The Hindu Business Line : Thumbs-up from market

Is the expansion of a company's equity base bad news for shareholders' earnings per share? An analysis of recent corporate results appears to counter the belief that an expansion in equity base results in erosion of such earnings.

Remember the controversy about Reliance Industries' private placement deal with Unit Trust of India, back in 1994?

The FIIs (foreign institutional investors) dumped the stock with the rationale that the deal would have an adverse effect on per share earnings, at least in the near term.

It is another matter that the Reliance stock has, over the years, rewarded its shareholders handsomely. But questions about equity expansion and its impact on the per share earning remain.

So, is the expansion of a company's equity base bad news for shareholders' earnings per share (EPS)? An analysis of recent corporate results appears to debunk the widely-held belief that an expansion in the equity base necessarily results in erosion of earnings.

A Business Line analysis of a sample of 81 companies that reported a significant increase (of 15 per cent and more) in their equity base showed that 51 companies (60 per cent) reported growth in the EPS within a year.

The expansion in the equity base between June 2004 and June 2005 was examined for the universe of over 2,500 companies to establish whether there was an effect on the EPS.

About 250 companies reported an expansion in their equity base during this period. The list was narrowed to 160 companies that reported profits during the three quarters ended June 2004, June 2005 and June 2006. It was then fine-tuned to cover just 81 companies, which expanded their equity base by a minimum of 15 per cent. Expansion in equity on account of bonus offers, IPOs and court-approved amalgamation schemes was not considered.

Expansion parameters

Broadly, the growth in EPS has kept pace with that in the equity base. However, when there has been a substantial expansion in the equity base, it has resulted in only a modest growth in the EPS.

For instance, where the equity grew by more than 40 per cent, the average EPS growth was 3.3 per cent in the June 2005 quarter. In contrast, companies which expanded equity at a more modest rate, had more attractive EPS growth, at 35 per cent.

Take the case of Granules India. The company expanded its equity base by 50 per cent in the quarter ending March 31, 2005. By June 2005, its per share earnings had grown only 7 per cent, from Rs 1.48 to Rs 1.53. There was, however, an improvement the following year when, by June 2006, the EPS moved to Rs 1.97.

Companies that widened their equity base by less than 40 per cent presented a contrasting picture to their counterparts on the EPS front. On an average, these companies reported a 29 per cent growth in EPS for June 2006 on the back of a 36 per cent growth for June 2005.

UTI Bank, which expanded its equity base by about 20 per cent between July 2004 and June 2005 primarily through GDRs (Global Depository Receipts), reflected the trend in this segment. The private sector bank's EPS rose to Rs 4.30 for the June 2006 quarter compared to Rs 3.30 a year earlier.

Impact of promoters' stake

Tracking the trends in the shareholding patterns presents an interesting angle. Though there was no marked difference in the earnings performance of these companies whether the promoters' stake increased or decreased, the change in shareholding pattern had a telling effect on the EPS.

Companies in which the promoters' stake went up by more than 5 per cent reported a 63 per cent growth in EPS for June 2006. Investors would have reaped a bonanza had they invested in United Breweries when Scottish & Newcastle raised its stake in April 2005. The brewer's EPS doubled for the June 2006 quarter.

The EPS growth was just 27 per cent for companies in which the promoters' stake dipped by 5 per cent and more. Amtek Auto, which came out with a GDR issue, was one prominent instance.

Sectoral trends

Sugar companies with facilities in the sugarcane heartland of Uttar Pradesh preferred the rights offer route to raise equity.

Oudh Sugar Mills, part of the K.K. Birla group, which put through a debt restructuring, was among the sugar manufacturers to adopt this route. Despite the up-cycle in sugar prices, most companies in the sector recorded dips in the EPS as a result of large expansion in equity base.

Bajaj Hindusthan and Rana Sugar appear to have taken a hit on account of the larger equity base. So, too, the drop in revenues accompanied by a larger equity base resulted in dips in the EPS of J.K. Sugar and Mawana Sugar. Volume growth and stable margins appear to have aided Balrampur Chini on the EPS parameter.

Shipping companies were sedate about expanding their equity base, with most of them sitting on piles of cash. However, quite a few companies in the mid-cap space registered large expansions in their equity base. Varun Shipping, strapped for funds to meet its expansion requirements, adopted the rights offer route, while Mercator Lines resorted to preferential allotments and ESOPs.

A decline in freight rates in the June 2006 quarter, along with a 40 per cent expansion in the equity base, resulted in a drop in the EPS of Essar Shipping by about 70 per cent. Mercator also reported disappointing EPS numbers on account of this trend.

Despite a 58 per cent expansion in the equity base, Varun Shipping reported but a marginal dip in earnings as its expansion was compensated to a large extent by higher cargo movement.

Hindustan Copper and Sterlite Industries were the only companies to have notably raised their equity base between June 2004 and June 2005. While Sterlite Industries resorted to a rights offering, the state-run Hindustan Copper offered about 3.7 crore shares on a preferential basis to the Union Government.

Despite a drop in metal prices in the June 2006 quarter, both the companies reported a surge in earnings and EPS. Hindustan Copper under performed its rival, despite a greater level of backward integration.

While Sterlite reported a five-fold rise in EPS, Hindustan Copper registered a two-fold increase, consequent to larger expansion and lower earnings growth.

Stock price impact

In the bullish market of the past couple of years, the stock market had given the thumbs-up to the equity expansion proposals of companies. The market reacted positively to the moves by different companies in the bull market that lasted until April 2006.

On an average, stock prices trebled in July 2005 compared to July 2004; however, the market meltdown in May, backed by the weak sentiment of July 2006, eroded a large part of this appreciation. Though the trend appears secular, the market has been enthused by relatively smaller expansion in the equity base than by the big bang ones.

Typically, stocks that registered a more than ten-fold rise in stock price came from the less-than-50-per-cent-equity-expansion category. Venus Remedies and ICSA India, which expanded their equity base by 31 per cent and 20 per cent respectively, were among the prominent gainers.

Teledata Informatics was the only stock in the sample to record a stock price decline.

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