JSW Steel: Serious case of corporate misgovernance

JSW Steel, one of the largest players in the Indian steel industry, has come under scrutiny after the Karnataka Lokayukta passed some strictures in its report of July 2011. But this is not the only time that the company has come under the scrutiny of the Lokayukta. The first
time it happened was in December 2008 when some serious allegations were levelled against JSW’s associate company Vijayanagar Minerals Pvt Ltd (VMPL). However, at that time investors had not taken much notice of the allegations leveled against the company. Even the company had maintained a stark silence without issuing any press release to rebuff those allegations. Its annual report of FY09 also did not mention anything about the issue.

But the latest Lokayukta report has put the company under the spotlight as the allegations are of a serious nature and also involve Karnataka’s former chief minister B S Yeddyurappa. Based on the findings of the report, Yeddyurappa has already quit from his post and is now fighting a legal battle. Additionally, in the wake of complaints filed by certain NGOs, mining has now come to a halt in Karnataka in its three districts of Bellary, Tumkur and Chitradurga since some serious abuse of mining rights of iron ore have been
unearthed. However, this not being the right space to get into the larger issues, our focus will only is on JSW Steel.

One of the allegations that JSW Steel is facing is the payment of donations to the Prerana Education Trust. This is a trust run by the family members of B S Yeddyrappa. The report says was done with intent to seek a favourable reply in response to the company’s pending application for mining rights in Karnataka. Another allegation is that a company controlled by JSW Steel has paid a much higher amount than the prevailing market rate to acquire land from the sons and son-in-law of the then chief minister of Karnataka. The report also suggests that the Government of Karnataka should take immediate steps to recover `324.42 crore from JSW Steel on account of having procured excess iron ore illegally from JSW Steel’s suppliers.

If all these allegations are proved they would raise serious corporate governance issues about the company. As it stands, India Inc. has been in hot waters of late due to various cases of fraudulent dealings that are being probed by investigating agencies. This has created some amount of discomfort amongst investors, including institutional investors. Since the allegations against JSW Steel call for a closer scrutiny, we decided to seek clarifications from the company’s management. We sent across an email as well texted messages to Seshagiri Rao, Joint Managing Director and Group CFO, to get their explanations. Till the writing of this report, there has been no word from either Seshagiri Rao or any one on his behalf.

A Genuine Donation?

A company called South West Mining Company was found to have issued two cheques of `5 crore each on March 17 and 18, 2010 to the Prerana Education Trust. As per the Lokayukta report, this money came from JSW Steel in February 2010. JSW Steel issued a press release on August 4, 2011 to counter this allegation, stating that it had not provided any funds to the Prerana Education Trust. The press release further stated that South West Mining being a profit making company had decided to give donations out
of its own corpus for a cause promoted by the group”.

“The payments made by JSW Steel to SWML were towards ongoing commercial contracts. The referred transactions in the Lokayukta report are backed by commercial contracts which were ignored and correlated to unrelated issues unnecessarily, leading to untrue and adverse inferences,” the release stated. On the other hand, the Lokayukta report suggests that when the payment was made by JSW Steel to SWML there was no trade of iron ore between the two companies during that period.

However, the Lokayukta report suggests that when the payment was made by SWML to the Prerana Education Trust, SWML’s bank balance in that particular bank account was in the overdraft mode. Therefore the truth must come out about whether the payment
was genuine donations or a bribe to seek commercial gains.

Who Owns South West Mining?

The way the press release was issued by JSW Steel on August 4, 2011 gave an impression that South West Mining is a group company of JSW Steel. But our scrutiny of JSW Steel’s annual report reveals that SWML has not been featured under its list of associate or group companies. Readers must of course be aware that all companies have to disclose transactions details with group or associate companies in the annual report. This is mandatory as per Accounting Standard 18. Since the press release suggests that money was paid to SWML for commercial contracts, that particular contract should have been reflected clearly.

This leads to either of the two possibilities. If SWML is not an associate enterprise, why would it give a donation for the construction of an auditorium to be named after the company’s Founder Chairman O P Jindal for a technology and management institute run by Prerana Education Society? Secondly, if SWML is a group company, the transaction between the two companies should have been clearly disclosed.

The very fact that JSW’s press release admits that SWML did donate funds to the relatives of the chief minister of Karnataka gives an impression that SWML is indeed a group entity of JSW Steel. If, as the press release indicates, there have been commercial contracts between JSW Steel and South West Mining, why is that JSW Steel does not show any payments or entries about goods purchased in its annual report? Why did the auditor of the company not disqualify the report since the disclosures were not made in accordance with the stipulations laid down by Accounting Standard 18?

Is SWML A Profitable Company?

One does not know what kind of profits have been earned by South West Mining in the last couple of years to be able to pay such high donations of `10 crore. Also, did the company made handsome profits in FY2010 to justify such huge donations? The Lokayukta report suggests that SWML was running an overdraft facility when the cheques for donations were issued. Will someone borrow money to pay such a huge amount as donation? In fact we have reviewed the State Bank of Mysore account (from where the cheques were issued for donation) of SWML and have verified that the company was indeed availing of an overdraft facility to the tune of `5.34 crore and after receiving funds from JSW Steel and later shelling out two cheques of `10 crore, the overdraft figure was at `4.81 crore. (Please look at the bank statements published earlier in this report.) Would any company be able to afford to give a donation while it was using a bank’s money costing a rate of interest as high as 16.50 per cent? We tried to unearth the profit and loss account and the
balance-sheet of SWML through the website of the Registrar of Companies but could find no trace of any such company. Has SWML submitted its documents to the RoC or not? There are many such questions that need to be answered. What is also surprising
is that JSW Steel has been donating funds but has never exceeded a limit of `5 crore in the last two years. So how can a relatively unknown company like SWML donate such huge amounts? For the benefit of our readers we have compiled a list of donations paid by
JSW Steel (consolidated) over the last few years.

Land Acquisition Issue

One more allegation levelled against JSW is that it acquired land at rates higher than the prevailing market rates from the relatives of Yeddyurappa to please the chief minister so that the state government would be moved into giving a favourable reply to the central government for the company’s pending mining lease. The Lokayukta report suggests that the rate to acquire this land at Bangalore was far in excess of what the market rate of land was. SWML paid `20 crore for one acre land at Rachenahalli village which, according to the Lokayukta, should not have cost more than `1.24 crore. In other words, what SWML paid was 16 times higher than the market rate.

JSW Steel’s press release issued on August 4 denies this allegation too stating that SWML purchased the land at appropriate market prices to set up a building and a guest house for the group companies at Bangalore. The press release further adds, “The plot
is located near the new airport and adjacent to the IT Park”. Is it just coincidence that the company that paid ‘donations’ also bought land at the ‘market rate’ from the chief minister’s relatives? We believe JSW Steel has to come out with transparent explanations
to be able to retain its image.

What about Vijayanagar Minerals Private Limited?

This company did not attract much attention in July 2011 when it was mentioned in the Lokayukta report but it had been extensively covered in a report of December 2008. Vijayanagar Minerals (VMPL) is a joint venture between JSW Steel and Mysore Minerals Ltd (MML) which is a company owned by the Government of Karnataka. This JV was formed so that JSW could exclusively source iron ore
from the Timmappanagudi mines for its steel plant. In other words, VMPL would supply iron ore only to JSW Steel. While Mysore Minerals are the lease owners of the mine, Vijayanagar Minerals is the operating agency for mining.

Looking at the Lokayukta report it gives the impression that JSW Steel got undue benefits from this joint venture. Since MML is a government-owned company, JSW procured such benefits at the cost of public money. Given below are some of the observations
made in the 2008 report.

As per the MOU signed in January 1997 between JSW and MML (the government company), the government company would get a premium of 10 per cent over the market price on iron ore lumps and 6 per cent in the case of iron ore. What has been pointed out in the report is that despite the iron ore prices going up in the last few years due to a surge in the international commodity prices, the premium percentage rate continued to apply to the old rate, thus resulting in a lower premium collected by the government company. The matter did not stop there. The mines also produced some more variety of ores which were not envisaged at the time of entering
into the MOU for which a premium was not fixed.

The Lokayukta report estimates that the total loss suffered by the state government due to these two instances was about `25.72 crore. The obvious gainers then were VMPL and JSW. We are not able to comment beyond 2008 as the July 2011 report of the Lokayukta has not touched upon this topic with no mention of whether this anomaly has been corrected or not. Our discussion with Santosh Hegde, former Lokayukta of Karnataka, reveals that no action has been taken on the report, suggesting that this anomaly continues even now.

Another finding of the Lokayukta report of 2008 suggests that the money for developing the mines of Timmappanagudi was supposed  to be spent by VMPL but this was done by the government company. This amount was as high as `11.52 crore. Why did a government company have to block its funds, the benefit of which was mainly derived by JSW Steel? We are unable to figure out the reason behind this issue. The report states that this money is still outstanding from VMPL.

One more anomaly that we came across for Vijayanagar Minerals is about the shareholding pattern. As per the MOU, the government company was to have 30 per cent shareholding in the company while 70 per cent was to be owned by JSW Steel. Instead of 70 per
cent, JSW steel has been found to be holding only 40 per cent stake in the company while the balance 30 per cent has been equally shared by two promoter companies’ viz. Gagan Trading Company and Sun Investments (P) Ltd. We are unable to understand why
JSW Steel does not hold 70 per cent and has allowed promoters to benefit from the holding of 30 per cent stake. Note that Vijayanagar Minerals is a highly profitable company and paid a dividend of `1000 per share (FV `10). We strongly believe that instead of the promoters’ holding in JVs, the real benefits should go to JSW Steel, which in turn would benefit the other minority shareholders of the company.

Our concern is about the disclosures made by JSW Steel. Why did the company not inform its shareholders about the allegations of wrong-doing in 2008 in the wake of the Lokayukta report published that year? Why did it not offer any clarification then, and even
today, it offers no explanations on the allegations levelled in the December 2008 report. Was it not the duty of the company to share vital development with the various stakeholders as part of better corporate governance?

Looking At Valuations

So what can one do with a scrip that has fallen by 41 per cent since this allegation became public (the Sensex fell by 15 per cent during the same period)? We believe that the company will face more trouble in terms of the government enquiry that will now follow. We also cannot rule out the possibility of Vijayanagar Minerals being asked to stop its mining activities for a long period of time. If this happens,
the company would miss out on an important source of buying iron ore at competitive rates. This could impact its production numbers as well as its margins. Also, the company is sitting on a large amount of Forex loans and with the rupee continuing to slide there would be huge mark-to-market losses even in the December quarter. The company as of the September 2011 quarter had reported Forex loss of `514 crore.

We also see another problem cropping up when the company’s FCCBs come up for conversion. The company had, in FY08, issued 3250 FCCB bonds of USD 1 lakh each. Out of these, 2744 bonds are still outstanding. Bondholders have a right to convert these bonds into equity shares at a price of `953.40 per share. Since the share price of JSW Steel at present stands at `515, it is very unlikely
that the FCCB bondholders would opt for conversion into equity shares. If the bondholders do not opt for this conversion then on June 28, 2012 the company has to repay the bondholders at 142.801 per cent of the FCCB’s face value. Looking at the current market
rate of the rupee, the outflow to the company would be to the tune of `2077 crore, assuming of course that none of the bondholders opt for conversion into equity shares.

The company has already lined up capex plans of `15000 crore in the next three years of which `8000 crore is to be spent in the current financial year. We believe that this bond repayment may create liquidity problems for the company, especially when the company was also banking on its promoter group to bring in close to `1600 crore by opting to go for the conversion of warrants into equity shares. The promoter group did not do so. In fact during the last analysts’ meet, Seshagiri Rao confirmed to the analysts that the promoters would exercise their rights to convert warrants into equity shares. With the promoters not opting to convert warrants into equity shares, this has now sent out a very wrong signal to the investors.

JSW Steel also has invested a big amount in various foreign subsidiaries but till now the returns from the same have not been noteworthy at all. The company, as of March 2011, was found to have invested more than `1000 in foreign subsidiaries. But this
amount has not adding great numbers to its financials.

On the valuations front, JSW Steel is quoting at a price earnings ratio of six times, which looks fairly priced when we look at the other Indian steel companies’ valuations. But our biggest worry is about the tainted image that now hovers like a dark cloud over the company. This will not allow it to command a premium on the bourses. Historically, institutional investors have never tagged any premium for a company that has been in the net of allegations from regulators or government agencies. The company has seen its institutional holding sliding down constantly since December last year, which at present stands at 26.63 per cent. We assume that institutional investors must have further reduced their stake in the company in the current quarter ending December.

At the same time there is a slowdown in the world economy and this could create some pressure on demand as well as in the pricing of the steel products. This should keep JSW Steel’s profits subdued. In the first half company has already seen its net profit number coming under pressure and we expect that trend should continue even in remaining two quarters. The company has already revised downward its production and sales numbers for FY 2012 for current financial year. It initially was looking at production of 8.75 million tonnes which has been revised to 7.5 million tonnes. But looking at the production numbers till November 2011, we believe that
the company will further lower the target. One would get some clarity on this issue only after the company announces its December numbers.

We suggest our readers to stay away from the counter despite the fact that the counter has taken a big fall. We expect steel companies to be market underperformers and so also JSW Steel