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 US$8.15 billion Bharti and the US$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 some US$13 billion, and earnings before interest, taxes, depreciation and amortization (EBITDA) of around US$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.

“Bharti Airtel and Zain have agreed to enter into exclusive discussions until March 25 for the acquisition of Zain’s African unit based on an enterprise value of US$10.7 billion,” Bharti informed the Bombay Stock Exchange (BSE). “This potential transaction does not include Zain’s operations in Morocco and Sudan and 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. Further announcements will be made in due course.”

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% 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.

High-debt Deal

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 US$10.7 billion will be largely debt-funded; the acquisition can thereby adversely affect Bharti Airtel’s gearing [debt-to-equity ratio] and debt protection indicators over the short term. Bharti Airtel’s gearing, 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 agency adds, however, that the company’s financial risk profile is expected to improve subsequently, as cash accruals will be used to de-leverage. “CRISIL believes that Bharti Airtel will benefit from the proposed deal by way of diversification of revenues and the growth opportunities offered by the under-penetrated African market.”

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 US$112 million against a profit of US$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 US$1 billion mark, lost US$88 million.

These are markets where the telephone penetration rates range from 14% in the Democratic Republic of the Congo to 123% 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% in Kenya and -6% in Nigeria to 51% in Niger. The average revenue per user (ARPU) is US$3 in Ghana and US$25 in Gabon. The ARPU, a frequently used yardstick in the telecom industry, is an average of US$6 for Zain’s African operations against US$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 US$55 in Kuwait and US$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. Besides, some operations are showing losses because of mismanagement. Bharti might argue it would change all that.

“A roadmap for synergy backed with flawless execution is what would drive success,” says K. Raman, practice head of infocomm, media and education at the Tata Strategic Management Group, an independent management consulting firm. “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% 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, perhaps the only research house that has been positive about the buy. “Only three out of 15 countries in the Zain Africa portfolio have a mobile penetration in excess of 50%. Moreover, Zain is a market leader in most of its operations, with 50%-75% market share in seven countries and 25%-50% share in six countries…. The balance sheet position appears comfortable for funding the deal.”

Business daily The Economic Times looks at the acquisition along another dimension. Bharti will be paying Zain US$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 US$394. Vodafone paid US$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 US$361 to US$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.

Views about whether Bharti is overpaying for Zain depend on people’s assessments about the growth potential of Africa’s mobile telecom market. “In the long run, the strategy of getting its footprint across the 15 African countries is definitely a great value proposition,” says Sudip Bandyopadhyay, group president of Spice Finance. “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.”

“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. Africa has average minutes of use per subscriber/month at just 100. In India, the numbers range from 350 to 400 depending on the operator.”

Other issues, too, could impact valuations. There is an ownership issue with the Zain Nigerian unit. (Bharti says Zain has to resolve that, and it is none of the India company’s concern.) MTN is a major competitor in most of the markets.

Cultural Factors

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 there is a problem on any of these fronts, it could make the deal look more expensive.

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. “The company will have no problems in getting the resources in place for this deal, too. All calculations have been made and there is no issue over which we need to fret. It is an all-cash deal and there is no issue of stock trading.”

“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 US$1.7 billion in debt and pay US$700 million after one year. This reduces the cash requirement to US$8.3 billion. Bharti has about US$1.5 billion in cash on its balance sheet. The amount of funding needed thus comes down to US$6.8 billion.

Funding the Deal

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, chairman of IndusView, a cross-border M&A consultancy. “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. “We have obviously got into the deal with our eyes open — very much open — and we are, therefore, very excited about this opportunity. We are also very happy that the Indian business model, that is the talk of the world, is now going global.”

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 US$2.5 billion. The bigger ones – Zain and the US$13.5 billion offer by Reliance Industries for bankrupt petrochemicals firm LyondellBasell – are still works-in-progress. Zain, if it goes through, will be the second biggest deal in Indian history after the US$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. However, we will need to see increased availability of external leverage [funding] for the momentum to increase.”