FCCB - TimeBomb Waiting to Explode
Stock prices of companies issuing FCCBs having fallen below their conversion price, and redemption looks likely. For many, this is a time-bomb
The equity market has witnessed a dramatic change. Two years ago, stocks flared up merely on talks of companies issuing foreign currency convertible bonds (FCCBs). Now investors shiver on thinking about the FCCB exposure of Indian companies. At that point, FCCBs were considered a very convenient and quick way of raising funds for organic and inorganic expansion. It was possible to raise funds through FCCBs at competitive interest rates compared with interest rates prevailing in the Indian market.
The massive plunge of the stock market and the rupee depreciation against the US dollar has completely changed the equation for FCCB-issuing companies. This unexpected turn of events has caught many Indian companies on the wrong foot. Indeed, FCCBs have actually become a major headache for the issuing companies. All the assumptions of the issuing companies have gone haywire and have put the financials of these companies in doldrums.
Indian companies issued FCCBs worth US$ 20 billion, or around Rs 90000 crore at an exchange rate of Rs 45 per US dollar, over the last five years, according to research firm CLSA. The fear is that a few companies could even face bankruptcy owing to the FCCB burden if they do not manage to find an intermediate solution to defuse the FCCB time-bomb.
Most FCCBs would start maturing in the next two to two-and-a-half years. With most companies trading way below the conversion price, redemption seems to be likely unless prices recover. The first company to face FCCB redemption would be Mumbai-pharmaceuticals company Wockhardt.
Interestingly, the FCCB fiasco is not happening for the first time. It also happened in 2005-2006, when the market witnessed a correction. Indeed, the popularity of FCCBs to raise finance has swung along with the fortunes of the equity markets. This time, the situation is really grim. In a couple of cases, funds repayable on FCCB redemption exceed the market capitalisation of the company.
For instance, Subex requires around Rs 720 crore (US$ 180 million) to meet its FCCB redemption commitment. Its stock is down by over 90% from its 52-week peak with a market capitalisation of around Rs 120 crore. Even worse, the company has reported a loss of over Rs 6 crore in the latest financial year ended March 2008 (FY 2008) compared with a profit of Rs 20 crore in FY 2007. Sales declined 32%. The company generated a mere Rs 10 crore from operating cash-flow, which is not sufficient to meet its heavy FCCB redemption requirement. Though the company can draw solace from the fact that the FCCBs are redeemable in March 2012, the conversion price of Rs 656.20 per share is too high considering its shares are languishing in the range of Rs 30-Rs 40. As per the terms and conditions of the redemption, the company would have to pay interest at the rate of 8% per annum calculated on a semi-annual basis. The coupon rate on these bond is 2%. Thus, the premium on redemption is 6%. This will essentially mean extra cost for the company if the bondholders opt for redemption, which is likely.
Subex is writing off or charging the redemption premium to the securities premium account over the life of the bonds. Likewise, it has charged Rs 59.99 crore as redemption to the securities premium. Had the company charged this redemption premium to profit and loss (P&L) account, its loss for FY 2008 would have been higher by this much amount: loss of around Rs 80 crore instead of Rs 20 crore in FY 2008.
One of the solutions for the issuing companies to prevent a bust is to consider reduction in the conversion price. However, reduction in the conversion price has two different sets of problems. First, it would lead to higher dilution if the bond holders decide to convert bonds into shares. This is assuming the share price would reach the conversion price till maturity of the FCCBs. The stocks have been so badly hammered on the trading floor that reaching even the revised conversion price also looks a distant possibility. Thus, redemption of bonds on maturity looks inevitable.
For instance, Core Project & Technologies reset the conversion price of its FCCB to Rs 82.86 from Rs 165.70. Against the original conversion price, the stock is trading at a discount of 63.9%. Compared with the reset conversion price, the stock is hovering at a discount of 28%. Though revising the conversion price is definitely one of the solutions, it could fail to do the magic if the stock market conditions remain bearish for a longer period. Promoters held a 47.69% equity stake end September 2008.
For companies where promoters do not have a sizable equity stake, revising downwards the conversion price is not an option as it would invite a hostile takeover. A higher quantum of dilution could adversely impact the earning per share and, eventually, P/E valuation, making the stock expensive compared with its peers. Redemption would not happen simply because the stock has touched or trading at the conversion-price level. This is because the stock price has to be substantially above the conversion price to take care of redemption premium that the bondholder is eligible for at the time of maturity. The probability of conversion improves if the market is bullish and bondholders are reasonably sure that they can make money on conversion into equity.
Companies with FCCBs maturing in the near future are running from pillar to post to raise money to fund redemption. For instance, Wockhardt is evaluating all the possible options to raise money right from selling off its assets, tapping private equity (PE) players and so on. In fact, raising money in this market is extremely difficult, particularly after the fall of Lehman Brothers.
The options that are available to companies to augment resources to redeem FCCBs are either limited and or not economically feasible in the current market scenario. The major options include internal accruals, fresh FCCBs or external commercial borrowings (ECBs), raising debt from the domestic market and equity dilution. Internal accruals would be limited in a slowing domestic economy. Developed economies are also in a recession. Issuing of FCCBs is, thus, almost closed as investors have turned risk-averse. Equity dilution is an option, but promoters would not be keen as this will fetch lower valuation. Too much of dilution will be detrimental to the interest of the existing shareholders. Raising money from the domestic market would increase the interest burden. A few companies could dip into the red purely due to higher interest expense.
Many companies such as Subex and Aurobindo Pharma have a highly leveraged balance sheet and raising fresh debt would be troublesome. Many companies have used the FCCB proceeds for organic expansion, which could be under implementation. These projects would take time to contribute to the bottom line, and increase the fixed cost, adversely impacting the P&L account. Already, research and brokerage houses have started giving ‘sell’ recommendation on companies stuck with FCCBs.
The FCCB burden could be extremely cumbersome for small- and mid-sized companies. This is very much evident from figures (see table: Non-convertible pain). A few companies have a high debt to equity ratio. These include Orchid Chemicals & Pharmaceuticals (3.01), SpiceJet (4.57), Kinetic Engineering (14.86), Gayatri Projects (2.31), Era Infra (2.99), Hotel Leela Ventures (2.13), Zenith Infotech (2.74), Dolphin Offshore (2.29), Ankur Drugs (3.07), and GTL Infrastructure (2.76). They would find it extremely difficult to raise further debt to fund FCCB redemption. Moreover, a few companies such as Dolphin Offshore have a negative cash-flow from operating activities.
Owing to the massive plunge since the market started its descend in January 2008, shares of many companies have been hit so badly that their market capitalisation is far less compared with their total debt. For example, Kinetic Engineering’s total outstanding debt end March 2008 is 10 times higher compared with its market capitalisation. Other companies include Orchid Chemicals & Pharmaceuticals (2.7 times), Gayatri Projects (4.4 times), Kamat Hotels (3.9 times), Prithvi Information (4.7 times), Subex (7.6 times), Ankur Drugs (3.4 times), and Pyramid Saimira Theatres (3.4 times). (For this comparison, market capitalisation on 6 January 2009 has been taken into account.)
Accounting treatment has saved the day for companies with FCCB exposure. Companies are exploring provisions in the Companies Act, 1956, to hide the losses from FCCBs. Presently, most companies are charging expenses related to the issue of FCCBs and premium payable on redemption of FCCBs to the securities premium account. The securities premium account is a sub-head that comes under, ‘Reserves and surplus’, appearing on the liability side of the balance sheet. This accounting treatment is in sync with Section 78 (2) of the Companies Act, 1956. However, as a prudent accounting practice, this entry should be disposed of through the P&L account. By not doing so, companies completly keep their losses arising from FCCBs under wraps. Under Section 78 (2), a company just needs to pass a book entry: debit the securities premium account and credit provisions for premium payable on redemption of FCCBs. Companies, in fact, need to create a separate provision account for premium payable on redemption of FCCBs.
Apart from showing higher profit, anther bigger problem with this treatment is that the company could pay dividend out of such profit and carry out other activities, which could drain cash from its balance sheet. When FCCBs become due for redemption, the company could have provision for premium payable on redemption but not enough hard cash to honor its financial commitment. This way, the company would have no option in future but to raise money from the market, one way or the rather, to repay the FCCBs.
FirstSource is one such company that has taken shelter under the Companies Act, 1956. It has not charged FCCB related cost to the P&L account. Instead, this has been treated in the balance sheet. This has enabled the company to report a decent profit. First Source raised US$ 275 million in FY 2008 through the issue of zero-coupon FCCBs to fund the acquisition of MedAssist Holding. As per the FCCB term sheet, bonds are convertible into equity shares at price of Rs 92.2933 per share at the option of the bondholder at any time from 14 January 2008 up to 23 November 2012. If the entire FCCB is converted into shares, the company will need to issue 117.0 million shares at a predetermined price. Further, if the bonds are not converted into shares, they would be redeemed to bondholders on maturity on 4 December 2012 at an yield to maturity (YTM) of 6.75% per annum.
As per the annual report of FirstSource, "these FCCBs are considered monetary in nature and premium payable on redemption of FCCBs is fully charged to the securities premium account in the period of issue, and the liability so created is reflected under provisions. This charge will be reversed if and when the FCCB holders opt to convert the bonds into equity at any time before the bonds are due for redemption." Thus, the company has created a separate provision account, ‘Premium payable on redemption of FCCB’, and provided Rs 434.37 crore through debiting securities premium account. Further, it has also written off expenses incurred for issue of FCCBs amounting to Rs 21.74 crore through the securities premium account. It reported a consolidated profit of Rs 130 crore in FY 2008. This comfort is available to only those companies with a substantial balance in the securities premium account. Else, companies would have to charge the expenses related to FCCBs to the P&L account.
Of the 91 FCCB issues, only in six instances are the stocks trading at a premium compared with the conversion price. Five are trading at over 90% discount to the conversion price. This means, these stocks should appreciate at least 10 times from the current level for bondholders to opt for conversion of FCCBs into equity shares. Further, 29 FCCBs are at over 75% to 90% discount to the conversion price, while in 34 instances the share price is at a discount between 50% to 75%.
Subex (94.9%), Nectar Lifescience (92.3%), Pyramid Saimira Theatres (90.9), Era Infrastructure (90.8%) and Prithvi Information (90.7%) are currently trading at over 90% discount to their FCCB conversion price. Unless the stock price recovers, which would be not less than a miracle, these companies would have to gear up for redemption of FCCBs. Besides Amtek Auto, Bharat Forge, Tata Motors, Bharti Shipyard, Easun Reyrolle, Suzlon Energy, Aftek, First Source Solutions, Aurobindo Pharma, Prime Focus, Bajaj Hindusthan and Moser Baer are trading at a discount of over 80% compared with the FCCB conversion price. On the positive side, a handful of firms — is Glenmark Pharmaceuticals, Lupin, HDFC, Tata Power and Sterling Biotech — are trading at a premium to the conversion price.
It would be prudent for the retail investors to look at the extent of debt in the balance sheet and exposure to FCCBs before investing in a stock. Focusing on the utilisation of funds raised through FCCBs should also provide good insights into whether the company would able to cope up with the crisis on or not. The companies that have utilised FCCB proceeds to fund inorganic growth or acquisition at exuberant valuation could be in for a spell of trouble. As the business confidence would take some time to restore, expensive buyouts of heydays would not yield the desired results, putting a further strain on the cash-flows and earning.
Edited by vijaygawde - 26/Jan/2009 at 4:58pm