Cloud of uncertainty

Investors need to be cautious as an increasing number of companies are reporting higher contingent liabilities

In all the dross number-crunching and ratio analysis done while analysing the financial performance of a company, one key aspect is often overlooked — that little entry in the books called contingent liabilities, which actually warrants a little more than just the cursory glance thrown in its direction. In fact, the quantum of contingent liabilities has grown in recent years as an increasing number of companies have taken to obfuscating their financial obligations under this accounting term. To put things in perspective, the cumulative contingent liability of the BSE 200 companies (excluding PSUs, banks and financials) has gone up from ₹178,789 crore in FY11 to ₹256,978 crore in FY14, an increase of 44% over a three-year period.

Need for closer scrutiny

About fifteen companies have a contingent liability that exceeds their market cap

A little more digging reveals that some companies have totted up liabilities in excess of their net worth and market capitalisation. On an average, these companies have contingent liabilities twice the size of their net worth and more than 100% of their market capitalisation (see: Need for closer scrutiny).

Not surprising, then, that market experts have advocated caution. Parag Parikh, founder, PPFAS, says, “Contingent liabilities are very important in assessing the investment-worthiness of a company, as it may erode the net worth of a firm and, in some cases, threaten its survival. It can create debts for a firm, turn a profit into a loss, change its capital structure and negatively impact a firm’s debt-to-equity ratio. The bigger risk is when companies do not provide for an event that could become a liability in the future.” 

Incidentally, it is mostly power and infrastructure companies that are sitting on huge contingent liabilities on account of large debt on their books. Companies such as GVK Power, HCC and Lanco Infra are among the few with the highest contingent liability.

Sitting ducks

In case of GVK Power, the contingent liability of ₹4,600 crore as of FY14 is nearly three times its market cap. Of the total amount, ₹3,133 crore is guarantees to banks for loans taken by subsidiaries. In fact, a market source who did not wish to be named suspected that out of this figure, ₹1,800 crore was given to promoter companies for the acquisition of a mine in Australia. “The mine acquisition (Hancock Coal) is a red flag in my opinion and I have some serious questions over what stage the acquisition is at. The promoter may own the asset but how exactly does he plan to monetise it? The mine should not end up becoming a contingent liability or a headache for the company,” he says.

Hyper contingency

Cumulative liability of BSE 200 companies has gone up 44% in three years

An ICICI Securities report mentions that the Hancock acquisition guarantee is an overhang. In September 2011, GVK Coal Developers – a JV between GVK (10% stake) and GVK Natural Resources acquired a coal mine from the Hancock group in Australia. The total acquisition cost was $1.26 billion for which it has tied up debt of $1 billion. GVK guaranteed 49% of the debt (₹6,788 crore), and as collateral pledged the shares of GVK Energy, GVK Airports and GVK Transportation. This remains a cause for concern, states the report. 

Investors are highly concerned about this guarantee as GVK Coal is currently under development and incurring losses. Also, as per GVK Power’s FY14 annual report, GVK Coal ‘s current liabilities exceed current assets by $259 million based on unaudited financial statements for the year ended June 30, 2013 and continues to look for more financial support indicating a mounting pressure on the debt servicing ability of the company. On the flipside, if the company is able to monetise some of its assets in the power, coal and other segments, which it has been talking about for quite some, these issues can ease out a little.

In many a case, contingent liabilities can actually threaten the very existence of the company. Construction and realty major HCC was earlier reeling under a pile of debt, as was its flagship township project Lavasa. But today, under a CDR exercise, the company has managed to get a two-year moratorium for repaying its debt. The bulk of its total contingent liabilities of ₹2,701 crore for FY14 were guarantees given to loans for Lavasa. Another chunk of liabilities was guarantees that were given to road projects. But while CDR has somewhat eased matters, consolidated debt is still a whopping ₹11,443 crore in FY14. In fact, at ₹1,091 crore, interest outgo was at a five-year high. All this puts into question the company’s ability to service its liabilities, should the need arise. As far as contingent liabilities go, however, the key variable for HCC is that it has nearly ₹9,000 crore filed as claims under dispute and, ever hopeful of winning the claims, the company has not listed any of these in its balance sheet. Second, as Harendra Kumar, head of research, Elara Capital, puts it, “If the economy fails to gather steam and the infra space doesn’t pick up in another year or two, many of the substantial loans of its subsidiaries could become NPAs and these contingents could threaten the survival of the company.”

In the case of ABG Shipyard, which is sitting on a contingent liability of ₹1,611 crore, or 141% of its market cap, analysts are apprehensive about the sustainability of the business, particularly in the light of subdued industry environment. Amit Agarwal of Kotak Securities mentions in his report that ABG’s profitability is expected to be under pressure due to the poor shipbuilding market, high interest costs and increasing liabilities. “We estimate the company to report losses over FY14 to FY16,” says Agarwal, who has a sell rating on the stock. Against such a backdrop, contingent liabilities will prove to be a double whammy.

A vast majority of contingent liabilities for FY14 were bank guarantees to subsidiaries, which the company has not provided for. Given that the company’s three subsidiaries themselves were facing debt problems and reported falling sales and profits, their ability to repay these loans remains in question. To top it all, contingent liabilities are likely to queer the pitch. Bharat Chhoda, analyst at ICICI Securities, says, “Going ahead, ABG definitely faces a risk from contingent liabilities.”

ABG has been feeling the heat of late, as a weak operating environment led it to post a net loss of ₹199 crore in FY14. Though its debt of ₹10,000 crore has been restructured under CDR, the company is facing serious cash flow problems due to rising raw material costs, deferral of deliveries, order cancellations and invoking of bank guarantees. The shipbuilding industry as a whole is faring no better with low demand, order cancellations and problems with financing.

In the real estate sector, the Mumbai-based DB Realty has been worst hit by this trend. The company has seen its fortunes take a knock after promoters Shahid Balwa and Vinod Goenka were arrested in the 2G scam and the company has taken a tumble ever since. With its reputation hit and very few customers coming forward to purchase its properties, inventory has piled up. As such, cash flows and profitability have been hit hard. A rejig of its management team also did not yield the desired results. Here, too, bank guarantees given to subsidiaries form the bulk of liabilities, at ₹2,567 crore. The notable and largest liabilities of the lot are the ₹853 crore given to Majestic Infracom, ₹829 crore given to Delux Hospital Mauritius and ₹350 crore given to Neel Kamal Realtors. To Majestic Infracom, it has provided collateral securities for Hotel Hilton, which forms a part of its inventory. In the case of the second property, it has received irrevocable guarantees from two DB directors. To the third subsidiary, a parcel of land in Byculla and the Orchid project were provided as surety. “These contingents pose a risk to DB, combined with weak sales, and delays in execution due to delays in approvals of the parent and fundamental problems with its subsidiaries,” says Amit Anwani, analyst at KC Research. He feels that DB may not be in a position to service its guarantees and this could turn out to be a serious investment risk.

Living with uncertainty

Well, thankfully, disclosure norms are improving. Parikh adds that in the past, most contingent liabilities were not disclosed due to lax regulation but today, firms are forced to disclose their liabilities. Also, the market tends to ascribe a lower valuation to these companies. A example is that of Ranbaxy, which saw its P/E halve from 30 times to 15 on account of court cases pending against it in the US.  

In case of smaller companies that wish to show larger profits, there is scope for accounting jugglery and they may not provide for these liabilities. Were the liability to actually arise, they would have to knock it off their reserves or charge it to the profit and loss account, which could mean a huge setback for existing shareholders of the company. So, the next time you zoom in on a stock, pay heed to any lurking contingent liability.