Essar Energy’s shareholders must be feeling pretty exposed. An unexpected legal defeat in a tax case before India’s high court knocked a quarter off the energy group’s stock price on January 17. The shares have subsequently fallen further.
The source of the trouble is tax. Barring a victory on appeal, Essar will no longer be able to defer paying $1.2 billion of sales tax on revenues from its flagship refinery in the Indian state of Gujarat. The cost to Essar is less than $1.2 billion because this is tax that would have had to be paid eventually. According to estimates by Deutsche Bank, the net present value of the lost tax benefit is about $300 million. Nearly $900 million of market cap has been wiped from the company this week, but Essar now has a proven ability to shock and shareholders can be forgiven for wondering if it will do so again.
Investors who paid about 20 times forecast earnings for the shares in 2010 must regret brushing aside big risks outlined in the group’s IPO prospectus. Big plans to expand the group’s refining operations and build nearly 10,000 megawatts of new power generation capacity remain in place. In a country where 400 million people still lack basic access to electricity the new capacity is also needed. But red tape has stymied new power projects throughout the country. In Essar’s case, governance issues have also weighed: the chairman, Ravi Ruia, was forced to step aside after he became embroiled in an Indian telecoms scandal.
Today’s forward p/e ratio on Essar shares of about seven better reflects the multi-layered risks. But it also comprises hope that India will push through reforms that will make life easier for industrialists. Will that be forthcoming? Power industry executives, pleading their case on January 18, left Prime Minister Manmohan Singh promising to set up a new committee to examine the problem. Yet there were few specifics.
Shares in the London-listed India-based energy group are worth barely a third of the May 2010 flotation price. Yes, it is a more reasonable valuation. But the all-too-real risks still appear to outweigh the potential rewards.