Stress But Not Too Much, Part 3

The recent announcement of the sale of Essar Group’s ‘entire’ holding in Essar Oil and Vadinar port to Rosneft, Trafigura and UCP will allay the market’s concerns about Indian banks’ exposure to Essar Group. The Rs.850 bn transaction will release Rs.450 bn of cash (our estimate) for Essar Group, which can be potentially used to (1) repay debt of Rs.235 bn in Essar Global Holdings and (2) reduce debt in financially stressed entities such as Essar Steel and Essar Power.

Sale of Essar Oil is quite significant for the Indian banking system

We view the 98% stake sale in Essar Oil and 100% stake in Vadinar port by the Essar Group for a total consideration of Rs.850 bn (all-cash deal) as a very significant event for the Indian banking sector for several reasons. (1) The formal announcement of the deal in the recent BRICS summit in the presence of the political leaders of India and Russia suggests a high degree of involvement of the Indian government in the transaction. We note that Indian PSU oil companies had earlier purchased a 49.9% stake in the Vankor oil block of Rosneft. (2) Indian banks have become very forceful in addressing the problem of bad loans. (3) Indian promoters may have little option but to sell profitable assets to reduce debt; this has been the case for the past two years.

Indian banks have large exposure to Essar Group; their exposure may reduce significantly

We do not have full financials of various Essar Group entities as most are unlisted and their FY2016 financial statements are not yet available with the Indian Registrar of Companies (RoC). Nonetheless, it appears that Essar Group has total debt of Rs.1.3-1.4 tn, with most of it raised from Indian banks. We note that VTB, a Russian bank, will finance around Rs.260 bn of Essar Oil’s debt (Rs.315 bn as per FY2015 annual report) as part of the deal, which will further reduce Indian banks’ exposure to Essar Group.

Money can solve some problems: cash from stake sale to bring down Essar Group’s debt

As per statements of Essar management, the group will use the cash available from the stake sale to reduce its debt. In our view, (1) Essar Group will likely repay the debt of EGHL, a holding company with Rs.235 bn of debt as per media reports; AXSB, ICICIBK and Standard Chartered are the prominent lenders to EGHL and (2) Essar Group may invest a portion of the cash as equity in Essar Steel (standalone debt of Rs.357 bn as per FY2015 annual report) and/or Essar Power to deleverage the companies. Exhibit 2 is a hypothetical exercise for Essar Steel’s interest coverage at various levels of debt and steel prices while Exhibit 3 is another hypothetical exercise of its interest coverage at (1) various levels of capacity utilization versus 34% in FY2015 and (2) lower debt of Rs.200 bn versus Rs.427 bn of debt at end-FY2015.

Time can solve the rest: some power assets may need time for resolution

We make a few observations on Essar Power’s assets. (1) Essar Power Gujarat’s 1,200 MW plant at Salaya generates reasonable EBITDA; 1HFY17 EBITDA of Rs.3 bn should be sufficient to service debt of Rs.45 bn. (2) Essar Power’s Hazira (1,015 MW) and Vadinar (1,010 MW) units provide power to group entities (Essar Oil, Essar Steel) or sell power under a PPA to GUVNL, a Gujarat state power utility. (3) Essar Power’s 1,200 MW Mahan plant (debt of Rs.67 bn) is operational but does not have a PPA while the 1,800 MW plant (current debt of Rs.20 bn) at Tori is under construction and has a PPA for 750 MW with the Bihar state power utility. In our view, higher PLFs will result in higher revenues and EBIT and partly address potential NPL issues. We do not see lack of coal or PPAs as challenges in the medium term. India has enough of coal resources and its power demand will grow over time.

This is an excerpt from Kotak Institutional Equities latest Strategy note dated October 16, 2016. Copyright 2016 Kotak Institutional Equities (Kotak Securities Limited). All rights reserved