January 2, 2012

Other: Capital Markets

Source: Financial Express

• The department of disinvestment's recent initiative to go in for share buyback and facilitate cross-holding between cash rich central public sector enterprises (CPSEs) for bridging the shortfall in disinvestment proceeds has attracted public attention.
• It will be interesting to see how the exercise impact individual CPSEs.
• It appears from media reports that around 15 CPSEs (mostly in the Navaratna and Maharatna categories) have been initially identified for the share buyback exercise.
• The reports further suggest that the identified CPSEs have been put into two groups: (i) those in which the cash balance is more than the annual turnover-—here the buyback will be to the extent of 10%— and (ii) CPSEs with a cash balance of at least 50% of the annual turnover—where the extent of buyback will be 5%.
• The maximum limit of 10% for buyback is not a coincidence. With the third quarter of the financial year drawing to a close, the government is in a hurry.
• As per Section 77A(2) of the Companies Act, any buyback of shares up to 10% of the paid-up equity capital and free reserves can be carried out through a board resolution.
• Anything above this threshold would require a special resolution to be passed at a general meeting of shareholders. However, this makes the role of the board of directors critical, as the board members have to balance the interests of government and non-government shareholders.
• The financial implications of buyback is also interesting. Share buyback would mean reduced cash outflow in the future as dividends.
• But the company loses an opportunity to invest its surplus cash either in new business or in approved financial instruments (mostly fixed deposits, treasury bills, etc.).
• For most CPSEs in the Navaratna and Maharatna category, the average annual dividend is as low as 2% to 3% of the market price of shares even at current depressed prices (see table).
• For example, if Coal India buys back one share (of R10 face value) at its current market price of R300, it saves annual dividend outflows of only R3.50 every year.
• Consequently, the internal rate of return on such cash flows is negative with an adverse impact on overall shareholder value.
• The situation is different only for select CPSEs like BHEL, where the annual dividend payout is as high as 13% of the current market price, translating into a positive internal rate of return on buyback-related cash flows.
• Buyback therefore makes sense only for CPSEs that pay annual dividends (as % of current market prices) over a threshold level.
• However, the situation looks different in a cross-holding scenario, i.e. one CPSE using its surplus cash to acquire a small part of government shareholding in another CPSE at market prices.
• Historically, CPSEs have been allowed to invest their surplus cash only in approved instruments, with returns ranging between 7.5%-8% per annum in the last couple of years. If they now get an option to buy government holding in other CPSEs, it may be an attractive investment opportunity.
• Most CPSEs are currently trading at close to their 52-week lows, with current prices being 20%-60% lower than the highest market price. In a situation where the extent of investment (as % of total surplus cash available) is small and the PSE buying shares is able to hold on to these investments for a couple of years, returns are likely to be higher than what historical returns on surplus cash have been.
• However, while government can only create an enabling framework to facilitate cross-holding through suitable guidelines for investment of surplus cash, interested CPSEs need to get their treasury management strategies in place for maximising shareholder value through such investments.