Brokelyn Ltd: Anatomy of a debt trap

“And they are broke! They are broke! They don’t have a negative cashflow position. They are f***ing broke!”

George Carlin’s voice echoed in my drawing room. He was poking fun at the use of euphemisms in English[1]. I love George Carlin. He i considered the greatest standup comedian ever. A perfect start for my Saturday morning when sun rises at a perfect time. Sometime after 11!

But wait a minute. I was in no mood to waste even one plank energy of my brain cells worrying about problems of financial world. But as luck would have it, I found myself thinking about the bunch of companies, which had admirable businesses growing at steady pace. And suddenly they are broke.

This is a grim story of a company which had no reason to get into the quagmire it has found itself in. As the new millennium arrived, Brokelyn Ltd, had manageable level of debt. It had debt of 800 Crs and networth of 1200 Crs. It made Rs. 400 Crs of operating profit. After paying 80 crs in interest, 50 Crs depreciation and 50 crs tax, it made 220 Crs of net profit which was decent 22% of the networth.

The company was a family owned business and had been quite conservative in financing. The aging promoter gave reigns of the company to an ambitious CEO who wanted to make company’s profits soar. To help him with his pyrotechnics he hired a new CFO who was well versed with the finance wizardry to achieve the magic. They wanted to expand their business empire and to that end, they chalked out an ambitious expansion plan. The plan needed additional cash for the job so decided to rely exclusively on debt. The interest on the debt was a drag on the profits which ensured that while the revenues grew, the net profits grew at a pace too slow for the linking of the CEO. By March 2004, the profits were 280 Crs after interest payment of Rs 200 Crs.

Immediately after FY04 results the CFO hatched a new plan. The RBI had allowed the companies to borrow from external markets. The risk appetite of the foreign investors had gone so high that they were willing to give dollar denominated loans to emerging market companies at very little premium over LIBOR. It was the time when banks were busy doling out mortgages people with no income, no job and no asset except the house they owned. Those were the days of easy money, at times, almost free money.

The company raised 1200 crs from Foreign Current Convertible bonds denominated in dollars. These were zero coupon bonds sold at par with yield to maturity of 7%. The bond holder had an option to convert the price into stock at a price of 252 Rs, 50% above ruling price of Rs 168. If he doesn’t convert into equity he will get all the 5 years cumulative interest at the time of redeeming the bonds.

The beauty of the scheme was that they had to show no interest in their profit loss account. In a zero coupon bond there is no periodic interest payment. You pay the accumulated interest only at time of maturity.

But what would happen at the end of 5 years? One of the 3 things:
The bond is a convertible bond. Assuming the stock price rises above Rs. 252, the bond holders would convert into equity. So there will be no debt repayment
If the stock price fails to rise, you can always take more debt to repay this debt issue. After all, the world was awash with liquidity.
The company is earning a healthy 17% on the capital. In 5 years, it would have made enough money to pay back the debt from internal accruals.

Sounds nice …like all the smart plans that lead to horrible disasters.

When you take foreign currently loans you get it cheaper than domestic loans but the depreciation of rupee against dollar adds to the interest. However, Brokelyn Ltd was lucky. In March 2007, the dollar was quoting at a rate little less than the exchange rate of March 2004. The company added 1000 Crs more in debt to its books and showed ONLY 90Crs in interest on loans of 3000Crs. Why? Because it didn’t have to pay interest till March 2009!

The company was not doing anything illegal. It was not even cooking the books. The accumulated unpaid interest was disclosed as contingent liability. Had they not done it so aggressively, it would have been a good hedge against the impact on dollar revenues.

The company noted in its annual report
The payment of premium on redemption is contingent in nature, the outcome of which is dependant on uncertain, future events. Hence, no provision is considered in the accounts in respect of such premium.

The auditors gave remark:
without qualifying our opinion, we draw attention to Note 3(g) and Note 3(h) of Schedule 22 to the financial statements. Management is of the view that the liability to pay premium on redemption if any, of Foreign Currency Convertible Bonds is contingent. As the ultimate outcome of the matter cannot be presently determined, no provision has been made for liability if any, that may arise on resolution of the contingency;

The next year, Brokelyn Ltd they got even luckier. Dollar hit a low of Rs 40 in March 2008. This made the company’s dollar liability go down and the difference was shown in the profit loss statement. The company’s business was also doing well. The operating profits rose to 800 crs and net profit rose to 555 Crs. The stock jumped from Rs 100 to Rs. 416.

I’m amazed how our accounting laws permit such things. A firm puts more than half of its capital in form of debt and shows no cost! Aren’t they creating incentives for companies to use unstable corporate structures to jack up the disclosed income?

Anyways, the good days of Brokelyn Ltd. didn’t last forever. In 2008, the falling dollar reversed the trend and hit a high of 49.77 on Oct 24th. In a matter of 6 months, all the calculations went for a toss. The crisis hit the global financial systems and creditors grew wary of lending. The tight liquidity caused the interest rates to shoot up. With many big banks going down under, the risk premiums shot up. Brokelyn Ltd was trapped.

Apart from the adverse business scenario, the same factors that artificially propped the reported profits , started acting in reverse. The rising dollar increased the rupee value of the debt which had to be disclosed as exchange loss.

Now lets take a tour of the future.
March 2009. The company reports 76Crs loss due to Rs 406 crore exchange loss. The market punishes this performance and beats the stock falls 75% to Rs 100. The fall in stock price makes the conversion option associated with bond, worthless. At the time of redemption the creditors have to be paid accumulated interest at a rate of 7% p.a.

The total liability of the loans taken in two tranches, 1200 Crs in 2004, 1000Crs in 2007 works out to Rs 3346 Crs after taking into account the rupee depreciation and the accumulated interest. The company has a networth of 2196 Crs. On top of this they have 800 Crs of domestic loans.

Who will refinance them for a loan twice their networth? The credit markets are still tight. There is little hope for raising capital through the equity market. What would the company do?

Luckily the company is still making good money at operating level. In early 2010, Brokelyn Ltd uses little breather from bear markets to raise fresh capital. But it pays a hefty price. It dilutes the equity by 33%, to raise mere 400 Crs from market. For a company with 400Crs operating profits in 2001, this is really bad.

In March 2010, the company reports exceptional item of exchange loss and accumulated interest on bonds totaling 915 Crs. On top of that the company pays hefty 14% on its refinanced loans of Rs 3000 Crs. All this results in a reported loss of 715 Crs

In 2010, the company with operating profits of Rs 800 Crs is selling at Rs 1500 Crs. Why? The company’s debt to equity ratio stands at 1.8. Its interest coverage is mere 1.9.
This sets the rating of the debt issued by company to junk and when senior securities are in junk category, the stock can’t be expected to be rated high.

Do you own stocks of Brokelyn Ltd? No?? If you are invested in stocks or mutual funds, there are chances that you do. Brokelyn Ltd is a fictitious name which represents all the companies that have found themselves in a debt trap.

These companies, as to today, are still in business. They are hoping desperately that the rupee will rise against dollar. They are hoping that someone will issue them new loans to repay existing ones. They don’t show the interest that’s accumulating on their debt issues.
The report huge exchange losses and derivative losses as exception items. As the debt repayment comes calling, these companies will disclose huge negative cashflows.

George Carlin wasn’t an expert in finance, but he was right.

“They don’t have a negative cashflow position.
They are broke! They are f***ing broke!”

References -

  1. George Carlkin on Soft Language view
  2. Broklyn Ltd - Snapshot of accounts

Operating profit400500650800600800
Exchange Loss-14-175406915
Profit Before Tax270230474735-76-747.34
Net profit202.5170354555-76-747.34
Market Cap3037.520407080832520001500
Interest Coverage5.
Book Value60.075.090.0113.6109.866.1
Contingent Liability0.00.0270.1443.0628.00.0

3. Broklyn Ltd - profits


Anonymous said...

This reminds of Aurobindo Pharma. Cuurently it is on top list of FCCBs going at deep discount. This company was discussed in very positive light on our user group. What went wrong other than FCCB?

Kamlesh Pandey said...

The tragedy of Broklyn was that its operating business continued to do well but that couldn't save the company.

Aurobindo Pharma is one of many companies which may enact Broklyn Story in next few years. At La Warren Buffett we did discuss this and I had been warning about the level of debt in its books since 2007.

You can read my post on Dec 2, 2007

Adjusting for actual finance cost

and on Apr 9, 2008
Drawing attention to Value: Aurobindo Pharma

But I must warn here that when i wrote about Broklyn, Aurobindo was not the only example in my mind. I have specifically chosen this name to ensure that people don't ignore this thinking "Oh! this is about XYZ company and I'm safe because I don't own its stock"

Broklyn stands for more than 25 companies from ET 500 list. You can do the search yourself by sorting these companies based on debt/equity and interest coverage ratios.


Anonymous said...

But do you think that Aurobindo Pharma has the wherewhithal and the intent to meet the debt burden?
Also, what happens if the dollar depriciates from these levels?

Kamlesh Pandey said...

Intent is irrelevant because they don't have the wherewithal to repay loans. The depreciation of dollar will of course relieve the pain and if that happens and the company manages to keep its cashflows from operations growing, they might pull back from their dire straits. Blog Search Engine blog catalog EatonWeb Blog Directory Bloggapedia, Blog Directory - Find It! Blog Directory Directory of Investing Blogs Blog Listings Superblog Directory