Hyderabad blues

Besides a credible business model and potential for growth, the GMR issue also seems to have factored in an exuberant stock market and investors with deep pockets.

Most of us fret about the incessant power cuts, pothole-ridden roads and cramped airports in the country. But here is at least one reason to stop worrying.

Hyderabad-based GMR Infrastructure with interest spanning across power, roads and airports is knocking on the capital market to raise money to further its business cause, and incidentally improve the state of infrastructure in certain pockets.

Given the crippled state of infrastructure, most certainly, the business opportunity is phenomenal for any company operating in this space. A rapidly expanding economy and increasing government thrust is helping things move faster.

Yet the GMR stock priced at Rs 210-250, looks rather expensive even after building in the value of the company's earnings stream from its existing projects for the next thirty years. At the lower end of the price band, the company is valued richly at nearly Rs 7,000 crore.

Premium to cash flows

While GMR has a vast mix of projects under different stages of development, guaranteeing milestone payments and annuity income on a regular basis, the company may not see a surge in profits any time soon.

While its airport projects are still at least three years away from yielding their fullest, its power business, from where the company currently derives 90 per cent of its revenues, has its own share of problems.

Its power plants are operating at very low levels due to lack of availability of fuel and there is little chance that this situation would change in the near future. Near term earnings are too little to assign any significant value to the company.

Last fiscal, the company earned a mere Rs 70 crore or Rs 2.4 per share, on a consolidated basis, valuing the company at nearly 88 times its earnings.

Investment bankers have priced the issue estimating earnings of around Rs 300-350 crore or Rs 9-10.5 per share, in year 2009 when earnings will get a big boost as most of its existing projects would get completed by then. Even then, the stock would trade at a price-earnings ratio of 20-23 times at the lower end of the price band.

Analysts, however, are quick to point out that the right way to value a company like GMR with substantial annuity business wherein money keeps trickling in year-after-year, is to take the value of future income stream rather than current earnings.

Based on the Discounted Cash Flow (DCF) method, which discounts the future stream of income from various existing projects to arrive at a net present value, leading analysts attribute a valuation of Rs 6,400 crore, which again is lower than the price pegged by the company. Whichever way one looks at, the stock looks expensive.

The Rao effect

If at all, the only way one can justify the company's valuations is by counting on chickens before they hatch because there is potential. Surely, having a capable management helps, especially in the infrastructure business where profits are driven by an ability to grab big contracts, prowess in execution and high degree of financial acumen.

One can repose confidence in the 56-year old G M Rao, the promoter of the group, not the least because he pipped Anil Ambani to the post for the Delhi Airport. Rao has been precise in choosing the right businesses at the right time.

Starting-off with a small jute unit in 1977, he led the group into ferro alloys in 1983, the finance sector in 1985 by acquiring a stake in Vysya Bank, into sugar and breweries in 1997, and further into the infrastructure sector in 1998.

Having played a key role in transforming Vysya into a new generation private bank, and tying the knot with ING for the life insurance business, Rao made a quick buck selling his stake in the bank to the foreign partner. Investment in breweries has been sold to United Breweries and the group is now focussed purely on infrastructure.

The big opportunity

And infrastructure, be it roads, ports, airports, telecom or power, is the next big area for growth in the country. According to industry estimates, infrastructure capex in the country is likely to see a 60 per cent growth to nearly $110 billion till fiscal '08 driven by the successfully emerging public-private partnership model.

By fiscal 2012, India's road capex is likely to quadruple from $40 billion in fiscal 05, covering over 50,000 km. Till fiscal 2008, order inflow of Rs 300 billion is expected as the National Highway Authority of India places orders for 6,000 km. Road projects usually offer an internal rate of return of 15-20 per cent.

Again, due to the already prevailing power deficit and strong growth in consumption, power supply is expected to double by the end of the eleventh plan ending fiscal 2012.

Airports are also set for a huge leap with airport traffic likely to boom on the back of growing income levels, faster economic growth, thrust on tourism, affordable air travel and favourable policy framework.

Currently, the country boasts of 449 airports, of which 132 are owned and managed by the Airports Authority of India and the Planning Commission has pegged the total cost of upgrading airports at Rs 40,000 crore.

The accelerated pace of traffic growth in future""air traffic penetration is still abysmally low at 3 per cent""and more privatisation initiatives will only mean new vistas for growth for players like GMR. The company has won two airport projects on build-own-operate-transfer basis (BOOT) with a 30-year monopoly over traffic.

The GMR basket

With consolidated revenues of Rs 1,090 crore last fiscal, GMR's asset portfolio now consists of four power plants, six road projects and two airport projects. Of the four power projects, two are in commercial operation, one more is completed and set for commercial production and another power plant""its first hydro power plant""is yet to begin construction.

In roads, of the six projects, two are operational and four are under development. Similarly, the two airport projects""the brown-field expansion of Delhi International Airport and the green-field Hyderabad Airport project are under development.

By fiscal 2009, when most of the existing projects are completed, GMR will have a fairly diversified revenue stream with a quarter of its revenues coming from airports, about 60 per cent coming from power projects and the rest from roads.

GMR has also managed another kicker in the form of the real estate that comes bundled with the airport deal. The company has got a lease for 5,500 acres for an initial 30 years at lease rental of 2 per cent with a 5 per cent escalation per annum in Hyderabad.

The company is thus planning to develop 700 acres for commercial purposes, by way of revenue sharing with other entities. When the Hyderabad airport project is complete in fiscal 2009, it will derive a fifth of its revenues from this real estate. Similarly, the company will also develop 200 acres of land near the Delhi airport, in a phased manner after fiscal 2010.

As for the performance of its power business, there are some ifs and buts. GMR's Vemagiri power plant has not been commissioned yet due to non-availability of gas and even when it kicks off, it is likely to run at a Plant Load Factor (PLF) of less than 30 per cent over the next couple of years, thus dragging down consolidated profits.

Similarly, its 220 MW naphata-based plant, (which can be retrofitted for gas firing) off the coast of Mangalore, has a power purchase agreement with the Karnataka Power Transmission Corporation, is expected to operate at PLF of less than 40 per cent till fiscal 2009 due to lower offtake by the customer.

PLF for both these plants is likely to improve only when gas supplies improve, after Reliance's gas plant comes on stream in 2009. Besides, for its two existing projects, the current power purchase agreement is expected to come to an end by November 2008 and November 2014, beyond which the company would be exposed to offtake and price risk for its power projects.

The new 140 MW hydro power venture at river Alaknanda in Uttaranchal will take around six years to complete. And in the first full year of operations, in fiscal 2013, the company is expected to generate net profit of Rs 60 crore.

The beautiful mind""good and bad

Besides, the company has displayed good financial engineering capabilities, which is critical in this business. Recently, GMR has securitised 75 per cent of its payments due from the NHAI through a consortium at a discount rate of 7.5 per cent and is expected to receive Rs 870 crore, which will improve its cash flow.

Keen financial acumen, however, can sometimes cut both ways. GMR recently bought its group company GVL Investments which holds 9 per cent stake in the Delhi International Airport for a consideration of Rs 400 crore valuing the airport project at Rs 4,400 crore, at least 20 per cent higher than what the analysts reckon as its value based on the DCF method.

Analysts question the wisdom in paying such a high price for a company which has hardly incurred any cost for getting the mandate, and capital investments for the development is yet to be made.

Another key concern for GMR is the risk of rising interest rates, since this can significantly affect funding costs and alter the rate of return from long-gestation projects. According to analysts, a 50 basis points rise in the weighted average cost of capital, could drag down the company's asset valuation by 11 per cent.

The fact that the company has managed to privately place equity at high valuations comes as little consolation. All said, the issue pricing may have been acceptable in a roaring bull market for investors with loads of cash to ride the momentum. The issue does not seem to be priced for common investors like us.