The meltdown

NO DRAMA. NO suspense. No excitement. The beginning of the meltdown in the power sector was surprisingly prosaic. In fact, it actually seems a bit boring. But like any good story, Lanco Infratech’s fall from grace gets more dramatic as more facts are uncovered. We still don’t know how it will end. Hint: There’s a good ending and a bad one.

L. Madhusudhan Rao, executive chairman of Lanco, hardly looks a hothead, and is generally balanced in his approach. He and his team refused to comment on this story, though he has met and spoken to Fortune India earlier. But on June 14, we are told he minced no words at a meeting with Finance Minister P. Chidambaram. A high-ranking executive of a rival power company, who was at the meeting in Hyderabad, says Rao was scathing in his criticism of the government, and what he called its flawed energy policy and regulations.

The meeting was part of a series of interactions between the finance minister, power companies, and banks. The agenda: reviving investor interest in the power sector, and importantly, reviewing the status of 138 stalled projects. These projects involve an outlay of Rs 7 lakh crore, and government, banks, and industry are afraid that the amount at stake will only go up.

In a note to the Cabinet committee on investment after these meetings, the government made its position clear: “Any delay in implementing infrastructure projects would also make the exposure [loans] of banks and financial institutions as non-performing assets (NPAs), halting the cycle of lending by these institutions, which would further depress the growth rate of GDP.” Representatives of the power companies complained that the government was one of the main reasons for the stalled projects—environment and forest clearances were pending; state electricity boards (SEBs) hadn’t paid dues; electricity regulatory authorities were refusing to hike tariffs; delays in land acquisition; as well as infrastructure problems such as unavailability of roads and ports.

Chidambaram and his team evidently took note of these complaints. Its communication to the committee asks government departments “to take immediate action and remove all bottlenecks so that the infrastructure projects which are stalled due to various reasons could be expeditiously implemented”. At the same time, the executive at the meeting says, Chidambaram didn’t let Rao off lightly. He pointed out that Lanco was equally responsible for its problems, and could not blame the government entirely.

ONE OF THE newest words to enter the Oxford Dictionaries Online is “omnishambles”. The definition: “A situation that has been comprehensively mismanaged, characterised by a string of blunders and miscalculations.” It’s easy to say that Lanco has made an omnishambles of its power ventures, what with aggressive bidding for projects it now finds it cannot complete, bad calls on due diligence, expensive acquisitions... The string of misadventures has brought this once promising company to the brink of disaster. To be fair, Lanco is not alone, and other power companies are also hit.

The current crisis has its roots in the Electricity Act, 2003, which allowed the private sector to set up power generation plants. To encourage companies, the government eased funding norms, and a 16% return on equity was promised to plants with 80% capacity utilisation. SEBs, which signed up to buy power, were willing to pay anything from Rs 4 to Rs 6 per unit, while production cost was around Rs 2 per unit. Coal India assured these plants that it would supply 90% to 100% of their fuel needs, and was ready to sign fuel supply agreements (FSAs) for 25 years. Private players rushed into the space, scenting easy money. Hindsight shows that it was too good to be true.

The gold rush proved too much for Coal India to handle, and by 2011, it was able to supply only 65% of plants’ fuel needs. Since it is a government body, private players are unwilling to take it to court. Meanwhile, they had to honour the power purchase agreements signed with the SEBs, and were forced to import coal since domestic supply in the open market was insufficient and inefficient. Power generators wanted the SEBs to pay the increased fuel price, which they could do earlier under the ‘cost plus tariff’ structure (variable costs would be met by the buyer). In fact, when the SEBs refused to pay the higher variable costs, some private players, including GMR, Lanco, and Indiabulls, began cancelling contracts like those in Chhattisgarh.

Meanwhile, the SEBs complained of poor financial health, and claimed to be unable to pay higher prices per unit of power. In a recent statement, Lanco admitted that it was yet to receive Rs 3,285 crore from the Uttar Pradesh and Karnataka SEBs, both of which are now cash strapped. Lanco can do very little to recover its dues from the SEBs, says the head of an infrastructure consultancy, not wanting to be identified. It can only appeal to the finance department of the state governments, since only states stand guarantor for the SEBs. “You really can’t hang the chief minister of a state for non-payment of dues, can you?” he says in jest.

But when companies were bidding for power projects, they did not know that the government bodies (Coal India, SEBs) would renege on written agreements. At the time of bidding, it still seemed that power was an easy way to big money. So private players bid aggressively, offering power at ridiculously low rates, assuming they would be able to produce it far cheaper. And that’s where things went south.

Lanco was one of the most aggressive bidders. An official from a competitor, who asked not to be named, says: “They [Lanco] believed they could [bid aggressively] because they had the necessary political connections.” He’s referring to Rao’s elder brother, L. Rajagopal, a second-time Congress member of Parliament from Vijayawada, Andhra Pradesh, who’s credited with transforming Lanco from a small construction firm to an infrastructure major.

For India’s first ultra mega power project—a 4,000 MW thermal power plant at Sasan, Madhya Pradesh—Lanco quoted Rs 1.19 per unit of power. This undercut even heavyweight Reliance Energy’s quote of Rs 1.29. Rahul Prithiani, director, industry research at rating agency Crisil, says: “Companies that bid for tariffs below Rs 2.9 per unit run a high risk of turning unviable.”

A former Lanco employee who had been associated with the Sasan project, disagrees. By law, he says, these plants would get captive mines to ensure access to fuel. Any excess coal, after feeding the power plant, could be sold to Coal India. He says the captive mine at Sasan would have given Lanco more than 200 million tonnes to sell. Except that Lanco lost that project. It had bid for Sasan in collaboration with Globeleq Singapore, an arm of multinational power producer Globeleq. News reports claimed that Lanco’s bid was disqualified by the group of ministers overseeing power projects, who alleged that Lanco had inflated Globeleq Singapore’s financials. The project went to Reliance Energy.

It’s not just thermal plants that are in trouble. Uncertainty over the availability of gas from Reliance’s D6 Krishna-Godavari (KG) basin means that Lanco’s 366 MW and 732 MW Kondapalli II and III plants in Andhra Pradesh, respectively, have been hit. Some experts reckon that Reliance’s production at D6 has fallen because of geological complications. “We went ahead because we were assured of gas from the KG basin. Kondapalli II was operational in 2000 and work began on Kondapalli III in 2009, when gas availability was clearly not an issue. Reliance had given a commitment that it would provide 80 million standard cubic feet a day by 2010 and we took their word,” says a former staffer. He adds that Lanco assumed that a verbal promise made to the group of ministers was binding.

Meanwhile, Lanco’s ambitious plans to set up solar power plants—from making photovoltaic cells to setting up solar farms—are also grounded. One of the reasons is, of course, the lack of funds. Also, the manufacturing of silicon ingots and polysilicon is unlikely to be profitable because the domestic and international markets are flooded with cheap Chinese products.

OTHER PRIVATE POWER players are also hit hard for the same reasons, but Lanco is in the unenviable position of being among the worst affected, because pretty much all its assets are energy linked. Peers GMR and GVK have interests in fields unrelated to energy; both are successful airport developers, for one. Adani Power, which also has significant debt, is hedged by Adani’s exposure to the ports and transportation businesses. Compare this with Lanco, which has close to 95% of revenues coming from its gas- and coal-based power projects and the engineering, procurement, and construction (EPC) division. This division—which focusses on in-house projects—has reported a 46% fall in revenue in FY13 to Rs 5,382 crore, and no addition in its order books, while three of its six operating power projects have declared losses. Lanco’s financiers are rattled because the company may not be able to pay off its debts—Rs 33,980 crore as on March 31, just on India operations. Lanco’s adjusted net worth has fallen to Rs 6,122.7 crore (from Rs 7,170 crore in FY12), and its debt-equity ratio has risen to 7.3:1, indicating that it is highly leveraged.

Banks fear that Lanco, India’s biggest power company by installed capacity, could default on current liabilities of Rs 2,603.7 crore, and Rs 5,372.5 crore of long-term loans maturing in the next 12 months. The only hope of repayment is if the company gets the Rs 3,285 crore that the SEBs owe it. That, or it has to find new sources of funds, which bankers privately admit is an extremely difficult task.

Lanco knows that it’s not going to be able to repay its lenders. Last month, when the company announced its first quarter results of FY14, gross revenue had fallen 28%
from the corresponding quarter of FY13, net losses were at Rs 579 crore, and debt added up to Rs 33,980 crore.

The company has tried to cut costs by pruning its workforce by 2,204 between 2012 and 2013 and selling off a few assets like its wind and energy assets in Tirunelveli (Tamil Nadu) for Rs 42 crore. That’s evidently not enough, since the company has not been able to pay salaries on time; two-month delays are the norm at Lanco. Finally, prodded by a consortium of lenders, led by Indian Bank, Lanco entered a CDR scheme. Details of the scheme have not been made public yet, but reports suggest that if Lanco has negotiated a reduction of even 1%, it could save up to Rs 90 crore a year. Like Lanco, the banks involved refused to comment.

THINGS ARE IN worse shape for Lanco internationally, where one of the company’s most expensive acquisitions turned sour almost before the ink had dried on the agreement. In December 2010, Lanco announced its acquisition of Griffin Coal, one of the largest coal mines in Western Australia, for A$750 million (Rs 4,270 crore at current rates). The location (closer to India than mines in New South Wales or Queensland) and huge reserves made strategic sense. “Production from the mine (with reserves of 1.1 billion tonnes) can be easily ramped up from the current 3 million tonnes per annum to over 15 million tonnes per annum in the near term, with some investment in mines and the infrastructure,” said a press release then.

Instead, the Griffin acquisition may well go down in business history as a classic result of unsatisfactory due diligence. Griffin Coal was already bankrupt. Also, it had signed a long-term contract to supply 2.8 tonnes of coal a year at a fixed price to Bluewaters Power Station (an arm of Perdaman Chemicals and Fertilisers). Lanco officials realised, just a little too late, that a long-term contract meant the company could not profit from rising coal prices.

Lanco asked for a renegotiation of the contract with Bluewaters, doubling the price of coal. Perdaman filed a lawsuit (for A$3.5 billion) against Lanco, alleging non-compliance with the coal supply pact. Back home, Lanco’s share price fell by 10% in one day on news of the suit.

The premier of Western Australia, Colin Barnett, called Rao to Perth and turned the pressure on, saying that if Lanco failed to honour the contract, it would damage the reputation of all Indian businesses in Australia. Since Barnett had the power to reject Lanco’s bid for an export licence or to block infrastructure approvals, Rao gave in. The courts had not yet ruled on the Perdaman case, so Rao pinned his hopes on a verdict in Lanco’s favour.

In December 2012, the Supreme Court of Western Australia allowed Griffin to revise the coal supply pact with Bluewaters. Though this meant that Lanco would gain some A$150 million, the time wasted in litigation has cost it. Unable to raise production, Griffin reported an operating loss of Rs 97 crore and a net loss of Rs 391.2 crore in FY13. Experts who track the energy sector don’t believe the recent guidance that Griffin will break even at Ebitda level by 2014, when its production touches 5 million tonnes. “We believe Griffin’s expansion beyond 5 million tonnes will take longer than earlier expected, given the lack of adequate cash generation both in Griffin mines and in the India business,” says a Morgan Stanley report.

Also, says a Mumbai-based fund manager, owning overseas mines no longer makes economic sense because Europe and the U.S. have shifted to shale gas. Meanwhile, he says, China and Indonesia will flood the market with cheap coal. “Debt-fuelled power companies such as Lanco and GVK, which have overseas mines, will be the worst hit because cheaper coal will be available at home,” he says.

THE BAD NEWS seems never ending, as most brokers have a “sell” rating on the stock. “I can’t even advise that today,” says a Delhi-based broker, explaining that investors who bought the stock when it was close to its high of Rs 72 in September 2010, would have paid more as brokerage than they will get by selling now at Rs 5 levels. (In April 2008, Lanco’s market cap was a little over Rs 10,900 crore; today, it’s Rs 1,233.16 crore.) Jagannadham Thunuguntla, strategist and head of research at SMC Global Securities, warns against buying Lanco just because the price has fallen. “It can go lower,” he says, adding that it’s unlikely to hit any highs in the future.

Rajiv Kumar, professor at the Centre for Policy Research, a New Delhi-based think tank, says most of Lanco’s assets have become unproductive and there is no defined revenue stream. Jitender Balakrishnan, former deputy managing director of IDBI Bank, adds that Indian banks do not understand the “time value of money”. Banks in the U.S., he says, will take a cut and declare a company bankrupt, but here they would want 100% of the money and continue with a losing enterprise. One of the big reasons is that if banks let Lanco fall, it will be seen as an NPA on the banks’ books, which means that the banks will have to make full provisioning for that asset. Hence, banks continue to categorise them as distressed assets although the provisioning for these assets will have to be increased from 2.75% to 5% under the new RBI guidelines.

Some analysts say this could lead to the unhealthy practice of evergreening, or providing a fresh loan to allow a company to repay an old one. “Why didn’t the banks and other financial institutions, with all their boards, risk assessment committees, and project assessment panels stop lending when the debt was still around Rs 15,000 crore? Why did they allow it to bloat to Rs 35,000 crore?” asks a Mumbai-based analyst who tracks the power sector.

Banks differ. “You cannot compare today’s situation with three or four years ago when interest rates were 8% to 9%, compared with nearly 14% now, and the sector was booming,” says Balakrishnan. But he adds that maybe the banks got greedy to meet their targets. The government, adds an ex-Lanco staffer, is as responsible. “The government’s apathy towards the sector, unwillingness to keep its promise on fuel linkages and raising tariffs, and the inability to pay generation companies on time have led to this mess,” he says.

But the blame game can be endless. To solve the problem, a Delhi-based analyst who tracks the power sector, says Lanco will need to find strategic investors or pare debts. That’s far easier said than done. Its existing financiers are unwilling to fund an overleveraged company. “It may be easier to sell its international assets as they are more credible assets,” says the head of the infrastructure consultancy.

Sources say Lanco will play a waiting game till 2015 when it expects the economy to revive. Meanwhile, the Cabinet has approved a proposal to allow power companies to pass on the higher cost of imported coal to consumers, and the electricity regulator to hike tariffs. It has also announced a one-time restructuring of SEBs’ debts.

It’s difficult to say what Rao will do now. His reputation is that of being a survivor; old-timers at Lanco talk of how he survived a helicopter crash in 1991, and walked several kilometres to attend a meeting. The general feeling is that if the boss could come through what later killed an Andhra Pradesh chief minister, there’s no reason why he can’t find a way out of this crisis. It’s difficult to know if the company can stay afloat, but for now, Lanco’s staff are keeping faith in Rao’s ability to survive.