Balco Disinvestment - On the Firing Line

http://www.karvy.com/articles/balcodisinvestment.htm

Balco Disinvestment - On the Firing Line

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critics lovingly call it - an example of selling family silver to butler. Yes, the Balco Disinvestment deal is at the center of controversy as opposition parties and worker unions at Balco have been fighting tooth and nail to see that the Disinvestment deal doesn't get to see the light of the day. The pressure tactics adopted by those opposing the deal has however not deterred the government to go ahead with it. The government fired a major salvo when it approached the Apex Court to intervene in the matter and help break the fauxpass. This has created much stir in the political corridors of Capital. What lies at the core of the entire controversy, apart from other issues, is the allegation that the government has sold off its 51 percent in stake in Balco for a meager 551 crore to Sterlite Industries. An allegation worth investigating. At the loggerhead Right from the day one when the government got the cheque worth Rs. 551.5 crore from Sterlite Industries, the opposition has launched an offensive against the deal. The government's stand on the proposed strategic disinvestment is clear - Balco needs new technology and cash to modernize and expand. Unfortunately, the government has neither of them. However, the critics argue that the company has huge assets worth over Rs 4,000 crore and is sitting on a cash surplus of over Rs 450 crore. And, this can be utilized for upgrading the technology and capacity expansion. Another suggestion, to the government, is that the company should go in for capital restructuring to reduce its equity base, the large capital base is responsible for the Balco's low earnings per share (EPS) of 2.29, by half before going in for Disinvestment. This, those opposed to the deal suggested, could have fetched a much better price for its shares. It is to be mentioned that sometime back, SBI Caps had proposed capital restructuring through conversion of 50 per cent of Balco's existing equity base into a government loan, carrying an interest rate of 8.5 per cent. As the restructuring of the equity was an essential prerequisite before the government Disinvestment as the large capital base is responsible for the Balco's low EPS. The Disinvestment commission had also recommended that in order to improve the company's profitability, it would be necessary to take steps to shed the surplus labor force, particularly in the Bidhanbagh unit, with an acceptable VRS. The said report mentioned that the company's internal generation is more than satisfactory and all diversification projects it was considering implementing, could be financed through the same and be supplemented by market borrowings. Critics say that Balco is cash rich and could carry out its capex plans on its own and hence does not require a strategic partner to bring in funds. Balco has a Rs 1,000 crore capex plan in the Ninth Plan including adding a new cold rolling mill, modernization of smelter operations and hiking the capacity of the captive power plant. The critics also contest the government's decision to choose a strategic partner for assisting the company in modernization, saying that it makes little sense. This is because Balco uses an older technology, the Sodeberg process, for reduction of alumina into aluminum. The commission report stated that improvements if any in the technology will be gradual and can be sourced from other countries. The critics question the wisdom of choosing a strategic partner who will help in technology in the light of the above statement. However, reality seems to be different. Upgrading technology, spending on brand building, expanding capacity are all easier said than done. A proposal for a simple 36,000 tpa cold rolling plant, aimed at strengthening Balco's product portfolio, took eight years to be cleared. By the time this clearance came through, the capital costs associated with the project had more than doubled. Other players in the private sector had meanwhile set up similar facilities and gained in market share. An extreme example of red tapism and lack of foresight. Balco and its Achilles' Heel Balco produces 15 percent of India's aluminum output. Set up in 1965 using technology from the former Soviet Union and Hungary, it runs a 200,000-tonnne-per-annum alumina plant and a 100,000-tonne aluminum smelter at Korba in Chhattisgarh. It also has a 40,000-tonne hot and cold rolling mill at Korba besides having a captive Power Plant of 270 MW.

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Balco Disinvestment - On the Firing Line

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The problems which are crippling Balco's growth today are manifold. The company has been on the verge of becoming a spent force in the domestic aluminum industry. From a market share of around 17 per cent in 1995-96 in the primary aluminum business, its share dropped to 14 per cent in 1998-99. With ambitious projects lined up in the private sector, this market share was expected to go down further. Another problem facing the company is that of lost opportunities. If the status quo is maintained, competition from imports and other players in the domestic industry would see Balco's market share and the profitability steadily deteriorate and begin eating into the government's coffers. However, on the other hand, if revived and restructured, the company stands a better chance to stake its claim in the globally competitive Indian aluminum industry. This has become even more imperative in the wake of growing cases of M&As, witnessed in the recent times. The problems, which are stunting the growth of the company, could be summarized as follows: Lack of economies of scale - While players like Hindalco were consolidating their position in the industry and coming up with growth strategies, Balco remained stagnant. Its manufacturing capacity of 100,000 tpa has remained unchanged over the past seven years. The acquisition of Indal by Hindalco has put the latter in a formidable position in the domestic industry. Old age technology - Most of the aluminum is manufactured using the Sodeberg process. This process is considered archaic in the aluminum industry. Other players use the pre-baked technique that uses less power. The old technology is labor-intensive as it is less mechanized. Overstaffing - The merger with Aluminum Corporation of India and its units at Bidhanbag in West Bengal has created problems of overstaffing for Balco. Currently the company employs around 7,500 workers and industry experts put this figure on the higher side. A voluntary retirement scheme offered by the company found few takers, as it was not considered attractive enough. Operational bottlenecks - Lack of in-house power generation capabilities and inadequate supply of bauxite are other problems that Balco faces. Technically, the company has captive power generation capability. But this caters to only about 75 per cent of the company's requirement. Similar is the case with its bauxite requirements. Most of the time, this critical raw material has to be hauled from other mines. This inflates costs. Lack of managerial autonomy - It is not that the management does not have ambitious plans. But these plans are often quashed because of the management's lack of autonomy. Delays not only rob the company of the opportunity to cash in on favorable conditions in the aluminum market but also add to the capital costs. Valuation Conundrum The valuation of the 51% stake, which the government sold in favor of Sterlite, has been one of the contentious issues. Although there were three bidders, Sterlites financial bid was the highest among the bidders, according to an official release by the government. The US-based Alcoa and Hindalco were the other two bidders. The company was valued by four different methods viz. Discounted cash flow, comparative valuation, balance sheet and asset valuation applied by the official valuer J P Morgan and the reserve price was fixed after studying each methodology and determining the best one for the company. In addition, a control premium was added to the valuation to arrive at a reserve price. The reserve price of Rs 514.40 crore was reached by marking up the valuation, arrived at by using the discounted cash flow (DCF) technique, by 25 per cent. The DCF method, by which a company is valued on the basis of its future earning potential, was taken as it is considered to be the best model to value a going concern. The DCF method takes into account the current market share of the company, the valuation of its brand, the competitive and pricing scenario and the likely movement in costs. Comparative Valuation: On P/E basis COMPANY P/E

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Balco Disinvestment - On the Firing Line

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Alcoa Alcan Hindalco Balco

17.60 10.40 7.00 19

If we take the P/E valuation method into consideration, we see that Sterlite paid 19 times the FY 2000 EPS of Balco. This was much higher than the P/E commanded by market leader Hindalco. Looking at some of the global aluminum majors like Alcoa and Alcan, it becomes clear that even they are quoting at lower valuation than what Balco has got. We will look at another valuation measure, current working capital. Working capital is what is left after you subtract a company's current liabilities from its current assets. Working capital represents the funds that a company has ready access to for use in conducting its everyday business. This is to say that if you buy a company for close to its working capital, you have essentially bought a rupee of assets for a rupee of stock price - not a bad deal either. Just as cash funds all sorts of good things, so does working capital. On this basis too the Balco deal seems to be a good buy for the government as as against the working capital figure of Rs. 478.92 crore (in FY 2000), the Sterlite paid around Rs 72 crore more. The valuation process was disputed by opposition parties on the ground that the methodology adopted by the government for valuation was wrong. They disputed the Disinvestment Minister's assertion that asset valuation was not important, saying that asset valuation was necessary for a capital-intensive plan. A look at the recently consummated Hindalco-Indal deal could provide some useful insights. Hindalco acquired Alcans 54.6 percent stake in Indal at a good bargain, by paying Rs190/share of Indal. The amount of Rs7.38 bln which Hindalco had to shell out for acquiring the controlling stake in Indal is equivalent to the replacement cost of Indals 43,000 tpa aluminum smelters and the related alumina and power generation capacity. Taking the Rs18 bln cost of Hindalcos on going 100,000 tpa smelter expansion as the benchmark for calculating the replacement cost of Indals smelter, the replacement cost on this basis works out to Rs7.74 bln. Apart from this, Hindalco further got large value-added product capacity, market share and brand equity in these products, surplus metal-grade and specialty alumina capacities. Comparing this with Balco Disinvestment deal, Sterlite gets access to 100,000-tonne aluminum smelting capacity besides getting control over 200,000 tpa alumina capacity, 40,000 tpa hot, cold rolling capacity and a captive Power Plant of 270 MW. If we take a look at the replacement cost of 1 lakh pta smelter capacity itself, it is worth Rs 18 bn, based on the said assumption taken above. On this basis, it does appear that Sterlite sealed the deal at a good bargain. However, one needs to appreciate the fact that in a free market economy it is the earning which matters above everything else. The return measured by EPS (of Rs. 2.29) in this case is nothing but peanut compared to the industry peers like Hindalco. The point here is that if the returns are not attractive, however valuable is the assets, it does not make any economic sense to go overboard and pay an abnormally high price. Furthermore, the outgo of Rs 10 bn in the form of capex also needs to be taken into account, which Sterlite would have to shell out over the next few years. Taking all these factors into account, the valuation seems to be reasonably good. Raw deal? Going by the crisis like the situation created by labor strike at Balco and Ajit Jogi government's resolve to block the deal, it seems that the Sterlite management had to sweat a lot before it actually got the right over the catch it craved for. Amid all these hullabaloo, one thing must be remembered that, the past experiences suggest that to optimize all objectives, including economic and social ones, handing over strategic control is the best option. The government stand is clear - "We are doing business. Its always on the basis of the shareholders money. If the shareholder puts in Rs. 100, he would expect us to earn 20 per cent or 30 per cent out of it. So, we will go on the basis of earning, not by the cost of

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Balco Disinvestment - On the Firing Line

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assets." Agreed. By selling the controlling stake to a strategic partner what the company gets is a professional management with proven skills and expertise in the field of metal. As far as fear regarding the worker's interest getting affected - the government still has control over 49 percent of the equity holdings in the company which it could use effectively to safeguard workers' interest. So one cannot say it is over for the government. It will also have right over the future cash flows in the form of dividends and could play a significant role in decision making. All this needs to be taken into consideration. Those opposing the deal are coming out with adventurous ideas with each passing day. The latest one being the offer by the Chattisgarh State government to buy the Center's 51 percent stake at Rs 5.52 bn. Most surprisingly they have woken up from their slumber only after the deal got cleared. Where were they when the disinvestment proposals were discussed over the last 5-6 years? This is bad politics. This is not going to serve any purpose. This could also derail the very process of disinvestment and deter future investments in investor non-friendly states. This would absolutely not be in the best interest of the tax paying people, the ultimate owner of the wealth of the nation. Whether it's a profit making or a loss making PSU, the government has no business to remain in these businesses. Amit Singh Feedback

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