Vodafone - Idea merger: Should you buy Idea Cellular?

Over the past two sessions, Idea Cellular has rallied nearly 35%

Idea Cellular continued its journey north at the bourses on Tuesday with the stock rallying over 7% on the National Stock Exchange (NSE) in morning trade to Rs 105 levels. Over the past two sessions, it has gained nearly 35%. By comparison, the Nifty50 index has lost 0.5% during this period.

The rally comes on the back of reports that UK-based Vodafone is in talks for an all-stock merger with Idea Cellular. This would make the combined entity the largest telecom player in terms of revenue.

“The combined entity will derive significant benefits from network consolidation as the network site requirement will reduce significantly. The combined entity will have concentrated spectrum portfolio with 36.5% of the liberalised spectrum in 1800MHz band, enabling it to deploy higher spectrum per site resulting in higher revenue productivity per site,” suggests a sector report from Edelweiss Securities.

Investment strategy

So what should you do with Idea Cellular then in case you already own the stock? Does it merit a buy at these levels? 

Though the news reports have triggered a rally in the counter, investors should also realise that the fall could be sharper in case the merger talks fail. Analysts believe any consolidation in the telecom sector is unlikely to result in reduction in competitive intensity as Reliance Jio (RJIO) will continue to disrupt market till it gains volume market share proportionate to its capacity market share.

Substantial data capacity and reasonably high gross margins are also likely to keep competitive intensity high, leading to significant pricing correction in the medium-term.

However, analysts at Edelweiss believe that the Idea-Vodafone merger will help the combined entity to take on RJio more aggressively it will have leaner operations leading to better profitability. This will also boost their ability to invest in the network. 

“In case of merger announcement, Idea may benefit from high synergy benefits which may potentially drive up market capitalisation by around 30%. However, in absence of merger announcement and lack of clarity on deal structure we maintain our estimates and ‘HOLD’ rating on the stock with DCF-based target price of Rs 85,” suggest Sandip Agarwal and Pranav Kshatriya of Edelweiss Securities in a report.

On the other hand, analysts at Phillip Capital estimate the combined entity to generate an EBIDTA (earnings before interest, depreciation, taxation and amortisation) of Rs 27,000 crore in FY19E with potential synergies worth Rs 3,500 crore. 

"Assigning an EV/EBIDTA multiple of 7x to the combined entity, we arrive at an EV of Rs 189000 crore. We estimate the combined entity will have a debt of around Rs 90,000 crore translating to an equity value of around Rs 1,00,000 crore. Assuming Idea Cellular will have around 40% equity stake, Idea’s market capitalisation post merger will be around Rs 40,000 crore translating to per share price of Rs 111," the Phillip Capital report says.

Key challenges

However, the deal could face two key challenges. First, India’s telecom M&A rules do not allow revenue and subscriber market shares above 50%. Similarly, spectrum holding in each band is not allowed above 50%. 

 

“The merger company’s revenue/subscriber caps and spectrum caps may get triggered in seven and six circles, respectively, experts suggest. However, the merged company’s revenue/subscriber share is more than 60% in only one circle – Kerala. In the rest of the circles, it is between 50% and 60%. This may get resolved once Reliance Jio starts charging subscribers and taking revenue market share,” says Gautam Duggad, an analyst tracking the sector at Motilal Oswal.