Zain Africa sale raises stakes for India’s Bharti

For several months, the principal shareholders of the Zain Group of Kuwait, one of the region’s largest telecom service providers, have been looking for a buyer for the company’s assets in Africa.

Meanwhile, in India, Sunil Bharti Mittal, the chairman of the country’s largest telecom company, Bharti Airtel, has been seeking an African venture for the past two years.

He negotiated twice with MTN of South Africa, but talks broke down.

The two sides had reason to come together — and so they did.

In a deal announced on February 14, the $8.15 billion Bharti and the $4.14 billion Zain told their respective stock exchanges that they were in “exclusive discussions” until March 25.

On the table were the African assets of Zain — Zain Africa BV — which comprises 15 countries.

The combined firm would have revenues of $13 billion, and earnings before interest, taxes, depreciation and amortization (EBITDA) of around $5 billion, after the deal closes in May, as Bharti expects.

Left with Zain would be Kuwait, Jordan, Bahrain, Lebanon, Iraq, Saudi Arabia and Palestine, and two African markets — Sudan and Morocco — which are considered part of the Middle East cluster.

“This potential transaction remains subject to due diligence, customary regulatory approvals and signing of final transaction documentation. There can be no assurance that a transaction will be consummated. ” Bharti informed the Bombay Stock Exchange (BSE).

The note is, of course, a measure of caution.

Talk to the people at Bharti and they will tell you off the record that they expect this deal to be smooth sailing.

“The MTN deal was complicated and needed many interventions from both governments,” Mittal told weekly business magazine BusinessWorld. “In Zain, there are no multiple clearances required. Only the Zain board has to give a go ahead, and we have to pay.”

Yet the proposed deal has given rise to misgivings.

Bharti shares plunged some 14 per cent on the Mumbai stock exchange in just two days.

Almost every research house has been critical of the deal.

The comments range from “Pained by Zain; Rating Cut” from Bank of America Merrill Lynch to “Very expensive diversification” by Credit Suisse.

On February 19, credit rating agency CRISIL, the Indian arm of Standard and Poor’s, placed Bharti’s long-term debt on rating watch with negative implications.

“(This) reflects CRISIL’s belief that Bharti Airtel’s proposed acquisition of Zain Africa BV’s business for an enterprise value of $10.7 billion will be largely debt-funded; the acquisition can thereby adversely affect Bharti Airtel’s debt-to-equity ratio and debt protection indicators over the short term. Bharti Airtel’s debt-to-equity ratio, after the acquisition, is expected to increase to more than 1 time, from around 0.15 times as on 31 December, 2009,” says CRISIL.

The principal issue is one of valuations.

Everyone seems to agree that Zain is a good target for acquisition, but is it worth the price Bharti is paying?

Zain’s African operations are losing money.

In the nine months to September 2009, they reported a net loss of $112 million against a profit of $169 million in the corresponding period the previous year.

Seven of the 15 countries reported losses.

The highest revenue earner, Nigeria, which was nudging the $1 billion mark, lost $88 million.

These are markets where the telephone penetration rates range from 14 per cent in the Democratic Republic of the Congo to 123 per cent in Gabon, though most are in the low double digits.

Zain has 42 million subscribers in Africa (September 2009) while Bharti has 121.7 million in India (December 2009).

Customer growth rates range from -14 per cent in Kenya and -6 per cent in Nigeria to 51 per cent in Niger.

The average revenue per user (ARPU) is $3 in Ghana and $25 in Gabon.

The ARPU, a frequently used yardstick in the telecom industry, is an average of $6 for Zain’s African operations against $5 for Bharti in India.

These numbers can be used to paint an optimistic picture or a pessimistic one.

For instance, low penetration rates could mean either a huge upside opportunity or lack of demand needing many years of expensive market development.

Low ARPUs could imply poor revenue streams or future growth potential.

In contrast to Africa, in its Middle East portfolio, Zain has an ARPU of $55 in Kuwait and $26 in Bahrain.

But if Bharti can successfully transpose its high minutes of use model — described as a “minute-factory” — to Africa, it could be highly profitable even at these low ARPUs.

“A roadmap for synergy backed with flawless execution is what would drive success,” says K. Raman, of Tata Strategic Management Group. “For a company like Bharti, this deal, if it goes through, will test its ability to integrate multiple operations across various countries and derive synergies.”

Bharti has operations in Sri Lanka and has recently bought 70 per cent of Warid of Bangladesh from the UAE-based Dhabi Group. But Zain is in a different league.

“We believe that Zain’s Africa unit is an attractive acquisition candidate for Bharti, given relatively low penetration in its footprint and high ARPU, which could enable Bharti to export its ‘minute factory’-based business model,” says Motilal Oswal.

The Economic Times looks at the acquisition along another dimension.

Bharti will be paying Zain $252 per subscriber.

In September 2009, when Bharti was trying to strike a deal with MTN, the two sides had valued each customer of the South African firm at $394.

Vodafone paid $743 per user when it acquired Hutchison’s India operations in February 2007.

Deals a few years ago have attracted even higher valuations in the $361 to $1,050 range.

“What needs to be noted is that these higher valuations of the past were out of expectations of a stupendous growth in India’s subscriber base,” the paper points out.

“Yes, the ARPUs are low in Africa at this stage, but the potential for growth over the next three to five years is significant both in terms of the number of customers as well as ARPUs,” says Sudip Bandyopadhyay, group president of Spice Finance.

“Bharti has demonstrated to the world its low-cost model,” says Nishna Biyani, telecom analyst at equity research house Prabhudas Lilladher. “The targets are (relatively) high ARPU countries with low usage. Over time, high minutes of traffic can be generated with lower dilution in ARPU.”

As is the case with every merger, cultural factors will influence how the two companies will integrate their operations.

Zain was launched in 1983 as the region’s first mobile operator.

It was known at that time as MTC. In 1994, the company introduced GSM technology in Kuwait, becoming one of the first companies in the region to do so.

The company embarked on an aggressive growth path after Saad Al Barrak took over as CEO of the Zain Group in 2002.

He worked hard to convert a Kuwaiti telecom operator into a global one.

With 24 countries and 71.8 million customers, Zain was close to fulfilling Al Barrak’s dream.

The target set for 2011 was to be among the top 10 telecom companies in the world with more than 150 million customers.

The proposed sale of Zain Africa BV represents a change in course in the company’s strategy.

A few days before the Bharti deal was announced, Al Barrak announced his resignation, which was promptly accepted.

But the Zain corporate culture is imbued with his go-getting style.

Bharti could run into integration problems in Africa.

Also, though Mittal says that no government permissions are necessary (in fact, both India and Kuwait have welcomed the deal), the telecom regulators of all the countries will have to approve the takeover.

If valuations are a cause for concern, raising the money is not.

“We managed to get the resources in place when the bigger MTN deal was being discussed,” Mittal told BusinessWorld.

“I don’t think raising funds for the proposed deal will be difficult,” says Bandyopadhyay of Spice Finance. “A share swap may have led to legal complications. [In the MTN case, the problem was the Indian shareholding in Bharti-MTN combined entity falling below the government-stipulated floor.] Raising funds for the deal from banks or other institutions in the international markets should be an easier and workable option. The strength of Bharti’s existing balance sheet and some structure around Zain Telecom’s shares or cash flows should do the trick.”

According to the agreement, Bharti will assume $1.7 billion in debt and pay $700 million after one year.

This reduces the cash requirement to $8.3 billion.

Bharti has about $1.5 billion in cash on its balance sheet.

The amount of funding needed thus comes down to $6.8 billion.

Funding pattern

Although the funding pattern is yet to be worked out, the consensus view is that it will be entirely in debt.

“Equity is expensive in the current depressed share price valuations and cash can be borrowed at a relatively low cost,” says Bundeep Singh Rangar of IndusView. “Bharti is likely to borrow in short-term currency loans. These loans will be replaced with longer-term debt after the March 25 deadline.”

Mittal says his team is working out the details of various funding options.

“All I can say is that funding has never been an issue and will never be an issue for Bharti,” he told The Economic Times.

The Bharti-Zain deal is also likely to usher in a year of mergers and acquisitions for India Inc.

According to a report by international consultancy firm Grant Thornton, January saw Corporate India announce 56 M&A deals worth $2.5 billion.

Zain, if it goes through, will be the second biggest deal in Indian history after the $12 billion Tata takeover of Corus.

“I think we will see a perceptible increase in outbound mergers over the course of the year,” says Srivatsan Rajan, a partner at Bain. “This is primarily because assets in developed markets are available at valuations more reasonable than they were at the peak a couple of years ago..”