Sunday, January 29, 2012

27% yield Essar Energy 4.25% 2016 Convertible Bonds-only for the brave

For some context, let me state that when Essar Oil was held ineligible for a sales tax deferment benefit by the Supreme Court, the shares of Essar Oil and its listed UK parent Essar Energy Plc fell by nearly 30%-40%, and the bond yield mentioned above rose by almost 700bps. This was although the promoter entities were seemingly liable for the payment, but investors did not factor it in. This post explains why.

In an earlier post(, I lambasted Essar Oil and its UK listed holding company Essar Energy Inc for withholding legible details of the sales tax dispute. It transpires that perhaps thanks to the UK Regulator FSA Plain English doctrine, they made a much more legible description of the dispute in the $550MM issue size bond prospectus of their 4.25 per cent. Guaranteed Convertible Bonds due 2016. On page 9 of the prospectus(read it here, they described their sales tax dispute. I reproduce below the salient features of the dispute
  1. Under the Gujarat State investment subsidy scheme titled "Capital Investment Incentive to Premier/Prestigious Unit Scheme, 1995-2000" , if Essar's Vadinar refinery could commence
    commercial production by 15 August 2003
    , then it would be allowed to retain interest free the proceeds of the sales-tax collected during the exemption period ,on sales of refined petroleum products from the Vadinar refinery. 
  2. The exemption limit's sunset clause is earlier of 13 years from fiscal 2008-09(viz till fiscal 2021-22) , or till cumulative sales tax worth 91 billion (presently US$1.8 billion) was collected.  which the company had expected in 2013-14.
  3. After the sunset clause was triggered, the tax collected was repayable in six equal annual instalments. Till Dec10, Essar had utilized Rs.42.60 billion (US$950.68 million) detailed below. The amount rose to Rs 63bn by Dec11($1.235bn), and Essar must have booked 80% of that cumulative figure as revenue going by previous years trend
  4. Since Essar could retain the revenue and repay it in interest free installments, it recognized nearly 80% of the tax collections as its revenues(viz total collections net of the NPV of tax dues). For example, the revenue recognition impact of that was as below(figures in Rs bn)
    Fiscal(all figs Rs bn) Tax Collected    NPVof tax dues Net Revenue recognized
    Mar08-Mar09 15.16 3.01 12.15
    Mar09-Mar10 14.74 2.95 11.79
    Mar10-Dec10 12.69 2.78 9.91
  5. Essar did not commission the project on time, yet availed the exemption. Driven by opposition clamour, the Gujarat Government reluctantly demanded the tax from Essar, which appealed the matter at the State High Court, where it won in Apr08. The State appealed the matter in the Supreme Court, where it was listed for hearing in Jul11, and order passed in Jan-12, where Essar was held ineligible to claim the benefit.
  6. Meanwhile, Essar Energy Plc(Essar Oil's holding company) had launched an IPO in the UK, in Mar-10. Perhaps to reassure investors of the tax liability, Essar Oil  decided to "assign" that liability to its group company Essar House Limited, under a "factoring agreement". It should be noted that under law, Essar Oil remained ultimately liable for the payment of the sales tax liability to the state of Gujarat in the event that Essar House defaulted. 
  7. Interestingly, while Essar Oil recognized only 20% of the dues as NPV, it paid Essar House around 28% of the tax dues as consideration for assignment. Even allowing for the passage for time, it implies Essar Oil understated its NPV for inflating revenues, albeit to small extent. This 28% remained constant, as evident by the fact that assigned tax dues were Rs 180bn($353MM)
  8. As if Essar House's factoring was not enough, Essar Oil entered into a tripartite agreement with Essar Investment Ltd (“EIL”), another(!) Essar Affiliated Company, whereby EIL would guarantee the payment of the sales tax liability to the state of Gujarat in the event of Essar House being unable to fulfil its commitments under the factoring arrangement. 
  9. In essence therefore, investors should not have had to worry about those tax dues payable by Essar Oil, even if it lost the Supreme Court ruling. This is because TWO Essar group companies have guaranteed the payments. However, the guarantee is contractual not statutory, with the onus of immediate payments resting on Essar Oil. 
Perhaps, investors are discounting this(both stock price and bond price) as they fear the promoter entities would find a way to wriggle out of paying the entire amount. After all, the promoter entities would  be suckers to pay 100% for having purchased at 28%. I'm sure high priced lawyers are working overnight on the agreement trying to discover loopholes for the unlisted promoter companies to escape, maybe by invoking a force majure clause etc. And the investor apprehensions seem justified. Compare the contrasting description of the factoring arrangements
  1. In May11 bond prospectus:- While, pursuant to a factoring arrangement, the Company has assigned its sales tax liability under the sales incentive scheme of Rs.42.60 billion (US$950.68 million) to Essar House Limited (“Essar House”), an Essar Affiliated Company, at the present value agreed pursuant to the factoring arrangement of Rs.11.83 billion (US$264.0  million) and paid Rs.11.26 billion (US$251.28 million) to Essar House as of 31 December 2010. A plain reading of this arrangement and the meaning of factoring would imply that Essar House took the present upfront, agreeing to pay the tax dues whenever they materialized. Also, it would seem that Rs 42.6bn was assigned. 
  2. In Jan12 announcement(, they said that As per previous disclosure, the sales tax deferment liability has been assigned to a third party. As of  December 31 2011, the amount assigned is Rs1800 crore (US$353 million). This amount is repayable to Essar Oil to meet any payments of the deferred tax benefit in accordance with the terms of the agreement. This implies that (i)The assigned amount was only the present value and (ii)Essar House will only repay the present value and NOT the total gross liability. This goes against all legal conventions and meaning of factoring, and is also contrary to the risk factor in the prospectus, which stated explicitly that the gross value was assigned.
I'm sure that if this matter is litigated, Essar promoters will be sued in UK Courts for misleading disclosures or press releases, IF they do not make full payment of the tax dues. Still, it would  take a long time, and UK investors may have apprehensions of timeframe etc. But for a Carl Icahn or an activist investor, this would be a great opportunity. While the bonds may still seem too risky in relation to the overall debt, I think it is a classic case of market panicking too much, especially if the promoters can be made to cough up their sale proceeds from Hutch Essar stake sale, into honouring their 'factoring'.

Thursday, January 26, 2012

Renewable energy India stocks collapse- ‘bubble’ bursting or opportunity?

Quick quiz. What is common to Suzlon, Moser Baer, Indo Solar, Websol Energy systems and Orient Green Power? All these stocks had successful runs on the stock market and hyped as the next game changers in wind energy, semi conductors, solar power and hydel/geo thermal power. Valuations were more on growth stories than through an hard nosed DCF spreadsheet. But now, they trade at record lows(like other stocks but what is different is the pressing fundamental concerns in each case). Is this a bubble finally bursting, or are investors panicking? 

Suzlon cherishes an ambitious vision of being the technology leader in the wind sector, and among the top three wind companies in all the key markets of the world. It expects that by 2015, total worldwide installation of wind energy would cross 442 GW which is almost 2.3 times of the current installation. This will cover about 7.5% of the global electricity supply by then, as opposed to just 4% now. But the solar bubble collapse in Spain, France and Germany(where subsidies were almost withdrawn) has put concerns on the very business model of solar(preferential feed in tariffs at peak hours(morning/noon)), as mentioned by First Solar in its 10K filing. So with gradual withdrawal of subsidies to wind energy generators, will Suzlon be able to regain pricing power for its equipment? Even in India, the most recent round of wind energy purchase tenders, saw bidders discount the CERC approved tariffs of Rs 17.91 by nearly 30%-35%, indicating that new players are willing to slash prices to gain market share. This would impact supplier pricing as well. 

Moser Baer, Indo Solar and Websol Energy systems, wanted to capitalize on the boom in demand for solar photovoltaic cells. Indo Solar wanted to take benefit of the 25% capital subsidy scheme for project capex over Rs 1,000 crores( as per the Special Incentive Package scheme announced by the Ministry of Communications and Information Technology, Government of India). But the global over supply(especially from China) backed by costs increases in key raw materials, led to EBITDA margin compressions, and short of domestic protectionism, I do not see a bright future for these stocks. While they are all trying vertical integration, entering into adjacent industries etc, the core business model is facing challenges due to global supply scenario, and price driven market. 

Orient Green Power is a slightly different proposition though. In 1H’12(Sep11 half year) alone, it added 80MW of wind energy, and had 300MW generation capacity(250MW wind+50MW biomass) in operation. However, with 250MW capacity wholly in Tamil Nadu and that State Electricity Board being in financial distress, investors seem to have discounted the stock which trades at P/BV of 0.5, despite its aggressive growth plans to reach 550MW capacity by Jun’12! At market cap of Rs 610 crores(with debt of Rs 190crores), the company had an EV of Rs 800 crores(assuming the Rs 170 crores of cash offset the current liabilities of Rs 195 crores, as the loans and advances of Rs 808 crores would presumably not be liquid), which would imply an EV of Rs 2.67 crores/MW, nearly half the estimated Rs 5.3cr/MW replacement cost of that capacity. 

So have the factors affecting thermal power stocks(bankruptcy like status of SEBs, increased fuel costs, project execution delays) rubbed off disproportionately on these stocks as investors blindly herd together to sell power stocks? Or is it that the favourable economics may change? For export oriented equipment manufacturers like Suzon, the subsidy withdrawal story may play out, but for domestic generators, the national solar mission and other such plans would seem to give a secure price floor and assured market to sell the generated power.  These stocks are worth tracking though, as a hedge against the general power sector decline.  For a wider perspective on these stocks, read this post by Mr Abhishek Shah, a buy side energy analyst(

Though not directly a renewable energy stock, ICSA India makes smart grid solutions and thereby helps to save energy. Even that is a distressed stock which I'd mentioned earlier on my blog(

Saturday, January 21, 2012

HDIL-time to invest at rockbottom values? SOTP Valuation included!

In my earlier post detailing why realty companies are trading at record low valuations(  I'd given a laundry list of factors and promised to give a SOTP valuation of HDIL. I chose the company due to its apparently low valuation, and seemingly good corporate governance record/information availability. The company trades at a P/BV to 0.37. And even after going through the notes to accounts, I realized that the company does seem having a good margin of safety, even after accounting for doubtful assets like promoter receivables, disputed loans etc.

But as the past 1yr data shows(broken into 6 month intervals), the equity has gone up, but the quality of assets has fallen,. Cash/non current investments have risen much slower than the project investments.

My SOTP valuation estimates the project value around Rs 12,000 crores.I estimated the percentage completion from the data in the investor presentations, and the market rate from websites like magicbricks, for project bookings presently. The riskier assumptions are in percentage completion, but I've tried to be conservative. As the breakup would show, bulk of value comes from SRA projects, whcih are inherently riskier given the dependence on TDR, and the expected release of land in Mumbai which would lower the prevalent rates. Unfortunately, the company does not reveal much data on their SRA projects, so I'd to be much more conservative. Those of you wishing to use different assumptions and see the rates, please modify the spreadsheet and check. Note-all area below only reflects the share of HDIL in the project, not the total project area.
HDIL SOTP Valuation Jan12
On the governance front, there are apprehensions about the tax demands. After the widely reported Sep09 raid on them by the Income Tax authorities, they offered Rs 350crore of previously undisclosed income to tax(potential tax impact of 30%-100% of that amount after factoring in penalty & interest). While that sum is accounted for in the books, the previous year assessments will be reopened, and thus the tax risk is a hanging sword.
Conclusion After reducing the debt worth Rs 4400 crore, it leaves around Rs 7600 crores equity on the table, is a good upside of 150% from the present market cap. Of course, with other stocks out there, it is an open question as to why would someone ditch a Piramal Holdings/Reliance Industries(both cash rich companies with similar risk/return ratios for such risky companies). But if someone wants to invest in the realty sector, then this seems one of the better stocks given management reputation for execution, good governance(despite tax issues) etc.

Friday, January 20, 2012

AVOID Essar Energy Plc/Essar Oil despite 33% decline post Supreme Court sales tax case

As seasoned Indian investors know, Essar Energy is no stranger to debt default, legal hassles, crony capitalism accusations, arrests etc. But foreign investors are a bit more gullible, which had lead Essar Energy Plc to list itself on the London bourses, despite having majority assets in India. Now, while foreign investors do accord higher valuations to metals/energy(atleast on London/Toronto exchanges), they do expect better governance. So when investors were hit by 2 shocks in quick succession(resignation of Chairman Ravi Ruia due to being charge-sheeted in 2G spectrum cases) and the Supreme Court ruling in Essar Oil deferment case, they reacted to the Supreme Court ruling by eroding 1/3rd of the market cap of Essar Energy Plc, taking the shareprice down from 180 pence to around 120 pence. Interestingly, Essar Oil witnessed a similar decline as well, but since Essar Energy Plc is a more liquid stock, I analyze that here. The same arguments hold for Essar Oil as well. I try to analyze whether the sudden crash makes it a value buy due to market 'overeaction'.

While Essar was quick to clarify(  that the order merely mandated prepaying the sales tax loan(and not cancelling an exemption), investors were not quick to believe that. I've read both the original Indian Supreme Court order( and the Essar press release is a fair summary of the same.  I reproduce the same below
Essar Oil would like to clarify that the sales tax deferment benefit to Essar Oil was a loan repayable in the earlier of  the year 2021/22 or on exhaustion of the full eligible amount, which the company had expected to occur in the year 2013-14, and was repayable in six equal annual instalments 
The company’s estimate is that the total amount of the sales tax deferment benefit was Rs
9100 crore (US$1.784 billion).  To date Essar Oil has utilised approximately Rs 6300 crore (US$1.235 billion) of this benefit under the sales tax deferment scheme.  Following the Supreme Court order, any repayment schedule is expected to be discussed and finalised with the State Government of Gujarat and/or be subject to court agreement. 

But should investors in Essar Oil have seen this coming? The auditor's report drew attention to this note below, which detailed the transaction in accountant speak(Note 16 Schedule 16)
  With respect to the Hon’ble High Court of Gujarat order dated April 22, 2008 directing the State Government to consider the Company’s application for granting benefits of deferment of sales tax/value added tax under the Capital Investment Incentive Premier/Prestigious Units Scheme 1995-2000, the Special Leave Petition filed by the State Government in the Hon’ble Supreme Court, challenging the order of the Hon’ble High Court, is yet to be decided. During the year, the Company has deferred payment of sales tax/VAT liability  `1,811.41 crore (Previous year  `1,474.05 crore) and has defeased the same to a related party at its present value amounting to  `591.48 crore (Previous year `441.21 crore). Sales tax/VAT amounting to  `917.12 crore (Previous year  `813.87 crore) shown as deduction from “Turnover (net)” in the statement of profit and loss includes the defeased value of sales tax/VAT liability of  `591.48 rore (Previous year  `441.21 crore) as per the defeasance agreement pursuant to which the assignee has undertaken to discharge the sales tax/VAT liability on the due dates.

The above disclosure informed investors of the matter being subjudice, but implied that a related party was willing to take the risk of the payment on its own books. No questions were raised about WHY would anyone do that, nor were any details supplied about the same. But HOW did Essar account for the 'deferment'? Where was the dual effect taking the amount as a liability as per AS-11?

I read the Essar Oil Mar11 annual report( and found that(pg 52, FY11 annual report) the deferred sales tax liability seemed accounted for as a off balance sheet contingent liability.

And despite Essar claiming to have accounted for the sales tax deferment as a loan, one cannot identify it as an unsecured loan. And while that amount might have been lurking in the Rs 7300 crores Other Current Liability figure for FY11, it is a fig leaf of a disclosure to say the least. 

Conclusion:-Till Essar Oil can clarify the rather murky details of its accounting, and the related party transaction honouring for repaying the 'loan', investors can be forgiven for avoiding this stock. After all, why go through all this complexity where there are umpteen stocks out there with easier financials and better governance records. By the most charitable interpretation, the company has fudged its disclosures, and by more conservative standards, it may well have avoided recording the deferment and securitization. Either way, investors could have seen this coming, but they did not. Since I do not touch Essar Group stocks with a bargepole, I did not face this issue till now..