Divestment: The Valuation Perspective

This was a tough story to do. For one, it meant a lot of late nights. But this time, no one objected to it one bit. For, we weren't exactly burning midnight oil. A fortnight ago, when BT began pursuing this story, we seemed to get a standard response from everyone we called. ''Let's meet over drinks,'' they'd say. And in the evening, we'd meet some really happy people, celebrating the completion of the Balco deal, even if they had little to do with it.

When Parliament gave clearance for the sale of Balco to Sterlite, investment bankers and potential bidders for PSUs that are on the block, raised a toast to the government's disinvestment programme finally making some headway. ''The fact that the government has gone through with the Balco sale is commendable,'' said Sanjay Jain, Associate Director, Rabo India. ''This has given the government's disinvestment programme a strong foundation.''

But by the time BT went to press, the mood had turned despondent. ''The government will meet its disinvestment targets only if it can tackle the politics of it,'' says Pramod Kumar, Assistant Director, ANZ Investment Bank. What happened? First, Ajit Jogi dug in and forced a shutdown of the Balco plant. If that wasn't enough, the Tehelka tapes rocked the government, leaving it with no political strength to push through the deal. ''A lot on hinges on Balco,'' says Naina Lal Kidwai, Vice-Chairman, JM Morgan Stanley. ''If it doesn't go through, then it will be difficult to achieve things on the disinvestment front.'' Kidwai's pessimism is shared by no less than the disinvestment minister himself. ''Given the fractured electorate and the perverse nature of public discourse in India, it is entirely possible that we may not be able to proceed far with the disinvestment process,'' says Arun Shourie (See Disinvestment Is A Reality Now).

Sure it's politics that stymieing disinvestment, but the crux of it all is valuation. That's what Jogi is using to hammer away at the Balco deal. So what if the money the government got was double of what was offered by the other bidder, and a fair amount more than the reserve price. If on such a clean deal, the government faces such political flak, what'll happen on the other ones? Can you put one value to a company that everyone, from the government, the buyer and the opposition agrees on? Or will the numbers always be at such variance, from the Rs 550 crore that the government says is a great value for its asset, to the Rs 5,000 crore that Ajit Jogi keeps harping on?

Over the last fortnight, BT put these questions to investment bankers involved with the disinvestment process. Here's a sample of their responses: ''Valuation lies in the eyes of the beholder,'' says Roddy Sale, Head of Investment Banking, JP Morgan Chase. Or hear Ashish Guha, Managing Director, Lazard India: ''Valuations can swing from one extreme to the other, depending on the kind of assumptions you make. There is never any one valuation.''

Look at what happened in the case of Modern Foods. Depending on the valuation method (See This Is What The Books Say) used, the company's value oscillated between Rs 28 crore and Rs 78 crore. Surprise, surprise, Hindustan Lever offered to pay Rs 125.45 crore. This despite it being a one-horse race. ''You might value the company at a certain amount. But the buyer will quote a price depending on what value he feels he can derive from the company,'' says Rajiv Memani, Director, Ernst & Young. Lever, for instance, wasn't merely buying a bread-making unit. Its aspirations of expanding its food product portfolio into rotis and increasing the reach of its Annapurna brand merged well with the distribution network that came with Modern Bread.

That's how it will be in most cases. DCF or comparable analysis methods are just reality checks. Talking to expected bidders for Videsh Sanchar Nigam Ltd. (VSNL), one comes across totally divergent views. Says one bidder: ''It doesn't own any end-use customers,'' says one potential bidder. And once telecom accounting rates come down, there will be erosion of value. The stock is quoting at a higher rate than it should only because of disinvestment talk.'' Others are a lot more bullish. ''It has Rs 4,000 crore of cash reserves; it can set up a domestic long-distance network at the drop of a hat, and it has 5.5 lakh internet subscribers. It would be a steal for anyone, especially since its market cap has dropped to less than half of what it was once,'' says another. So, what is the real value?

This Is What
The books say

There's no hiding it, this is the boring stuff: the theory of valuations. Read it if you must.

ť One way of valuing companies is by comparable analysis. It can be done by paying a comparable discount to a certain ratio. For instance, Sterlite valued Balco at 18.8 times its earnings per share, much higher than the value put on Hindalco, which has a PE of 9.5.
ť One can also use the enterprise value to sales or EBIDTA multiple. For instance, zinc companies typically command a multiple of around five times EBIDTA, while for airlines it's between 6 per cent and 9 per cent.
ť Unfortunately, this method looks at the existing value of a company and doesn't adequately cover for future cash flows.
ť The most commonly used method though, is that of discounted cash flow, which takes into account future earnings. And is usually done for a period of 5-10 years. In this, one takes the free cash flows available and discounts it by the average weighted cost of capital for the company.
ť But this number can also vary depending on underlying assumptions, including weighted average cost of capital and other assumptions.
ť Another way to value the company is the net asset value method. This is the net worth on the balance sheet as on the date of valuation.
ť A company can also be valued on the basis of revaluation of assets. But this has no relevance in a going concern and is only used if the company is being shut down. In this, one looks at the realisable value of assets. That is, if the company were to be sold for cash, how much cash would actually be realised. Is the land on lease or can it be sold? If it is sold, subtract the tax payable, the compensation paid to workers and debt repayments. The final figure would be the value of the company.

When we asked merchant bankers for value talk on National Fertilizer, where the government is selling 51 per cent, some stuck their neck out and gave a figure of Rs 500-600 crore for the deal. This was just a number based on some back-of-the-envelope calculations. There are at least two variables, which could turn these numbers on their head. National Fertilizer is the second-largest urea manufacturer in the country, giving the acquiring company huge economies of scale. Most fertiliser companies would need to make a serious bid it. If they don't, they'll have very few ways to grow and acquire marketshare in the future. Since National Fertilizer, in conjunction with the acquiring company would be totally dominating the market. ''Bidding for National Fertilizer is a must for most fertiliser companies,'' says an analyst. Therefore, stiff competition could drive values anywhere.

But on the other hand, the government's fertiliser policy, is due for a review. That uncertainty just might inhibit companies from bidding and also hammer valuations. ''It would be ideal if regulatory and policy issues are clarified before the expression of interests are invited,'' says Kidwai.

In fact, lack of clarity in government policy could also drastically alter valuations in companies like Air India and VSNL. First, Air India. Its main assets are the bilateral rights it enjoys by virtue of being the national carrier. Currently, Air India flies to 19 destinations and doesn't utilise all its bilaterals. Then, over the last year, the government signed many more bilateral agreements. Will these vest with Air India? If they do, Air India's valuation will be higher. ''But,'' says an industry analyst, ''no country has committed all its bilaterals to one airline. There are mechanisms to decide how to allot bilaterals.'' What will the scenario be in the future? That's something that will only be clarified once the shareholders agreement is finalised.

In VSNL's case again, the imponderables are many. For one, there is talk of the government increasing the FDI limit in telecom from the present 49 per cent. A move like that could affect valuations by attracting some more foreign bidders and increasing competition. But so far, it's stayed just that: talk. What it has done is add to the confusion. Then, its monopoly as the sole provider of international long-distance telephony will be removed in April, 2002. And to date, the government still hasn't clarified its intended compensation package. The rebalancing of international telecom rates, could affect cash flows either ways: if volumes increase, revenues might stay buoyant, if they don't, VSNL would need to expand revenues from other areas. When future cash flows could be so drastically different, how do you use the Discounted Cash Flow (DCF) method. By looking at historical trends?

Take CMC, for instance. Today, it derives a fair share of its orders from government departments, by virtue of being a public sector company that is given preferential price treatment. Will this stay when it is privatised? Some clarity on such policy and regulatory issues will certainly help. ''The problem in government is that many things have to proceed simultaneously,'' says Shourie, throwing up his hands. ''You can't say that okay, no disinvestment till I formulate a new policy. And those policies are subject to their own constraints, different ministries and interest groups.''

Bargain basement prices

They are scraping for every morsel they can lay their hands on. Investment bankers who till a year ago were extremely disenchanted with the entire disinvestment process are today making the rounds of the Department of Disinvestment, hoping to bag as many mandates as they can. Unfortunately for them, there seem to be more bankers than mandates going. And that's bringing the bids down, each time. From a high of 1.25 per cent charged by ANZ Investment for the sale of Modern Foods, commissions have come down to 0.19 per cent for the CSFB-SBI Caps combine, who have been appointed as advisors for the proposed VSNL disinvestment.

''Every time we make a bid, we think we've scraped the bottom of the barrel,'' says a banker. ''But we are forced to bid even lower for the next one.'' Globally, commissions range between 1 per cent and 1.5 per cent. But those numbers are rarely achieved here. ''There are so few mandates on offer, that competition is cut-throat,'' says another banker. And given that politics and government inertia cause each disinvestment to just go on and on, it's going to be some while before bankers can even mop up those crumbs.

And policies, which appear to restrict the number of bidders, just might beat down valuations further. In Air India's case for instance, where the government is selling 40 per cent, foreign ownership has been restricted to 26 per cent. And it was because the Air France-Delta combine couldn't get a suitable Indian partner that it had to bow out of the race. Even in Indian Airlines, where the government is not allowing any foreign or Indian airline to invest, there are only two bidders: Hindujas and Videocon. ''Give me a solution,'' says Shourie. ''If I had allowed an Indian airline to bid, I would have been accused of creating a monopoly in the private sector.''

All policy issues though, would need to get clarified in the final shareholders' agreement. And it's only after that that the T's are crossed and I's dotted on the bids. That's when clearer valuation numbers would emerge. But even then, given the pre-occupation of our politicians with valuing real estate and assets at replacement cost, it becomes difficult for the government to sell the authentic valuation numbers.

Politics and policy apart, the different proposed business plans, can alter the valuation of a company. Air India, for instance, would need infusion of equity and debt for new aircraft. Now, different bidders would decide on a different mix for the two. That would affect the weighted average cost of capital. In turn, influencing the discount rate and valuation, based on the DCF method.

Valuing companies in India becomes even more difficult, since there is no databank of transactions carried out in the past. In the US, the valuation report of any acquisition has to be filed with the Securities and Exchange Commission. There is no such stipulation here. Add to that, the fact that companies like VSNL, IPCL, IBP, and Air India among others, are unique in the Indian environment. That makes comparisons with other companies virtually impossible.

Another issue that decides the final value to be paid the acquirer is the controlling premium he is willing to pay. ''Most foreign companies aren't comfortable with less than 51 per cent holding,'' says an investment banker. But the government isn't offering 51 per cent in most strategic sales. Instead, it intends distributing the remaining equity among employees and ordinary shareholders, giving de facto control to the new managements. ''Controlling premium can vary from negative, to over a 100 per cent,'' says Kidwai. Some bidders might be comfortable with stakes of less than 51 per cent, while others may not, inducing them to offer a lower control premium.

If you thought these variables weren't enough to provide ammunition for Jogi copycats in the future to shout about ''selling our family silver dirt cheap'', there's another one coming. Stocks of most public sector companies where the government intends to disinvest have more or less bucked the recent carnage on Dalal Street. For instance, IBP is quoting in the Rs 270-330 bracket (these are volatile times after all), while its 52-week low is Rs 80. Ditto with CMC, which is quoting at Rs 340-350, while its 52-week low is Rs 230. This, despite the tech-sector crash. ''How will the government justify a sale made on the basis of discounted cash flow and earnings potential basis, when the market capitalisation of the stock is high simply due to speculation,'' queries an analyst.

This is only going to make it tougher to push ahead with the disinvestment plan. ''And foreign buyers don't have too much time to waste,'' says Kidwai. In turn, lack of interest is only going to drive down valuations further. And valuations have already taken a beating, with Sterlite claiming to have already lost Rs 100 crore, courtesy its Balco smelters being shut down.

Sad really. ''Till now, the government had done a good job with the disinvestment process,'' insists Memani. But add the imponderables on the policy front that make valuations difficult, to the craving our politicians have of making valuations into political weapons, to the precarious political position of the present government, and again, it's quite possible that valuation exercises don't go beyond the pages of BT.