Monday, August 31, 2009

Buyback of foreign currency convertible bonds (FCCBs

While in the near term, FCCB buybacks may help improve earnings, marking up equity valuations of companies based solely on this aspect may not be prudent.

Buyback of foreign currency convertible bonds (FCCBs) by companies has been the most frequently announced corporate event at the bourses in recent months. From large companies such as Reliance Communications and Suzlon Energy to the smaller ones such as Orchid Chemicals and Kalindee Rail Nirman, all have been equally interested in FCCB buybacks after the RBI eased norms. .

While the trend appears to be gaining momentum with a number of companies hopping on to the buyback bandwagon, the quantum of purchase so far has been modest.

But of what significance are these buybacks for investors? Do they signal improving or deteriorating fundamentals? And importantly, why haven’t these buybacks garnered the overwhelming responses they were expected to? Read on to find out.

The brass tacks

FCCBs, which are debt instruments that come with an option to convert into equity, have been the most sought after means of raising cheap credit (zero or low coupon rates) by corporate India in recent years.

Over the last five years, corporate India raised as much as $20 billion through FCCBs alone. However, after the equity sell-offs last year shut the equity conversion option for the bondholders, these outstanding FCCBs in the books may snowball into gargantuan debt. Elsewhere, widening international credit spreads on Indian debt and the heightened risk aversion among global investors (typically the holders of FCCBs) led to massive discounts on these bonds; with some trading at discounts of 50-60 per cent.

Reliance Communications bought back the first tranche (in December 2008) of its FCCBs, when the latter were trading at a discount of over 52 per cent. Financial Technologies, on the other hand, executed its bond buyback at an average discount of over 37 per cent in Feb-March 2009.

Sensing the gravity of the situation, the Reserve Bank of India, last December, stipulated that corporates could buy back their FCCBs using their forex resources held in India or overseas or even raise fresh external commercial borrowings (ECBs), provided the buyback price was at a minimum discount of 15 per cent to the book value of the FCCB.

It later eased the criteria and stipulated that companies could buy back their FCCBs from internal accruals with a minimum discount of 25 per cent of book value for redemption amount of up to $50 million, 35 per cent of book value for redemptions of $50-75 million and 50 per cent of book value for amounts between $75 million and $100 million.

Despite this allowance, so far (up to April 15) the central bank has approved only 18 proposals for buyback of FCCBs involving $765 million, with the discounts ranging from 25 per cent to 50 per cent. Here’s why.

Challenges Galore

ECB isn’t easy: The solution in this case also presents the problem. While the RBI has allowed companies to access external commercial borrowings to buy back their bonds, the overwhelming risk aversion among international lenders has been playing spoilsport.

Besides, as FCCBs of only those issuers hit by the downturn are trading at a discount, such companies may not be able to raise fresh ECB at competitive rates. These companies can, however, use their existing forex reserves held in India or overseas for the purpose. If that’s not a possibility, raising fresh ECBs isn’t easy, as debt programmes of most Indian companies have (for the same reason) not taken off well enough to make bond buybacks viable. The negative outlook on India’s sovereign credit rating by S&P (currently at BBB-) also adds to the hurdle.

Even if companies succeed in finding a willing lender, the challenge lies in conforming to the RBI pricing norms as well. While easing the buyback norms, the RBI had said that where fresh ECB was for less than three years and for the same period as that of the outstanding maturity of the original FCCB, the all-in-cost ceiling should not exceed six months Libor plus 200 basis points.

While such a norm dissuaded companies from exploiting the ECB option (as the prevalent rates are pegged at Libor+700-750 bps for most Indian companies), with credit markets now beginning to ease up and S&P considering a revision of India’s credit rating (once the next government outlines its fiscal policy), companies may consider the ECB option seriously. That in March alone, five companies lined up for ECBs (about $105 million) to fund their buyback programmes validates this.

To buy or not to buy: But if raising commercially viable ECBs has been out of reach, the other option, of digging into cash coffers, hasn’t been any easier.

The RBI’s stipulation of using internal accruals to buy bonds has also restrained participation, going by the sheer lack of companies that can boast of healthy internal accruals. Besides, most of these cash-strapped companies are currently more in need of funds to keep their business afloat.

Indian corporates increasingly need more money to fund their greater-than-before level of inventory, and receivables and lower credit periods. This presents a challenge, as the final decision to buy back FCCBs will depend on whether companies use the money to actually buy back the bonds or plough it in the business. So far, of just under a score of companies that bought back FCCBs, barring a couple, the others all relied only on internal accruals. Nonetheless, regardless of the bond discounts or cash availability, companies have had to pare gains as rupee depreciation has also taken away benefits, since repayments have been made from cash-flows.

Riding on buybacks

Immediate gains: Not only does the ability to buy back bonds from internal accruals reflect positively on the companies’ cash positions, it also bestows them with near-term gains on two counts. For one, their immediate earnings get a boost from the significant one-time gain accruing from the deep-discount debt payoff.

For example, for the quarter-ended March 2009, Moser Baer’s standalone profits of Rs 43 crore were helped by an exceptional gain of Rs 98 crore, largely due to FCCB buyback.

The other benefit, however, accrues only to companies that have adopted AS11 (without the recent changes). These companies, on buying back their bonds can, to the extent of the buyback, do away with the practice of marking to market their losses on such FCCBs.

For instance, Jubilant Organosys, which is AS11-compliant, posted extraordinary expenses of Rs 37 crore, net of the MTM losses of Rs 101 crore and gain on FCCB buyback of Rs 59 crore. Have stock markets too, recognised the benefits of the buybacks?

Stock gains for the companies that have executed buybacks have been a function of both the degree of discount as well as company fundamentals. For instance, while First Source Solutions (FSL) has appreciated by over 52 per cent since it first bought back its FCCBs, the stock price surge was only 15 per cent in the case of of Hotel Leela. For FSL, the bonds were bought at a discount of about 50 per cent and that too when ballooning debt was the bigger concern regarding the company. However, for Hotel Leela, not only was the discount detail not known, there were also looming concerns on the company’s profit growth. Besides, the company had earlier even lowered its conversion price.

What about valuations?: While in the near term, buybacks are money-spinners, marking up equity valuations of companies based solely on this aspect may not be prudent. For one, companies so far haven’t retired a massive portion of their overall debt.

Jaiprakash Associates has so far repurchased and extinguished only 10 per cent of the zero coupon convertible bonds worth $400 million due 2012. Though the bonds were bought back at an average discount of 47 per cent, implying savings of about $35 million, it is still under 3 per cent of the company’s total debt.

Second, most companies also have other significant business/financial concerns weighing on their stocks. But if the buybacks are substantial and improve the corporate’s credit profile, it may be followed by a fair amount of stock price re-rating. For instance, the stock of 3i Infotech bounced up by over 44 per cent after its first announcement of FCCB buyback.

The company earlier (in 2007-08) had about Rs 667 crore as outstanding FCCB, which was roughly over 1.2 times its net worth then. But last month alone, 3i Infotech bought back about 13 per cent and 27 per cent respectively of its €30-million and $100-million FCCBs due 2012.


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