Coal India: Inside the behemoth

Euromoney, December 2010

It is the very definition of a behemoth: the headcount of a decent-sized western city, an affiliation of nine companies, covering 471 separate coal mines. It faces 4,000 different law suits, powerful unions, and the threat of Maoist rebels around many of its mines. Yet when the books closed on October 21, Coal India became the largest IPO in India’s history, in a $3.46 billion deal that shot up 40% on its first day of trading and attracted US$52.5 billion of demand – most of it international.

How did this happen? The reasons stem from what one banker calls a “perfect storm” of circumstances: thirst for emerging markets, even more thirst for resource companies, buoyant markets and a company which, unlike many other state-owned leviathans around the world, proved both well run and able to communicate its story worldwide.

See also: Coal India Fees Go Up In Smoke here:  https://www.chriswrightmedia.com/euromoney-coal-india-fees-go-up-in-smoke/

But when 16 shortlisted investment banks filed into the offices of the Ministry of Finance’s Department of Disinvestment in New Delhi for pitch meetings in early May, it was not obvious that the deal would be such a runaway success. A previous state sell-down, a US$2 billion follow-on for mining company NMDC in March, had barely got across the line, ignored by both international institutions and local retail and only saved by domestic institutions – at the bottom of the range. It had swiftly traded down upon launch. It was not what the government, amid a galvanized program of divestments intended to generate wealth creation among ordinary Indians and tackle the budget deficit, had had in mind. And the omens for Coal India looked scarcely better: as the banks went through their pitches, European sovereigns appeared on the edge of default, and a second round of the financial crisis looked likely.

Still, the six mandated bookrunners were sufficiently enthused about the prospects of the float that they accepted a resplendently absurd fee of 0.000001% of the deal proceeds to be on the deal (see separate article).  They did so because Coal India represented something extraordinary: the largest coal mining company in the world, with the largest reserves, and a global leader in its sector. “One of the most significant things was not that it was the largest IPO out of India, but the largest company in its sector in the world out of India,” says Saurabh Sonthalia, managing director and head of capital markets at DSP Merrill Lynch. “We haven’t seen that before.”

So the six swallowed the cost – including a host of additional burdens lumped on them by the government, including document printing costs – and set about dividing up leadership for the tasks ahead. Citi, which bid lowest, was given the job of leading the prospectus (“it’s traditional that the lowest bidder gets that job, in return for causing us all so much pain,” says one banker, half joking, at most); Deutsche developed investor presentations; Morgan Stanley books settlement; Merrill set up the roadshows; Kotak Mahindra covered approvals; and Enam Securities led retail marketing.

Three different parties were involved in the sale: Coal India itself, headed by chairman Partha Bhattacharyya (see box for interview); the Department of Disinvestment, headed by Secretary Sumit Bose; and Ministry of Coal, headed by Minister Sriprakash Jasiwal. While Bhattacharyaa, who famously knows everything it is possible to know about Coal India, was the repository of all information on the sector and the company, Bose and his team had the clearest sense of what the deal needed to achieve for the country.

“The idea of the disinvestment program basically revolves around people’s ownership,” Bose says. It intends to get all profitable unlisted companies on to the market, and to increase the free floats of those with historically thin listings up to 10%, as well as other follow-on raisings. Doing so should trim the deficit and fund infrastructure, but that’s only part of the goal. “In all of this retail is very important,” he says. “Our budget estimates for the fiscal year are abut Rs40,000 crore [US$8.9 billion] and 15,000 of that has come from Coal India, so it was important in that context, but also in broad basing the ownership of companies to the people, giving them a chance to buy the shares.”

So the department sent its banks on the road with a clear mandate: make this deal work for everyone, get retail in, and get the price right. Another poorly performing deal could have been catastrophic for the state: if institutions and retail were disappointed in this deal as well as previous ones, there would be no way of coaxing them back in for vital subsequent deals like the forthcoming raising by Indian Oil Corporation. “You can stretch valuations and still get the deal done, but give a reasonably priced deal to the market and it will serve you well for the entire disinvestment program,” says Ravi Kapoor, managing director and head of global banking for India at Citi.

There were a few procedural matters to deal with, particularly around the powerful unions, before work started in earnest. For example, in Indian IPOs shares can only be reserved for employees in the company that is being listed, not subsidiaries, whereas in Coal India all the employees are in the eight subsidiaries and none in the holding company that was being listed. An exemption had to be sought from the Securities and Exchange Board of India – which was uncommonly swift and accommodating throughout.

Other questions and challenges were swiftly pre-empted. The certifier of coal reserves in India was not one that was widely known outside, so a new reserve engineer was appointed; the sprawling accounts of eight subsidiaries were brought into a palatable form that international investors would be happy with; and the fabulous amount of outstanding litigation – there are 4,066 separate cases mentioned in the prospectus, plus about 9,000 land cases and service matters – categorized and sorted in a 61-page chunk of the prospectus. (That prospectus, incidentally, was completed in 60 days, considered something of a record given its complexity.) “The idea was to get them prepared and up to speed in terms of what it takes to do an IPO,” says Kapoor. “No restructuring was needed, we just needed to make sure the story was correctly articulated.”

The toughest part was collating the sheer scale of the enterprise into one document. As one bookrunner puts it: “It’s not easy to do due diligence on 471 mines.”

As the banks hit the road, first in informal pre-marketing with their clients through July and then on a global roadshow with the company in August, it would quickly become clear that demand was not going to be a problem. But there were a lot of questions to answer. Some were about pricing and margins: why does Coal India sell coal at about a 50% discount to international peers? Others were about the company’s vast cash holdings: US$8.4 billion on the balance sheet. Still others were environmental. The government has declared certain areas of coal reserves no-go because of dense forestry above them; through the marketing process, it was still not clear how much of the reserves would be covered by this restriction, with numbers cited from 10 to 40%. Indeed, that’s still not clear.

If that wasn’t enough, by August questions started arising about Maoist rebels. Many areas in which Coal India operates mines – including much of the untapped reserves that support future growth – are in areas with Maoist populations, and prone to strike action, if not violence.

But for every question, Bhattacharyya had an answer that was equal to it. “He is very articulate,” says Sonthalia. “He has been with the company all his life. He knows every aspect of it intimately and never needs to consult notes.” Washeries would be introduced to improve coal quality and boost margins, he said. Environmental issues were not a problem because the company had a track record of returning more forestry to the government than it took away in mining, he said. Maoist communities like us because we give them jobs and schools: when they strike, they don’t hit the mines, he said.

The fact that the strikes do hit the transportation that moves the coal from the mines was ignored; the fervour for the deal was so strong by now, and international investors so enthralled by the story of the company, the country and the sector, that it was clearly unstoppable by the end of the pre-deal roadshow.

Indeed, by the time the company was readying to get on the formal roadshow in October, there was a new problem: too much demand. For the previous year, most Indian deals had included an anchor tranche, and the prospect of one in Coal India had institutions clamouring to be involved. “Nobody said no to the anchor tranche,” says one bookrunner. “There were a couple of sovereign wealth funds, almost all of the top 10 long-only funds globally, and at least eight of the top 15 hedge funds globally. Everybody wanted to be an anchor.” It is understood that the Government of Singapore Investment Corporation and Norges Bank were among them.

And then the government axed that tranche.

“What does an anchor tranche do?” asks Sanjay Sharma, managing director, equity capital markets at Deutsche Bank in Mumbai. “It allows you to allocate stock to sensible investors you want to lock in, and it gives you an early indication of value. But in this case demand was very clear and people were indicating what their valuation intentions were upfront. So from marketing perspective it wasn’t required.”

More than that, the government didn’t like the way it looked. With all of its ambitions about broadening the ownership base to the people, it didn’t want to be guaranteeing allocation to some distant pension fund while clawing back allocations to its own retail base.

There was another reason, too: practically speaking, it looked near impossible to get the anchor tranche properly signed off in the timeframe that regulations require. “An anchor tranche opens and closes on the same day and allocations have to be announced almost immediately,” says Sharma. Realistically, that leaves a few hours for six banks to reach consensus and get approvals through three levels of government, the top one a senior group of ministers. It was never going to happen.

While the would-be-anchors were disappointed, they simply joined the scrum for the institutional tranche. When the books opened on October 18, they were covered in a day; the institutional book would eventually be about 25 times covered. Most significantly, more than half of the institutional demand was from overseas.

This was quite something given the headwinds that they had to overcome to get in at all. Coal India was the first big equity deal to be done under a new rule from SEBI. Previously, retail and HNI (a sort of high net worth category) investors had to provide 100% margin, meaning that whatever they bid for, they had to provide the full amount of cash in advance, even if they were clearly going to end up being scaled back in final allocation. Institutions had got away with a 10% requirement, but with Coal India, they were asked to pledge 100% as well. Since it was evident early on that all would be scaled back, most institutions made very heavy bids, and had to shift the full amount of cash into India. That created a foreign exchange risk that is neither easy nor cheap to hedge, as well as taking out of action a huge amount of capital that was never used: for all the money they sent, institutions only got 4% of it to go into the deal, and then had to remit the other 96% back home again. “Lots of investors have written to us saying it cost them 30 to 35 rupees per share just to hedge the currency, bring it in and take it out,” says S Subramanian, managing director of investment banking at Enam Securities.

There was still the crucial retail bid to get over the line. But that worked too. Bose says there were 1.8 million applications. If you’ve ever seen the newspaper-sized forms that retail have to fill in to participate in a deal like this, it becomes clear what a feat this was. But retail found a connection with the stock. “If you speak to the man on the street, they will tell you Coal India is gold,” says one bookrunner. “It is the largest coal company, it has $8 billion of cash; to them, it’s like a fixed deposit investment. They can put their money in and forget it. They earn dividends and sleep peacefully at night.”

With that kind of backing, aftermarket performance was always going to be good, but the 40% first day performance surprised even the bookrunners. It has led some to conclude the deal was priced too cheaply, but those close to the deal reject that. “I would say that had we even priced it 10 or 15 rupees higher the whole thing could have got into a negative rather than a positive cycle,” says one. “It’s psychological, at the end of the day.” Having priced at a modest discount to its only obvious comparable, China Shenhua Energy, it is now at a premium.

The deal gives cause for optimism for a host of other deals that will follow it: the IPO of Manganese Ore, divestments of Hindustan Copper and the steel authority SAIL, an issue from Indian Oil Corporation that could be bigger than Coal India, and a host of others. “The knock-on effect is that India can do larger, $3 billion-plus deals,” says Sonthalia. “We have the confidence now, and a new set of investors who have woken up to the fact that India is a good story.”

Box: Bhattacharyya and the Coal India story

In the Coal India head office above a swarming, heaving Kolkata street, chairman Partha Bhattacharyya lives and breathes the company he joined as a management trainee in 1977, just two years after its foundation. There’s nothing he can’t recall about it, rattling off profit numbers from 20 years ago without resorting to notes. He has risen steadily through the ranks since the 70s, and many of the skills that were useful in presenting Coal India to the world this year were honed in difficult times decades ago. Because financially, for most of the last 35 years, Coal India was a mess.

Coal India came about as a consequence of the oil price shocks in the early 1970s. The government set up a high-powered committee to examine its energy options, and decided that coal should be given the thrust of providing energy security in the country. The coal industry at the time was growing at about 2.2% a year, whereas the country was aspiring for national growth of around 5%; it was lagging because of a lack of investment because prices were not remunerative. But the government couldn’t simply increase prices. “In those days coal was a domestic fuel, just to be used in the kitchens of houses,” Bhattacharyya says. “So it was not a socially or politically feasible alternative to increase coal prices.” The government decided the answer was to nationalize the industry and boost it with public funds, and after some restructuring Coal India was created in 1975: a holding company with five wholly-owned subsidiaries, later increased to eight.

The new company had more than 600,000 workers (compared to 400,000 today), all of them paid absurdly low wages, so as a first step the government increased wages by 80%. But since the increase was not compensated for by price revisions, it rapidly started losing money. About 40% of the equity that was pumped into the company was lost, roughly Rs25 billion. And since half of the government money was provided as long term loans, they required loan and interest repayments, which were frequently missed. The overdue liabilities eventually totaled Rs 22 billion. The company met its production targets, but at the cost of a hopeless balance sheet too weak to approach the capital markets with.

It was 1987, when he became a technical secretary to the finance director, before Bhattacharyya was in a position to see how bad things were. “It was an eye-opening experience,” he says. “Questions started coming into my mind: why are we making losses? What is it that needs to be done? We realized the losses were basically a product of the way the company was conceived and brought into being.”

Then the rules changed: the government decided to phase out budgetary support over five years from 1991. “An arm’s length concept was introduced: it was decided that you have to fend for yourself.”

The decisions made then would define the company that has proven so popular with global investors in the last few months. First, the idea of opening new loss-making mines was axed. “Financial viability has to be the cornerstone. No project will be taken up until it achieves an internal rate of return of 16% at constant prices.” Government debt servicing would be made on the due dates, with no more deferment. And the habit of shifting money from one company to another, using profits from one to meet losses or salary at another, was ended and a firewall was created between profitable and loss-making companies – a tough policy which would strike him as ironic when, having been instrumental in implementing it, he was later put in charge of one of the worst loss-makers and asked to reform it.

“This was basically a massive change of mindset,” he recalls. “The managers who were there when it was born were used to circumstances that coal has to be produced at any cost. They had the feeling: we have to do what the country wants, that is why we were born and why we are here. And to tell them the country’s demand is the country’s problem, that you and the country should not identify with each other – this was a huge task.”

But reforms like this turned the company profitable and allowed it to approach the World Bank and the Japanese Bank for International Cooperation for a US$1 billion loan, which they agreed to in 1998, although only half was taken up. With this, Coal India developed 24 world-class new projects which Bhattacharyya still sees as “like gold pieces” today. The World Bank loan would prove important for other reasons too: for example, all the projects had to have an environmental and social mitigation project (ESMP) component. These practices, too, would later prove crucial in the float, which was eventually marketed to retail on a green theme with posters of replenished forestry.

Other headwinds followed: deregulation, which came in phases from 1996 to 2000, exposed India to international quality coal, with which Coal India’s unwashed coal could not compete. “For the consumer, inconsistency of quality is a major pain. Therefore we don’t have a case for pricing it along the lines of imported coal.” To this day, Coal India sells coal at a 30% discount to international prices in most of the country, and as much as 60% in the country’s heartland.

However, because of imports, consumers are familiar with the quality and price of washed coal. “This leaves us with a corollary: a situation where if we can produce coal that is of comparable quality and consistency, there is a strong case for price convergence.” And so Coal India is entering coal washing, setting up 20 plants; by 2017, by which time the company is projected to produce 647 million tons of coal per year, 300 million of it will be washed. And although it’s more expensive per calorie of energy for the consumer, the freight costs reduce at the same time, in a country in which on average coal moves 600 kilometres by rail to get to the user. “By washing coal my margins get doubled straight away,” he says.

It is only in 2007 that this strategy was put in place; had the IPO been attempted any earlier, the story that the world investor community embraced so vigorously would simply not have existed. This disparate collection of more than 400 mines and a workforce with a higher population than Liverpool took more than 30 years to become palatable for investors, but having got there, it is not looking back. It has $8.5 billion on the balance sheet, has brought its debt to total capital ratio from 60% to 6% in eight years, and the next stage is global acquisition. “That money has to be well spent,” says Bhattacharyya, who says he wants equity stakes in coal mining companies in Australia, Indonesia, South Africa or the US, with offtake agreements better than spot prices. Three proposals are already undergoing due diligence.

It all seems some distance from multi billion rupee losses, unpaid government debts and mines that were opened with every expectation of losing money. “This kind of story,” he says, “you don’t get too many of those.”