The Hindu Business Line : Overseas offerings: The capital Nirvana

RAISING FUNDS in the overseas market is quite the in thing. Almost every other day, there is news of a company raising a few million dollars abroad. Mid/small-cap companies have been at the vanguard of this fund mobilisation drive. News of a GDR/FCCB offer is also often accompanied by a sharp rise in stock prices in the local market, to boot.

Why overseas offers?

Until a couple of years ago, the terms Foreign Currency Convertible Bond (FCCB) and Global Depository Receipt (GDR) were hardly au current in corporate circles. Now, these ubiquitous abbreviations spell out the ambition of Indian companies to make a mark beyond their shores. And no longer are such issues limited to large companies such as Gujarat Ambuja Cements, Tata Motors or Zee Telefilms. Zicom Electronic Security Systems, Dishman Pharmaceuticals & Chemicals, Nagarjuna Construction and Bajaj Hindusthan are a few of the small/mid-cap companies that recently went the FCCB/GDR route to raise funds.

FCCB is a foreign currency-denominated bond, which offers the holder an annual or semi-annual interest, called the coupon rate, and the option to convert to equity shares at the end of its tenure. If the conversion option is not exercised, the bonds are redeemed at a premium. Hence, the total return on the bond, if redeemed, is the coupon rate plus the redemption premium and is termed the yield to maturity (YTM).

Low coupon rates, shorter time required to raise funds compared to local market, absence of rating requirements or conditionalities attached to the securities, and prominence in international markets drive mid-size and even newly-listed companies to seek out foreign markets for meeting capital requirements. The overseas offers, no doubt, enhance the visibility of these companies that seek new markets. But investors must look beyond dollar/euro-studded balance-sheets and understand the impact such an issue can have on the future financial position of the company and, consequently, on shareholder wealth.

Should investors see such instruments as sources of low-cost funds and, hence, higher profits for shareholders? What are the risks involved?

For one thing, the cost is never what is apparent.

The real cost

Take the case of the coupon rates of convertible bonds. With the coupon rates of most FCCBs issued this year in the 0-1.5 per cent per annum range, the initial interest outflow appears extremely attractive compared to the cost of raising funds in the domestic market.

However, the YTM, or the compounded annual return after factoring in the premium on redemption of the bonds, is the real cost to the company on non-conversion. Hence, while interest payments appear nominal, the effective cost at maturity may turn out to be much more if the bonds are not converted to equity.

For instance, in the case of Strides Arcolab, the FCCBs issued in April 2005 have a coupon rate of 0.5 per cent while the YTM is 6.8 per cent.

There has so far been no announcement of conversion to equity. Hence, while the yearly interest outflow appears insignificant, the outgo on the bond's maturity can be quite significant. So also with Jindal Stainless, which has a coupon of 0.5 per cent but a redemption value of 130 per cent. Importantly, any depreciation in the rupee is likely to add to the cost of principal and interest repayment.

The risks associated with non-conversion may be higher in the case of highly leveraged or loss-making companies. LML's interest coverage is negative because of the losses from operations. The interest outgo, if any, will add pressure to the bottom-line with only $1 million out of the $26-million FCCB offering converted into equity so far.

The interest commitment risk is reduced in the case of companies such as Bajaj Hindusthan, where FCCBs have largely been converted.

The company has been able secure conversion of about 70 per cent of its zero coupon FCCBs into equity within seven months of issue.

Risks with cyclicals

Investors need to tread with much caution in the case of cyclical industries where capital expansion plans are ambitious, and the earnings volatile. For sectors such as metals any volatility in earnings and cash flows can get amplified in a downturn and, can weigh down the company with debt.

Capital expansion plans of companies such as Monnet Ispat and Jindal Stainless appear significant vis-à-vis their asset base and net worth. Even assuming that the bonds are fully-converted to shares, the expanded equity may not generate commensurate returns in the short-medium term until production goes on stream. If the price cycle turns negative, it could further postpone gains from such expansion.

Another commodity sector company, Bajaj Hindusthan, although aggressive in capacity expansion, successfully scaled up operations this year by starting production at three new plants.

With sound asset block and net worth, the company appears better placed to handle the equity expansion through the FCCBs. The current expansions have coincided with the uptrend in the sugar cycle and, hence, prevented dilution in earnings. It remains to be seen if the company can sustain the gains from expansion over future cycles.

A proxy for debt

While the FCCBs are most often considered a phased-out method for expanding equity, the worst-case scenario, that some may remain as debt and never get converted into equity, should also be factored in.

In such a case, issues vital to the future fundamentals would be whether such companies will continue to enjoy comfortable leverage and whether their cash flow positions will be sufficient to repay the debt. For highly geared companies such as PSL and Satnam Overseas, which issued FCCBs recently, any continuance of the bonds as debt may expand financial risk. As of March 2005, PSL enjoyed a better cash flow position vis-a-vis its quantum of foreign borrowings while that of Satnam Overseas was tight. As the stock price of Satnam Overseas has been languishing in the local market since the FCCB issue, the conversion of bonds may not happen in the near term.

Naturally hedged or...

A majority of the FCCBs issued this year happened to be at a time when the rupee appeared strong against the dollar. However, with the tenure of most FCCBs in the range of three-five years, issuers probably cannot bank on a favourable exchange rate.

Whether the borrowings are matched by foreign exchange earnings, may give a hint of how well the risks of forex fluctuations are hedged naturally in a company's business.

Of the recent issues, those of Welspun Gujarat Stahl Rohren and Bharati Shipyard, had negative earnings from foreign exchange the last fiscal.

PSL, Hotel Leela Venture and Strides Arcolab have cushion for their borrowings through foreign exchange earnings.

Riskier GDRs

While FCCBs offer the option of postponing immediate expansion of equity, GDRs do not. Therefore, it is important, in the case of GDRs, to know whether there is a specific project against which the funds are being raised.

For infrastructure companies such as Nagarjuna Construction, which recently raised funds through GDRs, the funds are clearly earmarked for specific projects; so it is likely that earnings will be boosted proportionately.

The same cannot be said of others such as Gateway Distriparks or Rei Agro. With an immediate enhancement of equity by about 20 per cent through GDR issues, it is still unclear if the capital raised will be used to amplify earnings or at least prevent earnings dilution in the near future.

In the case of Essar Oil, the FCCBs were converted into GDRs, thus expanding the equity capital from Rs 372 crore in December 2003 to Rs 966 crore in March 2005.

This was done under a scheme of corporate debt restructuring, but the company may have a long way to go before it reaps the benefits of debt reduction. The company's per share earnings more than halved as a result of this exercise.

Growth is at stake

While several of the companies discussed above have been backed by strong fundamentals and performed reasonably well in the current market, profitable growth over the long term may be the real indicator for creation of shareholder value.

To that extent, where the capital is heading may well indicate the return on net worth. For small/mid-size companies going for FCCBs/GDRs, deficiencies in the above parameters may well mean that the risks in their stocks could be higher than that of the others.

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