Sunday, March 16, 2008

FCCB has a short fuse

The Rupee appreciation and market declines have struck a double whammy to Indian corporates – especially those who have raised funds thro FCCB route during the boom times. I am not surprised. Most of them raised FCCB debt because it was available or worse, I-bankers goaded them into it. Now they grieve. Here is the Business Standard story.

It says “Non-conversion into equity may erode profits by 12% in FY09: Study”. I fear the erosion could be lot more if the study has provided only for annual interest outgo on FCCB borrowings. Let’s figure it out by a case study.

Take Amtek Auto (featured first in the list of companies in that report). It has $250 M (Rs.1000 cr.) in outstanding FCCB liability. I checked its operating profits [BSE CODE:520077] for CY 2007 (being the trailing four previous quarters) and its operating income is Rs.460 crores. (I hope the company follows prudent norms and accordingly assume the pro-rata interest on FCCB is included in the interest figure for respective quarters.) Now, after providing for depreciation and taxes, the company has a net income of Rs.257 crores.

As per the table, the market price of the stock is currently quoting at a 35.2% discount to the agreed conversion price of Rs.414. FCCB is due for maturity on June 2011. If the stock price goes further down or if it maintains below the conversion price, the liability shall remain as debt in its balance sheet and the company will have to provide for its repayment. Given the gloomy outlook, I don’t see the market getting back to its Jan 2008 peak levels any sooner and so would recommend providing for repayment of its principal (Rs.1000 cr) out of current profits. That would call for creation of a FCCB redemption reserve and transfer a sum of Rs.250 crore each year for 4 years between 2008-11. That would leave a net income of Rs.7 crores.

Now imagine the dent in the EPS. It’s earnings are currently at about Rs.16 per share. After creating the FCCB redemption reserve, it’s net income would stand reduced to Rs.7 crores and the resultant EPS would be Rs.0.63. Give it a liberal PE ratio of 16 as at present, even then the stock price would be a dismal Rs.9.90. That’s the emerging picture if FCCB leverage is taken out. The company may either choose to recap it with other means of finance of equal amount to sustain its liquidity and operating leverage. Even then, with the cost of debt going up, it may not be able to borrow at those low FCCB levels of 5.5%. This means higher interest outgo and lower EPS in the event the company is not able to accelerate its revenues or improve its margins. Both the options are unlikely since the company caters to auto sector that is rate sensitive and runs on low cost financing for sale of vehicles. That spells disaster for shareholders.

Now I have nothing against Amtek Auto as such. I just picked it up as it was figuring on top of the list in that table. But then this is a sufficient case study that highlights what over-indulgence during boom times can entail. Don’t bite off more than what you can chew.

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