Perfect bonding: Vodafone's Arun Sarin (left) with Essar's Ravi Ruia

In mid-2005, Rajeev Chandrasekhar sold BPL Communications to Essar Teleholdings for Rs 4,400 crore, and signalled the dawn of the billion-dollar M&A era in the Indian telecom space. His operations, spread across four circles, including the lucrative Mumbai circle, then had a subscriber base of 2.63 million. This was only the beginning. More such deals followed. In October 2005, Vodafone picked up a 10 per cent stake in Bharti Airtel for $1.5 billion (then Rs 6,750 crore); then, in December 2005, Maxis Communications of Malaysia and the Reddys of Apollo Hospitals bought out C. Sivasankaran's 100 per cent stake in Aircel for $1.08 billion (then Rs 4,860 crore); and in April 2006, the Aditya Birla Group acquired the Tata Group's 48.14 per cent holding in Idea Cellular for Rs 4,406 crore. The mother of all telecom deals in India, of course, was Vodafone's 52 per cent buyout of Hutchison Essar for $10.9-billion (Rs 44,690 crore) last year, that valued the company at $21 billion (Rs 86,100 crore). It's almost as if the law of gravity had been put in suspended animation-what went up could only go higher in the Indian telecom space, it seemed.

There were (and are) sound economic reasons for the exponential growth in the valuations of Indian telcos. "Two years ago, one couldn't have anticipated a monthly subscriber growth of six million new additions," says Rajeev Gupta, Managing Director and Head of the Carlyle India Buyout Team. Then, India's wireless subscriber base of 167 million at the end of April 2007 translates to a penetration level of less than 16 per cent. For China, a comparable market, the figure has already crossed 400 million, a penetration of 35 per cent.

Clearly, then, the Indian market has massive headroom to grow. It is this potential that excites global giants like Vodafone and others that now view India as a long-term play. The natural corollary: they are willing to pay high premiums to grab a slice of this pie. "India is a compelling telecom story; no wonder all serious players want to be a part of it," says Manisha Girotra, Managing Director and Chairperson (India), UBS Securities. Her firm represented Vodafone in its buyout of Hutch-Essar.

Many Buyers, Few Sellers

A decade ago, there were a large number of players to choose from. Today, following several rounds of consolidation-which saw the exit of players like JTM, RPG, Usha Martin, Skycell and Telstra-there are five large private operators, Bharti Airtel, Reliance Communications, Hutchison Essar, Tata Teleservices and Idea and the public sector bsnl that have largely carved out the market among themselves. The implication: buyers who want to enter the Indian telecom sector at this stage have to buy a large operator; this will naturally involve the payment of a hefty control premium. The Vodafone-Hutch deal is a case in point. "Valuations are about projections of future cash flows discounted to their present value. Earlier, the subscriber base was the key determinant of valuation since EBITDA figures of most players were largely in the negative," says Sanjeev Aga, Managing Director, Idea Cellular. Today, the EBITDA margin is the key indicator of valuation; going forward, earnings multiples, and not EBITDA margins, are likely to emerge as the key to valuing telcos. "EPS will become important when current exponential growth rates and the high levels of CAPEX slow down to more normal levels. Today, we are still in the investment mode," he adds.

To put the issue in perspective, AT&T last year acquired BellSouth (both us-based) for $67 billion (Rs 3,01,500 crore). A few months before that, Spain's Telefonica agreed to acquire UK's O2 for just over $31 billion (Rs 1,39,500 crore). BellSouth had 54 million customers spread across wireless voice and data services and earned a net profit of $3.3 billion (Rs 14,850 crore) last year. o2 had a pre-tax profit of $614 million (Rs 2,763 crore) at the time of the acquisition and 27 million customers globally. This means, that on a like-to-like basis (profits to enterprise value), Vodafone's acquisition of Hutchison Essar is between two and four times more expensive than these deals.

R-Comm's Ambani: Keen on a GSM footprint

Ironically, the era of high valuations and steroid-charged growth in subscriber numbers comes at a time when Average Revenue Per User (ARPU), a key metric in the telecom industry, has been falling. According to data released by the Cellular Operators Association of India (COAI), the apex body of GSM operators, the national ARPU for the October-December 2006 quarter was Rs 315.93 compared to Rs 335.46 for the July-September quarter of 2006. Interestingly, every player in the market has been hit by this phenomenon (See ARPUs Are Headed South).

There have been a few indicators to suggest that there could be a slowdown in subscriber growth. For instance, BSNL added 0.32 million subscribers in April this year compared to 1.98 million in March, an 83 per cent fall in growth rate.

But this doesn't seem to have had any adverse effect on the companies. The Bharti Airtel share price has appreciated 126 per cent over the last year from Rs 370.15 to Rs 836, valuing the company at Rs 1,58,322 crore as on May 24, 2007, while Reliance Communications has seen its scrip rise 83 per cent from Rs 269.95 to Rs 493.75 over this period, giving it a market capitalisation of Rs 1,00,952 crore as on May 24, 2007. The latter, in fact, recently joined the exclusive club of seven Indian companies with M-caps in excess of Rs 1,00,000 crore. The Aditya Birla Group, meanwhile, has sold a 33 per cent stake in Idea Cellular to a clutch of investors for $833 million (Rs 3,415.3 crore), giving it an equity valuation of $2.5 billion (Rs 10,250 crore), while Temasek's decision to pick up a 9.9 per cent stake in Tata Teleservices for $300 million valued it at $3.03 billion (Rs 12,423 crore).

How Stretched Are Valuations?

Rajeev Chandrasekhar, who was Chairman of BPL Communications before its sale to Essar Teleholdings, thinks the valuations are fully justified. "Till 2001, telecom was considered a part of infrastructure; but today, it is seen as a consumer business. Valuations depend on demand and supply, and India is the most exciting telecom market in the world," he says.

Spice Telecom's Modi: Spreading wings for more

Analysts say that valuations will be sustained at current levels, though they do not expect to go up much further. "We estimate that the sector will see CAPEX of $22 billion (Rs 90,200 crore) over the next three years against the $13 billion (Rs 53,300 crore) it has witnessed since 1995," says Subhabrata Majumder, Telecom Analyst at Macquarie Securities, a financial services firm. This will be driven by the existing Big 5 private players and also by the national ambitions of regional players like Spice Telecom, which has a presence in the Karnataka and Punjab circles. "We are looking to spread our presence to 21 more circles. This will increase our valuation from $1 billion (Rs 4,100 crore) today to $20 billion (Rs 82,000 crore)," says B.K. Modi, the company's Chairman.

Then, analysts also foresee the probability of more M&A activity in the sector, as more global players seek to enter the market. Says Carlyle's Gupta: "The multiples in the sector seem to have peaked. And while the ownership pattern in individual companies may change, there may not be a change in the number of players."

Players, for their part, will need to offer more value-added services and with the expected launch of 3g services soon, some big-ticket investments will be made. Assuming that these investments will take time to pay back, there is a good chance that valuations will be affected.

Analysts also feel that the contrarian trends-of falling ARPUs and rising valuations, both driven, ironically, by rising subscriber numbers-will play out simultaneously, and the occasional big-ticket deal will create periodical spikes in valuation, and add excitement to the market. Clearly, the valuation story for Telecom India could not have got more interesting.