The African elephant

The stock market can react in dramatically opposite ways to the same piece of information.

On February 15, 2010, it became known that Bharti Airtel is in exclusive discussions with Kuwait’s Zain Telecom for acquisition of its telecom business in Africa. The market gave this a thumbs down and the stock fell by 9.2% to Rs 285.40.

On June 8, 2010, the company announced that it had achieved deal closure with Zain. On June 9, 2010, the stock rallied 5.6% to close at Rs 272.15. This is the highest the stock has gained since it became known that the company is looking to expand out of India and go into Africa.

The company is paying $9 billion for this, as well as taking over debts amounting to $1.7 billion of Zain. It has already paid $8.3 billon upfront, and will pay the remaining amount next year.
To make this payment, the company has raised money from a consortium of international banks as well as the State Bank of India.

Analysts suggest that Bharti is paying an interest of around 2-2.25% on this debt. So the interest cost on a total debt of $9 billion that the company will have to in order to finance this acquisition will work out to around $200 million yearly, wrote Rumit Dugar, Manoj Singla and Udit Garg, analysts at Religare Institutional Research.

The interest costs on the debt are not high, and can easily be met from the combined operating profit of $4.7 billion of both the companies. However, the problem is the amount of debt that is being taken on to finance this acquisition. The rating agency Standards and Poor’s lowered credit rating on Bharti to ‘BB+’ from ‘BBB-’.

What works for the company is the fact that Zain has operations across 15 countries with 4.2 crore customers, currently. The population of these countries is 45 crore and the telecom penetration a low 32%. So of course there is scope for tremendous expansion. It is logical to assume that the company will implement its successful minute factory model even in Africa. As Rajiv Sharma and Tucker Grinnan, analysts at HSBC, point out in a report dated June 8, 2010, “Given the low wireless penetration (35%) and low usage (one-third of Bharti minutes of usage in India) in the African markets where Zain operates, we believe the opportunity to grow Zain’s earnings is meaningful.”

Analyst estimates suggest that average minutes of usage per subscriber of Zain is currently at around 110 minutes per month, which is around a third of the Indian average. It need not be said that there is tremendous scope for growth in Africa. For this growth to be possible Bharti will have to ensure a decent network for its customers in Africa, as it has in India.

Building networks of course is very expensive. News reports suggest that Bharti is planning to join hands with telecom operators in Africa to share each other’s networks. This is something that the company has already done successfully in India. As Ranjay Gulati, professor at Harvard Business School, says, “At one point of time owning towers was absolutely core for a telecom company. So you needed to be sure you have towers in place. Bharti used to be the second-largest buyer of diesel in India till 2007 (to ensure power at its towers where electricity could be a problem), when it spun off its cellular towers into a separate entity Indus Towers.”

The challenge of course is operating in 15 different markets, where each market could have its own sensibilities as well as regulations. Also, cutting prices to increase minutes of usage may not be that easy. As Sharma and Grinnan of HSBC point out, “Bharti continues to face several other challenges in Africa, including (1) tariff cuts and elasticity (experience of other operators in Kenya is discouraging); (2) high taxes, which remain a barrier to cutting tariffs; and (3) the need for a generalised approach, replicating the minute factory model separately in all 15 of Bharti’s markets, which we believe will not work in Africa. It will be important to provide a local flavour in each market.”

Global experience also suggests that two out of three acquisitions that happen do not create value for the shareholders of the acquiring company.

But what Bharti basically seems to be backing on is its Indian experience and its belief of implementing it in Africa as well.
Despite this, Africa remains a challenge for the company. But at a trailing 12 month price to earnings ratio of 8.8, the company remains an attractive bet for those still willing to bet on the telecom sector.