Selling Balco makes perfect sense

Aruna Bagchee

With the striking workers having returned to work at Balco’s Korba plant, the intense media attention on this company may now begin to wane. In the aftermath of the controversy, though, there are a few niggling questions that may persist in the public mind: was the government justified in selling a profit making company? Did the price realised undervalue the enterprise? Did the privatisation violate tribal land rights? These questions deserve some simple, straightforward answers.

Because of the writ petitions challenging the Balco privatisation, now before the Supreme Court, certain issues, e.g. interpretation of the constitutional provisions relating to tribal lands, should not be commented upon at this stage. But the facts relating to the reasons for selling a controlling share of Balco, and the facts regarding the outcome of the bidding process can be discussed.

In this three-part article, therefore, we first dwell on these two issues, and then, in the last part, see what lessons one can learn, from this case, in executing government’s programme of further disinvestments.

The rationale for selling Balco
It must be admitted that in the whole Balco divestment controversy, what has probably stuck in the public mind is the argument that this was not a suitable company for divestment because it was a profit-making unit. The government’s defence that the criterion for selecting a company for divestment was not whether it made profit or loss, did not, somehow, make the same impact.

Yet the forces that led to the privatisation of Balco must be traced to the early years of the economic reforms programme in the country. Balco had been set up in 1965, in an era of administered prices regime and high customs tariff walls. But the Aluminium Control Order was withdrawn in 1989; through the 1990’s, customs rates were progressively reduced from 60 per cent to 20-25 per cent; and aluminium became freely tradable since it was put on the open general licence (OGL) list.

By the late 1990’s, therefore, the underlying market forces had completely changed, and the Indian aluminium industry had to gear up to global competition, where economic scale, and operational efficiencies were crucial for survival.

An analysis of the international as well as domestic aluminium scenes clearly brings out that scale of operations is key to economic viability in this sector. In the last 25 years, about 25 new smelters have come on stream, adding a capacity of close to 7.7 million tons per year (tpy). The average size of new smelters is 234,000 tpy.

Even more revealing is that about 50 smaller smelters have closed down over the same period. These smelters had an average size of 69,000 tpy. There is a lesson here for a company like Balco whose smelter size is just 100,000 tpy. The average economic size for a smelter today is said to be 200,000 to 250,000 tons, i.e. twice the current capacity of Balco.

Besides the constraint of small size, the smelter technology in Balco is of 1960’s vintage. This Russian technology, known as Soderberg technology, requires a large number of manual operations, and is very high in power consumption, as compared to the more efficient pre-baked anode technology.

This technology requires a large number of manual operations, and is very high in power consumption, as compared to the more efficient pre-baked anode technology. Nalco uses the latter, licensed from Pechiney of France. Hindalco has licensed its technology from Kaiser of USA and Indal from Alcan of Canada. For producing one ton of aluminium, the power and fuel cost in Balco was Rs 25,386, compared to Rs 16,764 in Nalco and Rs 13,393 in Hindalco.

Added to these high power costs, were the high employee costs of Balco. Over its 30 years of existence, Balco’s employee strength had gone up to 16 per cent of its sales, whereas its competitors, Nalco and Hindalco had manpower costs at 6-7.5 per cent of sales.

Given this situation, it is not surprising that Balco’s cost of production of 1 ton of aluminium was about Rs 63,000, compared to Nalco’s Rs 43,000 and Hindalco’s at Rs 39,000. This naturally reflected in its lower operating margins. The EBIDTDA (earnings before income tax, depreciation and amortisation) margin for Balco was 11.80 per cent compared to Nalco’s 43.50 per cent and Hindalco’s 40.70 per cent.
The resultant situation, not unexpectedly, was one of declining profits. Although, the company could boast of increasing sales turnover, it could hardly claim the same for its bottom line. But only the fact that it was making profits was highlighted.

The truth was that the profits came from higher prices, and interest earned on the cash surplus it would put in fixed deposits. Retaining amounts it should have paid as dividend to government, and earning interest on it was not its mandate. But about 60 per cent of its profit before tax came from such “other income”.

For a company like Balco, given these multiple disadvantages, the future did not look very bright. Its competitors were growing in size. While Hindalco had followed the path of creeping capacity increase, Nalco had gone in for a one-stroke expansion project.

The conclusion was that, even though Balco was presently earning profits, it was a company under threat from the inexorable impact of global competition. The only way out was for the company to overcome its constraints of technological obsolescence and diminutive scale of operations. To overcome these constraints, it needed upgradation in size and technology, which would require considerable fresh investments of Rs 3000-3500 crores.

It could be seen that even given the cash surplus of Rs 350 crores that the company had and adding about Rs 70 crores annually to this surplus, at the end of 2002, the company could at best have a fund of Rs 600-700 crores for its modernisation. By raising an equivalent amount of debt, it could generate about Rs 1,300-1,500 crores for the purpose. This would still leave a gap of about Rs 1,700-2,000 crores to finance a worthwhile modernisation programme.

Given the volatility of commodity markets on the one hand, and the sovereign responsibilities that government has in the social sectors on the other, it was considered inappropriate for government to increase its exposure in the business of manufacturing aluminium when its resources were required on priority in education, health, and infrastructure.

Given the inability then of government to commit this order of investment, the only logical alternative was to find a strategic partner that would bring in the necessary finances. And for a party to bring in this order of capital, he would require management control to ensure that the expansion/modernisation was undertaken in the most cost-efficient manner. Balco’s was therefore almost a classic example of a company requiring recapitalisation through a strategic tie-up.

It may well be asked: if the case for privatising Balco was so clear, why was it not put out more effectively? Instead, the process attracted an allegation that it was not transparent - right from the reasons for selling a profit-making unit to the final reserve price and the bid outcome. We will return, in part-III, to answer this point.

(Continued tomorrow)
(Aruna Bagchee is Joint Secretary in the Union Ministry of Mines. The views expressed here are her own)