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UBS Investment Research
Key Call: Lanco Infratech
Share price implying unlikely events
Share price down 36% so far in 2011
Lanco Infratech’s (Lanco) share price has fallen from Rs63 to Rs40 since the
beginning of the year. Several factors combined to lead to this, including worries
about changes in accounting policies, security of fuel supplies (coal linkages), and
merchant tariff weakness. The BSE Sensex has corrected 14% YTD as there are
macro concerns such as inflation. The share prices of Indian utilities under our
coverage are down 17% YTD.
Is it a buying opportunity?
The question now is whether to review our investment recommendation. To answer
this, we perform stress test valuations and conclude that the current share price is
implying either: 1) that 65% of projects under construction will stall and the
company will have to bear debt and contract liabilities for them; or 2) the coalbased
projects are not contributing any value. We believe either of these scenarios
occurring is unlikely.
Lower FY11/12/13 EPS estimates 30%/26%/25%
We lower our FY11/12/13 EPS estimates from Rs3.91/5.61/9.28 to
Rs2.72/4.16/6.97 because of lower merchant tariff assumptions, a lower
engineering, procurement, construction (EPC) multiple (from 6x to 4x FY12E
EBITDA); lower value for new power projects (now valued at 1x equity
investment versus Rs60m EV/MW earlier). We think the stock is cheap—to
assume an FY13E PE of 10x, merchant tariffs would need to fall to Rs1.3/kWh
(our assumption is Rs3.5/kWh).
Valuation: maintain Buy rating; lower price target from Rs105 to Rs70
We derive our price target from a sum-of-the-parts methodology. We value Lanco
as a conglomerate with power contributing 67% of valuation and EPC 23%.
Summary
We believe Lanco’s share price has been affected by general poor sentiment on
the Indian infrastructure sector, worries about the reasons behind Lanco’s two
changes in deprecation accounting policies, coal supply security concerns and
worries about project implementation.
In light of these concerns, we met with Lanco’s Chairman and CFO to review
some investor concerns. In this comment, we review the reasons behind the
accounting changes and stress test our valuations to estimate what risks in terms
of fuel and project implementation are reflected in the share price.
Lanco’s current share price is implying either of two very unlikely scenarios —
that either the coal-fired power plants are worthless or construction projects will
be cancelled, and the liability for capital commitments and loans drawn down in
special purpose vehicles roll up to the company.
We think the stock is attractive after the recent share price declines and reiterate
our Buy rating. On our new earnings forecasts, the stock is trading at 9.6x
FY12E earnings and 5.7x FY13E earnings. To assume a double-digit (10x)
FY12E PE, we would have to assume the merchant power prices, which
averaged Rs4.5/kWh for Lanco for the nine months up to 31 December 2010
and would fall to Rs1.4/kWh for FY13.
Accounting policy changes
In Q111, the company changed its accounting policy to a diminishing value
basis, but then in Q311, they changed it back to a straight line. The depreciation
periods remained unchanged. We think investors have looked at this flip-flop in
accounting policy and are worried the changes are hiding a more fundamental
problem with the company.
Our view is the change is more a failure to fully think through the implication of
the original accounting policy change before implementation. When moving to a
diminishing value method, management was trying to reduce political risks from
very high returns when merchant power prices were high by front-end loading
depreciation. Naturally, this made reported earnings very vulnerable when
merchant power prices normalised in the second half of 2010. We think the
return to the original straight line policy is more appropriate and brings the
policy back into line with industry practice.
Worries on coal
If we refer to Table 1, the coal-based projects contribute Rs28 in our valuation
(Rs18 for operational/ready projects and Rs10 for projects under construction).
This Rs28 is part of our Rs70 price target. If we look at current market price, it
could be implying all these projects are worthless (that is, from a DCF
perspective, they have zero value).
Projects under construction not moving forward
There are three valuation effects of a project getting stuck or cancelled.
Valuation contribution of the project goes away;
Additional liability gets created due to debt taken and orders given to
external vendors, which rolls up from the off-balance sheet special purpose
vehicle up to the company;
EPC business revenues take a hit, which would reduce the EPC business
valuation.
We show the effect of these in Table 2. If we assume all development projects
will be cancelled at their current state of completion, the negative effect would
be Rs47/share. However, the actual effect would likely be somewhat lower. If
the cancelations were part of an overall trend for the industry, fewer power
projects being built would have a positive effect on merchant power prices, so
there would be a positive effect on Lanco’s portfolio of operational plants.
Table 2: Valuation impact—what is the liability if projects are cancelled?
Rs/ share
Valuation contribution of under construction projects (refer Lanco SoTP) 18
Impact on EPC valuation (refer SoTP and discussion at later pages) 12
Total impact 30
Effective price target 40
Additional liability created 17
Net Price target 23
Total impact due to project cancelation 47 (Rs70 – Rs23)
Market price implying (% cancelation) 65%
Note: 1) In valuation contribution, Rs18 includes Rs13 for coal based projects and Rs5 for hydro projects.
Source: UBS estimates
We use a DCF methodology for three of the businesses, and an EBITDA
multiple for EPC. We value the new under-construction power projects at book
value.
What Lanco currently has
Lanco has two main divisions, power plant ownership and operation, and a
construction and EPC business. It also has some smaller infrastructure and real
estate investments.
Power business
Lanco has nine power plants with a combined capacity of 2,092MW in
operation (Table 4), five of which are very small and can be ignored. It has
another 7,148MW under construction, with a further 11,070MW of development
pipeline. For the nine months to 31 December 2010, this segment provided more
than 95% of the group’s consolidated earnings.
One key factor is that the construction projects are generally held off balance
sheet in special purpose vehicles (SPVs) during the development and
construction phase. This is relevant for our stress test valuation later.
Lanco’s operating generating capacity increased 4x from 500MW at the end of
FY09. The key projects that became operational in the past sixteen months were:
Amarkantak I and II; Kondapalli II; and Udupi I. Table 4 shows the plants that
are currently operational.
Operating capacity will double in six months
In the next six months, the company is adding another 1,870MW in its operating
capacity. These projects are:
Udupi II (600MW)
Anpara I and II (1,200MW)
Lanco Green (Budhil, 70MW)
Under development pipeline is strong
Apart from the projects under execution, the majority of which are nearing
completion, Lanco has made satisfactory progress on its new projects. The key
projects are shown in Table 5.
Table 5: Projects under development
Plant State Fuel Capacity (MW) Completion
Kondapalli - III Andhra Gas 742 FY13
Amarkantak III, IV Chhattisgarh Coal 1,320 FY14
Vidarbha Maharashtra Coal 1,320 FY 14
Babandh Orissa Coal 1,320 FY14
Source: Company data, UBS estimates
Execution progress is good for these projects as most of the prerequisites listed
in Table 6 are already in place. The company has already made significant
investments in these projects as reported in its Q3 FY11 results.
Engineering, procurement, construction (EPC)
Lanco’s construction segment provides engineering, procurement and
construction services for the power sector. Its largest customer is itself, but it
also does work for third parties. For the nine months to 31 December 2010, this
segment provided less than 5% of the group’s consolidated earnings.
Real estate
Lanco has 4m square feet under development in Hyderabad, India. Lanco is
developing Lanco Hills, mixed used space of high-rise residential structures, ‘IT
Special Economic Zone’ office spaces, shopping malls and hotels. As of now,
construction is in progress for six residential towers and the possession of
apartments will commence shortly.
Infrastructure
The group was awarded two national highway projects in Karnataka. It has two
toll roads that it is developing at the moment.
Table 7: Progress on projects under development
Project Concession period (years) Length ( km)
Bangalore – Hoskote – Mudbagal 20 years 81
Neelamangla – Devihalli 25 years 82
Source: Company data
Currently, construction is under progress and expected to be completed in the
next six months.
The real estate and infrastructure businesses are relatively very small for the
company and the prime focus remains on its two businesses—power and EPC.
Our price target is Rs70
Stock is attractive on forward earnings now
We think the stock is attractive after the recent share price decline. On our new
earnings forecasts, the stock is trading at 9.6x FY12E earnings and 5.7x FY13E
earnings. To assume a double-digit (10x) FY13E PE, we would have to assume
merchant power prices would need to fall to about Rs1.4/kWh. As can be seen
from Chart 1, this is low compared to the merchant power price over the last
three years. However, because of bilateral contracts, Lanco would not be
exposed to a price this low. For the first nine months of FY11, Lanco’s average
realised merchant price was Rs4.5/kWh. Chart 2 shows the sensitivity of our
2013E PE for Lanco, which reflects this partial exposure to the merchant tariff.
Price target is 74% above current share price
We use a DCF methodology for three of the businesses, and an EBITDA
multiple for EPC. We value the new under-construction power projects at book
value.
We do not believe its EPC business should be valued at zero as some investors
may argue, as the projects are largely internal. The key reasons are: 1) the EPC
division is a key strength for any power developer as it controls the key part,
which is execution; 2) the 25% order book is external; and 3) despite healthy
margins for EPC, the per MW cost for Lanco as a developer is still competitive.
Our price target cut is driven by:
(1) Lower merchant tariff assumptions. Table 9 shows our new and old
forecasts. The effect of these changes on our price target is Rs10.
(2) Lower EPC multiple from 6x to 4x FY12E EBITDA (impact of Rs14 to
our price target). With a significant correction in the construction space
valuation, we think it would be sensible to use a more conservative
valuation multiple for the EPC business.
(3) Lower value for new power projects (impact of Rs12 to our price
target). The new projects under development are now valued at 1x equity
investment versus Rs60m EV/MW earlier. This effectively means a change
from 2.5x P/BV to 1x P/BV, equivalent to valuing only the investment in
the projects.
FY11/12/13 EPS estimates cut 30%/26%/25%
We believe that due to lower merchant tariff realisations, profitability will be
impacted. We cut our EPS estimates by 30%/26%/25% to Rs2.72/4.16/6.97 for
FY11/12/13.
If we compare with consensus numbers, we are 9%/5% below for FY11/12. For
FY13, consensus is 18% below our estimate.
Stress testing: price implying unlikely negative
events
As can be seen from Chart 3, Lanco’s share price fall has been dramatic in 2011.
We perform various stress tests to work out what we think the company would
be worth if one or several bad scenarios were to play out. These include:
What if some coal linkages were not honoured and no alternative domestic
supply was available?
What could lead to one or several of Lanco’s power projects being unable to
be built and cancelled? And if this happens, what would be the effect on
Lanco, in terms of liabilities and capital commitments that could roll up from
the SPVs and loss of EPC profits?
Loss of coal linkages
Coal supplies will be tight for the industry in the medium-term
According to the Coal Ministry, India has vast thermal coal resources, and the
coal industry is being deregulated. Hence, we think coal could remain the
primary energy source due to its favourable supply dynamics and competitive
costs. It is a fact that coal-based thermal power generation is the most preferred
choice in India for power generation and would continue to remain so.
We think the emphasis on coal-fired power plant development will present
challenges in the medium term. The pace of development could pressure the
ability of the coal industry to meet the power sector’s coal needs.
Over the next five years, we believe India may face a shortage of domestic
linkage-based coal (supplied by CIL) as significant coal-based power capacity
additions are likely. We expect India to add around 45,000MW of coal-based
capacity over FY10-15 compared to an installed base of 85,000MW as of FY10,
that is, coal requirement will record a CAGR of 8%.
Coal India has said that in case of insufficient production (which is likely the
case, in its view), it would not be able to supply the required quantity (for
optimal utilisation rates (plant load factors: PLFs) of coal to power plants.
However, we believe CIL should be able to increase its production at a CAGR
of 5.2%. For details, please refer to UBS Indian coal analyst Navin Gupta’s note
India Power Utilities: Is coal a constraint for India power story?, published on
14 January 2011.
We think it is vital for companies to proactively take steps to anticipate and
mitigate coal risk. Power purchase contracts generally have fuel cost passthrough,
transferring the risk from the power plant operators to the purchaser,
which usually a State Electricity Board (SEB).
However, relying on this alone is risky in our view. It assumes there is ability
and willingness for the SEB to take power at potentially ever higher and less
affordable prices.
Lanco’s management expect medium-term power prices to trend up as the
percentage of coal supply at artificially low, regulated prices declines. Its
strategy is to focus on cost reduction at the development stage and in operations,
and believes its EPC capabilities help with this.
In addition, we think the company also has to take steps to acquire its own coal
assets, both in India and Australia, which could help manage coal costs. This is a
trend we see industry-wide—as shown in Table 13, captive coal production
within the power sector is quite significant now.
What if Lanco cannot get local coal?
Even though we think CIL will face challenges in meeting all coal commitments,
we assume fuel cost pass-through arrangements will be robust. While some
shortfall is possible, we think it is extremely unlikely that CIL will fail to meet
any commitments whatsoever.
However, what if some coal linkages were not honoured and no alternative
domestic supply was available? We assume this would force Lanco to source
coal from overseas. We estimate the landed cost of coal from Indonesia at
present would be about US$100/tonne or Rs4,600/tonne, which is about triple
the local price. Lanco’s power purchase agreements generally have fuel cost
pass though.
A tripling of the coal price would require a substantial 30%-40%% increase in
tariffs to maintain project profitability. This may be difficult to recover from the
SEBs. We also believe an increase of 20%-25% would be required to maintain
the project IRR at 11.4%, which is our estimate of Lanco’s WACC. A return at
this level would still enable us to view the project as being worth at least the
replacement costs and the construction of the project to be NPV-neutral. If the
coal price triples, but tariffs remain unchanged, companies would not be able to
recover even the variable costs and projects would not remain operational.
If we refer to Table 14, the coal-based projects contribute Rs28 in our valuation
(Rs18 for operational/ready projects and Rs10 for projects under construction).
This Rs28 is part of our Rs70 price target.
Project cancellation
Possible factors that could lead this could include: a failure to procure coal; an
inability to obtain bank funding; or Lanco having insufficient cash to develop
the project. Our discussions with management suggest it recognises coal
procurement risks and have been taking steps, through direct coal investments to
secure coal. Management also says it can fund the equity requirements for the
development projects from the operating cash flows of the power generation
segment alone, without relying on cash flows from the EPC segment.
However, what would be the effect on our valuations for Lanco if the projects
are abandoned? If the project is yet to begin construction, then the answer is
simple—the project will simply come out of our forecasts, but we do not give
value to them anyway, so there would be no impact.
However, there is further risk in the less likely and remote event of the project
being cancelled once it is already under construction. Lanco, like other Indian
power developers, creates SPVs for the administration of power plant
construction projects. These SPVs are carried off balance sheet. We consider
several risks if a project is cancelled during construction—through guarantees,
any commitments for EPC contracts in the SPV could become a liability for
Lanco, as could any debt already drawn down by the SPV.
To estimate this for each SPV, we discussed with management whether any EPC
commitments have been entered into. For projects under construction, we have
assumed any equity contribution has happened first, and after that, debt is
progressively drawn down as construction proceeds, and we have applied a
‘percentage of completion’ approach based on these assumptions to estimate the
off balance sheet debt of each SPV.
However, we believe this exercise is largely theoretical as even in a worst-case
scenario of the project getting stuck, there have been cases in the past where
there are buyers for the projects available (at least it can recover the money
already invested in the project).
We also need to look at the difficulties involved in the pre-execution work for
projects in India. This includes land acquisitions, approvals, and arrangements
for fuel linkage. Thus, any project where the pre-execution work has been
completed and construction has begun should be worth much more (to a thirdparty
purchaser) than the investment Lanco has made.
Ideally, we should only assume that the liability could be created for internal
projects because of the fact that in most of the external projects, contracts with
suppliers are only signed once the advances are received. Thus, we do not
expect the liability will be more than Rs17, even in the worst-case scenario of
the internal projects getting cancelled.
Impact on EPC business
The EPC business has around 75% internal projects. However, the impact on
valuation could be about Rs4 (proportionate impact if we take Rs16 as EPC
valuation).
Thus, there are three valuation effects of project cancelations: 1) the valuation
contribution of the project goes away; 2) additional liability gets created due to
debt taken and orders given to external vendors; and 3) EPC business revenue
takes a hit, which would impact the EPC business valuation.
Table 16: Valuation impact—what is the liability if projects are cancelled?
Rs/ share
Valuation contribution of under construction projects (refer SoTP) 18
Impact on EPC valuation (refer paragraph above) 12
Total impact 30
Effective price target 40
Additional liability created (refer Table above) 17
Net Price target 23
Total impact due to project cancelation 47 (Rs70 – Rs23)
Market price implying (% cancelation) 65%
Note: 1) In valuation contribution, Rs18 includes Rs13 for coal based projects and Rs5 for hydro projects.
Source: UBS estimates
Merchant tariff
We assume a long-term merchant tariff in India of Rs3/kWh, below power
purchase agreement tariff levels, which are close to Rs3.5/kWh and compares to
the recent price of about Rs4.5/kWh.
We have already built in this impact in our price target reduction. However, if
we assume another decline in merchant tariffs is possible, it would be minor and
affect long-term estimates only. We believe a further reduction (compared to our
new estimates) is highly unlikely.
Lanco Infratech
Lanco Infratech Limited (Lanco), established in 1993, is an integrated
infrastructure developer with interests in power, infrastructure, construction and
real estate. Lanco is among the leading private sector power generation
companies. It has a captive construction division that directly benefits from the
award of in-house power, real estate and infrastructure projects.
Statement of Risk
Risks include: failure to procure coal for existing or future power plants, the
inability to fully recover changes in coal prices, slow or non-collection of
accounts receivables, difficulties in securing bank or other funding for
development projects, lower than expected merchant power prices.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
UBS Investment Research
Key Call: Lanco Infratech
Share price implying unlikely events
Share price down 36% so far in 2011
Lanco Infratech’s (Lanco) share price has fallen from Rs63 to Rs40 since the
beginning of the year. Several factors combined to lead to this, including worries
about changes in accounting policies, security of fuel supplies (coal linkages), and
merchant tariff weakness. The BSE Sensex has corrected 14% YTD as there are
macro concerns such as inflation. The share prices of Indian utilities under our
coverage are down 17% YTD.
Is it a buying opportunity?
The question now is whether to review our investment recommendation. To answer
this, we perform stress test valuations and conclude that the current share price is
implying either: 1) that 65% of projects under construction will stall and the
company will have to bear debt and contract liabilities for them; or 2) the coalbased
projects are not contributing any value. We believe either of these scenarios
occurring is unlikely.
Lower FY11/12/13 EPS estimates 30%/26%/25%
We lower our FY11/12/13 EPS estimates from Rs3.91/5.61/9.28 to
Rs2.72/4.16/6.97 because of lower merchant tariff assumptions, a lower
engineering, procurement, construction (EPC) multiple (from 6x to 4x FY12E
EBITDA); lower value for new power projects (now valued at 1x equity
investment versus Rs60m EV/MW earlier). We think the stock is cheap—to
assume an FY13E PE of 10x, merchant tariffs would need to fall to Rs1.3/kWh
(our assumption is Rs3.5/kWh).
Valuation: maintain Buy rating; lower price target from Rs105 to Rs70
We derive our price target from a sum-of-the-parts methodology. We value Lanco
as a conglomerate with power contributing 67% of valuation and EPC 23%.
Summary
We believe Lanco’s share price has been affected by general poor sentiment on
the Indian infrastructure sector, worries about the reasons behind Lanco’s two
changes in deprecation accounting policies, coal supply security concerns and
worries about project implementation.
In light of these concerns, we met with Lanco’s Chairman and CFO to review
some investor concerns. In this comment, we review the reasons behind the
accounting changes and stress test our valuations to estimate what risks in terms
of fuel and project implementation are reflected in the share price.
Lanco’s current share price is implying either of two very unlikely scenarios —
that either the coal-fired power plants are worthless or construction projects will
be cancelled, and the liability for capital commitments and loans drawn down in
special purpose vehicles roll up to the company.
We think the stock is attractive after the recent share price declines and reiterate
our Buy rating. On our new earnings forecasts, the stock is trading at 9.6x
FY12E earnings and 5.7x FY13E earnings. To assume a double-digit (10x)
FY12E PE, we would have to assume the merchant power prices, which
averaged Rs4.5/kWh for Lanco for the nine months up to 31 December 2010
and would fall to Rs1.4/kWh for FY13.
Accounting policy changes
In Q111, the company changed its accounting policy to a diminishing value
basis, but then in Q311, they changed it back to a straight line. The depreciation
periods remained unchanged. We think investors have looked at this flip-flop in
accounting policy and are worried the changes are hiding a more fundamental
problem with the company.
Our view is the change is more a failure to fully think through the implication of
the original accounting policy change before implementation. When moving to a
diminishing value method, management was trying to reduce political risks from
very high returns when merchant power prices were high by front-end loading
depreciation. Naturally, this made reported earnings very vulnerable when
merchant power prices normalised in the second half of 2010. We think the
return to the original straight line policy is more appropriate and brings the
policy back into line with industry practice.
Worries on coal
If we refer to Table 1, the coal-based projects contribute Rs28 in our valuation
(Rs18 for operational/ready projects and Rs10 for projects under construction).
This Rs28 is part of our Rs70 price target. If we look at current market price, it
could be implying all these projects are worthless (that is, from a DCF
perspective, they have zero value).
Projects under construction not moving forward
There are three valuation effects of a project getting stuck or cancelled.
Valuation contribution of the project goes away;
Additional liability gets created due to debt taken and orders given to
external vendors, which rolls up from the off-balance sheet special purpose
vehicle up to the company;
EPC business revenues take a hit, which would reduce the EPC business
valuation.
We show the effect of these in Table 2. If we assume all development projects
will be cancelled at their current state of completion, the negative effect would
be Rs47/share. However, the actual effect would likely be somewhat lower. If
the cancelations were part of an overall trend for the industry, fewer power
projects being built would have a positive effect on merchant power prices, so
there would be a positive effect on Lanco’s portfolio of operational plants.
Table 2: Valuation impact—what is the liability if projects are cancelled?
Rs/ share
Valuation contribution of under construction projects (refer Lanco SoTP) 18
Impact on EPC valuation (refer SoTP and discussion at later pages) 12
Total impact 30
Effective price target 40
Additional liability created 17
Net Price target 23
Total impact due to project cancelation 47 (Rs70 – Rs23)
Market price implying (% cancelation) 65%
Note: 1) In valuation contribution, Rs18 includes Rs13 for coal based projects and Rs5 for hydro projects.
Source: UBS estimates
We use a DCF methodology for three of the businesses, and an EBITDA
multiple for EPC. We value the new under-construction power projects at book
value.
What Lanco currently has
Lanco has two main divisions, power plant ownership and operation, and a
construction and EPC business. It also has some smaller infrastructure and real
estate investments.
Power business
Lanco has nine power plants with a combined capacity of 2,092MW in
operation (Table 4), five of which are very small and can be ignored. It has
another 7,148MW under construction, with a further 11,070MW of development
pipeline. For the nine months to 31 December 2010, this segment provided more
than 95% of the group’s consolidated earnings.
One key factor is that the construction projects are generally held off balance
sheet in special purpose vehicles (SPVs) during the development and
construction phase. This is relevant for our stress test valuation later.
Lanco’s operating generating capacity increased 4x from 500MW at the end of
FY09. The key projects that became operational in the past sixteen months were:
Amarkantak I and II; Kondapalli II; and Udupi I. Table 4 shows the plants that
are currently operational.
Operating capacity will double in six months
In the next six months, the company is adding another 1,870MW in its operating
capacity. These projects are:
Udupi II (600MW)
Anpara I and II (1,200MW)
Lanco Green (Budhil, 70MW)
Under development pipeline is strong
Apart from the projects under execution, the majority of which are nearing
completion, Lanco has made satisfactory progress on its new projects. The key
projects are shown in Table 5.
Table 5: Projects under development
Plant State Fuel Capacity (MW) Completion
Kondapalli - III Andhra Gas 742 FY13
Amarkantak III, IV Chhattisgarh Coal 1,320 FY14
Vidarbha Maharashtra Coal 1,320 FY 14
Babandh Orissa Coal 1,320 FY14
Source: Company data, UBS estimates
Execution progress is good for these projects as most of the prerequisites listed
in Table 6 are already in place. The company has already made significant
investments in these projects as reported in its Q3 FY11 results.
Engineering, procurement, construction (EPC)
Lanco’s construction segment provides engineering, procurement and
construction services for the power sector. Its largest customer is itself, but it
also does work for third parties. For the nine months to 31 December 2010, this
segment provided less than 5% of the group’s consolidated earnings.
Real estate
Lanco has 4m square feet under development in Hyderabad, India. Lanco is
developing Lanco Hills, mixed used space of high-rise residential structures, ‘IT
Special Economic Zone’ office spaces, shopping malls and hotels. As of now,
construction is in progress for six residential towers and the possession of
apartments will commence shortly.
Infrastructure
The group was awarded two national highway projects in Karnataka. It has two
toll roads that it is developing at the moment.
Table 7: Progress on projects under development
Project Concession period (years) Length ( km)
Bangalore – Hoskote – Mudbagal 20 years 81
Neelamangla – Devihalli 25 years 82
Source: Company data
Currently, construction is under progress and expected to be completed in the
next six months.
The real estate and infrastructure businesses are relatively very small for the
company and the prime focus remains on its two businesses—power and EPC.
Our price target is Rs70
Stock is attractive on forward earnings now
We think the stock is attractive after the recent share price decline. On our new
earnings forecasts, the stock is trading at 9.6x FY12E earnings and 5.7x FY13E
earnings. To assume a double-digit (10x) FY13E PE, we would have to assume
merchant power prices would need to fall to about Rs1.4/kWh. As can be seen
from Chart 1, this is low compared to the merchant power price over the last
three years. However, because of bilateral contracts, Lanco would not be
exposed to a price this low. For the first nine months of FY11, Lanco’s average
realised merchant price was Rs4.5/kWh. Chart 2 shows the sensitivity of our
2013E PE for Lanco, which reflects this partial exposure to the merchant tariff.
Price target is 74% above current share price
We use a DCF methodology for three of the businesses, and an EBITDA
multiple for EPC. We value the new under-construction power projects at book
value.
We do not believe its EPC business should be valued at zero as some investors
may argue, as the projects are largely internal. The key reasons are: 1) the EPC
division is a key strength for any power developer as it controls the key part,
which is execution; 2) the 25% order book is external; and 3) despite healthy
margins for EPC, the per MW cost for Lanco as a developer is still competitive.
Our price target cut is driven by:
(1) Lower merchant tariff assumptions. Table 9 shows our new and old
forecasts. The effect of these changes on our price target is Rs10.
(2) Lower EPC multiple from 6x to 4x FY12E EBITDA (impact of Rs14 to
our price target). With a significant correction in the construction space
valuation, we think it would be sensible to use a more conservative
valuation multiple for the EPC business.
(3) Lower value for new power projects (impact of Rs12 to our price
target). The new projects under development are now valued at 1x equity
investment versus Rs60m EV/MW earlier. This effectively means a change
from 2.5x P/BV to 1x P/BV, equivalent to valuing only the investment in
the projects.
FY11/12/13 EPS estimates cut 30%/26%/25%
We believe that due to lower merchant tariff realisations, profitability will be
impacted. We cut our EPS estimates by 30%/26%/25% to Rs2.72/4.16/6.97 for
FY11/12/13.
If we compare with consensus numbers, we are 9%/5% below for FY11/12. For
FY13, consensus is 18% below our estimate.
Stress testing: price implying unlikely negative
events
As can be seen from Chart 3, Lanco’s share price fall has been dramatic in 2011.
We perform various stress tests to work out what we think the company would
be worth if one or several bad scenarios were to play out. These include:
What if some coal linkages were not honoured and no alternative domestic
supply was available?
What could lead to one or several of Lanco’s power projects being unable to
be built and cancelled? And if this happens, what would be the effect on
Lanco, in terms of liabilities and capital commitments that could roll up from
the SPVs and loss of EPC profits?
Loss of coal linkages
Coal supplies will be tight for the industry in the medium-term
According to the Coal Ministry, India has vast thermal coal resources, and the
coal industry is being deregulated. Hence, we think coal could remain the
primary energy source due to its favourable supply dynamics and competitive
costs. It is a fact that coal-based thermal power generation is the most preferred
choice in India for power generation and would continue to remain so.
We think the emphasis on coal-fired power plant development will present
challenges in the medium term. The pace of development could pressure the
ability of the coal industry to meet the power sector’s coal needs.
Over the next five years, we believe India may face a shortage of domestic
linkage-based coal (supplied by CIL) as significant coal-based power capacity
additions are likely. We expect India to add around 45,000MW of coal-based
capacity over FY10-15 compared to an installed base of 85,000MW as of FY10,
that is, coal requirement will record a CAGR of 8%.
Coal India has said that in case of insufficient production (which is likely the
case, in its view), it would not be able to supply the required quantity (for
optimal utilisation rates (plant load factors: PLFs) of coal to power plants.
However, we believe CIL should be able to increase its production at a CAGR
of 5.2%. For details, please refer to UBS Indian coal analyst Navin Gupta’s note
India Power Utilities: Is coal a constraint for India power story?, published on
14 January 2011.
We think it is vital for companies to proactively take steps to anticipate and
mitigate coal risk. Power purchase contracts generally have fuel cost passthrough,
transferring the risk from the power plant operators to the purchaser,
which usually a State Electricity Board (SEB).
However, relying on this alone is risky in our view. It assumes there is ability
and willingness for the SEB to take power at potentially ever higher and less
affordable prices.
Lanco’s management expect medium-term power prices to trend up as the
percentage of coal supply at artificially low, regulated prices declines. Its
strategy is to focus on cost reduction at the development stage and in operations,
and believes its EPC capabilities help with this.
In addition, we think the company also has to take steps to acquire its own coal
assets, both in India and Australia, which could help manage coal costs. This is a
trend we see industry-wide—as shown in Table 13, captive coal production
within the power sector is quite significant now.
What if Lanco cannot get local coal?
Even though we think CIL will face challenges in meeting all coal commitments,
we assume fuel cost pass-through arrangements will be robust. While some
shortfall is possible, we think it is extremely unlikely that CIL will fail to meet
any commitments whatsoever.
However, what if some coal linkages were not honoured and no alternative
domestic supply was available? We assume this would force Lanco to source
coal from overseas. We estimate the landed cost of coal from Indonesia at
present would be about US$100/tonne or Rs4,600/tonne, which is about triple
the local price. Lanco’s power purchase agreements generally have fuel cost
pass though.
A tripling of the coal price would require a substantial 30%-40%% increase in
tariffs to maintain project profitability. This may be difficult to recover from the
SEBs. We also believe an increase of 20%-25% would be required to maintain
the project IRR at 11.4%, which is our estimate of Lanco’s WACC. A return at
this level would still enable us to view the project as being worth at least the
replacement costs and the construction of the project to be NPV-neutral. If the
coal price triples, but tariffs remain unchanged, companies would not be able to
recover even the variable costs and projects would not remain operational.
If we refer to Table 14, the coal-based projects contribute Rs28 in our valuation
(Rs18 for operational/ready projects and Rs10 for projects under construction).
This Rs28 is part of our Rs70 price target.
Project cancellation
Possible factors that could lead this could include: a failure to procure coal; an
inability to obtain bank funding; or Lanco having insufficient cash to develop
the project. Our discussions with management suggest it recognises coal
procurement risks and have been taking steps, through direct coal investments to
secure coal. Management also says it can fund the equity requirements for the
development projects from the operating cash flows of the power generation
segment alone, without relying on cash flows from the EPC segment.
However, what would be the effect on our valuations for Lanco if the projects
are abandoned? If the project is yet to begin construction, then the answer is
simple—the project will simply come out of our forecasts, but we do not give
value to them anyway, so there would be no impact.
However, there is further risk in the less likely and remote event of the project
being cancelled once it is already under construction. Lanco, like other Indian
power developers, creates SPVs for the administration of power plant
construction projects. These SPVs are carried off balance sheet. We consider
several risks if a project is cancelled during construction—through guarantees,
any commitments for EPC contracts in the SPV could become a liability for
Lanco, as could any debt already drawn down by the SPV.
To estimate this for each SPV, we discussed with management whether any EPC
commitments have been entered into. For projects under construction, we have
assumed any equity contribution has happened first, and after that, debt is
progressively drawn down as construction proceeds, and we have applied a
‘percentage of completion’ approach based on these assumptions to estimate the
off balance sheet debt of each SPV.
However, we believe this exercise is largely theoretical as even in a worst-case
scenario of the project getting stuck, there have been cases in the past where
there are buyers for the projects available (at least it can recover the money
already invested in the project).
We also need to look at the difficulties involved in the pre-execution work for
projects in India. This includes land acquisitions, approvals, and arrangements
for fuel linkage. Thus, any project where the pre-execution work has been
completed and construction has begun should be worth much more (to a thirdparty
purchaser) than the investment Lanco has made.
Ideally, we should only assume that the liability could be created for internal
projects because of the fact that in most of the external projects, contracts with
suppliers are only signed once the advances are received. Thus, we do not
expect the liability will be more than Rs17, even in the worst-case scenario of
the internal projects getting cancelled.
Impact on EPC business
The EPC business has around 75% internal projects. However, the impact on
valuation could be about Rs4 (proportionate impact if we take Rs16 as EPC
valuation).
Thus, there are three valuation effects of project cancelations: 1) the valuation
contribution of the project goes away; 2) additional liability gets created due to
debt taken and orders given to external vendors; and 3) EPC business revenue
takes a hit, which would impact the EPC business valuation.
Table 16: Valuation impact—what is the liability if projects are cancelled?
Rs/ share
Valuation contribution of under construction projects (refer SoTP) 18
Impact on EPC valuation (refer paragraph above) 12
Total impact 30
Effective price target 40
Additional liability created (refer Table above) 17
Net Price target 23
Total impact due to project cancelation 47 (Rs70 – Rs23)
Market price implying (% cancelation) 65%
Note: 1) In valuation contribution, Rs18 includes Rs13 for coal based projects and Rs5 for hydro projects.
Source: UBS estimates
Merchant tariff
We assume a long-term merchant tariff in India of Rs3/kWh, below power
purchase agreement tariff levels, which are close to Rs3.5/kWh and compares to
the recent price of about Rs4.5/kWh.
We have already built in this impact in our price target reduction. However, if
we assume another decline in merchant tariffs is possible, it would be minor and
affect long-term estimates only. We believe a further reduction (compared to our
new estimates) is highly unlikely.
Lanco Infratech
Lanco Infratech Limited (Lanco), established in 1993, is an integrated
infrastructure developer with interests in power, infrastructure, construction and
real estate. Lanco is among the leading private sector power generation
companies. It has a captive construction division that directly benefits from the
award of in-house power, real estate and infrastructure projects.
Statement of Risk
Risks include: failure to procure coal for existing or future power plants, the
inability to fully recover changes in coal prices, slow or non-collection of
accounts receivables, difficulties in securing bank or other funding for
development projects, lower than expected merchant power prices.
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