For a very long time, people were raising concerns about high leverage in Adani group companies. The debate had multiple layers ranging from imminent bankruptcy to Gautam Adani fleeing the country like Vijay Mallya and Nirav Modi. The other angle was whether Adani group companies were in a position to service the interest and debt with the operating cash flows of the companies. The investors in the companies, financial analysts, etc had observed this for a long time. Those who were positive about the stocks had factored this risk in the valuations. Those who were not comfortable with this high leverage, were negative about the stock. The Hindenburg Research report has also highlighted the similar concern about high leverage and the risk it carries.
In financial management and financial analysis, capital structure is one of the most critical factors. Returns that the company delivers on its equity capital or net worth depend on three factors: (a) returns that it generates on its total capital employed, (b) the extent of dependence on debt in total capital, and (c) the cost of debt. Till the cost of debt is less than the return on capital employed, it is always attractive for the company and its promoters to borrow more. The reason is simple. On a lesser equity base, the company and its promoters are able to earn a higher return on net worth. Thus, it is always extremely attractive for any entrepreneur to increase leverage in order to improve his returns on net worth. Although, higher leverage comes with commensurate increase in risk for all—the company, the lenders, and the equity shareholders. In a good cycle, there is no issue. However, in a bad cycle, when revenues fall and operating margins shrink, the ability of a borrower to service interest and repay debt becomes difficult.
This is where the risk appetite of the promoters comes into play. Promoters with high risk appetite tend to opt for higher leverage, and vice versa. The other factor that has a huge bearing on leverage is the sector in which the company operates. Traditionally, highly capital intensive sectors with long term sustainable revenues tend to rely on higher leverage. Sectors like infrastructure—be it ports, airports, power plants, etc, hotels, hospitals, shipping, etc—are eligible for higher leverage than other sectors. This is because the one time investment keeps generating revenues for a very long time. In case of Adani, not only Hindenburg, but also overseas bond holders felt concerned over the ability to Adani group companies to service interest and debt. This is the reason Adani group’s bonds crashed in the US markets. These bonds are held by global institutional investors. A global financial and markets media organisation reported that Adani group’s bonds crashed amid fears of a bankruptcy akin to Evergrande. After the initial crash, the bond holders realised that the fears were exaggerated and unwarranted. This resulted in bonds rebounding from the bottom. Amid all kinds of rumours about Adani’s possible or plausible bankruptcy and its comparison with Evergrande, it is imperative to understand the business model and revenue streams of Adani group companies visa-vis Evergrande. Evergrande borrowed money to build real estate inventory and could pay interest and repay principal amount to the bond holders only after selling that inventory. With slowdown in Chinese economy and in turn real estate market, it had become extremely difficult for Evergrande to sell its inventory. This resulted in default by the company. Against that, Adani group firms have a steady revenue. Adani operates in broadly three categories. First is regulated business, i.e. power generation and transmission. Second is cement and edible oil. Third is infrastructure assets like ports and airports. In the situation that has arisen, there are no possibilities of any divisions of Adani losing business. People will continue flying and airports will continue earning money. Ships will continue to come for unloading and loading cargo, ensuring ports’ revenues are not hurt. People will continue to consume electricity, driving revenues of power companies. Cement demand will not get hurt due to the ongoing controversy that Adani is embroiled in. Same is the case with coal and edible oil. To sum up, the current crisis created due to the Hindenburg Research report doesn’t have any impact on the business, revenues, and profitability of Adani group companies.
Sumeet Mehta is a Chartered Accountant by qualification and a Corporate Finance professional. He is author of the book “Diagnosing GST for Doctors” published by CNBC Books18. He tweets from @sumeetnmehta. This is the third and last part of this series. Opinions of the author are his own and personal.
