NSEL Fiasco – What Went Wrong?

Author: Bharat Goswami, NMIMS Mumbai

On 1st August, an army of brokers thronged the NSEL office in Mumbai, demanding commodity bourse pay up. The exchange could not meet its payout commitment after it suspended trading on several contracts that were disapproved by the Govt. Trading positions worth Rs. 5,500cr are pending on NSEL i.e. National Spot Exchange Limited, which have halted trading for fortnight.

Let’s see how NSEL managed to get into this mess

In simple terms NSEL mechanism was used by farmers/any party to take loans keeping items such as castor seeds, cotton, etc as security as these items are considered safe and loan amount used to be around 60-70 % of the market value of those items. Consider a situation where a farmer wants a loan, enters into an agreement with a trader who is an intermediary between investor and farmer. In consideration of the loan the farmer deposits his seeds (or any registered item) on T day at the warehouse and receives the loan on (T+3) day. Now, the farmer has to pay back this amount on (T+36) day (mostly) and can take back his security. In practice, the farmers used to involve in a rollover transaction where in they did not used to pay back the whole amount on T+36 day but only give some payment (mostly interest with the principal due to be paid on a later date) to the exchange which was then passed on to the investor. So, in a way it became a regular source of income for investors. Traders used to lure their clients by promising them 13-15% fixed return through such transactions.       

                                                                      Source:NSEL

But a few days ago, the Govt. issued a directive to  NSEL to cancel these forward contracts as they should not be more than 11 days. So, NSEL cancelled those long term contracts and issued 11 day contracts. So, ideally, after  the 11th day investors should have received their payments but the farmers did not have the money as they had got into a habit of paying interest after 38 days. Also, hearing the news of issue of new contracts most of the investors did not want rollovers and wanted their entire money back. But farmers were not ready to pay back the entire sum and there was liquidity crunch at the exchange. This resulted in payout demand exceeding the money that they used to get from investors via rollover transactions. This led to a cash crunch and NSEL had to suspend its working for 15 days. Although the NSEL management  has said that it has enough warehouse commodities or cash to cover the counter party risk the market does not believe so and it led to stock of its promoter company Financial technologies plummeting by 65% and 40% respectively in last 2 days.

Where does NSEL stand post this fiasco?                                                 NSEL MD and CEO, Anjani Sinha has told the media that they have physical stock of goods at their warehouses which were kept as a security from the borrower which is estimated to have a worth of around Rs. 6200cr. He also claimed that NSEL has Settlement Guarantee Fund which is set up mainly to insure timely payment to seller members on execution of trade. The Components of Settlement Guarantee Fund (popularly known as SGF) comprises of initial and additional contribution by members. Initial contribution refers to member providing a minimum security deposit. Additional contribution refers to providing additional securities mostly to open an account or in case if transaction is greater than 1cr. SGF is maintained in form of either cash, fixed deposit receipts or bank guarantees. But the reality is that NSEL which had SGF of Rs 800 cr has now been reduced to Rs. 60 Cr post settling the liabilities for month of March. Now to settle liabilities of Rs 5500 Cr against cushion of Rs 60 Cr will be a herculean task for the bourse

What is the possible way out of this mess?                                                       On 5^th August, NSEL officials met 21 entities (borrowers) and 2 options were considered. Under the first option, 8 members who have outstanding payments of Rs. 2,181cr agreed to pay the dues as per due date or even earlier (i.e. last date being 29^th July since the longest contract of (T+36) days was issued). 13 members who have outstanding dues of Rs. 3,107cr agreed to pay 5% of the total dues every week. And there are 3 other borrowers with outstanding dues of 311cr with whom negotiations are still going on. It was decided that borrowers who cannot meet the normal payment schedule have agreed to pay 16% interest. NSEL said it would take 5 months to settle the total amount. Under the second option, NSEL said that it is in possession of postdated cheques (PDCs) from various processors aggregating to Rs 4,900cr and thus proposed to use these PDCs for settlement. However, since it is thought that a settlement backed by PDCs may not be as smooth as under Option 1, market participants are not willing to accept this option.So, it has been decided that option 1 will be used to settle the pending obligations. So, Rs. 2,181cr i.e. 39% of the money will be paid to the investors by the end of the 1st week of September. And the rest about 5% per week till 20 weeks. Interest of 16% will be charged after the due date. To prevent itself from such a situation in future, NSEL has said that it will resume operations only after commodity regulator FMC (Forward Markets Commission) issues guidelines for the spot exchanges.

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Circuit Breaker - 3rd August 2013 Edition

Circuit Breaker is a new initiative by Investocraft, MBA Capital Markets to capture the fortnightly activities and movements of the markets. 

We welcome feedback and suggestions from everyone.

Here is the link : Circuit breaker 3rd august

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THE TATA STEEL STORY -“A global Ambition gone wrong”

Authors: Abhishek Behal  & Vatsal Jain , NMIMS Mumbai

Shares of Indian Steel Major, Tata Steel have corrected by almost 40% in the past six months closing at Rs 210 on Thursday afternoon. What has been the reason behind this meltdown in the value of a company that is amongst the highest producers of steel in India?

Tata Steel, formally TISCO seemed to be on a constant growth path since its inception in the year 1907 with no major hiccups during the journey. However things started getting sour for the company since their 2007 Acquisition of the European Steel maker Corus for a massive 12.04 Billion Dollars, an overvalued acquisition involving a bidding war with Companhia Siderúrgica Nacional of Brazil.The finalization and integration of the acquired organization was followed by the Sub Prime Crisis that hit most economies with nations witnessing deep recession. If this wasn't bad enough, the European Union found itself in the midst of a major crisis starting from the year 2009, when once well performing nations like Greece were found to have violated the requirements of the 1992 Maastricht Treaty and required billions of dollars of aid so that they could continue to service their sovereign debt requirements.

At the time of finalization of the deal, with most major countries experiencing a period of boom, Europe’s annual real steel consumption stood at180 million tones which as a result of the economic crisis fell to just above 140 million tonnes in 2012. The falling demand as common sense would state was experienced with a sharp fall in prices of steel all over Europe. The Company’s European business has since seen a downward trend.

The falling demand in EU for steel can be attributed to Automobiles and Infrastructure sector that accounts for nearly 50% of metal’s consumption. Since the Eurozone crisis, the EU has been affected by extreme contractions in Infrastructure spending due to austerity measures. This fall has been further compounded by a sharp fall in the automotive sector, one of the biggest contributors to the European economy, which saw car sales drop by 9.7% Y-o-Y as compared to 2011 - 12. The graph below shows the steel demand trajectory in Europe from 2007 to 2013 (E). Steel demand between 2007 and 2013 has dropped by almost 30 %.

Steel demand in Europe

The Company’s European operations are operating at capacity levels of 70% which reflects an ineffective utilization of available assets due to contracting demand in Europe as compared to its Indian counterpart where Tata Steel is planning to increase its current production by 3 million tones before the end of Q3 2013 and the capacity utilization levels have been fairly healthy.

What has made life more difficult for Tata Steel is the humongous amount of debt on their books and the consequent interest liability that comes with it. A large part of this debt was taken up to complete the Corus acquisition in the year 2007. The net debt on company stands over Rs 60,000 Crores, on which the company is paying an annual interest of about 7 %. The financial effect of this debt on the company can be gauged by the fact that in FY 13, out of a total EBITDA of Rs 5400 Crore, a sum of Rs 4,000 Crore alone went into the Interest payment for this debt, meaning effectively 75% of the EBITDA is being used to service the Interest payments only. The continuously falling rupee means that the company’s debt standing close to $ 10 bn which is partly foreign and partly local, is going to see a rise, while its Rupee earnings are going to face stiff pressure to match up to the massive interest payments required.

In May this year, Tata Steel announced a $ 1.6 billion goodwill write off as a ramification of loss in value of its European and South East Asian assets owning to depressed macroeconomic conditions which have led to lower steel demand all over the world. This was factored into their 2012 – 13 Annual Report in which the company has reported a loss of Rs 7,362 Crores down from a profit of Rs 4,748 Crores during 2011- 12. Analyst reactions to this decision were mostly mixed with few arguing that such a step was not completely unexpected and will in no way affect their cash flows in the future and maintained their Buy rating on the stock. Whereas some analysts went to the extent of suggesting that the company should consider selling its European assets as well, however any such rumors were rejected by the firm.

This write off made by the Company will be adjusted against the Goodwill that was created by the acquisition of Corus. If we examine the realistic impact what comes up is that since the write off is a non-cash event it will have no real impact on the company’s operational or financial flexibility.

  PAT (Impairment Factor)

As we can see had TATA STEEL not factored in the Impairment charge towards a Goodwill write off the PAT for FY 2013 would in fact have been a positive Rs 2434 crores (Assuming Effective Tax Rate on Group Income of 42%).

The reaction in the short-term in our opinion has been overly pessimistic with disregard of the fact that writing-off the goodwill has given the organization a chance to lighten its balance sheet and reduce the tax liability that the organization would have had on its reportable profits. The Company’s balance sheet still holds Rs 9000 Crore of goodwill on account of Corus which can see further deduction if the profits in the Domestic Market continue to rise which accounted for nearly 90% of the Profit after Tax of the consolidated figure.

Barring the debt levels of the Consolidated Group, a company which values Corporate Governance has its fundamentals intact with strong upside in revenues from its Indian Operations. Future expectations of revival of the European steel market in 2014 with expected growth of 3.3% (Source: World Steel Association) will help the organization increase its earning potential as it continues to bring down its fixed costs and adds new products to its portfolio that are in sync with the European market.

Latest news doing the rounds are that Tata Steel is in the running to acquire British firm Stemcor’s Indian Iron Ore assets which is being currently valued at $ 800 Million which is seen as a beneficial opportunity with the Steel Industry currently at the bottom of its business cycle. Though it is advised that the company tread with caution and avoid packing on more debt on its Balance Sheet and reduce margins at a time when they are attempting to reduce unnecessary costs and planned expansions towards capacity enhancement.

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St.Petersburg Paradox

By : Harish Srigiriraju
MBA Capital Markets ,NMIMS 2011-2013

“Price is what you pay and value is what you get” –Warren Buffet

Everything in this world has a price and not paying the right price will always create problems. Warren Buffet waited for about 30 years before he bought Coca-Cola. He waited for that long only to get the right price which will then give him the necessary returns. Many of the M&A deals have failed only because of paying more than what was necessary. It is essential not only to select good assets for investments, but also to pay the right price to acquire them, and this brings us to the concept of St. Peterburg Paradox.

Petersburg Paradox is a paradox related to probability and decision theory. It is an essential theory to understand the behaviour of an investor and pricing decision. The problem and its solution were first presented by Daniel Bernoulli in 1738. Assume that a casino offers a play where there is an unbiased coin which is tossed at each stage. The prize money starts with one rupee and doubles every time a tail appears. At any point of time if the head appears, the game ends and the player can take away the money earned so far.

Now think about how much would you be willing to play for this game? As per the probability theory since there is a payoff which is unlimited, it would suggest that a player should ideally be willing to put any amount of money to play this. However, people would not be willing to pay a high price for this. In a survey conducted in 2004 on an average, people were ready to play it by paying up around 25 Rs. Now what is the reason behind people paying up so less despite the possibility of unlimited payoff? Few theories can be used to explain this phenomenon. The “Expected Utility Theory” explains this on the basis of diminishing marginal utility of money but this might not be true in most of cases. The “Probability Weighting theory” gives less weight to unlikely events but contrary to this it was observed that people give more weight to unlikely events. Can it be explained based on the fact that the casino cannot have infinite resources? How much ever finite the resource are, this does not explain the low amount the players are willing to pay.

This paradox can be explained in two ways. One with the help of the “von Neumann and Morganstern axioms” where it can be explained that the investor does not take decisions only based on the expected payoff but always on the basis of the risk taking ability and the payoffs are thus risk adjusted. As per the “Erodig Theory” the time averages maybe different from space averages and the probability theory should only be used when the systems are erodig in nature. To make things simple, it implies that the expected gains increase with the increase in number of games. So if only one game is played, the probability theory will not hold true. These two theories explain that there is a rationale behind the paradox which is based on risk aversion.

Similar to this paradox are real life situations which investors face in order to decide the price for a particular stock. For high growth companies, it is often assumed that the payoffs are unlimited and any price paid can be justified. However this is absurd as the payoffs even if unlimited, has to be risk adjusted and hence there is always a right price for everything. In my recent encounter with Ashwath Damodaran, someone asked him if he was willing to invest in a company with very good growth prospects but corporate governance issues. His answer was a bit surprising but logical when he said he would definitely invest but only at the right price.

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Circuit Breaker -6th July 2013 Edition

Circuit Breaker is a new initiative by Investocraft, MBA Capital Markets to capture the fortnightly activities and movements of the markets. 

We welcome feedback and suggestions from everyone.

Here's the link -Circuit Break 6th Jul 2013

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