Come to think of it, it was almost as if Ajay Piramal could monitor the goings-on within the Vodafone India boardroom from his eighth-floor eyrie in Piramal Towers at Mumbai’s Peninsula Corporate Park; the two-floor Vodafone House is right next door. Known to combine a stockpicker’s instinct of singling out an opportunity with an entrepreneur’s intuition of identifying a sector, Piramal was looking to invest the Rs 10,271 crore he’d made by selling Piramal Healthcare’s domestic formulations business to Abbott Laboratories.

That was in 2011; Piramal knew that Vodafone had to restructure its shareholding—in July 2011, Essar had exercised its $5 billion (Rs 22,500 crore) put option for 33% in what was then Vodafone Essar, and foreigners can’t own more than 74% of a telecom company. (In February 2007, Vodafone had bought out Hutchison Whampoa’s entire 67% stake in what was Hutchison Essar, in a deal routed through the Cayman Islands.) So Piramal picked up 11% of Vodafone for Rs 5,900 crore in two tranches in August 2011 and February 2012.

Telecom company valuations were already sliding because of a cut-throat war on tariffs: between the two deals, Vodafone’s enterprise valuation had slipped from $11.6 billion to $11.2 billion. But Piramal’s investment reaffirmed Vodafone’s credentials as a great bet. In the past, he had invested smartly in other sectors, and the market expected telecom to be the latest in a string of successes. Speaking to Fortune India to discuss his investment strategy after he had picked up the first 5.5% in Vodafone, Piramal had said he would exit during the company’s forthcoming primary issue. (In 2011, the British multinational had decided on an India listing.) Piramal said he expected the investment to fetch him between 17% and 20%, with “limited risk and in a short period”.

Vodafone’s risk profile has altered hugely since Piramal invested. In March last year, then finance minister Pranab Mukherjee proposed to amend the corporate tax laws with retrospective effect. The amendment targeted overseas mergers and acquisitions of companies with assets in India, and for Vodafone, it meant that the parent company would have to pay $2.2 billion in tax on the Hutchison Whampoa deal. The case reached the Supreme Court, where Vodafone won, but investors are still not sure whether to provision the tax liability on their books or not. Vodafone is now waiting for a decision from the government on amendments related to the Finance Bill 2012-13, as suggested by the Parthasarathi Shome panel report on taxation of indirect transfer of assets.

Then, in April last year, the then chief of the Telecom Regulatory Authority of India (TRAI), J.S. Sarma, released draft recommendations for the sector. His recommendations included spectrum auctions, pricing, refarming of spectrum, and the renewal of telecom licences. For Vodafone, this was bad news: It is estimated that all these regulatory changes will cost the telecom company at least Rs 21,800 crore by 2015. That’s in addition to Vodafone India’s Rs 6,300 crore annual capital expenditure.

But, according to Vodafone officials, plans for the primary issue are still on. So, will the IPO be worth an investor’s money, and will the company list at a price that will make Piramal’s exit profitable? Piramal refused to comment.

Caption
Caption

MARTEN PIETERS, VODAFONE India’s 59-year-old Dutch managing director, says the company doesn’t necessarily need the IPO to raise capital. Vodafone’s London-based principal has very strong cash flows and can keep funding India for some time, he says. Also, its shareholders aren’t clamouring to see returns on the India business. This, despite the fact that market activity and regulatory changes have reduced the value of the business in the five years since Vodafone entered; and Vodafone Group Plc has pumped nearly $9 billion into India so far. “But for strategic reasons we would like to do it [the IPO]. We cannot postpone it indefinitely,” says Pieters.

Some of these reasons are reasonably straightforward. The 24% that mandatorily has to be owned by Indians is held by financial investors, such as Piramal. By the very nature of their investments, such investors are always looking for a return and, therefore, a time-bound exit. So, the company’s view is that in the long term it’s better if the Indian shareholding is held by the Indian public. Says Pieters: “Replacing financial investors from time to time is a problem. These are billion dollar deals and we are a very valuable company, making each round of negotiations difficult. How often and how long can you keep changing your investors? Getting that 24% anchored with the public or institutions is far better than with individuals.”

Again, if Vodafone Group Plc needs to recapitalise its Indian operations (at 3.4 net debt-to-Ebitda ratio, the company, might just be comfortable compared to Airtel’s 2.4, Idea’s 2.7, and Reliance Commmunication’s 5.5), it’ll need to convince the strategic investors, who may not necessarily agree with London’s ideas.

But there’s one issue which is discussed in hushed voices and in some ways lays bare the risks associated with Vodafone. A senior executive, who asks not to be identified, says the company hopes to hit the market with its IPO before the 2014 general elections, hinting at some behind-the-scenes political manoeuvring by competitors. Indeed, one of the key objectives of the IPO is to reposition Vodafone India as an “Indian” company.

Within Vodafone, there is a perception that it has been unfairly targeted. Sure, the TRAI guidelines apply to all telecom companies. “But there are indications that efforts are being made to prevent Vodafone India’s operations from being successful in India, and there is pressure being applied to frustrate and destabilise the company,” says a telecom industry official, who did not want to be identified but who works closely with the political and bureaucratic system in New Delhi. He’s referring to tax cases and notices, raids and investigations by the Directorate of Revenue Intelligence (DRI), Enforcement Directorate (ED), and Central Bureau of Investigation (CBI), related to money laundering and tax evasion. Targets have been Vodafone and its non-executive chairman Analjit Singh.

Some of the cases are from the Hutch-Essar days in 2001-02, where Vodafone wasn’t directly involved. In some others, like a DRI allegation that Vodafone hasn’t paid the mandatory duties on some imports, the government agency has been pulled up by the Bombay High Court for seeking differential tax dues from Vodafone Essar by threatening the company’s directors with arrest. DRI says that anti-dumping duty is payable on some of the equipment being imported from China.

Vodafone is also anxious about the three circles—Delhi, Mumbai, and Kolkata—that come up for renewal in 2014. While it’s highly unlikely that some other player will actually bag them, company officials wonder what kind of money Vodafone will have to stump up to retain them.

Some analysts believe, but won’t talk about it for attribution, that Vodafone could even be the target of acquisition. It’s far easier to convince and pressurise a handful of investors to part ways when a company is privately held. Listing a company on the bourses makes it difficult for any takeover bid, simply because a bunch of Securities and Exchange Board of India (SEBI) guidelines kick in. Pieters refused to comment.

Within Vodafone, preparations are on for an IPO at short notice, as soon as the tax issue and regulatory concerns are sorted out. The company has been declaring its India results and has appointed consultants to restate its financials and balance sheet according to SEBI guidelines. The management structure has been changed; the board has three independent Indian directors, in compliance with the rules of a listed company.

Caption
Caption

Pieters has a council of 10 executive officers, including chief operating officer Sunil Sood, and director for Vodafone business services Naveen Chopra, who are responsible for the day-to-day running of the company. There’s no company secretary yet, but the investor relations and corporate affairs teams are in place to smoothen the IPO process. Pieters has also done preliminary road shows with investment bankers and other potential investors, and says they are “excited” about the IPO. He adds that the current market conditions (Sensex levels, etc.) are good enough. However, none of the Vodafone managers venture an IPO size; at the least, says one, it will be the largest in Indian telecom.

FOR INVESTORS WISHING to participate in the telecom sector, the Vodafone IPO could be a great opportunity. Pieters calls it an “India exposure [to telecom] with Western transparency [read corporate governance]”. For the moment, park all the shadowy games being played and Vodafone emerges as a solid telecom company. “The sector is mature and valuations have been dropping. But the Vodafone IPO will be a success even in these circumstances,” says Mahender Swarup, president of the Indian Private Equity and Venture Capital Association.

A key stat to look at is revenue market share (RMS)—Vodafone’s stands at 21%, second to Airtel’s 28%. The next, Idea, is at 14%. Among the big players, Airtel and Vodafone are the two whose RMS is higher than their subscriber market share. Globally, an RMS of 15% is considered the threshold. This is enough to sustain the company, pay debts, manage fixed costs, and even make a small profit. But this is a difficult number for an operator in India; with 12 players jostling for space, it is difficult to reach the threshold RMS in a market where customers are seeking value for every paisa spent. Unlike other markets, where loyalty ensures revenue for the operators, here customers do not hesitate to switch for a better deal even if it is for a few months.

Vodafone is able to post superior RMS figures despite having upended the business model. It inherited Hutch’s network of urban, high-paying customers. While it retained them, it realised the need to widen the base. It invested in network expansion, adding 90,000 towers in five years, compared to 30,000 during the 12 years of Hutch. Today, Vodafone’s towers in India outnumber all the towers in its European operations combined. “Hutch had left the business to fend for itself. For us it was a very deliberate decision to make large investments and go for the whole market. We cannot afford to be a Ferrari or a Porsche. We are like Volkswagen, present across all segments. We cannot be a niche player, we are too big for that,” says Sood. These investments have lifted Vodafone’s total subscribers to 153 million from 26 million five years ago. Of these, 74 million come from 376,000 villages.

There are multiple factors holding up Vodafone’s RMS figures. One, it has the highest number of postpaid customers. Two, rollouts in Bihar and Jharkhand have reduced interconnect charges (what one operator pays another for using its network): Many of Vodafone’s customers in Maharashtra and Gujarat are migrant workers from Bihar and Jharkhand. Three, of the 22 telecom circles in India, Vodafone is market leader in five (Mumbai, Kolkata, Gujarat, Haryana, and West Bengal). Given the kind of fixed infrastructure costs (towers, licensee fees, etc), telecom is ultimately about scale. “One who has the most business has the best margins,” says Pieters. Vodafone’s upfront investment in infrastructure is also showing up in improved Ebitda margins which fell from 33% in FY08 to 25.5% in FY11, and has now risen to 28% in the first half of FY13.

Analysts also like Vodafone’s focus on India. “That makes it a good investment. Investors would like to buy the India story of Vodafone rather than Airtel’s Africa story,” says Rumit Duggar, telecom and IT analyst (India), Religare Capital Markets. Ever since Bharti picked up Zain in Africa, analysts have been sceptical of its abilities to build the right kind of clientele and earn the right returns from the 17 African countries it operates in.

Despite its superior RMS figures, consultants such as Rishab Gulshan, partner and director, Boston Consulting Group (India), believe that 60% of Vodafone’s revenue and 80% to 90% of profits come from 15% of subscribers. (Vodafone doesn’t share these numbers.) So, while Vodafone may still wish to add more subscribers to squeeze its assets better in a low average revenue per user (ARPU) environment, beyond a point its impact on the bottom line is negligible. That’s where its data strategy becomes important.

The ARPU of data is four times voice. That’s exactly why there’s a rush towards bagging more and more data customers, resulting in a price war of sorts. Though it’s nowhere as bad as in voice, customers have begun swapping dongles, for example, based on higher bandwidth and lower costs. For companies such as AT&T and Verizon, data accounts for nearly 40% of revenue, while in India it averages between 5% and 8%. Vodafone’s data share has risen from 5% of revenue to 8% between FY08 and FY12. “The importance of data for operators lies in giving access to applications. The data code still needs to be cracked in India,” says Gulshan.

Ideally, Vodafone would like to bundle voice with different data packages, but given the nature of the Indian market (mostly prepaid customers, prevalence of feature phones, etc.), that won’t work. But, instead of just offering connectivity, it is focussing on service and applications. Data is a bit like electricity: It helps power up devices. But the difference is, power companies don’t really care about what gizmo gets plugged in (toaster or an air-conditioner), telecom service providers can hugely influence data usage. Moreover, data is addictive. Pieters says that just the awareness about data after the 3G auctions has bumped up demand for Vodafone’s data services.

“IT distributors and channel partners understand data better than our SIM outlets. We will take their help to sell the new products as well as reskill our existing team to talk the new language,” says Sood. The company now plans to introduce sachet or small data packages, such as prepaid recharges for low amounts. This is also where services such as M-Pesa, its proprietary mobile money transfer system, come into play, where Vodafone will get a fee per transaction.

It is in projects such as M-Pesa or implementing 3G data that synergies between India and the global operations of Vodafone become evident. There is a constant exchange of best practices between the 30 Vodafone countries. For instance, machine-to-machine services, cloud services, fixed-line data, and tiered data pricing in Europe are being studied with an eye on implementing the same in India. Vodafone India had flown down executives from Egypt and Britain to help put its 3G services in place.

Meanwhile, the company is paying more attention to Vodafone Business Services (VBS). Vodafone has 110,000 km of fibre spread across 100-odd towns and cities. Then, nearly half of the top 10,000 companies use Vodafone, making it the largest mobility service provider by corporate SIM usage. Vodafone is now offering them enterprise data services, such as leased lines, multiprotocol label switching (MPLS, a mechanism that directs data from one point to the next through the shortest route possible), video and voice conferencing. The infrastructure mostly exists and an additional customer means incremental cost to extend the line to his premises. “For us it means leveraging our mobile and fibre network to service these clients. Voice over this network is tactical, data is strategic. We have to decide to what extent we want to go on fixed line services,” says Chopra. He says this business is growing “much faster than the consumer business”. Any new business will be incremental, he argues, because “so far we’ve mostly been selling SIM cards to such people”.

According to Chopra’s math, VBS should contribute up to 15% of Vodafone’s revenue by 2017, from 10% today. To differentiate themselves from others, such as Tata Communications, Airtel, or Reliance Communications, Vodafone is banking on quality of service—it has created a separate network operating centre in Pune and a dedicated call centre for VBS clients. And as these services are used more, it’ll start showing up in the margins. Not to forget the global bandwidth, services and customers that the $1.7-billion acquisition of Cable & Wireless Worldwide will add to the portfolio while reducing dependence on other global connectivity providers.

“India has at least another decade of runway revenue growth and Vodafone shareholders’ calculations will be based on such potential,” says Mohammad T. Chowdhury, executive director and telecom industry leader, PricewaterhouseCoopers India. He adds that the investment that Vodafone will make over the next 10 years will require a different approach to fetch adequate returns.

OVER HIGH TEA at New Delhi’s Imperial Hotel, in his second meeting with Fortune India, Pieters makes a biting observation about Indian entrepreneurs. “Indian businessmen are sometimes just as interested in destroying competition as in making money. That’s a strange mindset—I haven’t seen it anywhere,” he says, adding: “[They’d] rather all die than one or two make money.”

It’s a characterisation of the local telecom industry, plagued by unsustainable tariffs and altering regulation. While costs have risen, ARPUs have fallen, destroying margins over a five-year period. That’s clearly a worry for investors. The lack of takers among retail investors for Bharti Infratel’s recent IPO shows that.

However, there is some hope. The bidding pattern in the November 2G auctions indicated rational thinking by operators, while there are signs of the government easing its stand on spectrum pricing. The cautious bidding meant that operators weren’t in any hurry to get spectrum. Unlike the rush during the 3G auction, they are now calculating returns on each megahertz of spectrum and may be willing to wait instead of paying higher in desperation. They are also looking to squeeze efficiencies out of their current assets before paying for new ones. Tata Teleservices and the newer operators, such as Telenor and Videocon, are restricting themselves to better paying circles and exiting others. This means they are conscious of the cost of servicing unprofitable circles. They are happier being a regional player than being a loss-making pan-India operator.

It’s becoming increasingly clear that the downward spiral in the telecom industry is hurting everybody, Pieters’s misgivings notwithstanding. Etisalat and Batelco have already exited, while Uninor and Aircel are downsizing operations. A drop in subscriber numbers in November 2012 indicates a clean-up of the user base. Though new customers are being added, inactive subscribers are being weeded out, which has resulted in a negative growth of 1.34% for GSM operators. This will expose the real number of active subscribers and spectrum provisioning will improve. It will also end the mad rush for subscribers at any cost and the resultant tariff war that squeezed operators. This is not to say that some other player can’t trigger another moment of reckoning. Reliance Industries’ big push through broadband wireless access (BWA) could change the dynamics once again.

“Telecom was a simple business and followed a global pattern, but in India it has become complex because of regulatory and government interventions. Unlike home-grown entrepreneur-led telecom companies, a lot will depend on pricing issues, and on how Vodafone’s professional management handles the system,” says the managing director of an MNC investment bank who did not want to be named as he works with telecom operators in India.

For Vodafone’s shareholders, it will always be the environmental issues that’ll rankle. After all, the things that keep the company’s officials up at night are spectrum pricing, spectrum availability, refarming, licence extension, and the one-time settlement of the tax issue. 

Follow us on Facebook, Twitter, YouTube & Instagram to never miss an update from Fortune India. To buy a copy, visit Amazon.