The Hindu Business Line : Is there a price disconnect?

Irrespective of assumptions about growth in consumer numbers and operating margin percentages, the Hutch saga displays symptoms of irrationality associated with the 3G auctions in Britain. Will the deal really help the consumer, asks SUMIT MAJUMDAR.

The race to acquire the stake of Hutchison'soperations in India, jointly owned with the Ruias of the Essar Group, has an uncanny resemblance to the 3G auctions in Britain held less than a decade ago. At that time, on the premise that 3G was the hot new technology to immediately transform mobile telecommunications, firms bid insanely high prices to acquire the licences that would enable them to offer 3G services.

Of course, the British Treasury, as the agents of the 3G spectrum seller, made out handsomely, collecting several billion pounds as a result of bidder irrationality. It was, however, taxation without representation. The large prices firms paid for the 3G spectrum were recoverable only via high consumer prices.

The factoring of such high prices, amounting to a significant and regressive tax on consumption of mobile services, into the business plans for the launch of 3G effectively killed that segment in Britain. Under no circumstances would the 3G segment break even for a decade unless consumers were taxed by factoring in the cost of 3G licences in the price.

Wages of Irrationality

Irrational exuberance has an impact which, if not controlled, can cripple companies. The main bidders, such as BT and Vodafone, ended up paying very high prices for commercially worthless 3G licences. For years they wrote off these licence costs and took huge charges against profits. BT's share price plummeted, never to recover. To aid in the recovery of 3G costs, the licence fees were spread over other services and affected the population at large. The 3G fees became a tax that all consumers in Britain paid for years for the incompetence of telecom company executives.

By the same token, the race to acquire the Hutchison stake in the mobile operator branded Hutch can have consequences similar to that seen in Britain. The valuation of a two-thirds share of the Hutch business at $14 billion, or Rs 63,000 crore, makes it the largest Indian acquisition deal. The full enterprise is worth $20 billion. But is it a reasonable deal?

In the race to acquire a substantial population base that makes up India's mobile sector, many firms such as Reliance, Orascom, Vodafone, the Hindujas, and the Essar Group, are willing to pay very high sums per customer. At Hutch's current customer base of approximately 20 million individuals, the price per pop (PPP), the terminology used in these deals, works out to Rs45,000, or $1,000 per customer. Such a high price has never been paid in the US market. On the other hand, the average revenue per user (ARPU) in India's mobile sector is Rs 5,400 per annum, as per the Telecom Regulatory Authority of India. Indian mobile operators are not profitable either. Their gross operating margin is about 32per cent, or Rs 1,728 per customer annually. Even if all the operating margin amounts were to be re-invested, an extreme assumption, it would take over 20 years for the purchase of Hutch to be justified if no growth were to be assumed in the customer base, or no declines in the ARPU either.

Growing customer base

Fortunately, India's mobile customer base is growing rapidly, recording the fastest growth rate in the world. Nevertheless, saturation will be reached one day. At super-normal growth rates, in customer numbers, it will take at least a decade for the Hutch deal to break even for the company buying it, if it were to re-invest all its operating margin amounts in writing off the purchase. If, being financially realistic, the amounts available for write-offs were lower, say by a half, the deal would take two decades to be cash-flow positive.

The above scenario assumes that the ARPU stays flat. In reality, the ARPU in India is declining rapidly. India is an extremely competitive mobile telecommunications market. Indians are also highly price-sensitive and will shop around for the best deal. India generates the lowest ARPU among the major world markets.

As yet, Indians use the mobile phone for basic communications, and the provision of value added services, for additional fees that can positively impact the ARPU, is in infancy. Such being the case, if the decline in ARPU is to be factored in, even if consumer numbers are growing rapidly, and all of the operating margin amounts are available to write-off the purchase price, at the current PPP the deal will take two decades to be cash-flow positive.

Irrespective of assumptions about growth in consumer numbers, the ARPU or the operating margin percentages, the Hutch saga displays symptoms of irrationality associated with the unfortunate 3G auctions in Britain.

Knee Deep in Big Muddy

At best case projections, the Hutch deal will be cash-flow positive only in a decade, as the 3G situation was forecast to be. Realistically it could be two decades before the deal is cash flow positive.

The phenomenon one is witnessing can be explained using the concepts put forth three decades ago in a classic piece, "Knee Deep in the Big Muddy: A Study of Escalating Commitment to a Chosen Course of Action," by Barry Staw, which described the roles that social and psychological factors play in decision making.

All the firms concerned are rationalising their escalation of commitment, and are willing to place large sums of money in the deal, because it has now become a battle of egos. The framing of decisions is now taking place in a context where the visceral and intangible factors are more important.

Justification of the deal

Resources are being brought to the table, not for economic reasons but because the context within which decisions are being framed is now defined by psychological considerations. The justification of the deal will lie in an articulation of the presence of idiosyncratic and unobservable management capabilities that the bidder will bring to bear, and these skills will enable the deal to be successful in the long run.

For the players inextricably caught in the bidding game, such as Reliance and Vodafone, backing out of the deal at this stage will lead to a severe loss of face in the global economic community. Their commitments have escalated to a point of no return. Other than upping the ante, and hoping that their operational skills will enable them to drive down costs and enhance cash flows, there is no other recourse. To make the decision seem rational now requires that all available operations skills are brought to the fore to be applied in making the Hutch operations commercially viable. For Vodafone it will be the second time, after the 3G fiasco, that it has made an investment decision in the face of economic odds showing the commercial outlook to be bleak. The quality of governance and management will be called into question if they win the deal and then are unable to generate the requisite cash flows, a most likely contingency since they have no prior experience of operations in India, within a decade.

Is it a Good Deal for Consumers?

Where does this leave the consumer? If the race to acquire Hutch is won by an Indian player with a fifth of the market, such as Bharti, not in the game, or Reliance, it leaves the Indian consumer in an invidious position. Immediately, the share of that company rises to almost half the Indian market and it is classifiable as a dominant operator that can exercise market power.

A dominant operator, labouring under the weight of heavy acquisition costs, will then have incentives to raise prices. It could get away with this strategy, since the number of players in the sector is reduced and given the unconscionable absence of India's regulatory teeth. An absence of regulatory competence means that regulatory scrutiny accompanying mega-deals are absent in India.

Win-win situation

If, on the other hand, the winner is a player such as Orascom or Vodafone, it makes the Indian mobile sector more competitive by bringing in organisational variety into the market. Such organisational variety can have important consequences, since the winning firm in question will not have the ability to raise prices by virtue of its market power. If it does so, then there are enough players in the market to which customers can migrate.

There are no clear-cut answers in the Hutch deal. The Indian consumer will, at best, be no better off but can be worse off if market dominance occurs. The players concerned, Reliance, Vodafone, Orascom, the Hindujas, are betting their shirts based on not-so-sure odds. Those that lose the deal will be the winners. The real winners, then, are Hutchison and the Ruias. They had the foresight to invest in India when it was not-so-fashionable to do so. The advisers will also win, come what may, because intermediation is always risk-free.

(The author is Professor of Technology Strategy, University of Texas at Dallas. He can be contacted at majumdar@utdallas.edu)

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