Divestment: Make the right choice

Though the Centre rakes in the money, not all investors are assured of gains from the divestment candidates. We have analysed numbers over the last decade to help investors pick the best stocks

The immediate task before the new Finance Minister is preparing the full Budget for 2019-20. With balancing the fiscal math likely to be a challenge, the divestment number will be keenly watched.

Disinvestment in the past few years has become the easiest way for the Centre to balance its books and shore up its finances. These have included buybacks, initial public offerings of central public sector enterprises (CPSEs), strategic disinvestments of CPSEs and shares in companies held by Specified Undertaking of Unit Trust of India (SUUTI). The Centre has also used exchange traded funds to sell its stake in profitable companies.

In all, from 2009-10 to 2018-19, the Centre has raised nearly ₹3,80,000 crore through disinvestment of its holdings in state-run companies or public sector undertakings (PSUs). Of this, nearly ₹2,80,000 crore was divested by Narendra Modi’s first government, from FY15 to FY19.

While the Centre rakes in the money, how did investors in these companies fare? Is it a good idea to invest in future divestments? What are the factors to be kept in mind while putting money in divestment candidates?

To get the answers, we analysed the stock price and financial performance of companies whose shares were sold by the Centre from 2009-10 to 2018-19, according to data put out by the Department of Investment and Public Asset Management (DIPAM) of the Ministry of Finance. Banks, finance companies (excluding Power Finance Corporation and Rural Electrification Corporation) and insurance companies have been excluded from this analysis.

Stocks of companies such as HPCL and BEML that were not divested in the above period have also been excluded.

Stock price moves

Of the 30 stocks in the BSE PSU index considered for this study, only 16 have given positive returns (CAGR) from the end of the financial year in which the Centre sold shares — either through an initial public offer or a follow-on offer — till the end of FY 2019. And this return (total return) is adjusted for any dividend, stock split and bonus shares issued.

Only three stocks — BPCL, NBCC and IOCL — have given double-digit returns to investors. Most of these returns in the oil marketing majors accrued after the Centre deregulated fuel prices at the end of 2014. NBCC has been an investors’ favourite due to the strong growth in revenue and profitability recorded over the past decade.

Nine out of the 30 stocks have, however, delivered negative returns to investors. These include Rashtriya Chemicals & Fertilizers, Steel Authority of India, NLC India Ltd, NALCO, Bharat Heavy Electricals Ltd, Shipping Corporation of India Ltd, Hindustan Copper Ltd, Engineers India Ltd and NMDC Ltd. Of these, SAIL, BHEL, Shipping Corp and Hindustan Copper, have been the worst performers with negative returns of 14.48 per cent, 13.40 per cent, 13.74 per cent and 22.97 per cent respectively.

In the same period, seven stocks have given less than 5 per cent return (Oil India, ONGC, NTPC, Power Finance Corp and NHPC), while two (Coal India and MOIL) have given less than 5 per cent return from FY 12 to FY 19.

In short, investors are not always assured of capital appreciation from divestment candidates and the probability of picking stocks that deliver double-digit returns are very low — 6 in 100.

Financially speaking

Revenue of the 30 companies used for our analysis shows a healthy compounded annual average growth rate of 9.67 per cent between FY10 to FY18. ONGC’s revenue has nearly tripled (CAGR 17.2 per cent) during this period, as has Power Finance Corp’s (CAGR of 15.72 per cent) and REC’s (16.45 per cent). Power Grid’s revenue has risen over four times in this period (CAGR of 19.65 per cent).

Aggregate net profit growth has however been more tepid at 4.4 per cent in the period between FY10 and FY18. The poor performance of some companies such as SAIL, ITDC, RCF and Hindustan Copper, that reported losses in some years, have weighed on the aggregate picture. Many PSUs, backed by policy supports have however put up a stellar growth in net profit in this period. These include Power Grid Corporation (19 per cent CAGR in net profit), BPCL (25.1 per cent), NBCC (14.9 per cent), REC (11.1 per cent) and Power Finance Corporation (11.9 per cent).

Some PSUs in sectors such as hydro-power, power transmission and metal mining have robust operating margins and can be good long-term bets. NHPC, SJVN, Power Grid, NMDC and MOIL have enjoyed robust operating profits over the years.

So, the financial performance of the PSU tends to vary depending on the industry it belongs to. But these government-run companies have lower ability to weather business down-cycles when compared to their private sector peers and tend to easily slip in to losses.

If you are wondering how to decide on investing in disinvestment candidates in future, here are few factors you can keep in mind.

Nature of business

Owning near-monopoly businesses or companies that have a dominant presence in the industry might also be a good idea for investors.

A case in point is Power Grid. From FY 11 to FY19, the company has given investors a compounded annual return of 9.5 per cent adjusted for bonus, stock split, dividends etc. It is a near-monopoly in the inter-state power transmission space and has good prospects; it plans to expand power transmission infrastructure across the nation with many new transmission projects slated to come up in the next few years. To put it in perspective, India’ power consumption per capita is very low for a country of its size even though it is the third-largest power producer in the world, according to the International Energy Agency.

Similarly, Gail India Ltd is the largest gas utility company in India. It has a large presence in gas transmission with cross-country pipelines and has presence in 38 cities in city gas distribution. From FY10 to FY 19, the company’s stock gave a compounded annual return of 7.08 per cent.

On the other hand, there are some businesses that have a very bleak future; MTNL for instance is unable to cope with the competition from private telecommunication players. Similarly, the shipping industry has been in the doldrums since 2008, making companies such as Shipping Corporation of India risky bets.

Takeaway:Companies that have a dominant share in an industry with good prospects should be selected for investment

Focus on government policies

PSUs tend to be large behemoths that need impetus from the government to grow their profits.

It would therefore be a good to keep an eye on the policy announcements of the new Modi government to understand which companies would fare well over the next five years. For instance, IRCON International and Rail Vikas Nigam will benefit from the drive to convert all viable rail tracks to broad gauge by 2022.

The commitment to provide 24x7 power to all will benefit NTPC and Power Grid Corporation. Power Grid would be a good bet because it can execute transmission projects on a large scale. While Coal India has, thus, far delivered tepid returns, it could do better as power generation increases.

Similarly, for Gail India, the Modi-led government’s policy to increase gas consumption in the country to 2.5 times by 2030, will provide a boost. This will include domestic piped gas- and gas-powered public transport like buses and last-mile connectivity with cabs and auto rickshaws.

The resolve to construct 60,000 km of National Highway over the next five years will translate into order flows for PSUs in the road construction business, such as NBCC.

Takeaway:PSUs in power transmission, road construction and railway infrastructure may be good bets in the medium term

Dividend doles

One of the selling points for PSU stocks has been their strong dividend payouts over the years. With the Modi government leaning on these companies to shore up its fisc, dividend payouts have been quite healthy in recent years. This can ensure steady returns to investors, even if capital appreciation is hard to come by.

Average dividend payout ratio of the 30 PSU companies in our basket was 48.5 per cent in FY18, implying that almost half the profits were being distributed to shareholders. This ratio has risen steadily over the last nine years from 32 per cent in FY10.

Investors can, therefore, be assured of a robust dividend yield from these stocks. Twenty one of the 30 PSU stocks had dividend yields of more than 2 per cent in FY18, while 10 yielded more than 4 per cent. Power Finance Corporation (9.1 per cent), NALCO (8.5 per cent) and REC (7.3 per cent) topped the chart of stocks with the highest dividend yield in FY18.

DIPAM’s new capital allocation policy in 2016 mandated that PSUs return excess cash, based on a threshold. Listed PSUs with net worth of over ₹2,000 crore and bank balances of over ₹1,000 crore had to mandatorily buy back shares and pay the maximum dividend legally allowed to investors.

The idea was to make PSUs leverage their balance-sheet strength and borrow more. The market prices of many PSU companies has stayed in a range, thanks to this shift. These stocks have since turned in to dividend yield stocks, rather than capital appreciation plays.

Takeaway:Investors are assured of healthy dividend payouts from almost all PSU stocks; this can compensate for the lacklustre stock price appreciation

Valuation discount

Despite strong payouts and some companies operating in lucrative sectors, the stock prices of PSUs have traded at a discount to their private sector peers.

NTPC, the largest thermal power producer in India, trades at a discount when compared to peer JSW Energy. JSW Energy is far smaller than NTPC, but commands a higher price-earnings multiple than NTPC. Power Grid, the largest power transmission company in India, trades at a discount when compared to Adani Transmission.

Investors should, however, not be swayed by these lower valuations as the attached risk emanating from majority government control — higher payouts, stake sales between PSUs, mergers and buybacks — calls for a discounted valuation.

The government has been found to be quite avaricious in many instances, in demanding dividend payouts. In case of Coal India, the company’s dividend payout ratio has been more than 100 per cent since 2013-14. This is when the company’s profits have halved in the same period to nearly ₹7,100 crore. This is the company that holds the key to Indian thermal power generators getting cheap domestic coal, and needs to invest in improving its operations.

Obviously, cash lying idle is no good to anyone and it must fetch suitable returns for its shareholders. This was the thrust of DIPAM’s new capital allocation policy in 2016. Result: there has been a gradual increase in the debt on balance-sheets of IOCL, BPCL, and ONGC from 2016, while cash balances have been used to pay dividends and buy back shares for improving ‘investor confidence’, as DIPAM puts it.

The DIPAM policy of 2016 has now resulted in these companies taking on more debt to fund expansion. This has moderated the ROCEs of companies — ONGC, Oil India and NTPC. At the same time, the interest coverage ratios of these three companies have also moderated; from an extremely comfortable 61.6, 1068 and 6.3 times the operating profit in 2009-10 for ONGC, Oil India and NTPC, the interest coverage ratios have moderated to 8.8, 8 and 3.8 times respectively in 2017-18.

Surprisingly, the squeezing of PSUs’ balance-sheets for cash hasn’t affected them as badly as one would think. None of the BSE PSU index constituents in the analysis has seen its debt-equity ratio deteriorate as badly till the end of FY18, except SAIL.

With government still calling the shots, the valuation discount may continue. But its focus seems to be on altering the capital structure of these companies, with higher debt on the books, and reducing cash balances.

Takeaway:While investors can still buy these stocks for dividend payouts, it would be wrong to expect capital appreciation simply because these stocks trade at a discount to their private sector peers

Finally...

Not all PSU stocks are suitable for retail investors. Sometimes, government policies could result in tepid profit growth. Investors in oil marketing companies such as BPCL and IOCL enjoyed most of their gains after the Centre decided that it could no longer foot the subsidy bill on retail fuel prices, and the under recoveries started falling over the years.

One should also see if the businesses are future-proof. If we look at Coal India, majority of its coal mines feed power plants. However, beyond a point, coal consumption will not continue to rise because it is polluting, and India has made global commitments to cap the emissions. This means there will be a plateau in coal consumption in the future. The fact that the Centre is promoting renewable power is just one reason why coal consumption will eventually plateau.

Investors should also note the lifecycle of the industry in which the PSUs operate. One must also not lose sight of the fact that the Centre will increasingly squeeze cash out of PSUs to meet its budget targets. If a stock becomes a dividend play, you shouldn’t park your savings hoping for capital appreciation.

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