Do Idea Cellular and Vodafone need to be recapitalized?

Things have changed dramatically since Idea Cellular Ltd and Vodafone India Ltd announced the terms of their proposed merger in March this year. Back then, based on earnings for 2016, the combined entity had a net debt to Ebitda ratio of 4.4 times. This has now risen to 8.5 times, based on annualized earnings for the September quarter. Ebitda stands for earnings before interest, tax, depreciation and amortization.

For one, this is far higher than the maximum leverage ratio the two companies envisaged when they agreed on merger terms. Both companies are to ensure that at the closing of the merger, its leverage ratio isn’t higher than an agreed upon “maximum closing leverage ratio” (MCLR). At the end of the September 2018 quarter, which is roughly when the deal is expected to close, the agreed upon MCLR is a net debt to Ebitda of 6:1, using earnings of the preceding 12 months.

Currently, Idea Cellular’s leverage ratio stands at 9:1, while Vodafone India’s is 8:1 using annualized earnings for the September 2017 quarter. Going forward, there will be pressure on earnings because of the 57% cut in interconnection usage charges, although some of that is expected to be offset by an increase in average realizations, thanks to Reliance Jio Infocomm Ltd’s recent tariff hikes.

So unless the two companies waive the MCLR clause, there would be a need to bring in a considerably large amount of additional equity capital. This shouldn’t be a big problem for Vodafone, considering that its 42% stake in Indus Towers Ltd (valued roughly at $5 billion) isn’t part of the merger transaction. It can use the proceeds of the proposed Indus stake sale to recapitalize its telco subsidiary in India.

While there’s no such luck for Idea, the silver lining is that appetite for telecom stocks has improved in recent months, and it may be better placed trying to raise capital. Of course, the fact that its promoters have already committed to buy a large stake from Vodafone Group Plc in the merged entity could act as a constraint.

Asked about the need to raise capital for the merged entity because of its high leverage, Vodafone said in a call with analysts that things are improving thanks to recent tariff hikes, besides which a relaxation by the government on payment terms for the deferred spectrum obligations will ease things as well.

Even so, the fact remains that the high leverage has put constraints on the ability of the two companies to invest as much as Reliance Jio and Bharti Airtel Ltd in their respective businesses. While they have done well to protect market share in their leadership circles by concentrating capex in these segments, the fact remains that they have lost ground in the past year. David Wright, an analyst at Bank of America Merrill Lynch, said on the post-earnings call with Vodafone, “It feels like you’re struggling a little bit on the capex side; Bharti is certainly attacking you, and that’s a very essential cost of business in India.”

On a pro forma basis, the Idea-Vodafone combine reported an Ebitda that was around 98% of what Bharti Airtel reported for its India wireless business for the September 2016 quarter. This has now fallen to 81% in the September 2017 quarter. Likewise, the combined entity has lost ground in terms of subscriber share as well.

While things are expected to ease post merger, especially after cost synergies kick in, the current high leverage seems to be hurting for now. To that extent, bringing in additional capital soon seems like a good idea.