Vodafone's Mergers and Acquisitions Criteria

Today I read one interesting article in The Economic Times on Vodafone's MandA criteria. I am reproducing the same with slight changes for your benefit. This is a classic example of how strategic moves may some times prevail over the financial decisions.

Vodafone may be going all out to clear possible regulatory hurdles it faces in India, but the world’s largest cellular operator seems to be ignoring its own acquisition criteria, going by which Hutch Essar (HEL) is a questionable buy. Vodafone may be able to please regulatory authorities, but pleasing its own shareholders may turn out to be an uphill task for Vodafone, say analysts. In May, Vodafone envisaged a lower level of merger and acquisition activity in the future. Where value adding opportunities arise to acquire mobile assets, strict criteria will be applied. Firstly, targeted businesses should consolidate Vodafone's presence in a local or regional market. Second, a clear path to control will need to be identified. In addition, any acquisition must deliver an Investment Rate of Return exceeding the local, risk adjusted, cost of capital by at least 200 basis points and the return on invested capital should exceed the local, risk adjusted, cost of capital within 3 to 5 years.

If Vodafone goes ahead with buying HEL, it may not be able to meet these criteria. HEL has been valued at between $21 billion and $22 billion and Hutchison Telecommunications International (HTIL) itself is looking at valuations of above $14 billion for its 67% stake in HEL.

According to a JP Morgan note: “Vodafone may struggle. At $22.8 billion, we estimate that the RoIC would reach 7% in five years (appropriate weighted average cost of capital being 12%). Whilst our estimate excludes cost-reduction initiatives such as site sharing, investors might be uncomfortable if these need to be unduly substantial for MandA criteria to be upheld.”

Also, based on analyst expectations and assuming a $15-billion enterprise value, cash returns from HEL would be below 5% till 2010, compared with a cost of capital of at least 10%. The rate of return too is not likely to exceed the local risk-adjusted cost of capital by the required 2%.

Meanwhile, Goldman Sachs in a note said that Vodafone’s balance sheet would be stretched if it paid over $20 billion for a controlling stake in HEL, while adding that the company stood a better change “by aligning its interests with the Essar Group. It has also assigned an enterprise value of about $17 billion for HEL.

Besides, it has given two possible scenarios — if Vodafone were to buy HEL at $18 billion, then in the fifth year, the post-tax return on invested capital works out to 9.5%, but at $20 billion, it works out to 8.6%. In both cases, Vodafone will see earnings accretive only in the third year, Goldman Sachs said, while pointing out that “given the potential for bidding tension, the prospects of value accretion in the short-term look limited”.

Analysts also cautioned that parallels should not be drawn with Vodafone’s successful purchase of Turkish telco Telsim in May last year. Telsim, unlike HEL, was a case of turnaround, leaving enough room for improvement and growing margins.

However, in the case of HEL, EBITDA already stands at around 34%. This implies Vodafone will have to largely bank on increasing penetration to push up EBITDA margins. This won’t be an easy task as the Indian telecom sector is likely to see a slowdown in the future.

According to research firm Ernst and Young, urban tele-density is expected to reach close to 87% by the end of the decade and in rural areas, the cost of delivery is likely to be higher in view of the vast geographical spread and lower population density. This implies expanding margins will become tougher for telecom companies in the future, as a Europe-like saturation may set in.

Glossary:

Cost of capital
weighted average cost of capital (WACC)
Risk adjusted return on capital
Internal rate of return
Return on capital


Related Study :

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