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Report that Changed India

The 2G report by the CAG has transformed the way business is conducted in India

Three years since the Comptroller and Auditor General's (CAG) momentous report on 2G spectrum allocation, India is a country transformed. Whilst most of these transformations feel adverse at present (non-existent capex growth, rising stress in the banking system, and political confusion), the catharsis triggered by the CAG's report is for the better as it has retarded the rise of 'connected' companies.

I argue in this column that over the next two years as policy paralysis ebbs away, some of the better managed large companies such as Bharti, Idea, IDFC and L&T that have suffered over the past three years will make a comeback.

The three business models of 'connected' companies
Starting in the mid-1990s, a few (then) small road contractors figured out how to game the public contracts system to perfection. As India became more prosperous, these contractors became very large, very fast using a mix of the following business models:

The 'traditional' contractor model
: This model, which is almost as old as independent India, entails bidding for a public works or infra contract at a low rate which other bidders/contractors cannot match and then, once the contract is given, maximising the upside by either asking the government for more funds or by imposing levies on the public.

The 'resource grab' model
: This model came of age in the noughties as the burst of prosperity enjoyed by India combined with the country's weak institutional structures allowed opportunistic promoters to capture under-protected natural resources and then monetise them for personal gain. Based again on the CAG's audit reports two prime examples of such behaviour appear to be the 2G spectrum allocation and the allocation of coal blocks.

The 'capital grab' model
: Starting from 2004 onwards, as first the banks and then the stockmarket got very excited about the whole Power & Infra (P&I) 'opportunity', certain promoters realised that regardless of whether they possessed the innate abilities to put together viable infra projects, they would be able to get funding for the same on a 70:30 debt:equity basis. As a result, they underbid to win small contracts for which they availed of debt funding from banks. Those loans then formed the equity for the next (larger) project bid which then gave the promoter access to an even larger bank loan. Combined with some creative accounting (especially around AS-21, the accounting standard pertaining to 'consolidation'), these small contractors grew rapidly to show not only large balance sheets but also large P&Ls (boosted by the construction work being done for the projects won by the promoter). The easy access to debt and equity capital combined with the ability of certain promoters to bring into play the two models previously mentioned in this section meant that certain infra companies became very large, very fast over the course of the noughties.

The unravelling of the three business models
The publication of the CAG's report on 2G spectrum allocation in November 2010 changed the way India works. This report was followed-up by Supreme Court verdicts which not only cancelled all of the 2008 2G licenses but also went on to ban iron-ore mining in Goa and Karnataka. In parallel, RTI-fuelled media exposés stymied the three models once civil servants stopped signing off on files and politicians sought shelter behind committees. As a result production of natural resources either stagnated (coal) or fell sharply (iron ore and gas) and this hit downstream sectors (steel and power). Capex growth fell from 14 per cent in FY11 to 0.2 per cent in 1QFY14. Banks' stressed assets ballooned from 3.5 per cent of loans outstanding in FY08 to 9 per cent in FY13.
Now, whilst a lot of finger pointing is taking place as to who is to blame for the slowdown, many of you will be reassured to know that Ambit Capital's index of the 75 most 'connected' companies has underperformed the BSE 500 by 60 per cent since the publication of the 2G report.

The long, hard road to recovery
Whilst the outlook for the banking sector continues to be bleak due to loans given to either inexperienced or corrupt promoters, the outlines of a new regulatory construct for the P&I sectors are emerging. In the new world, the execution risk for infra contracts will stay with the government and the RoE for such contracts will be barely above the cost of capital. For example, CERC, the electricity regulator, is stating that Power Purchase Agreements signed by state electricity boards (SEBs) should henceforth give a minimum RoE of 15.5 per cent for a base level of plant utilisation. If a utility company is able to generate higher RoEs, say by running the plant at higher utilisation, it will be allowed to earn up to something like 18 per cent. Returns above 18 per cent will be taken away by the exchequer.
That said, it is unlikely that these frameworks will be finalised in the life of the current administration. Hence, India's power, infra and construction companies will have to wait for at least two years before they get to bid for contracts which would not damage them further.
Regulatory behaviour in the telecom sector is also normalising. In the telecom sector, after the CAG's audit three years ago, the intense competition unleashed by the now infamously unfair 2G spectrum allocations of 2008 is now abating thanks to: (a) the DoT's insistence since the CAG exposé on seeking high prices for spectrum; and (b) the cancelling of the 2G licenses in January 2012.
Furthermore, the TRAI chairman's statements in August in support of 3G ICR (intra circle roaming) agreements and lower spectrum pricing is the first definitive change in attitude towards the industry after a long time. Moreover, the introduction of the unified licensing regime (released in August 2013) and likely clarity over the M&A policy may help clarify longstanding grey areas in policy.
Just as importantly, Indian society is for the first time being able to hold its politicians accountable. Finally, politicians are being sentenced by the courts for age old excesses and, thanks to the Supreme Court's July 2013 verdict, stand to lose their seats post-conviction.

Buy before the market discounts specific election outcomes
Bharti is the listed telco best placed to benefit from consolidation in India given its higher ARPU (average revenue per user) footprint and hence lower susceptibility to negative elasticity in a rising tariffs scenario. Idea too will benefit from the greater pricing power which comes from consolidation and expected pick-up in data revenues. L&T's FY13 and 1QFY14 order booking growth of 25 per cent not only displays its rising competitive strength (vis-à-vis its weaker peers) in the core business but more importantly provides strong visibility on revenues. IDFC is the lender most positively exposed to the recent developments in the Power, Infra and Telecom sectors.

Saurabh Mukherjea is CEO of Institutional Equities at Ambit Capital. The views expressed here are personal.