India's Navratnas should do their bit for the country - By Prashant Jain

India's Navratnas should do their bit for the country

17 Apr, 2013, 06.34AM IST

By Prashant Jain (Executive Director & CIO, HDFC AMC) 

It is commonly believed that fiscal deficits crowd out private borrowing. A similar, if more prominent, trend is playing out in equity. The government is divesting equity in PSUs to fund its fiscal gap, thereby crowding out genuine seekers of equity (mainly infrastructure, power and manufacturing businesses). Since equity money is lesser (and more fickle) than debt, the crowding out effect is more pronounced in equities. 

PSU divestments seem to be relatively insensitive to pricing/valuations. Stock prices of SAIL and Nalco fell ~30%, 20%, respectively over three months prior to divestment, and yet the government divested. Collateral damage played out. Tata Steel, Hindalco also plunged ~30% each around the same time. India desperately needs a capex cycle in key sectors, but government's eagerness to divest is crowding out equity and impairing equity capital raising ability by adversely impacting valuations. 

Payout is the Way Out 

The government's need for cash (to bridge the fisc) is as real as the need for equity by private companies. Here's a solution: one-time special dividends/buy-backs by select large PSUs. This will raise cash for the government and leave room for equity issuances by other businesses. PSUs like Coal India, NMDC, NTPC, Oil India have hoarded Rs 65,000 crore, Rs 22,000 crore, Rs 19,000 crore and Rs 14,000 crore, respectively (September'12). In contrast, Reliance has done a buyback of Rs 4,000 crore. Hindustan Unilever and TCS pay out 50-80% of profits as dividends. Why can't PSUs do the same? 

Less Can be More 

There are three big benefits of distributing cash: Hoarding cash depresses RoCE/RoE. Incremental returns on cash (5-6% post tax) lag the cost of equity capital (~15%) or even Government of India borrowings (~8%). Second, the higher RoCE/RoE profile achieved after cash is paid out leads to better valuations. NTPC's valuations have fallen as its RoE is falling (cash hoarding is a key reason). It can drive up RoE if it distributes dividends. Third, potential misuse of cash under pressure to use cash is prevented. Overseas asset purchases use precious foreign exchange. Barely two in 10 overseas acquisitions have met their cost of capital. There is little merit in Coal India buying coal mines abroad. Instead, Coal India must develop local resources quickly - domestic coal is not only cheaper but also creates employment. It is better to buy coal/oil in the short-to-medium run rather than acquire mines/fields at current high commodity prices and in low interest rate environment, both leading to high valuations. 

Need of the Hour: Revival of Investment Cycle 

Imagine a scenario in which Coal India, NMDC, NTPC, Oil India etc declare a special dividend of (say) Rs 50,000 crore. Even after this payout, they should still have a cash balance of Rs 95,000 crore in March 2014.

Now consider the benefits: Equity supply will be reduced/eliminated. This will ease pressure on equity markets and create room for other companies to meaningfully raise equity. Divestment will be postponed to better times, to say the least. Valuations of these companies should improve with higher RoE, better utilisation of cash. 

Roughly Rs 6,000 crore (after dividend tax and government's share) will accrue to minority shareholders (insurance companies, FIIs, mutual funds and retail investors). This pool will probably come back to equity markets, thus further enabling creation of fresh capital. Bond yields will move lower as investors begin to believe in the fiscal deficit target.

Perils of Interest Income 

Investors see excess cash (and interest income) as an outcome of capital misallocation. Return on cash typically lags core business return. Hence, such companies are penalised through poor valuations. Investors want them to invest only in their core businesses. Else they must return excess cash to shareholders. 

"How many millionaires do you know who have become wealthy by investing in savings accounts? I rest my case," Robert G Allen. 

High interest income often masks deterioration in underlying core profitability and returns of a business. Several uncompetitive PSUs (in the telecom sector, for example) hoarded cash and grew complacent even as their sectors transformed. They now make operating losses. 

A special dividend of (say) Rs 50,000 crore by 4-5 large PSUs will do a lot of good to the country and no harm to these companies. They will be seen as efficient allocators of capital. The government will not be forced to divest at low valuations. There will be room for other companies in the core sectors to raise equity capital. 

(The views expressed are of the author as on date and not of the company.)