Waiting To Explode

Swelling exceptional items are a clear and present danger to investor wealth  

To be crude, the commodity downcycle is far from over. Similar is the case for industrial metals, who have been hit by lower demand. In such a scenario, the stress has been manifesting itself in the form of exceptional items. For the nine months ended December 2015, write-offs stood at Rs.16,854 crore. Already higher than the Rs.13,063 crore (2.3% of operating profit) written-off in FY14, the number is expected to swell once the March quarter numbers are out. 

The stress in the system over the last two fiscals can be gauged by the fact that write-offs by BSE200 companies (excluding banks, financials and companies with exceptional gains) in FY15 stood at a mammoth Rs.44,228 crore. This was over 8% of the operating profit and 3.5% of the sales turnover of Rs.1,254,000 crore. 

Slippery slope
Not surprisingly, the energy sector has seen the most pain, logging exceptional items of Rs.5,463 crore till Q3FY16. Of this, ONGC has written-off close to Rs.3,994 crore, citing impairment losses due to the fall in crude price. According to the company, the severe industry downturn has hit the cash generation capacity of some of its oil and gas assets or in other cases, led to reduction in book value.

Meanwhile, impairments have been on the rise in the metals and mining space too. In the December quarter, JSW Steel took an impairment hit of Rs.5,600 crore. This was due to losses at its US plate and pipe plant (bought from Jindal Saw in 2008) on account of high operating costs and lower steel prices. Tata Steel also continued to report impairment losses in FY16, largely on account of its European business. Not just impairments, the collective write-offs were at Rs.3,600 crore in FY16, second only to oil companies. This is similar to FY15 when oil and gas companies made up 70% of the total write-offs, followed by metals at 18%. 

Another victim of tepid demand has been the infrastructure space. Reliance Infrastructure wrote-off close to Rs.3,104 crore, largely due to losses because of termination of the Delhi Metro contract. 

“The recent spike in exceptional items could be a reflection of the current economic environment, both in India as well as globally. While for some it has been triggered by sectoral issues, including commodity cycles, or due to the debt situation, for some it is a combination of both, accentuated by cash flow and liquidity pressures,” says Sai Venkateshwaran, partner and head, Accounting Advisory Services, KPMG.

Pinning blame
But is economic slowdown the main culprit? While it’s hard to pin the intention behind such transactions, the spike reminds one of an accounting term – ‘Big Bath’. This is a strategy employed by some companies wherein they manipulate the income statement to make poor results look even worse, and is often implemented in a bad year. “Managements often look for the best time to offload certain investments and losses sitting in the books. In a poor market, when the share prices are already low and investor sentiment is down, dropping one more bad news will not hit you badly. You don’t know if some of these (write-off) announcements are to facilitate buybacks or to help promoters accumulate shares at lower prices,” says Abhishek Asthana, a forensic accounting expert, who previously worked with KPMG.

For instance, Cairn India logged its first ever quarterly loss of Rs.241 crore in the March 2015 quarter despite posting a profit (before tax and exceptional items) of Rs.721 crore. This was because of the Rs.505 crore impairment hit as the company declared one of its Sri Lankan exploration blocks unviable. The company’s realisation was already hit by falling crude. When the merger with parent Vedanta at a swap ratio of 1:1 was announced, the stock fell from Rs.213 to Rs.180. The deal continues to face the objection of minority shareholders. 

A complex operating structure with multi-layer subsidiaries is another grey area that investors need to be mindful of. For instance, auditor, SR Batliboi, in its notes on JSPL’s FY15 results mentioned that they didn’t audit the financial statement of 87 subsidiaries, four associates and three joint ventures, having total revenue of Rs.6,131.8 crore and total assets of Rs.31,401 crore. Sure, JSPL is audited by several others, but the complex structure raises suspicion when the amount involved is close to 83% of its consolidated assets and 30% of sales turnover. 

“For investors, understanding exceptional transactions become even more important when companies have several layers of subsidiaries or complex structures because you don’t know if there are any potential losses or related party transactions that are being routed through these subsidiaries,” explains Karan Khanna, who specialises in forensic audit at Ambit Capital. Even then, he adds, it’s difficult to predict if there are more potential exceptional items sitting somewhere biding their time. 

On July 3, 2013, United Spirits recorded a Rs.1,337 crore unsecured loan given to its subsidiary United Breweries Holdings at an interest of 9.5%. Not only did the company not get any interest in FY14, it wrote off close to Rs.330 crore of the outstanding loan, stating that it will not be able to recover the money. In end-FY15, it wrote off the remainder. While the company has said it will pursue loan recovery, the outcome remains to be seen. United Breweries, too, has suffered because of non-payment from various creditors of the now-defunct Kingfisher Airlines. 

There is more. During its restructuring, The Indian Hotels Company (IHCL) wrote off the value of subsidiaries that it had previously acquired at higher valuations. In addition, due to the divestment of subsidiaries engaged in non-core businesses like leather goods exports, food and beverages and cold storage, its exceptional items rose to Rs.302 crore. While they were very small businesses, they were divested in favour of an associated company. “We had in the past invested in various businesses as a part of our backward integration strategy as also to diversify the business portfolio. However, over a period of time, for variety of reasons, these companies either discontinued/significantly scaled down their operations, therefore, the company decided to exit from such entities,” IHCL said in an emailed response.

Why and when?
Another tricky lane to navigate is figuring out if a company is mis-allocating capital. “One of the dangers to equity investment is mis-allocation of capital, which often happens through creation of unnecessary subsidiaries and investment in unrelated businesses. If you are not equipped to assess such investments because of lack of transparency or other reporting issues, it could lead to surprises in the future,” says Khanna. 

As investments in subsidiaries are reflected in the carrying value of goodwill, faulty investments seem to have no impact till the time the management decides to accept the impairment. However, these charges are like time bombs. For instance, Vedanta took a Rs.22,129-crore hit because of exceptional items, including the Rs.19,180 crore impairment charge due to acquisition goodwill relating to Cairn India. This was due to a drop in the investment value of its Cairn holding. Because of the impairment, it made a loss of Rs.15,646 crore in FY15, which eroded its FY14 net worth and book value by 21%. 

Coal India is another example. The company, after investing close to Rs.500 crore in Mozambique, said it found no coal worth extracting from its two blocks. Analysts now expect the company to write-off the entire investment. The Mozambique foray also turned out to be a value destroyer for Tata Steel and ICVL, a joint venture of Coal India, NTPC and NMDC. In July last year, mining major Rio Tinto sold a 65% stake in its Mozambique mines to ICVL, writing-off its $4 billion investment. The Benga coal mine in Mozambique’s Tete province, in which Tata Steel is also a 35% stakeholder, is losing $7.5 million per month. Similarly, Essar group’s $600 million investment in Trinity Coal Corp in the US turned bad as the company filed for Chapter 11 in 2013. “Several write-downs are seen in situations where companies have made costly acquisitions in the past, and those valuations are not sustainable any longer, resulting in goodwill and asset impairments,” says Venkateshwaran.

The biggest issue with write-offs though arises when little information is available in the public domain, making it difficult to understand the magnitude, intention and timing of losses. “In the December quarter, there were no losses and all of sudden in March you have disclosed something that was never talked about before – that’s the problem. It’s the job of independent directors and auditors to be vigilant, but unfortunately most just push things under the carpet,” says Asthana.

It’s not that there aren’t Sebi reporting and disclosure norms with respect to exceptional items. Thanks to auditors disclosures, JSPL revealed that it has an overseas subsidiary, whose total assets are Rs.4,740 crore (12% of consolidated assets). The unit, however, earns a revenue of just Rs.18.69 crore. Justifying the figure, a JSPL spokesperson said, “The overseas subsidiary was yet to start production, pending approvals and hence the low revenue.” Other companies that Outlook Business reached out to had not replied till the time of going to press. 

The trouble with the disclosure norms though is that they are very fluid, says JN Gupta, co-founder, Stakeholders Empowerment Services. “While there are accounting guidelines and Sebi norms, to ensure true and fair representation of accounts, it still suffers from subjectivity relating to the amount to be determined as an exceptional item and timing of such write-offs, which is often in the hands of management or promoters.”

Company managements in these cases opt for either of the two tricks – either they opt for Big Bath accounting or wait for a quarter where there is an exceptional gain/profit to offset the impact. “Companies often keep on postponing certain things by sleeping on rotten inventories or a certain restructuring never come into the picture till they become too big to hide,” says Amit Bansal, partner, Deloitte India. 

For instance, Tata Steel has several subsidiaries, particularly in Europe, which have been reporting impairment losses for the last couple of years. The company reported an exceptional loss of Rs.3,929 crore in FY15, largely because of its European business. Had it not booked an exceptional gain of Rs.1,146 crore by selling certain assets, the cut would have been deeper. If one goes through the footnotes of JSPL’s FY15 annual results, auditors have noted that the company has not made adjustments in the carrying value of investments in mining assets to the tune of Rs.603 crore, pending finalisation of the claims filed with the government. Had this amount been included in the exceptional items list in FY15, the company’s write-offs would have gone up by about Rs.2,600 crore or 47% of its operating profit.

In another instance, during FY15, Ashok Leyland made an exceptional loss of Rs.610 crore, involving fixed assets, non-moving inventory and tax liability, mostly pertaining to its troubled subsidiary – AL Nissan Vehicles. But due to sale of properties worth Rs.310 crore, the net exceptional amount came down to Rs.295 crore. Interestingly, in the following year when the property sales actually materialised, the balance-sheet showed an unexpected rise in receivable of Rs.200 crore against immovable properties. 

Since auditors play a limited role in quarterly results, the most obvious ploy is for losses to be shifted to the March quarter. But it can be longer, depending on the intention of the management. While it’s not possible to read their minds, the spurt in exceptional items is a good enough reason for investors to dig into the details of the write-offs. “One really needs to see if the business situation warrants the exceptional items. There are companies where there will be genuine exceptional items. And then we also have a set of companies who use this as a tool to hide things under the carpet,” says Bansal. Learning which is which can spare you a lot of pain.