Mumbai: The liquidity crunch in the global markets has led to a rise in the cost of raising debt. In the case of companies from emerging markets such as India, the spreads over Libor (London interbank offer rate, a benchmark interest rate) have risen by 100-200 basis points. At first glance, Indian companies seem relatively well prepared to handle the rise in interest cost.
Only 18 firms in the BSE 500 (the Top 500 companies listed on the Bombay Stock Exchange in terms of their free-float market capitalization) had an interest cover ratio of less than two times based on their results for 2006-07. In 2005-06, there were 25 firms with an interest cover of less than two times. An interest cover of less than two times means that a firm’s Ebitda (earnings before interest, taxes depreciation and amortization and including other income) is just about enough to meet its interest costs.
A rise in interest costs, or a downturn in business fundamentals would mean that profit generation by such companies wouldn’t be enough for interest payments. Ideally, non-recurring other income should be excluded for interest cover calculations, but such data is not yet available for 2006-07.
If one were to exclude all other income, there were 36 companies last year with an interest cover of less than two times, slightly lower than the 2005-06 figure of 38. The study excludes banks and financial firms, for whom interest costs are essentially operating expenses. But not all market observers are comforted by this data.
The research head of an asset management company who did not wish to be identified said that a large part of Indian debt (in the form of foreign currency convertible bonds) is not reflected in the profit and loss account of companies. Interest payments on most such bonds are payable only on maturity (provided they aren’t converted in the interim) and companies needn’t account for the interest burden in the profit and loss statement. But with the outlook for Indian equities not being as sanguine as it was a month ago, the likelihood of the bonds not getting converted into equity shares has become higher.
Most bonds carry a reasonable yield-till-maturity, and foreign investors are expected to convert them only if the prevailing market price is at a fair premium to the conversion price. It’s not enough that prevailing market price should be higher than the conversion price; rather, the difference should be enough to cover the return from holding the bonds till maturity as well as to cover the risk of holding and liquidating the acquired equity shares. For instance, a five-year bond with a yield-till-maturity of about 5% would return about 30% on the original investment. Foreign investors would convert the bonds into shares only if there is a high chance of making a return well over 30%.
A recent CLSA report says that in the case of companies such as Wockhardt Ltd, Ranbaxy Laboratories Ltd, Suzlon Energy Ltd, Reliance Communications Ltd and Mahindra & Mahindra Ltd, the interest cover ratio is overstated because these companies aren’t paying interest on zero coupon, out-of-money convertibles. Besides, companies in cyclical sectors such as commodities are now close to the peak in terms of the earnings cycle. If there is a downturn in the cycle, those with high financial leverage would get hurt badly. And the 2006-07 interest cover figures do not reflect the true current position.
Companies such as Tata Steel Ltd, Hindalco Industries Ltd and Suzlon who have undertaken large-sized acquisitions this year will see their interest cover ratios decline substantially in 2007-08. The CLSA report points out that power utility companies that have won ultra mega power projects could be hit because of higher funding costs since they resort to debt for a large portion of their financing.
Standard and Poor’s recent downgrading of its corporate credit rating on Tata Power Co. Ltd from BB+ to BB- is a case in point.
The report also points out that airline companies could be hit as lease rentals are likely to rise, at a time when delivery of new aircraft is also set to increase. As it is, airline companies have low interest cover ratios.
The numbers may not show it yet, but rising interest costs are set to impact corporate performance in the near term.
Ashwin Ramarathinam contributed to this story.