easily get $5-7 bn for its 33% stake.

Man Financial's equity analysis dated December 20, 2006 says
that HTIL's stock (which holds 67% economic interest in Hutchison Essar and is
listed in Hong Kong) has posted a 41% gain over the past three months, though it
has underperformed its peers-Bharti and Reliance Communications. "We
estimate that 85% of the value in HTIL comes from its holding in Hutchison Essar.
Based on this, the equity value of Hutchison Essar, as reflected by the current
HTIL stock price, is estimated at $14.4 bn. We believe that the deal is likely
to value Hutchison Essar's equity at $14-15 bn," according to Man
Financial.

At present Reliance's market capitalization is around $20 bn
with subscriber base of 28 million (GSM + CDMA) while Bharti, India's largest
private cellular operator has a market capitalization of $29 bn with subscriber
base of 30 million. Analysts have valued Hutch at $18 bn, which currently has an
ARPU of Rs 374 and a base of 22 mn subscribers. Bharti has an ARPU of Rs 349
while Reliance ARPU is Rs 320.

Analysts are skeptical about the current valuations. Goldman
Sachs, in its analysis dated December 21, 2006 said: "Using our local
analysts' SOTP valuation of $15.5 bn for Hutchison Essar's enterprise value
and deducting $1.1 bn of net debt for end 2007 leaves an equity value for the
theoretical maximum 74% of $10.8 bn."

Only Two can Tango

It takes two to tango and three to make a race. Clearly, the
fight for Hutch is between Reliance and Vodafone and the chieftains of both
companies have already started lobbying with the government and the other
stakeholders to get a piece of the pie. If Essar decides to compete with either
of the two, then this horse race might take an ugly turn, as the Hutch deal is
an important business milestone for both Reliance and Vodafone while for Essar,
it's purely a money spinning wheel that can make lot of difference to Essar's
fortunes.

The deal will be a tough one, but would strengthen the hand of
Vodafone's under-pressure chief executive Arun Sarin if he manages Vodafaone's
successful move into India, and would lay to rest all questions about the group's
future growth.

Make no Mistake

Vodafone would be a bigger loser if it fails to acquire Hutch,
though the deal is equally critical for Reliance. Reliance apparently fully
recognizes this and is desperately waiting to outbid Vodafone's offer.

Buying Hutch would establish a major Vodafone brand in India.
Vodafone would have compounded its error if it had not actively continued to
explore its options in the Indian market. However, it will require a far greater
understanding of the Indian market than the company's advisers on the Hutch's
deal possessed. Though valuation metrics in Hutch are not completely broken down
but with some huge anomalies, Vodafone can uniquely capitalize on it.

Arun Sarin, though keeping a low profile, has kept all doors
open to snatch the deal from its rivals. He is even ready to partner with Essar
to own majority stake in the deal.

"Essar is a natural partner. It is already there in the
joint venture. We are talking to several companies. We will see who we can have
as partner on a long-term basis," Vodafone CEO Arun Sarin had told
reporters at the close of his two-day visit to India.

Vodafone's bid has advantages over an offer of roughly the
same amount by Reliance, because there would be less regulatory risk involved
and much of Hutch's management and work force would remain intact.

But CLSA Asia Pacific Markets, in its research dated January 2,
2007, said Vodafone seems to be offering a large premium for Hutchison Essar,
but the business is growing at 30% per year. When Vodafone bought a 10% stake in
Bharti for Rs 351/share, 7.4% premium to Bharti's market price at that time,
Singtel believed that the valuation was too high, but really missed out as
Bharti's share price has gone more than 60% since then.

If Vodafone prevails in the bidding, it will have to sell its
10% stake in Bharti Airtel. But Vodafone has not yet reached an agreement with
Bharti to sell its stake.

The main sticking point with Reliance is committing itself to
taking whatever steps are needed to win regulatory approval. Anil Ambani has
already had an initial round of discussions with the Union Minister of
Communications, Dayanidhi Maran. As per regulatory directives, unlike Vodafone,
which is a foreign operator, domestic buyers will have to buy 100% of Hutch or
10% of it. This has become a major stumbling block for Reliance. According to
sources, it is now trying to push the government to relax regulatory norms so
that a level playing field can be created, which essentially means Reliance's
Hutch. Anil Ambani has already roped-in a string of bankers including
Blackstone.

Anil Ambani's ambition to be successful in the GSM arena can
only happen if he manages to get hold of this deal where Reliance will get 16
circles and 22 mn customers on a platter. Not only this, Reliance would get the
status of one of the biggest telecom operators in the world.

Both parties are still evaluating the deal, and the formal
process is yet to start. It would be interesting to see what shape this intense
battle takes eventually.

Troubleshooters

The auction of Hutch, with its 22 mn customers across the
country, comes at a time of intense competition for the wireless phone industry,
which has been engaged in heavy price wars and marketing campaigns. The battle
is over billions of dollars of annual revenues. And, the business is expected to
grow still more lucrative over the next five years as wireless providers are set
to roll out next generation networks. In addition, the Indian market is
considered less saturated than many markets in Europe and Asia, offering strong
growth potential.

Acquisition of Hutch by an Indian operator will initiate a round
of consolidation for the industry, where a few regional operators are acquired
by the biggies. This could lead to lesser competition, especially if two major
operators merge. Hutchison Essar's buyout would make Reliance, currently the
second largest mobile operator by subscriber numbers, the undisputed leader with
50 mn subscribers (against Bharti's 30 mn).

An acquisition by Vodafone will intensify competition benefiting
the consumer. With 3G set to be rolled-out in 2007, entry of a foreign player
will significantly alter competitive dynamics of the industry, bringing in new
and improved offerings for consumers as well as increased focus on service
quality.

Troubles exacerbated the struggles of Hutch, one of the industry's
strongest brand names. Over the last year, it has had technical and operational
problems, though company executives maintained that the problems were isolated
cases and not caused by systemic problems. Executives also said the recent
lapses were not the reason Hutch was put up for sale. Rather, they said, because
of changing dynamics in the market, the time seemed right to gain an optimum
price.

"The ongoing dispute with the Essar group, Indian
government's equivocal stance on Orascom's 13% beneficial stake in Hutchison
Essar, coupled with high valuations in the Indian telecom industry is driving
its sale of 67% stake in the JV. The Indian telecom industry has been witnessing
robust growth (overtaking China for the first time in 2006 in terms of monthly
subscriber additions), with valuations soaring high, almost to unrealistic
levels. This is probably the right time for Hutchison Whampoa to cash out and
invest in other businesses," says Sameer Walia, MD, The Smart Cube.

Operator's Outlook

Mobile phone penetration in India is very low (one in eight
people have a mobile phone). Hutchison Essar has historically enjoyed higher
ARPU than other Indian operators and is viewed as a high-end urban operator.
Also, the post-paid to prepaid ratio for Hutch is much higher than that of other
operators-a very attractive proposition for any buyer.

Indian operators such as Reliance Communication will gain from
Hutch's premium brand/image in the market, strong network and a dominant
market position as a result of the acquisition. Reliance, primarily a CDMA
operator and the second largest cellular operator in the country, has been
looking to enhance its operations in the GSM space and Hutchison Essar fits in
very well with this strategy.

Of course, at the end of the day 'value' is a straight
function of the price one pays for the asset!

"I see this as a two-horse race between Vodafone and
Reliance. Other investors are likely to drop out due to high valuations offered
by these two operators. Plus, you need clout with the Indian government to pull
this deal through," adds Walia.

But any deal of this scale can happen only after due diligence,
and all the concerned stakeholders are still assessing the situation, only then
the final bid would be made. But, whoever manages to get it, would undoubtedly
be the Lord of the Telecom Ring.

Rahul Gupta


rahulg@cybermedia.co.in