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'.


  1. Hi Annand .. I'm not as familiar with Indian companies as you and recently bought Eesar Energy, the London listed entity .. I have a contrarian/value approach and the shares came onto my screen when they were going to be kicked out of the FTSE and when combined with the Gujurat Court revoking the sales tax seriously depressed the shares .. I figured that at £1.00 the shares were trading at 55% of Net assets and implying a rights issue or some form of debt equitization .. So clearly the price was right but there were other reasons that I thought th shares were oversold .. I figured that in the event that Essar has to pay the tax, the banks would lend them the money and not accelerate the loan and this looks to be the case judging by Friday's announcement .. They've just finished upgrading refineries and commissioning a number of power stations that will all contribute to earnings .. That they will eventually get permission to mine land adjacent to the power stations and that in any event falling coal prices will help Essar .. I'd be interested in your thoughts or whether Essar is a fiction factory !?

  2. @the Woozle-sorry for the delayed response(was out of circulation for months!)..nice analysis and looking from the news, your optimism seems justified. the reason I'm sceptical about the group is that be it defaulting on bank debt, depressing the share price and delisting the company to squeeze out gainvestors; Indian capital providers have not had a good experience with the group.

    Regarding the 'eventually get permission', given the land acquisition hurdles under way and all, that is doubtful.

  3. @anandh-- can you please let me know how did you compute 27% yield on convertibles of essar energy...thanks

  4. @Robin, I did not compute it myself(I did try but the bond price data was not readily accessible), so took it from this article

  5. Hi Annand

    It looks like the debt has now been sorted out and thereby reducing the chance of a default.

    In the UK they committed the ultimate sin of issuing profits warnings within a year of listing, which never goes down well. But with the refinery upgrades and the major capex investment in power stations complete, we should be in the position to see the company kicking off lots of cash in the coming years. At which point the company will have regained some credibility with the international shareholder base. Most investors have very short memories and when they see the EPS growth, the shares should rerate.


    I really like your research. It's thoughtful and thought provoking. I hope you're making some decent money from your investments.

    If you're interested in value, some of the US investment banks are trading well below net assets. In fact, last week, I was able to buy well out of the money call options on Jefferies and Morgan Stanley, with strike prices at 50% of book.

  6. Hi "The Wozzle", the operative word is 'it looks like'. When they get the line of credit for that, I'll buy that! Agreed with the profit warnings sin-its kind of violating the anchoring expectations which the IPO induced.

    Yes, the operating assets should produce cash flows, but knowing Essar, they'll find some novel way to drain that out. Even for this tax case for which they are raising loans, my blog post shows that actually the group company(promoter owned) should have borne the liability but Essar is silent on that(unsurprisingly) and is insted raising debt. Investor short memories is the reason they listed in UK, and the share will probably rerate.

    About my investments, making decent money but bulk of income still comes from my full time job! Will see on the US banks, investing directly in foreign mkts difficult for retail investors in India though. anyways if u can relinquish ur annonyity, keep in touch thru Linkedlin( or email. it should be interesting

  7. Hi Anand, given the debt levels it's going to be v difficult to take out anymore cash without plunging the company into bankruptcy. Essar have gone as far as listing the company in New York with ADRs. This doesn't look like an outfit that are going to let this company fail. If the company were to fail then surely the majority shareholders or the promoters would loose, unless of course they've figured out a way of taking all the assets out the company and leaving the banks and shareholders in a worthless shell.

    I've no idea how the Indiian finance laws work but In the India vs China debate, India is always held up as having a robust legal system and I'm hoping the promoters can't use the laws to shaft us.

    The two things that stops me adding to this position is the level f debt, which shouldn't be a big problem given the size of the cash generating assets, and uncertainty about the Indian legal system.

    Btw my email address is

  8. Hi Anandh, don't know if you saw Essar had it's senior det obligatiions affirmed as BBB minus byFitch. They, as I do, expect the company to start generating a lot of cash now that the caped cycle is complete. Those converts looking good value with a 22% plus yiield. Also the Rupee being weak and with much of Essar's income being USD linked this should ease the debt burden in the short term.