If the IFCI Ltd stake sale had been successful, it would have laid down the following road map for state-owned banks: First run your bank to the ground, turn around and ask the government and other public sector banks to bail you out, wait for an upturn in the economy to start recovering your bad loans, start talking of all the potential that exists in your real estate, sell a largish stake to so-called strategic investors at inflated prices, enticing them with vague promises of a back-door entry into banking or asset reconstruction, and then continue business as usual.

Thankfully, the fall in the IFCI stock is a confirmation that the laws of valuation are not dead—they had merely been in suspended animation. The irony is that the frenzy that led to the vertical ascent for the stock was also the factor that led to the so-called strategic investors’ loss of appetite. Add to that the inexplicable wrangling about management control and the stage had been set for the debacle.

Several theories had been floated supporting IFCI stock’s rise. One mentioned the value-unlocking potential of IFCI’s investments; another waxed eloquent about its real estate assets; others pointed to the potential for speedy recoveries, now that the real estate assets of IFCI’s borrowers had gone up in value. Some argued that foreign banks would be interested in a stake as it would give them a much valued banking licence. Others pointed to the presence of several banks with expertise of restructuring distressed assets among the bidders and said that this was a back-door entry for foreign asset reconstruction companies.

Each of these justifications held elements of truth. But, in the final analysis, these reasons were clearly not good enough to take the market capitalization of IFCI beyond that of big, well-capitalized, well run and profitable public sector banks with their widespread branch networks and large deposit base. Especially considering that its net worth was positive chiefly because of the creation of a deferred tax asset, a revaluation reserve and grants received from the government. There was also no clarity on whether IFCI would be allowed to be converted into a bank, or allowed to sell its real estate or what would happen to its staff. Also, while the company may have assets that can be unlocked, its new businesses would have had to be built from scratch.

Kingfisher and Deccan

It’s interesting that shares of Deccan Aviation Ltd have corrected by 12% in the past two trading sessions, especially after the confirmation late Wednesday that it would be going ahead with the merger with Kingfisher Airlines Ltd. Deccan shares had more than doubled in a month’s time on rumours of the merger and the expectation of value accretion for its shareholders.

While there is substantial merit in the case for a merger, the correction in Deccan’s shares in the past two days clearly shows that market expectations had run too far ahead of fundamentals. But even after the correction, Deccan trades at a market capitalization/sales multiple of about two times based on annualized revenues for the first half of the current fiscal year, more than double the valuation of Jet Airways Ltd.

For perspective, a number of leading airline analysts find Jet Airways expensive at current valuations. Needless to say, Deccan trades at highly expensive valuations.

The companies are yet to announce a swap ratio for the merger, but it’s reasonable to assume that it may not be heavily tilted in favour of Deccan shareholders. According to reports, Kingfisher would turn profitable this quarter, which would help its case for a higher valuation. Its revenues, too, are higher than that of Deccan Aviation. In that case, Deccan shareholders are likely to be disappointed with the swap ratio, and there could be a further correction in its shares. Unless the market believes that the Kingfisher-Deccan combine deserves a much higher valuation than the Jet-JetLite combination.

While there are significant benefits from the merger, such as route rationalization and other cost-cutting opportunities, analysts say that it isn’t enough to assume that Kingfisher-Deccan’s profitability would be much higher than Jet’s.

Meanwhile, oil prices remain high, posing a serious threat to airline operators. And though the rate of fleet addition has slowed, capacity continues to be high in the country, resulting in low yields. Once the markets’ euphoria over the merger cools, valuations of Indian airline companies could correct and reflect such underlying concerns.

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