SOLUTION
Introduction
The ultimate question in this case is whether it makes economic sense for the foreign investor to invest in Shyam Telelink.
The company acquired the license to provide basic telephony services in the state of Rajasthan in India due to the recent privatization of the telecommunication sector. The Government of India’s efforts to privatize had been largely touted as the investment opportunity of a lifetime. With a population of over a billion people, the new liberalized environment in India (in early 2000) had almost the same attraction that China had to the western world a hundred years ago, when it was said that 'all one needed do for success was to sell one shirt to each Chinese citizen'.
To that end, this project has a similar appeal as it entails providing basic telephony services in the state of Rajasthan, with a population of over 53 million and a dismal teledensity ratio of 1.98% (amongst the lowest in the world). However, falling prey to this sort of investment fever has led many investors down the road to ruin. So with each project in India, as with any project in any emerging market, the investor should seek to answer the crucial question: ‘is this the right project for the right price?’ To address this question, it is imperative that the investor examines the risks associated with the project. In addition to that, the investor has to also examine the financial projections as well as the valuation parameters to ensure that they are not overly optimistic. Following the above procedure will enable the investor to make an informed decision on whether the investment should be made or not.
Risks and risk mitigants
Inherent in every emerging markets project are several risks. These range from local currency risks, such as inflation and exchange rate volatility; to risk of expropriation from the government either directly or through means of ever increasing taxes. In addition to these general sets of risks, the project may have the added risk of being a start up. Accordingly, the evaluation of any investment option has to begin with the process of identifying the risks associated with the project and also laying out the steps taken to mitigate them.
Pre-completion risks
Completion (timing) risk
In Telelink’s case, the completion risks are of little significance. This is because the company has initiated, and in certain cases completed, a majority of the pre-completion steps prior to seeking outside funding. As an example, the company had already taken the following steps at the time of this case:
Wireline and wireless equipment supply contract had been finalized with Lucent;
Wireline and wireless switch with five BTS sites had been installed and commissioned at Jaipur (the capital of the state) and TEC of the Jaipur system had been completed;
30 km of OFC had been laid in Jaipur for intra-city access network and planning of access nodes for Jaipur had been completed;
Clearance from Wireless Planning Cell (‘WPC’) had been received for CDMA equipment in the frequency band of 800 mhz for 8 locations and application had been submitted for the CorDECT sites; and
Rights of way for the Jaipur-Jodhpur backbone route had been received and 200 km of OFC laying work had been completed.
Resource risk
The resource risk is not very significant in this case. The project does not rely upon natural resources, the availability or otherwise of which could significantly impact the outcome of the project (as in the case of oil exploration projects). The resources that the project relies upon are the resources needed to complete the construction and implementation of the infrastructure for the project. As mentioned above, the fact that the company has already built a substantial portion of the infrastructure (and has enforceable contracts in respect of the balance) significantly mitigates the resource risk in this case.
Technology risk
Technological risks are also mitigated to a great extent due to the credibility of the contractor implementing Telelink’s network. Telelink’s network has been designed by Lucent Technologies to provide state-of-the-art telecommunication services in Rajasthan. The network design provides extensive benefits, including savings on capital and operating costs, single point-of-contact for all network requirements, ease of network and system integration as well as a largely future proof network.
Post-completion risks
Market risk
Although there are a number of relevant post-completion risks (force majeure risk, supply risk, etc) the market risk is probably the most important post-completion risk in Telelink’s case. Telelink’s demand projections are based on the assumption that actual demand would be consistently 20% over the Economic Research Unit’s (ERU) projections. Moreover, the projections also assume the following market share:
Category / 2001 / 2002 / 2003 / 2004 / 2005Medium* / 10% / 18% / 25% / 32% / 35%
High* / 10% / 18% / 25% / 32% / 35%
Low* / 2% / 5% / 9% / 11% / 14%
* Classification into high, low, medium based on quantum of revenue per subscriber.
While it is true that a market share of 35% (in high and medium category of subscribers) seems high in the fifth year of operations, it is important to note that the state owned incumbent is fraught with corruption and bureaucratic issues, which make it extremely inflexible in the ever changing telecom scenario.
Moreover, the Shyam Group has been operating in Rajasthan for over 25 years and has established extensive business relationships as well as a strong brand presence in the state. Further, Telelink is also poised to gain significantly from the fact that its group company, Hexacom India Ltd, is the premier cellular service provider in Rajasthan. Significant synergies are anticipated by means of not only sharing infrastructure, but also bundling of services and market development to jointly grow the market and capture a large market share. Finally, Shyam Telecom’s telecom equipment and solution capabilities would also enhance the Company’s abilities to provide complete communications solutions to its customers.
At the same time, there may be some uncertainty surrounding the management’s assumption that actual demand will consistently be about 20% over ERU’s demand projection. However, if one compares the actual teledensity in the state with these projections, it is way below the teledensities of other comparable countries (Exhibit 5) and also much below the stated objective of the Government of India.
Force majeure risk
In the case of Rajasthan, there are two factors that enhance the force majeure risk. One is the susceptibility of the region to drought and the other is the risk of military conflict with Pakistan. The risk of drought, although high in Rajasthan, is of little concern to the telecom industry as it is not likely to affect their inputs or the demand for their services. However, given the history of hostile relations between India and Pakistan, the risk of war is a more immediate concern, particularly because communications centers are likely targets in the event of war.
In this connection, one should consider the fact that the border between Rajasthan and Pakistan is covered by the Great Indian Desert, making the likelihood of invasion or offensive strikes from the state relatively small. In fact, over the last 30 years or so, all the major/minor military conflicts with Pakistan have taken place further north in the state of Jammu & Kashmir. Moreover, the state of Rajasthan is home to one of the largest military and air force bases in India, thus the risk of war in Rajasthan is no greater than the rest of the country and as such this risk should already be included in the cost of capital model used.
Sovereign Risk
Inflation/exchange rate risk
The primary risk exposure in this project is in the inflation and exchange rate volatility risk. As the project revenues are solely in Indian Rupees there is a substantial exchange rate risk to any foreign investor. There is nothing in the way this project has been structured which mitigates the inflation/exchange rate volatility risk. As such, a substantial premium would have to be built in the cost of capital used to evaluate this project.
Expropriation risk
While there was a lot of skepticism way back in 1991, when the Government of India embarked on its liberalization process, that has since faded away. India's process of economic reform is firmly rooted in a political consensus that spans her diverse political parties, having been promoted by each of the last three different political parties in power. As a result of the above, the expropriation risks related to this project have been significantly mitigated. In addition to the above, a significant portion of the project costs are proposed to be financed through debt, this provides additional protection against expropriation and also provides an assurance to investors that the company will work in its best interest, not just to line the pockets of the managers. Finally, the fact that this debt comes from an Indian financial institution and that Telelink is a member of an important local corporate group, with substantial political clout within the region, serves to further decrease the chances of expropriation.
In addition to the above, there is another type of expropriation that investors should be aware of and consider, ie, creeping expropriation through a gradual increase in taxes. This is not a major concern in Telelink’s case, at least in the short and medium term, since the company has a tax exemption for a period of 5 consecutive years out of the initial 10 years of its existence. Given the fact that Telelink does not expect to generate much profit in its first 5 years of existence, this tax exemption significantly mitigates the risk of creeping expropriation on the part of the Government of India. Moreover, it is important to note that even after the first ten years are completed, the company has a further tax exemption, whereby it pays taxes on only 30% of its taxable income.
Political instability risk
The final item traditionally included in this section is the risk of political instability. India is the largest democracy in the world with over a billion people. Though there is a significant amount of corruption in the Government, the risk to policies that affect the company are small. The broad based support for the reforms process further insulates the company from any political instability.
Cost of Equity and Financial Risk
Calculation of Cost of Equity
Although many academics and financial services firms have attempted to build decisive models for calculating the risks and costs of capital in emerging markets, the results are always debatable. The International Cost of Capital and Risk Calculator (‘ICCRC’) captures many of the essential factors surrounding sovereign or country risk, and calculates with better consistency the cost of capital in international capital markets. In this case, it was necessary to determine the cost of capital for the average Indian project. Using a Risk-Free Rate of 4%, U.S. Risk Premium of 4%, and anchoring to the U.S. equity market, the ICCRC calculates a 19.7% cost of capital for the average Indian project.
Adjustment for beta of comparable projects
The first step for adjusting the standard Indian cost of capital is to find the betas of comparable firms. For this purpose, we obtained the average beta of comparable telecommunications projects from NYU Professor Aswath Damodaran’s website. Using the average beta of 1.09, we computed the cost of capital for the project at 21.1%
Adjustments for specific risks/risk mitigants
Next we considered adjusting the cost of capital for risks/risk mitigants specific to this project that would impact the cost of capital computed above. In this case, we find that there are a number of mitigating factors inherent in the project, however, these are primarily for the lesser risks (eg, technology risk, resource risk, completion risk, etc). The risks that make up the largest portion of the country risk premium, ie, currency and inflation risks, are very credible and may significantly impact the overall outcome of this investment. In addition, though the Indian promoters have taken various steps to mitigate the risks associated with a start-up, there are still certain risks attached to this project that have not been fully mitigated (the project is still under an advanced stage of development). As a result of the above, it seems appropriate to say that the increase in risks and the mitigants are roughly equivalent and that the appropriate cost of capital is equal to the 21.1% computed above.
Valuation
For the most part, the assumptions in the financial model used by the company seem right. The revenue projections though ambitious, seem achievable given the synergies between Telelink’s group companies and the significant experience of operating in Rajasthan that the Indian promoters bring to the project. Overall, the Indian promoters’ approach towards the implementation of this project seems very thorough. In fact, it seems that one of the big reasons why the Indian promoters did not seek funding earlier in the life cycle of the project (the path followed by most other telecom companies in India who bid for the license together with the foreign partner), is to seek a higher valuation for Telelink by mitigating some of the major risks associated with a start-up venture.
However, the one glaring aspect of the valuation is the fact that the terminal value comprises over 95% of the total value of the company. A further analysis of the terminal value calculation reveals that the terminal value has been calculated based on the market comparable methodology (as a multiple of revenue). Further, the company adopted the position that since there were no comparable companies in India to Telelink, the comparable multiples were chosen for companies in the United States of America (‘US’), rather than those from India or other emerging markets (no basis for not including companies from other emerging economies!).
As a result of the above and given the inflated valuations that the Competitive Local Exchange Carriers (‘CLECs’) were commanding at that time in the US, the terminal value was computed as 9 times the revenue of the company in 2018. Based on this approach, the total value of the company was pegged at close to US$ 400 million.
In our analysis, we computed the terminal value of the company based on a constant growth approach. Further, we also performed a sensitivity analysis by varying the rate of constant growth. Based on this analysis, we pegged the value of the company in the range of US$ 96 million – 135 million.
What happened?
Though Telelink’s valuation was considered high, it did generate considerable foreign investor interest. However, while Telelink was still engaged in valuation negotiations, Hughes Telecom, the basic telephony services licensee for the state of Maharashtra (one of the most affluent states in India and includes the city of Bombay) went public. Based on the offer price, Hughes Telecom was valued close to US$ 117 million.
The Initial Public Offering (‘IPO’) of Hughes Telecom set the benchmark for all telecom companies’ valuation in India and Telelink’s valuation at US$ 400million was way too high. However, the promoters of Telelink were unreceptive to the suggestion of reducing their valuation and having to sell off a larger portion of their company to get the needed equity investment dollars.
Thus, Telelink decided to go it alone and given the limited availability of cash decided to defer their aggressive roll-out strategy. They finally launched their services in October 2001 (a year later than originally anticipated).