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Institutional EYE

Commentary on Corporate Governance Issues

Deepak Fertilisers: Preying on the market price?

Deepak Fertilisers’ promoters recently let their warrants lapse but may subscribe to the company’s rights issue. The fall in the company’s stock price will enable the promoter group to increase their shareholding for the same quantum of equity infusion. Is this another case of opportunistic behaviour from promoters? The board and SEBI need to take heed of promoter behaviour and intervene.

The board of Deepak Fertilisers & Petrochemicals Corporation Limited (Deepak Fertilisers) (Exhibit 2) is scheduled to meet today to consider a rights issue. Deepak Fertilizers has a dominant market share (over 70%) in the manufacture of technical ammonium nitrite (TAN), and isopropyl alcohol (IPA). The company is expanding its TAN capacities and the downstream chemicals,IPA and nitric acid, for which it announced planned capital expenditure (capex) aggregating Rs. 53 bn in FY18. The capex was to be funded by Rs. 37.1 bn in debt[1], Rs. 2.0bn in warrants to promoters, Rs.6.0 bn via a QIP, and the residual from sale of non-core assets, and internal cash flows. The promoters (Exhibit 3), after infusing the initial 25% of capital, let over 80% of the warrants lapse, resulting in a funding gap. To fill that gap, the company now proposes to raise equity via a rights issue.

[1]Deepak Fertilisers’ debt has outstanding ratings of ICRA A+/Stable/ICRA A1. In its rating rationale dated 14 April 2020, ICRA states that capex will be funded in a debt to equity ratio of 7:3

[2] 22.53% votes of institutional shareholding (present and voting) did not support the resolution.

The preferential warrants to promoters

In September 2018, Deepak Fertilisers’ shareholders approved, with a 95.92% majority[2],the allotment of ~6.5 mn warrants to Robust Marketing Services Private Limited (RMSPL), a company belonging to the promoter group, to raise an aggregate of Rs.2.0 bn in equity. IiAS had recommended voting AGAINST this resolution (Exhibit 4).In October 2018, RMSPL infused Rs. 500 mn – the 25% upfront infusion towards the warrants required under regulations – and were allotted the 6.5 mn convertible warrants at a price of Rs.308.79 per share. RMSPL had another 18 months to infuse the residual Rs.1.5 bn (75%) to exercise the warrants and convert them into equity.

But, in FY19, the business cycle turned. Raw material cost started to increase, and the prices of products softened, resulting in lower operating profits: Rs. 5.1 bn in FY19 from Rs. 5.7 bn in FY18. The largely debt-funded capex further squeezed net profits, which halved to Rs. 0.7bn in FY19 from Rs. 1.6 bn in FY18. Margins continued to remain under pressure in during the first nine months of FY20, despite increasing revenues.

The stock price reacted, falling all the way from levels of Rs. 400 in January 2018 to below Rs. 100 levels by December 2019, a pre–Covid 19 correction

Promoters allow over 80% of the warrants to lapse

On 1 October 2019, within 12 months of the allotment of warrants, RMSPL infused Rs. 250 mn and were allotted 1.08 mn shares. By then, the share price had fallen to Rs. 99.2 – a third of the Rs.308.79 warrants price. RMSPL had till 15 April 2020 to infuse the residual Rs.1.25 bn and convert the remaining 5.4 mn warrants into shares. Yet, SEBI granted RMSPL another month and allowed an extension to complete the infusion upto 15 May 2020. Despite the extension of the deadline, the promoters did not infuse the residual equity and let the remaining warrants lapse.

There is no rationale provided for the RMSPL exercising only part of the warrants and allowing over 80% of these to lapse. One could argue that because of the sharp correction in stock price, the RMSPL let go of the Rs. 416.6 mn of the 25% upfront payment (of Rs. 500mn), rather than infuse another Rs. 1.25 bn and buy shares that are out of money by over Rs. 1.1 bn[3].

[3] 5.4 mn warrants times the difference in warrant price of Rs. 308.79 and the current market price

Yet, the promoters will likely subscribe to the rights issue

The cycle turned once again for Deepak Fertilisers with the COVID-19 crisis. The company is India’s largest manufacturer of IPA, which is a key ingredient of sanitizers. The IPA prices have almost doubled recently. The Government of India capped the price of IPA for making sanitizers, but for the remaining demand, market prices apply. For Deepak Fertilisers, where only an estimated 25% of its production is being used to make sanitizers, which has price control, this is a windfall. The government’s move to allow commercial coal mining is expected to increase the demand of TAN, since ‘TAN blasting solutions’ are required for mining activities. With IMD’s forecast of above average rains in India for the current year, company’s crop nutrition business is expected to do well.

Despite the positive outlook on the business, at current market prices hovering at about Rs. 100, the rights issue will be priced at about 30% of the warrants price. If RMSPL were to invest the residual Rs. 1.25 bn into the rights issue, it would likely get 12.5 mn shares now, against 5.4 mn with the rights issue. Bridging the gap at the rights issue price (- we assume at below the current market price of ~Rs 100.0) as against Rs 308.79, will result in a higher dilution for all shareholders, impacting per share future earnings

Unanswered questions

The pieces of the puzzle, as they fit now, seem to suggest that the promoters risked the company’s capex plans to suit their personal profits:the board’s silence leaves minority shareholders with no other conclusion.

RMSPL and the Deepak Fertilisers’ board need to answer two questions:

  1. Why did the company forward a request to SEBI to extend the warrant exercise date, without ascertaining RMSPL’s ability and willingness to bring in funds?

  2. Having forfeited their warrants, should the promoters be forced to forfeit their rights? Afterall, if they have no money for the warrants, can they have money for the rights issue? SEBI must take heed in this instance.

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