Pare Your Interest Costs
The central issue here is how the choice of a conglomerate business model affects the profitability of the flagship company. Since Peekay's flagship company has borrowed funds to start several subsidiary ventures, the interest on borrowings has, over the years, become so high that the core product itself, despite being produced highly efficiently, has become uncompetitive. Logic dictates that the fault lies with strategic focus. And that Peekay should, therefore, stick to in steel-making and spin-off the other units into independent entities.
The two issues of strategic focus and interest burden are, in my view, unrelated. The first pertains to the roadmap for Peekay. Should it adopt what is known as the core competency approach? This route has its merits, no doubt. It channelises resources and capabilities towards only those activities that not only provide a distinct personality to the firm but also enable it to achieve competitive advantage over its rivals. Or should it adopt a conglomerate route that spreads risks wider?
Peekay has chosen the latter route. Having done so, there is no reason why the various units can not work as independent, legal entities under the umbrella of a holding company. Citigroup is a successful global example of this model. True, the core problem at Peekay is the huge interest burden on the parent firm. Funds borrowed from the parent firm have been diverted into activities unrelated to its core, and that in turn has led to an erosion in value.
Clearly, the group is highly leveraged. The interest burden must be brought down. The steps already taken by the company-in terms of replacing existing high cost debt by raising long-term low cost debt from overseas and tapping the market through an issue of convertible debentures are in the right direction. The latter may, however, not solve the problem till conversion. In my view, a better alternative is to issue equity share capital or Cumulative Convertible Preference Shares (CCPS). Raising of subordinated debts could be another option. It is also possible to reschedule the debt by stretching the repayment period. This will enable Peekay to reduce the interest burden in the short-term.
The long-term issue, however, is to define the strategic agenda. Global experience, by and large, has shown that break-ups have helped in unlocking values of individual companies as the distinct units become more focused. This might help in improving the competitiveness of the individual companies. However, Kumar feels otherwise-that businesses like telecom and power have great future, and Peekay must stay invested in them. Therefore, the best option appears to be creating a holding company and then spinning off the businesses into separate companies. Apart from creating value, this will prevent one company from suffering because of the ineffective functioning of the others. In the ultimate analysis, an unviable unit will go out of business on its own.
There are two basic issues before Kumar and his team. The first is a reduction in the debt burden, which is preventing Peekay from leveraging its low-cost advantage. The second is the dilemma over whether to retain portfolio diversity or become more focused. This is ordinarily an independent issue. But in Peekay's case, the two issues are inter-related because the promoters could decide to reduce the debt burden by reducing their stake in one of the subsidiary businesses. Let me, however, deal with the issues separately.
First, the debt. The key assumption here is that the business is viable only at the EBIDTA (Earning Before Interest, Taxes, Depreciation, and Amortisation) level. If the current trend continues, the business will eventually turn sick. All stakeholders-promoters, FIs, and the minority shareholders-will stand to lose. Theoretically, it is true that debt providers, like the FIs, are more secure than equity providers. But, in reality, when companies turn sick, FIs stand to lose as much as shareholders. Further, FIs typically hold significant equity in Indian companies.
The key here is to work out a debt-restructuring plan with the FIs wherein all stakeholders take an equal share of the losses. The focus of restructuring must be to reduce debt, thereby improving cash flows, EPS, and, finally, the share price. The increase in the share price will eventually compensate the stakeholders for the losses arising from debt restructuring.
While there is no single formula for restructuring Peekay's debt, several options are available and need to be explored: a write down of equity, conversion of debt by FIs to equity (maybe at a premium), a reduction in interest rates, or linking interest rates to steel prices.
Now, let us come to the issue of diversification. Current thinking seems to favour focus-let the markets play the portfolio role. Ultimately, it boils down to the management's ability to successfully run the conglomerate. As long as each business in the conglomerate is being profitably run, I doubt the markets would bother. But most management teams at conglomerates fail to add value to each of the businesses. Rarely is the total value of the conglomerate more than the sum of its parts.
I would suggest Peekay take a hard look at its portfolio and prune it. The choice of businesses to exit would be driven by a number of criteria: the value creation potential, timeframe for cash breakeven, ability of Peekay's management to significantly add value to the business, the corresponding management intervention it would need, the price at which it would be possible to cash out, availability of partners, and the quantum of capital that could be released. Peekay could then use the capital released to restructure the debts of the steel business.
Corporates that invested substantial capital in low-gestation projects, resorted to aggressive gearing and followed faulty organisation structures have significantly eroded shareholder value. They have also become vulnerable to predators. Peekay Enterprises has been a victim of the lure of diversification. It could well have deployed the surplus cash to repay outstanding debt, but it chose to leverage the existing operations for investments in unrelated new ventures.
The decision might have been judicious at the time it was taken. But, clearly, there was no provision for project delays, cost overruns, and the downturn in the steel sector itself.
The present state of Peekay only drives home the point that using debt to finance equity investments in new ventures results in the entire project being funded with debt. An effective debt: equity ratio of 1:0 is a risky proposition even for a highly profitable business. However, a break-up of the business in itself will not result in the reduction of debt, unless it is accompanied by an improvement in the gearing through appropriate restructuring.
Equally, a break-up in itself will not improve competitiveness or profitability. Only a suitable restructuring will ensure that interest costs are allocated to appropriate businesses and are not left in the lap of the parent.
The fact that the new ventures are independent fully-owned subsidiaries makes such reorganisation even simpler, since no de-mergers or break-ups from a corporate viewpoint are necessary. Peekay should dilute its stake in all or some of the subsidiaries by selling off its holding in them either fully or partly depending upon the total funding requirement (to reduce debt burden and bring the interest cost to about 10 per cent of operating cost).
A number of options are available to companies to reduce their cost of capital. For example, an increase in business focus may lower the investor's risk-perception of a company, thereby reducing its cost of capital. Similarly, increase in exports or expansion of operations geographically across the world may reduce a company's dependence on the domestic market, while perhaps making it possible to access funds overseas.
Some groups have restructured their ownership and operations in recent years in order to facilitate access to overseas funding, or list on stock exchanges overseas.
Accessing overseas markets could drive Peekay to improve its investor communication and, perhaps, enable it to raise money cheaper. Renegotiating existing debt with lenders to reduce the interest burden, or converting debt into equity, can be combined with the alternatives listed earlier to achieve the same result.
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