Why investors think Firstsource deal is risky for CESC

Shares in Sanjiv Goenka-led CESC dropped 15 percent on Friday as investors questioned why the power utility has agreed to buy a stake in business process outsourcing company Firstsource Solutions.

Brokerages have termed the BPO buy as an unrelated diversification. Secondly, CESC has a poor track record when it comes to diversification. In April 2007, CESC merged Sanjiv Goenka’s loss-making retail company Spencer’s which will take at least a couple of years before the retail business shows profit.

CESC said on Thursday it would purchase a 49.5 percent stake in Firstsource for Rs 400 crore as growth opportunities in the power sector were getting challenging, while returns were no longer as lucrative. The total acquisition cost will be about Rs 650 crore (assuming an additional 26 percent stake via open offer). Of the total proceeds, about Rs 280-290 crore will be utilised towards repayment of Firstsource’s outstanding FCCBs.

Broking firms, including Citigroup Global Markets, Karvy Stock Broking, Spark Capital and Edelweiss, downgraded the stock to “sell” from “buy”.

Although Firstsource is an established player in the BPO industry, it has been struggling to turn around over the last three years in the face of aggressive competition from Philippines-based BPO companies as well as the low scalability of its business. Market analyst SP Tulsian does not see any financial or strategic sense behind this accusation. “The only solace in the case of Firstsource is that it is not a loss-making company,” he said in an interview with CNBC-TV18.

“Infusion of Rs 280 crore is unlikely to improve Firstsource’s debt-laden financials significantly (the company will still have a net debt of approximately Rs 1,500 crore after the infusion). Moreover, the unrelated nature (no identifiable synergies) of the investment is a clear negative,” Vijaykumar Bupathy, Senior Research Analyst at Spark Capital Advisors, said.

The deal is expected to increase CESC’s debt since it will be mainly funded through fresh debt. Citigroup downgraded CESC to ‘sell’ from ‘buy’, saying the acquisition was “unrelated” to its core business, while noting the utility’s prior record of diversification into the retail sector. The bank added that buying Firstsource would increase CESC’s leverage and depress profits, and cut its target price to Rs 300 from Rs 345.