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Idea Cellular is an Aditya Birla Group Company, India's first truly multinational corporation. Idea is a pan-India integrated GSM operator offering 2G and 3G services, and has its own NLD and ILD operations, and ISP license. Idea has won spectrum to launch 4G services across 10 key markets and has initiated multiple steps towards introduction of 4G LTE services on 1800 MHz, in a phased manner from calendar year 2016 onwards.With revenue in excess of $5 billion; revenue market share of nearly 18.2% (as on Q4FY15); and subscriber base of over 165 million, Idea is one of the top 3 mobile operators. Idea is the sixth largest mobile operator in the world, based on number of subscribers in single country operations (GSMA Intelligence). Idea carries a traffic of over 2 billion minutes a day.

Idea has a deep rooted network across the length and breadth of the country comprising of over 1,49,196 cell sites covering 7,513 towns and 3,63,580 villages as on Q1FY16.

Investment Rationale:

Vodafone-Idea merger:  Telecom behemoth in the making:

Vodafone and Idea Cellular issued a press release on 30 January 2017 highlighting that they are in a preliminary discussion to explore merger opportunities. This deal is likely to have large-scale ramifications in the telecom industry, as the merged company may emerge as a leader with ~42% revenue market share and a strong broadband network. It would also help reduce their annual capex by ~20-25% and improve EBITDA margin by ~500bp. Assuming both Vodafone and Idea have an equal stake, the combined entity should be valued at ~7x EV/EBITDA, reducing leverage by 10-15%, albeit with a low posttaxRoCE of 5%. We believe Idea’s stock is not a play on valuation, but on the likely improvement in its market standing post the merger, which should address the key concern around its earnings visibility.

Performance highlights:.

Challenges: Spectrum and revenue caps remain the key hurdles :In our view, the deal could face two key challenges: India’s telecom M&A rules do not allow revenue and subscriber market shares above 50%. Similarly, spectrum holding in each band is not allowed above 50%. The merger company’s revenue/subscriber caps and spectrum caps may get triggered in 7 and 6 circles, respectively. However, the merged company’s revenue/subscriber share is more than 60% in only one circle – Kerala. In the rest of the circles, it is between 50% and 60%. This may get resolved once RJio starts charging subscribers and taking revenue market share.Based on the current 50% band-wise spectrum cap, the merged company has ~33 MHz of excess spectrum, of which ~15 MHz is 900 MHz paired spectrum. Based on latest spectrum valuation (pro-rata for the remaining license term), the merged company may be able to generate over INR75b from the excess spectrum. This should support the merged company’s cash outflow toward liberalizing the administered spectrum, which is ~20% of the merged company’s spectrum.

How would the combined entity look :The merged company should have revenue of INR745b (1HFY17 annualized), assuming 20% lower revenue due to the weak outlook and revenue market share shrinkage. We expect the merged company to garner healthy EBITDA margin of 35%, at ~500bp discount to Bharti India wireless’ FY17E EBITDA margin. This implies about 500bp margin improvement, which could potentially come from network synergies, employee costs and SG&A.Improving combined EBITDA could improve Idea’s leverage, albeit by a moderate 10-15%. Current net debt to EBITDA of 5x could reduce to ~4x. This would still remain high for the merged company.Assuming about 20% synergy on total assets as well as EBITDA synergies, the merged company’s post-tax RoCE could improve to 5%, from 3-4% for Idea and Vodafone.

Financials :

Highlights the fact:

* Vodafone and Idea currently are the second and third largest telecom operators, respectively, in the Indian telecom industry. We thus believe that the merged entity could emerge as an industry leader, with combined revenue and subscriber market share of 42% and 36%, respectively, and blended ARPU of INR178.

* Bharti and RJio currently hold the highest spectrum (20% of market) and cell sites. They are also the most aggressive players in the industry, given their deep network and low capacity utilization. However, the merged company could pose a major challenge with combined spectrum share of ~23% and broadband cell sites of over 1,60,000 (close to Bharti’s 1,70,000 sites and ~40,000 lesser for RJio).

* Post-merger, the three strong operators –  the merged company, Bharti and RJio – could be equipped with equal armory to compete in the market. This scenario could support our expectation of an improving competitive landscape and industry ARPU accretion in 2HFY18.

the merger should impact bharti infratel’s tenancies

We expactBhartiInfratel to grow tenancies and rental revenues at 7% and 9%, respectively, over FY16-19E. We believe if this deal goes through, it will impact BhartiInratel’s tenancies given that 85% of the tenancies are derived from the top three operators. As the merged company may pair down unwanted network overlaps between the two entiies, we suspect a one time 10% tenancy reduction. Also as the merged company may have higher geographical coverage, we expect ti to offer potentially 30-40% reduction in annual tenancy.

VALUATION & OUTLOOK:

Assuming Vodafone is an equal shareholder, the combined entity should be valued at about 7x EV/EBITDA, factoring in 500bp EBITDA margin improvement. Vodafone should fetch EV of INR917b and equity value of INR360b.

We have not changed our estimates for Idea on the back of limited clarity on the deal. We put the stock under review until we gather more clarity on the likelihood of the deal and the potential impact of the same on valuations and earnings. We believe Idea is no more a play on valuation at potentially ~7x EV/EBITDA for the merged company. If the deal goes through, the merged company’s wherewithal to stand in the highly competitive market will be a key monitorable. Given the merged company’s superior spectrum/network position, higher revenue market share and ~20-25% lower capex requirement, the high FCF could be used to strengthen its market position.