Imagine a situation where you
are about to buy a product, which costs Rs 100, and the seller is desperate to
sell it off. However he is selling it at Rs 120, despite the product having
several plaguing issues. Would you still buy it, knowing that the seller is so
desperate to sell this product that it may well sell it for Rs 80 a few weeks
later?
I wouldn’t.
Something similar happened
at the ONGC’s (Oil and Natural Gas Corp
Ltd) share auction on Thursday, March 1st. For the benefit of
some readers, let me start with the backdrop. In the last Union Budget, the
government had planned to sell a stake in several state-owned companies, aiming
to raise Rs 400 billion, but unfavorable market
conditions prevented them from doing so. The only stake-sale that went through successfully
was an FPO (Follow on Public Offer)
of Power Finance Corp., which fetched the government Rs
11.45 Billion. Simply put, the government only managed to achieve 2.9% of its divestment target for the year. Furthermore,
the economic slowdown resulted in tax revenues falling short
of expectations. But its expenditure bill on the multiple welfare schemes only
ballooned. Hence, hard-pressed for funds, and with the fiscal deficit target
getting topped already in 10 months ending January, the government made a
desperate attempt to sell some stake in ONGC Ltd through a share auction (the Indian Government seems obsessed about
auctions) just weeks before this year’s Union Budget.
The government’s frantic attempt
to narrow the budget deficit through an untested divestment method was near
disastrous. Up for auction were 428 million shares, at
a floor price of Rs 290 per share; this equated
to a 5% stake in the nation’s biggest energy
explorer, valued at Rs 124 billion. The auction started at 9:15 am, but the lukewarm
response was causing concerns among officials and merchant bankers alike. Until
3:20 pm, 10 minutes before the bidding
closed, only 14.3 million shares were bid for, which is less than 3.4% of the total offer. To add to the theatrics, the
websites of the two main exchanges, Bombay Stock Exchange (BSE) and National Stock Exchange (NSE), stopped updating the bidding
activity on their respective websites at 3:20 pm.
Then, in typical Bollywood
fashion, the last 10 minutes saw bids for 406 million
shares, led by other state-owned entities such as State Bank of India (SBI) and Life Insurance Corp (LIC). Seven hours later, at 10:30pm, Government
officials confirmed that the final demand from investors was for 420.3 million
shares i.e. 98% of the total offer, and the
average price received was Rs 303.67 per share, which was a 4.7% premium on the floor price of Rs 290. The total amount
raised was Rs 127.67 billion, of which over 110
billion was coughed out by LIC alone, roughly 87% of the total amount. While
the reason behind LIC’s last minute endeavor may be open for debate, the 377
million shares it bought increase its total stake in ONGC to 9.48%.
All
said and done, the government only has itself to blame for the debacle. It had
not put in adequate work to ensure that the auction process went through
without any hiccups. Instead, it rushed through it, aiming to raise some quick
cash, and hoping to show a lower fiscal deficit number in its Budget session of
the Parliament, due in 2 weeks. However, now that the Divestment Department has
established that the auction results were satisfying, and that an auction would
be the method of choice for further divestments hence forth, the government can
take away some valuable lessons from this episode.
The Price – Setting the floor price for the auction at Rs 290
per share was the government’s first mistake. Usually, when a firm tries to
sell a stake to public, be it in the form of an IPO or an FPO (or an auction as in this case), they
issue the shares at a discount. This is attractive, especially for the retail investors
as it leaves some money on the table for them by giving them an opportunity to
sell the stock in the secondary markets. When the floor price of Rs 290 was formally
announced on Feb 29th, it was at a 1.1% discount from the previous
day’s closing price of 293.2.
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| ONGC Shares, up 14% in 2012 - A misleading benchmark perhaps? |
However, what the government
(or their advisors) failed to factor
in was the wave of liquidity around the world in the last 2 months, which saw foreign
investors pour in $7.2 billion (Rs 360
billion) in Indian equity markets, and another $4.8 billion (Rs 240 billion) in the debt markets. Such
large inflows caused the ONGC stock to climb 14%. Hence, a more appropriate price
would have been somewhere between Rs 260 - 270,
the average price in the last few months, thereby offering an attractive discount
from the previous trading day’s closing price. Just for the record, the share
price as I write this piece is Rs 283 i.e. Rs 7 lost on every share from the auction’s
floor price overnight. I wonder how LIC feels about its loss.
The Risks – Another reason why it would have been more prudent
on the government’s part to auction at a discount is the operational risk
underlying ONGC. In any economy, the nation’s largest energy explorer would be
the darling of the investors. However, the case is slightly different in India;
on one hand, over 80% of its oil is imported, but on the other hand, the
government subsidizes the price of fuel. The problem (not to mention the current account deficit) for investors is that
ONGC, being a state-run company, is forced to share a portion of the government’s
subsidy burden. In fact recently, the government increased ONGC’s share of
burden, and with oil prices edging higher (already
above $125 per barrel), chances are that this ratio will increase much
further.
In addition to the impact on
costs and earnings, investors have also been worried about the ad hoc nature of
the subsidy sharing arrangement. According to the Economic Times, the company’s
subsidy burden for the first 2 quarters of FY12 was close to 30% of the oil marketing
companies’ under-recoveries. However, in the third quarter (ending December 2011), the methodology
was changed and the burden was calculated to be $56 per barrel, rising from 33% to 38% for the entire 9-month period,
April - December. As a result, there was a steep rise of
47% in burden in a single quarter, and no assurances that the
methodology wouldn’t change again in the future. Hence, with such uncertainty over
issues that have a direct bearing on its profitability, a floor price of Rs 290
was totally unjustified vis-à-vis the underlying risk.
The Timing – The government has been teasing the markets with
the idea of an ONGC FPO since December 2010. While the offering was postponed
several times, a mere discussion about it stagnated the share price as
investors were anticipating a discounted offering. So much so that the stock
did not even react to developments such as a bonus issue and a stock split (both of which would otherwise cause a
significant rally) in February 2011.
However, when the time
finally did come, the government rushed through the process, in order to fill
its coffers before the financial year ended. They neither gave themselves and
their bankers enough time to market the auction, nor did they give the markets
enough time to arrange liquidity to participate. The auction was held barely 48 hours after an official announcement. For a
market where the average IPO size ranges between Rs 30
billion to Rs 50 billion, a much greater effort was required by brokers
and investment bankers to sell an auction worth Rs 124 billion. Therefore, the
government should have been more diligent and given
themselves and the market about 8-10 days to prepare for the auction. Alternatively,
they could have carried it out in multiple steps, for example, 4 auctions of Rs
30 billion each. This would have calmed some jittery nerves among investors,
who fundamentally remain very bearish and indecisive due to several domestic
and international overhangs (European
Crisis, Slowing GDP, etc.)
All
in all, I can see why the government tried to rush through the auction. I can
also see why they set the floor price at Rs 290. In the grand scheme of things,
ONGC is still undervalued at Rs 290; therefore longer-term investors wouldn’t
mind the price too much. However, it is important that the lessons are learnt
from this experience. I am convinced that we are living in a world where
sentiments control stock prices (at least
in the short term), and government interventions drive the economy. Hence
the single most critical factor one should evaluate is the underlying risk –
risk of a bad investment; risk of mismanaging a stake sale; risk of making a
wrong decision. Come to think about it, it’s a life lesson isn’t it?
Ouch !
An interesting piece!
ReplyDeleteAn interesting piece!
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