The ONGC Divestment Debacle

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 1^st. 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 29^th, it was at a 1.1% discount from the previous day’s closing price of 293.2.

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?

Update: According to news reports, the decline in ONGC’s share price over the last 2 days (post auction) has cost LIC Rs 9 billion.

Ouch !

India Macroeconomic Snapshot 2011

 

For almost 2 years, India’s Central Bank has been busy battling Inflation, even at the cost of Economic Growth. However, instead of being commended on their efforts to tame this stubbornly sticky inflation (which is clearly a product of Supply Constraints and Fiscal Mismanagement), the RBI has been heavily criticized for the slowdown in GDP growth.

In response to the slowdown, the RBI cut the Cash Reserve Ratio – the percentage of deposits that banks must keep with the central bank – by 50 bps (0.5%) in its review on Jan 24, a move that would release Rs. 32,000 Cr ($ 6.5 billion) into financial system. In his policy statement, RBI governor D. Subharao said, “the growth-inflation balance of the monetary policy stance has now shifted to growth, while at the same time ensuring that inflationary pressures remain contained”.

Slowing GDP Growth

According to the official estimates, the GDP grew at a mere 6.9%, compared to 8.4% in the previous year. The slowdown was mainly driven by the manufacturing sector, where growth slowed down from 7.8% last fiscal to a meager 2.7%. Other sectors have fared poorly as well with the Industrial output slipping into negative territory at -5.1% in October before bouncing back to 6.8% in November, mostly on account of a large base-effect. Strapped for funds, core infrastructure sector too saw dismal growth at 0.3%, owing to poor execution of projects.

Inflationary Pressures

Averaging around 9%, throughout the year 2011, headline inflation has been well above the comfort levels of the Government and RBI. While their desired range for headline inflation is 5 – 5.5 %, that range has continuously been breached every year since 2005 – 2006. However, much to everybody’s relief, Food inflation declined to lowest in 6 years (6 years – what a coincidence) albeit thanks to a strong base-effect, and seasonal impact. Since monetary actions take about 4-6 months to show results in the economy, there is some respite for 2012 for inflation to be contained. However, considering the risk of oil prices spiking up, the Central Bank will have to be extremely careful and ensure that inflationary headwinds have genuinely subsided before adopting any stimulus measures throughout 2012.

Burgeoning Fiscal and Current Account Deficits

Another alarming issue for the economy has been its mounting fiscal deficit. The previous Union Budget (FY 2011-2012) had set a target of the fiscal deficit at 4.6% of GDP. However, the fiscal deficit during the first half the fiscal alone was 85.6% of the full-year target. Hence, it is quite clear that the government is set to miss the target, and the deficit is more likely to be around the 5.2% mark, or perhaps more if oil prices rise and/or tax revenues decline (I believe that both events are highly likely, and a deficit of around 5.6% or more should not come as a surprise). With tax collections sluggish, and divestment ambitions foiled by poor market conditions, the government has no option but to borrow more to pay for its ever-growing subsidies bill. In doing so, it essentially mopped up most of the funds in the market, and crowded out private sector investments (i.e. increased interest rates by excess borrowing in the money markets). Rising oil and fertilizer prices and the implementation of the Food Security Bill are all going to further increase the subsidy burden for the government. With a tax base of less than 10% of the GDP, the picture doesn’t look very bright.

To make matters worse, high interest rates, big-ticket scandals, and the government’s reform-inertia had dampened the business environment to such an extent that manufacturing and industrial production plummeted. Exports growth was very trivial (due to economic slowdown in major export destinations), and was merely a fraction of the sharp growth in imports (thanks to robust domestic consumption demand), thereby worsening the trade balance. In addition to the worsening trade-balance, imports of Oil and a huge appetite for Gold (India imported 969 Tons in 2011) dented the Current Account Deficit even further. In fact, Oil and Gold together account for about 70% of the nation’s Current Account Deficit. Furthermore, high interest rates dampened corporate investments, and foreign capital inflows dried up too. All this put pressure on the nation’s foreign exchange reserves, which reflected on the Indian Rupee.

Currency Woes

2011 was a challenging year for the Indian Rupee, which depreciated 16% in 2011 (its biggest annual fall since 2008) and was the worst performing Asian currency of the year. Concerns about the rising fiscal and current account deficits amidst an uncertain global environment, loss of confidence in the Indian reform process, doubts over its growth momentum and stubbornly high inflation led foreign institutions (FIIs) to sell the Indian currency, pushing it to an all-time low of 54.30 against the US Dollar in the December.

The RBI refused to deploy India’s foreign exchange reserves to curtail this slide, as it was not a phenomenon that monetary action could fix alone. So RBI used alternative methods to curb speculation on the Rupee. It banned firms to enter multiple forward contracts to cover a single foreign currency transaction, and also eased rules for companies to raise offshore debt. It also raised the interest rates payable on deposits made by Non-Resident Indians. Also in December, India and Japan signed a $ 15 billion currency swap agreement. The RBI has pledged to keep a close eye on Rupee levels throughout 2012 as a weak rupee would further hurt imports, and on the flipside, exports won’t benefit much either owing to a global slowdown. In fact, firms that had resorted to foreign-currency debt in the form of External Commercial Borrowings, or ECBs (against a backdrop of rising interest rates in India), had to face tremendous pressure servicing that debt with the Rupee at such depressed levels. All in all, a weak currency would hence only add more inflationary pressure on the Indian economy.

Dominated by negative news-flow, such as the FDI in Retail debacle, or missed Divestment targets, criticisms of Policy Paralysis, failure of introducing GST, etc., 2011 was a year to forget for several investors, business leaders, and parliamentarians alike. So as we enter 2012, many “experts” will be hoping for the Union Budget in March to introduce crucial economic reforms. However, the challenges now are more complicated than they have been in recent years. Too much emphasis has been given to the role of RBI’s monetary policy, discounting the importance of the Finance Ministry (Fiscal Policy) in driving the economy. Personally, I expect FY13 to be much choppier than last year, and expect things to get much worse before getting any better. Considering the nature of coalition politics in India, any reform announced during the budget would come as a surprise, albeit a positive one.