Reliance Energy's stock price slumped 13 per cent the day after the company finalised its share buy-back. It is time promoters stopped using such props to support stock prices; they don't always work and can be harmful. By Vivek Sharma

One of the reasons given in the Reliance Energy press release announcing the share buy-back was that "it will send a strong signal to the capital markets on the perceived under-valuation of the company's share price".

Unfortunately, the market had other ideas about the company's valuation and sent the stock crashing by as much as 13 per cent the next trading day. At Friday's closing price of Rs1,269, the stock is now at a discount of as much as 21 per cent to the indicated maximum buyback price of Rs1,600 per share. What gives?

Last year's big surge
Reliance Energy was by far the best-performing large cap stock in 2007. From a level of around Rs500 in early 2007, the stock jumped more than 400 per cent to its peak of close to Rs2,600 in the first week of January 2008. The Anil Ambani-group wasted no opportunity to brag about this 'phenomenal and unprecedented' surge in shareholder wealth. But, it was not as if this massive rally in share price was backed by any substantial change in the financial performance of the company.

For the financial year 2006-07, ended 31 March 2007, Reliance Energy reported a 43 per cent increase in consolidated total revenues to Rs6,575 crore and a 23 per cent rise in net profit to Rs801 crore as compared to the previous year. The numbers appear good enough until the other income component of Rs882 crore for 06-07 and Rs610 crore for the previous period are factored in. The bulk of this other income is from interest receipts on surplus funds and foreign exchange gains.

After excluding other income, Reliance Energy earned a profit before tax of Rs196 crore for the full year 2006-07 from its core businesses of electricity generation, distribution and EPC. This was 34 per cent lower than the Rs297 crore in profits before taxes from the core businesses for 2005-06.

The story is no different for the current financial year as well. For the first nine months of 2007-08, Reliance Energy has reported an 18 per cent increase in total revenues to Rs5,525 crore and a 37 per cent rise in net profits to Rs773 crore as compared to the same period of previous year. Once again, the improvement in bottom line is only because of the rise in other income to Rs853 crore from Rs607 crore. Profit before taxes from the core businesses for the first nine months of current financial year at Rs174 crore is 15 per cent lower than the same period of previous year.

Power dreams
The only reason behind the Reliance Energy share price surge was the move to hive-off its future power generation projects and list it separately. The company transferred all its large power generation projects to Reliance Power in return for a 50 per cent stake in the latter, the balance being held by Anil Ambani group. As speculation about the aggressive pricing of Reliance Power IPO became rife in the market, there was no stopping the Reliance Energy stock price.

Predictions about the likely IPO pricing went higher and higher as the Sensex set new records during the great emerging market bull run of last year.

Reliance Energy's stock price peaked as the Reliance Power IPO opened during the first week of January. At its peak, the company's market value barely topped the value of its entire post-IPO holding of 45 per cent in Reliance Power at the IPO price. This encouraged some analysts to argue that the stock was worth even more, as the value of its existing businesses was not reflected in the price!

Those dreams were shattered soon after, as the market started correcting. Reliance Power's listing was a disaster as the stock opened substantially below its issue price. To lessen the pain, the Anil Ambani group came up with the ingenious proposal to issue bonus shares to all minority shareholders of Reliance Power to lower their acquisition costs. (See: Reliance Power mulls issuing free bonus shares after sub prime listing)

Though the Reliance Power stock recovered briefly after the bonus announcement, it has slipped again. Friday's closing price of Rs337 is 25 per cent below its issue price of Rs450 per share. This 'decline in value' had to reflect in the share price of Reliance Energy, which will be the single largest shareholder of Reliance Power after the bonus issue.

How is this share buyback beneficial?
Companies should ideally buy back their own shares only when their core businesses generate huge cash surpluses, which are way above the future capital investment requirements. Share buyback is one way of returning surplus cash to shareholders when the management feels it cannot generate above average returns by retaining and reinvesting that cash. In other words, share buybacks should be announced only if a company can find no better use for the surplus cash.

Reliance Energy does not generate huge cash surpluses in its core businesses. As detailed above, its core businesses contribute only a minor share of the bottom line. On the other hand, the company has mega plans in infrastructure development, which needs significantly large investments over long gestation periods. Ideally, the company should be conserving cash to fund its capital investments.

It is true that the share buyback will be made from "the company's substantial balances of cash and cash equivalents", as explained in the company release. However, most of the cash and cash equivalent balances the company has on its balance sheet were raised from shareholders, including foreign investors who participated in the company's FCCB issue.

When the company raised capital in recent years, it was obviously for financing capital investments. Unless the company has dropped some of its investment plans, there is no reason why the money should be considered a surplus and be returned to shareholders by way of a share buyback.

If Reliance Energy has not scaled down its expansion plans, this buyback is akin to admitting that the company's recent capital raising exercises were excessive or unnecessary.

Then why this buyback now?
Reliance Energy issued 4.3 crore warrants to its promoters as recently as last January. When converted before the stipulated time frame of July 2009 at the declared price of Rs1,812 per share, the company will raise nearly Rs7,800 crore. The size of this preferential issue and the short conversion period of less than 18 months shows that the company needs funds to finance its expansion in the near future. When that is the case, why is Reliance Energy returning cash to shareholders?

The only possible justification for trying to defend the share price through this buyback is that, if the company is planning to raise more capital in the near future, the cost of such capital will be low if the share price is fairly high. When the company will be raising Rs7,800 crore through conversion of warrants issued to promoters, does Reliance Energy need more capital?

If the share price is being propped up to save capital raising programmes of group companies, why should Reliance Energy shareholders bear the costs?

Since January when the market started the correction, Anil Ambani has been complaining that his opponents were manipulating stock prices of his companies. No prize for guessing the target of his ire! The group has even filed a formal complaint with SEBI, urging the regulator to investigate into the alleged manipulation.

However, the allegations appear somewhat far-fetched. It would have been believable even a decade back, but not now when it is next to impossible for anyone to rig a large cap stock over a period. There are far too many strong players in the market now, who will jump in to buy if any stock is beaten down unnecessarily.

The reality is that most investors, including foreign investors and domestic institutions, went along with the Reliance Power story, which in turn drove the Reliance Energy stock - hoping to make a fast buck. Though everyone knew that the valuations were ridiculously high, potential downside risks were perceived to be low as the market was quite strong. Power generation was suddenly transformed into the new growth sector, from the dull and drab utility business that it actually is. When the market turned weak, all of them became acutely aware of the unsustainable valuations and rushed to the exit door.

When that is the case, the bonus issue by Reliance Power and the share buyback by Reliance Energy will not stem the slide in share prices. Such measures may lead to a short-term revival in sentiment. In the long run, these measures will only be harmful by distracting management attention from the performance of core businesses to an almost obsessive focus on stock price movements. It is time promoters accepted that real shareholder wealth is not created by unsustainable, short-term share price movements, but by building strong businesses that generate high returns on capital invested.