A 4-G framework for sell-off

Published: December 17, 2014 1:05:09 AM

An analytical approach could maximise disinvestment outcome

With the successful closure of the follow-on public offering (FPO) of the Steel Authority of India Ltd (SAIL) earlier this month, the debate on the government’s disinvestment programme has once again come alive. In particular, there seems to be some anxiety related to the success of disinvestment plans for the remaining part of this fiscal. The government and investors must now think through the long-term prospects for the public sector undertakings and the underlying valuations. The 4-G Framework is an effective analytical approach in this regard. The framework is focused on Growth and Expansion, Governance, Gap in Valuation, and Glitter of the Jewels (Navratna and Maharatnas).

The Indian economy is still emerging out of a cyclical downturn. In all likelihood, the next phase of India’s GDP growth will be significantly driven by the manufacturing/industrial sector. Growth is key to the valuation of several PSUs as many of these are disadvantaged due to a high fixed cost structure, mainly because of high employee-related costs. Growth and scaling up of operations of such companies could lead to a marked improvement in profitability. Accordingly, PSUs, which are better rated on the profitable ‘Growth and Expansion’ parameter, are likely to command relatively higher valuations.

Governance is increasingly emerging as an important criterion for valuation of companies and PSUs are not going to be an exception. Business practices, transparency, professional management, board composition, operational independence, management team and it’s stability, meritocracy and a market-linked reward and compensation framework are some of the important indicators of corporate governance.

From a governance perspective, two actions of the new government are noteworthy—first, disbanding of the prevailing mechanism of appointment of chairman and managing directors of public sector banks (PSBs) and second, the government stating its intent to dilute ownership in PSBs to around 52%. This could have a significant bearing on how investors could view the long-term valuation of public sector enterprises (PSEs), including the government-owned banks.

The writing on the wall seems to suggest that we are now entering a phase, wherein the government will gradually dilute its ownership in PSEs and pave the way for these entities to enjoy greater flexibility and perform profitably. A case in point is the oil marketing companies (OMCs), which have traditionally been highly dependent on the government for subsidies. However, with the prices of petrol and diesel now having been fully decontrolled, these OMCs will now not only be more independent but also be able to manage the businesses profitably and enhance shareholder value. Thus, ‘Governance’ and the extent of on-going engagement with the government are going to be important drivers of valuations of specific disinvestment candidates.

Across all industries, PSEs face a wider gap in valuations than their private sector peers. More than anything, this is an issue of perception and optics. The across-the-board discounting of PSE valuations is driven by a set of perceptions, including a belief that government-owned entities are relatively less efficient and flat-footed. It is generally believed that PSEs face challenges such as government control and have limited flexibility to manage a high fixed cost structure, especially in a cyclical downturn. Accordingly, on commonly used valuation measures such as price to earnings (P/E) and price to book (P/B), PSEs suffer from a ‘Gap in Valuation’ compared with their private sector peers. It will be important for the government to encourage a governance model that adopts an arm’s length approach towards PSEs, to get attractive valuation outcomes and plug the valuation gap.

The government considers the PSEs represent family silver. Many of them are labeled as ‘Navratnas’ and ‘Maharatnas’ (Jewels). It is the ‘Glitter of the Jewels’, which is not always reflected fully in the valuation. Besides their competitive business position, these companies have contributed to the creation of strong physical and social infrastructure. PSUs, particularly the Navratanas and the Maharatnas, have made significant investments to remain competitive. The replacement value of assets of many of these PSUs is huge. A combination of good governance and strong management could help these companies generate significantly enhanced shareholder value. Many of these companies have real estate assets on their books, the value of which cannot be ignored in valuation. An example of this is Mahanagar Telephone Nigam Ltd (MTNL), which is incurring huge losses over the past several years, yet enjoys a valuation largely driven by its real estate assets in Delhi and Mumbai, which could be monetised at some stage.

The 4-G framework is a robust analytical tool to develop a view of the long-term valuation of PSEs being considered for disinvestment by the government. From a practical standpoint, the other relevant considerations include high levels of price volatility ahead of the launch of a selloff programme and the role of quasi government investors such as the Life Insurance Corporation of
India (LIC).

Massive subscription by investors such as LIC could be viewed as a success dampener for the disinvestment programme. If the underlying valuation of the PSU entity is right, large institutional investors could warehouse the stock for a limited period and sell it in the secondary market in tranches and make a profit in the process. What is more important for the government as well as the investors is to see the long-term valuations in the 4-framework, focusing on each parameter.

By Kishore Gandhi
The author is chief credit officer, India Ratings and Research

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