It’s hard to say where valuation math ends and acquisitive ego begins with the current high bidding levels for Hutch Essar, India’s second largest mobile phone services provider, which currently has 22.3 million subscribers and Rs. 5,800 crore in revenues ($1.3 billion). Active bidders include the world’s largest mobile telecommunications company Vodafone, the Anil Ambani-led Reliance Communications and the Hinduja Group. Verizon Wireless of the U.S. is also said to be kicking the tires of a potential deal.

Others in the fray are Japan’s NTT DoComo, Egyptian telecom operator Orascom and other big-name investment banks, including Goldman Sachs, Blackstone and Texas Pacific. In the past month, Hutch Essar’s valuation has doubled to $20 billion — the enterprise value that Hong Kong parent Hutchison Whampoa likes for its 67% stake with partners. The other 33% is owned by the Ruias of the Mumbai-based Essar group, who seem open to either running the entire company themselves or in partnership with others.

At first sight, it seems obvious why Hutch Essar’s valuations climbed so rapidly to such high levels. India’s current high economic growth makes it an attractive market for foreign investors. Also, it is not every day that one gets to control a big player in a tightly-regulated policy environment where entry barriers are high.What’s more, the country’s mobile phone subscriber base is adding six million new subscribers each month and fast approaching 200 million, or a tenth of the world’s subscribers. India Knowledge at Wharton interviewed faculty members at Wharton and the Indian School of Business, and other experts to get closer to the valuation metrics and see what’s in store for a new owner at Hutch Essar.

At least two theories are floating around as to why Hutchison Whampoa wants to sell its stake in Hutch Essar. One is that the company badly needs the cash since it has committed up to $30 billion in investments across Europe. The other is that Li Ka-Shing, the Hong Kong-based shipping and real estate baron who controls Hutchison, wants to cash out. “He is a fairly astute entrepreneur and, in the past, he has been known to sell when he thinks valuations have maxed out,” says Saurine Doshi, partner at consulting firm A.T. Kearney in Mumbai. India’s FDI regime prevents Hutch from buying out the Ruias of Essar and gaining complete ownership. Hutchison, however, would have to settle a dispute with Essar that recently arose and now seems headed for the courts. Essar claims that under its partnership agreement with Hutchison, it has the “right of first refusal” in case the latter sells its stake in Hutch Essar. Hutchison says that right of refusal is not a blanket agreement, and is good only in specific circumstances.

Of the several possible configurations under consideration, the two most popular are first, a Vodafone-Ruia partnership and second, Reliance Communications buying out both Hutchison and the Ruias, and merging it with existing operations. India’s policy regime doesn’t allow much elbow room in those scenarios: FDI rules require Vodafone or any foreign player to have a local partner holding at least 26%; and Reliance or any other company cannot own more than a 10% stake in two different operators.

GSM and 3G

The quicker tempo being set in the race for Hutch Essar is a testimony to the appeal of the Indian opportunity, says Ravi Bapna, professor and executive director of the Center for Information Technology and the Networked Economy at the Indian School of Business in Hyderabad. “This is as strong a signal as you can get — for the valuation to double in six months [to more than $20 billion] is totally unprecedented; it was $10 billion in June [2006]. Part of what people are responding to is the growth rate of mobile phone subscribers in the market as a while. No country in the planet is adding six million customers a month, and the cost of handsets is going down.”

Those higher valuations could be justified only with a couple of significant assumptions, says Bapna. “The key for the underlying valuation is the hypothesis that the Internet is going to be played on the mobile phone in India. This implies higher average revenue per user (ARPU) for the mobile operators, which, coupled with the explosive growth and potential in the subscriber base, is a deadly combination.” He says Hutch Essar’s new owner will expect the subscriber base to double in two to three years, and also a doubling of the ARPU from current levels of between $10 and $20 a month.

Two other big attractions for international players in Hutch Essar are the opportunity to gain a significant presence on the GSM technology platform, and a 3G opportunity that is coming up soon, says Doshi. GSM is the fastest-growing and most popular wireless standard, with penetration in more than 200 countries, according to the GSM Association, a trade group based in London. Third generation (3G) services on the GSM platform would be made possible when those licenses are issued by the Indian government next year. “Part of the reason the [Hutch Essar] valuation is high is you are [getting] an option to buy 3G licenses in 2007-08 when preference will be given to the existing operators,” says Doshi, adding that while the 3G market has been slow to take off in Europe, this technology is the way to go in the future, especially with the convergence of voice, data and video.

A Skeptical View

Wharton marketing professor Peter Fader senses serious disconnects between what he calls the “base behavior of our species” and the valuation assumptions made by both bidders and sellers of companies such as Hutch Essar. The revenue promise held out by Hutch Essar’s existing and projected subscriber base is often seen as crucially linked to how the service is priced and the functionalities it offers. Here is where the deal makers may be off-key, says Fader. “When it comes to, ‘Should I keep this contract or not?’ often it’s the silly little things that make you stick around or leave. They are not necessarily big, major, obvious factors like the pricing policy.” He says it is precisely because the swings could take place due to seemingly small issues in a mobile phone service — like “a goofy design aspect” — that it is difficult to pinpoint specific drivers.

“When you boil it all down to individual behavior, whatever the device is that they are holding in their hand, their tendency to stick with it or switch to a new one — and other kinds of very basic behavioral patterns — will still be largely the same in 10 and 20 years as it is today, even though the functionality being delivered is different,” says Fader. “That’s a point I’m willing to stand by, and it’s a fairly radical point.”

Fader and Bruce Hardie, a marketing professor at the London Business School, did capture some of those behavioral patterns in a June 2006 study titled, “Customer-Base Valuation in a Contractual Setting: The Perils of Ignoring Heterogeneity.” They say in their paper that M&A deal makers have, in recent years, relied increasingly on extending the concept of customer lifetime value (CLV) to value a customer base. “The application of standard textbook discussions of CLV sees us performing such calculations using a single aggregate retention rate,” the researchers write. But these retention rates typically increase over time due in large part to a “sorting effect” in a heterogeneous population. “Failure to recognize these dynamics yields a downward-biased estimate of the value of the customer base,” they suggest 

In making such flawed assumptions, Fader feels sellers are “just being naïve; they’re only hurting themselves and they are leaving so much money on the table when they do these valuations.” Mobile phone customers are no different in their behavioral patterns than purchasers of other consumer products like magazine subscriptions, he adds. “There is enormous heterogeneity among customers in every contractual database I’ve ever seen. In other words, for every person who’s going to churn the instant he is able to do so, there’s another person who’s completely, blindly loyal and foolishly will keep his contract forever. And so the real key here is to capture the variability across customers. Too often, what these firms are doing when they make their calculations is they are assuming an average customer. In doing so, and in ignoring the variability across customers, they end up systematically undervaluing the future value of the customer base, which is really what it is all about.”

Wharton marketing professor Raghuram Iyengar has closely studied the impact of pricing strategies in the U.S. mobile phone services market. He says the concept of CLV, which combines profits per customer and the retention rate, gained currency as a valuation tool during the tech boom of the late 1990s. At that time, “a lot of companies in this space were not making profits, but they had big customer bases.”

The key factors in analyzing the enterprise value of a mobile phone services provider include the ARPU, the retention rate of customers, the cost of capital and the costs of customer acquisition. With a natural limit on the number of minutes each customer could conceivably use each month, the best opportunity to increase revenue per subscriber is in providing value-added services that command a premium. Having said that, it is the retention rate that has the maximum impact on the company’s valuation, says Iyengar.

Pointing to a November 2006 report from Verizon for its latest quarter, Iyengar says the company is “extremely happy about the fact that its churn rate is 1.3% per month — one of the best in the industry — because it ensures that their customer lifetime value will be high.” Verizon had posted the fourth consecutive quarterly drop in its churn rate, which measures defecting customers. The churn rate in the U.S. wireless phone services market is between 1.5% and 2% per month. Cingular Wireless last quarter reported a churn rate of 1.8%, up slightly from 1.7% in the prior quarter; T-Mobile’s churn rate also edged up, from 2.2% to 2.3%, over the past two quarters.

Keeping Customer Churn Low

A. T. Kearney’s Doshi says that, as with other global majors, customer retention will be the top challenge Hutch Essar’s new owners will face. “Customer churn is high across the world for mobile users, but higher in India,” says Doshi. “The only way [mobile phone services companies]do it globally is by strengthening customer relationships; price becomes a factor, in addition to service levels and dropped calls. Once you have parity on those dimensions with all others, you need to adopt an end-to-end customer touch model.” Doshi says at that stage, the key issues include convenience in the billing and payment cycle, the resolution of customer problems and “customer reach” — how companies proactively reach out to customers on an ongoing basis with new options and offers. “In sum, the big challenges facing Hutch Essar will be how to reverse the ARPU decline and how to put in place a leading end-to-end customer relationship model,” says Doshi.

He tempers an optimistic outlook with other, more sobering considerations. In the short term, he says, the challenges a new owner faces will be in customer retention and ARPUs. “While everything started with a bang [a few years ago], most operators have seen a decline in their ARPUs,” he says. Hutch Essar’s ARPUs of Rs. 375 a month ($8.50) compares with industry averages of Rs. 325 ($7.30), according to Doshi, who adds that Hutch Essar’s current ARPU levels have actually fallen from levels of Rs. 450 about 18 months ago, and that they have declined at a faster rate than those of others. “Initially, customers were thrilled with the mobile phone, but now they have started optimizing their use,” says Doshi. “That is one thing that [any potential buyer] will have to deal with.”

If trends in the U.S. mobile phone services industry could point to things to come in the Indian market, a simple expression that Iyengar employs to arrive at customer lifetime value is useful: ‘M’ multiplied by ‘R,’ divided by 1+I-R, where ‘M’ stands for the margin per customer, ‘R’ for the retention rate and ‘I’ for the cost of capital. The ARPU in the U.S. market is currently around $50 a month, Iyengar says. Assuming a margin of 45% and the churn rate at 1.5% a month (or 18% annually, meaning a retention rate of 82%), Iyengar arrives at $790 as the customer lifetime value.

If one applies those ARPU numbers, profit margins and retention rates to Hutch Essar’s 22.27 million existing customer base, the total value works out to $17.6 billion. That, incidentally, is close to the $17.4 billion that Goldman Sachs believes is the appropriate break-even price its client Vodafone should keep in mind. Goldman Sachs further said that Vodafone would be overpaying if it valued Hutch Essar at more than $20 billion. Hypothetically, if one assumed a higher customer retention rate of 90% (instead of 82%), the enterprise value shoots up to $26.75 billion. In contrast, with other things being equal, a lower capital cost of say, 7%, pushes up the enterprise value to $19.5 billion.

Doshi feels Hutch Essar’s price tag is on the high side: “At $20 billion, that’s almost $1,000 a user,” he says. He points to China Mobile’s failed bid last July to acquire Millicom International Cellular SA of Luxembourg, a provider with then about 10 million subscribers across Latin America, Africa and South Asia. (Its current subscriber base is closer to 13 million, and like Hutch Essar, it, too, is adding about a million subscribers a month.) By the time the deal talks failed, China Mobile had offered $5.3 billion for Millicom, or about $500 a customer. The company had the added attraction of licenses in 16 countries including Chad, Bolivia, El Salvador and Cambodia, with a combined market of 400 million people.

Hutch, Hunch, IRR or Instinct

Fader suspects the valuation math in deals like Hutch-Essar is far from scientific, basing his assessment on statements in corporate financial documents. “I’ve never seen a case where a company has estimated customer retention — or at least admitted to doing it — in a manner that their shareholders should insist upon,” he says. “They are using very crude estimates of retention; they are assuming that they are constant across customers or over time rather than capturing the huge dynamics that take place there.”

India’s mobile phone services market is quite different from that in the U.S., says Bapna, and he points to India’s higher growth in data traffic as one example. “Voice usage levels aren’t likely to increase dramatically; you can make more money from data and multimedia applications and from residential middle-class and enterprise users,” he says. “Startup businesses are developing software for seamless video conferencing and other applications for the mobile phone. It’s like taking a application and pushing it on the mobile phone.”

Fader agrees that the mobile phone industry is in “a time of unique change,” but is equally skeptical about the long-term projections floating around. “People who sit around and say what the landscape will look like, say, 10 years from now are fooling themselves,” he suggests. “I think a lot of people have placed the wrong bets, if you look at the U.S. side. People talking about the nature and speed of convergence have been way off. It’s really, really hard to say how it’s going to play out.”