Vodafone Group Plc has said it is considering a merger of its Indian subsidiary with Idea Cellular Ltd. If the two companies agree, they will settle for a reverse merger, obviating the need for an IPO (initial public offering)

Investors in telecom stocks, who had turned wary after Reliance Jio Infocomm Ltd’s relentless onslaught, lapped up the news of possible consolidation in the sector. The market capitalization of Vodafone India, Idea Cellular and Bharti Airtel Ltd cumulatively rose by $4 billion on Monday. Shares of Idea Cellular and Bharti Airtel are now 4-5% higher compared to levels before Reliance Jio’s launch. While it’s true that a merger can result in meaningful synergies, investors are perhaps being overly sanguine about the sector’s prospects post-consolidation.

An analyst at a domestic institutional brokerage firm points out, “Competitive intensity doesn’t merely depend on the number of companies fighting for share; it largely depends on the strategy of the most credible challenger in the fight for market share.” In other words, Reliance Jio will still hold the key to the sector’s competitive dynamics.

In fact, if the Vodafone India-Idea Cellular combine materializes, it may well inspire more competitive moves by Reliance Jio. Klaus Uhlenbruck et al., researchers based in the US, say in a paper titled Rivals’ reactions to mergers and acquisitions: “Under conditions where rivals have significant resources to respond to a competitor’s acquisition or when rivals consider an acquisition to be a threat to their market position, they respond with a heightened number of actions, perhaps with greater breadth and complexity.” On that note, besides Reliance Jio, even Bharti Airtel has the capacity to use significant resources to respond to the new market structure.

Vodafone’s idea for an escape route from its Indian torment

And they might well have an upper hand, as Vodafone India and Idea Cellular navigate the troubled waters of integrating two very large companies. Analysts at Bank of America Merrill Lynch said in a 24 January note to clients, “The focus of a merged entity could shift toward integration, thus diverting management attention from market dynamics. We believe that both Vodafone and Idea are behind Airtel and Jio in their 4G rollout strategy and any resulting material delay in rollout would lead to some market share loss in the long run.” See chart for a previous M&A (merger and acquisition) involving Vodafone that faced integration issues. While Ebitda margins have improved lately, the joint venture continues to report net losses. Ebitda is short for earnings before interest, tax, depreciation and amortization.

Of course, all of this is not to say that a Vodafone India-Idea Cellular merger doesn’t make sense. Reliance Jio’s enormous investment in the sector—around $30 billion for an industry with revenues of $27 billion—is driving down profits and cash flow of incumbents on the one hand, and forcing them to up investments on the other. As a result, for companies such as Idea Cellular, leverage will soon reach alarming proportions.

A merger will result in a stronger balance sheet, and can potentially result in higher profit margins. As such, it will provide the merged company more firepower to take on Reliance Jio and Bharti Airtel.

Having said this, it is too much to expect it to be a panacea. Since Vodafone India and Idea Cellular are both behind the curve in terms of investments and their broadband network rollouts, they have little time to lose. The success of the merger will depend largely on the structure the new company adopts. While an organization structure that allows nimble moves is an imperative, it remains to be seen if this is possible in a company that has two large investors with equal rights.