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..

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