Should ONGC and GAIL shares be sold at a discount?

DEBATE

Sunil Shah
Managing Director,
HDFC Securities

The government is planning to raise Rs 100 billion by selling shares of two public sector undertakings "" Oil and Natural Gas Corporation (ONGC) and Gas Authority of India Limited (Gail) "" in the capital market.

It has announced the names of the merchant bankers and both issues are slated to hit the market well before the end of the fiscal year. Undoubtedly, both issues will provide the stock markets with a big boost.

While investors could find the offer price at a discount to the market price a compelling reason to invest, the government is well advised to price the offerings close to market price. Why? Well, there are some key reasons why we believe no discount should be offered.

They are:

• guarding against "false expectations";
• valuation; and
• quality of offering.

Let's discuss the three issues in detail.

Guarding against "false expectations": The government should encourage mature long-term investment behaviour from investors. In other words, investors should look to make an "investment" in the offering rather than look for quick "trading opportunities".

It is the trading mentality that will get a shot in the arm if an unnecessary discount is offered for a listed company. In that situation, even existing shareholders may resort to selling their holdings in the market and put money in the public offering.

Valuation: The Bombay Stock Exchange sensitive index (BSE Sensex) at 6,100 is quoting at its financial year 2004-05 price earning (PE) multiple of 16 times.

In spite of the recent rise, the government companies in the oil and gas sectors "" Bharat Petroleum Corporation Limited (BPCL), Hindustan Petroleum Corporation Limited (HPCL), Gail, ONGC "" are quoting at eight to 14 PE multiples, at a discount to the Sensex PE multiple. These public sector companies are market leaders in their respective business segments.

They are also generating strong cash-flow. For example, ONGC is going to generate Rs 100 per share of free operating cash flow (total Rs 14.4 billion free-cashflow), BPCL will generate Rs 75 per share and Gail is going to generate Rs 27 per share of free-cash flow in the current financial year.

On cash-flow valuation, these stocks offer good long-term value. Free cash flow should be a real determinant of business strength and on that ratio these stocks offer future value at current market prices.

Quality of offering: The PSUs for which public offerings are to be made are giant economic entities. The Indian economy has picked up speed recently and the future economic growth outlook is very strong. In the second quarter of the financial year 2003-04, the economy grew by 8.4 per cent, which is one of the fastest growths in the world.

In a situation of higher economic growth, these entrenched old economy players in oil and gas exploration, refining and distribution offer significant cash flow growth opportunities.

In case the government decides to go for strategic divestment, these companies will attract international bidding and a significant valuation premium over their current market price. For example, the minimum strategic valuation of ONGC is Rs 1,500 per share (market price Rs 950 per share), HPCL Rs 550 per share (market price Rs 455 per share).

Similarly, the minimum strategic value of National Aluminium Company Ltd (Nalco) is Rs 300 per share (market price Rs 195 per share). In fact, most of these players have assets the true economic value of which is not entirely reflected in their balance sheets.

Against the backdrop of strategic value of these shares, the market price only discounts current and next year's earnings. Given the quality of these companies, investors will benefit even if they invest in these stocks at current market price.

Prithvi Haldea
Managing Director,
PRIME Database

"Millions of investors in the country would fondly remember George Fernandes and the year 1977. Fernandes, as the minister for industry, had then ordered all multinationals in India to either divest a part of their equity in favour of domestic retail investors or leave the country.

Many called him a maverick but he stuck to his guns and created history. It was the scores of offerings by multinationals such as Hindustan Lever, Colgate, Cadbury, Ponds and Lipton that spread the equity cult for the first time in India.

Twenty-six years later, Arun Shourie has an opportunity to create history. It is heartening to note that the government has finally accepted that some public sector undertakings (PSUs) will make public offerings.

My view is that all PSU divestments should be made only through the public offering route, only in the domestic market, only for retail investors, through the fixed-price method and at an attractive price.

Why the public offering route?
Through PSU "public" issues, the latent wealth created by the "public" enterprises would be shared rightfully only by members of the "public". PSUs would also reactivate the primary market that, despite the sustained bull run, remained near-comatose in 2003 with only 15 public issues mobilising a meagre Rs 2,194 crore.

These PSU issues would bring millions of investors back to equity and help deepen our secondary market that continues to breed excessive speculation and volatility.

Why only domestic retail investors?
The current appetite in the domestic market is strong, the prerequisites being the issuers' quality and price. This explains the domination of the primary market in 2003 by the "safe" PSUs.

The opposition that there is no depth in the domestic market is untenable because the past has witnessed huge mobilisations. As many as 22 issues have collected more than Rs 2,000 crore each, and significantly only from retail, all in fixed-price issues. Foreign institutional investor (FII) participation did not exist at that time.

In addition to increasing household savings, huge liquidity has been created recently in the marketplace. Between May and December 2003, the total market cap of all listed companies has grown by Rs 8 lakh crore.

The primary market would need but a small fraction of this. Wide retail distribution shall also reduce the selling pressure, and can, in fact, lead to higher prices because FIIs/funds would then start acquiring from the market.

Alternatively, the government should at least reallocate the quotas, like in the case of Maruti. My recommendation is to reduce the FII quota from 60 to 10 per cent, retain the high networth individual (HNI) quota at 15 per cent and increase the retail portion from 25 to 75 per cent. In an unlikely event of undersubscription of the retail portion, there could be a flowback clause allowing greater allocation to FIIs/HNIs.

Why only the fixed-priced route?
Retail investors are ill-equipped for book-building and, in any case, use the cut-off option. Moreover, experience suggests that book-building can create an undesirable hype about oversubscriptions.

Book-building should not even be considered because price discovery takes place only nominally given the pre-fixed-price bands and also because the stock is being subjected to a minute-to-minute price discovery in the secondary market.

Why attractive prices?
The key to the success of the PSU offerings is clearly the issue price. For the already-listed companies, like ONGC and Gail, the issue price should be determined by taking the weighted average of the market price of, say, the past six months and then discounting it by, say, 20 per cent.

We should be conscious that if these issues are done through book-building and the final offer price is close to the market price, it might not only affect the response to the issue, but also entail a backlash whenever the market price falls below the issue price.

The total unexpected but real gain to the government on a 10 per cent stake in ONGC and Gail works out to Rs 7,721 crore. The government should not attempt to maximise its returns in the short-term.

By pricing realistically, the doors would open for bringing millions of investors back to the capital market, which will not only help future divestments but also the sentiments in the IPO market.