It is amazing how the mind is able to attain higher levels of focus when there is a lot more at stake. Students of management understand this only too well. The prospect of not doing well in the exam and consequent poor grades, which make all the difference between summer placement at a top-notch organisation (the stepping stone to a plum job offer) and internship at a so-so one at best, helps the mind to focus just that bit more on studies than would have been possible in the normal course.
For Interglobe Aviation Ltd, the company that operates Indigo Airlines, such a sharp focus should prove useful. Between July 2015 and March 2016, Interglobe must earn roughly another ₹1,000 crore if not more, in profits. Why?
The promoters of the company had, in the run up to the company’s Initial Public Offer (IPO) that was successfully concluded last month, given themselves and the other initial investors ₹1,000 crore in ‘interim’ dividend. This not only wiped out the accumulated profits of close to ₹500 crore notched up until then, but also the entire paid up capital of ₹300-plus crore lying to their credit in the books.
Company law
Interglobe was perfectly within its rights to do so. Company Law does allow a company to pay, in any given year, dividends to its shareholders from the accumulated profits of the past, even if there was no surplus in the current year. Additionally, the Law also allows a company to pay interim dividend in anticipation of profits likely to be earned in the current year, even if there are no accumulated profits to draw upon.
Evidently, Interglobe has taken advantage of both these elements of flexibility in dividend distribution and paid out a hefty interim dividend to current shareholders.
The catch here is that if the payout not only wipes out the accumulated profits and if the current year does not generate enough surplus to cover the deficit after netting out the accumulated profits, the management would be held in violation of the law on distribution of profits, with all its attendant consequences.
The problem
Any distribution of dividends in the absence of inadequate profits (either past or current) puts at risk the financial interests of other stakeholders, such as lenders and suppliers of various goods and services. For they have only the monies belonging to shareholders as the cushion for a satisfactory settlement of their dues. A dividend payout that has the effect of draining out shareholders’ own capital contribution thus exposes creditors to undue risk which the Law, quite rightly, seeks to prevent. Even if the company is able to claw back the amounts already paid out as excess dividends, the breach of Law, already committed, cannot be undone.
It is in this context that one must accord prime importance to the management’s focus in ensuring that the operational and financial performance in 2015-16 is quite satisfactory. You can be sure the management will strain every nerve to ensure that such a happy denouement comes to pass.
Corporate governance
Quite apart from the legal aspects, the issue did appear to raise some troubling questions from a corporate governance perspective. The action of the management in taking out ₹1,000 crore in dividends just when they were in the process of raising a little over ₹3,000 crore from the general public, drew a fair bit of criticism from the professional investment community.
They saw it as an act that was tantamount to the management wiping the cash box clean of its contents before letting in the new shareholders. Viewed from another perspective, it appears as though the promoters themselves didn’t believe in the prospects of the company that they were asking public shareholders to invest in.
Neither of these perceptions are, however, valid and indeed this would be a rather simplistic view of corporate governance. For one, the company was worth much more than the amount the initial investors took out by way of dividends. So they weren’t wiping the slate clean ahead of letting in new investors. Second, it is possible to structure the IPO in such a way that the existing shareholders could be richer by ₹1,000 crore compared to the new investors who were subscribing to shares in the company.
Akshayapatra
The technical details are rather complex and cumbersome. So we will not go there. It is easier to understand the process with an analogy. Imagine that the owners are in possession of a magical vessel, akin to the mythical ‘akshayapatra’, that is forever brimming with food, replenishing itself even as you empty it of what it currently holds.
The promoters of ‘Indigo Airlines’ are in the position of owners of such a vessel and they are setting a price for a part ownership of it. They had two options.
One, set a price that takes into account the value of the food that is already in the vessel and the flow of food that would accrue in the days to come. Alternatively, they could abstract from the vessel the food that it already holds and invite the new shareholders to pay only for their share of all the future food that will flow from it.
Of course, the ‘akshayapatra’ is never supposed to run out of food as it gets filled up to the brim even as it is emptied of its contents. But imagine for a moment, for the sake of easier understanding, that there is an infinitesimal fraction of time in which it stands bereft of food as the existing content is being emptied out.
In such a situation, the new investors would be equally open to both the options as they would only pay the equivalent of all the future value they are going to be entitled to. This is analogous to promoters asking new investors to pay ₹1,000 per share with the existing ₹1,000 crore retained in the cash box or pay ₹765 per share after abstracting from the company a value of ₹1,000 crore (dividend paid out to existing shareholders). Why they chose the second option can only be a matter of conjecture.
Maybe they felt nervous about asking shareholders to cough up ₹1,000 per share, even though they genuinely believed the company to be worth that much, but instead preferred to play it safe by asking them to pay only ₹765 per share but after the dividend cash had been taken out. As events unfolded subsequently, the promoters could have had their cake (the real metaphorical cake and not the one from the ‘akshayapatra’) and eaten it too. It took all of three trading days for the share to climb past the ₹1,000 mark.
The Indigo Airlines story was never about the cash in the till but rather a belief in the attractiveness of future cash flow from running an airline bushiness. This is clear from another example. Back in the mid-1990s, promoters calling upon investors to participate in the profits to be had from cultivating teak trees long before the seeds had even sprouted or of sheep that were yet to be reared and from myriad other collective investment schemes was all the rage. True, investors burnt their fingers badly in trusting their savings with such schemes. But nobody can fault the investors for not having an intuitive understanding of investment as a present value paid out to acquire a share of future profits or cash-flows.