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Underperformance despite fundamentals offers favourable risk-reward
After the sector’s near-100% underperformance (worst-performing sector) since
Jan'09, we believe pessimism is overdone, even discounting further short-term
macroeconomic deterioration. With risk-return turning favourable after a long gap,
we upgrade the sector to Outperform. A peaking interest rate cycle (we expect a
75bps increase after the 250bps hike in the past 15 months) and property price
cuts, which will bring back demand, should be key sector catalysts (as in 2009).
We upgrade DLF to Buy and Unitech to Hold; we prefer Sobha, a low-beta stock.
A sense of déjà-vu – sector awaiting catalysts for a bounce-back, à la 2009
We see a repeat of 2009, when the sector saw sharp recovery (outperforming the
Sensex by 113% between March and September 2009) after the liquidity crisis.
Outperformance was driven by: (a) rate cuts of 425bps between September 2008
and April 2009, (b) counter-intuitive c.20% cut in property prices to kick-start
demand and (c) equity dilutions. Despite improving fundamentals, most stocks
trade below book value, and at a >30% discount to DCF-based NAV, higher than
the region. Having stabilized since January 2011, this high-beta sector, is awaiting
catalysts, which can be perceived peaking of rate hikes by the RBI (after 250bps in
the past 15 months) and price cuts by developers in the next six months.
Sector fundamentals have improved dramatically since 2009
Since 2009, companies have slashed land banks and significantly improved
gearing, a key source of investor concern. Gearing levels are down to 47% from
the high of 126% seen in March 2009. Developers are refocusing on the cash–
flow-generating mid-end residential vertical rather than on margin-driven high-end
office space, where we see continuing oversupply.
While sizeable risks are known, sector characteristics favour developers
Robust GDP growth, rising disposable incomes, attractive demographics and
finance availability remain long-term growth drivers. However, opaque approval
processes by multiple regulators, non-transparent markets, long delivery
schedules and high transaction costs have constrained supply, favouring
developers. However, pricing remains the key to demand returning. We concede
that corporate governance in a few companies will likely remain an overhang.
Analysis suggests DCF is the most independent valuation tool
The shortcomings of DCF (lack of clarity on land banks) force investors to use
other valuation tools. Our proprietary analysis (pages 34-42) of the varying
accounting policies of developers suggests that P/E is significantly influenced by
the definition of the threshold and in including land in revenue recognition (RR).
Thus, RR is quicker for DLF and Puravankara and higher for DLF and Sobha, but
then normalises. Hence, we prefer DCF, an independent valuation tool.
P&L, a trailing indicator, getting constrained; cut estimates and target price
Data from property consultants indicate that the supply of office space will likely
run ahead of demand for more than three years. Despite developers delaying such
projects, we expect rentals to remain suppressed for about six quarters, unlike the
Street. Data from listed developers indicate a slowdown in residential presales.
This, coupled with high inflation and aggressive accounting policies, constrains
revenues and margins, which are lag indicators. We cut estimates and DCF-based
target prices by up to 52% and 40%, respectively.
Investment summary
The bear market story so far
Real estate sector hit by Murphy’s Law – anything that could go wrong, has gone
wrong:
Deteriorating corporate governance, especially in a few companies
Significant slowdown in demand coupled with spiking prices and rising interest rates
This, coupled with approval and execution delays, is constraining cash inflows, while the
spike in inflation is constraining profitability, aggravating operating leverage.
Developers are facing difficulty in raising funds in a tight liquidity environment, thus
raising solvency risks.
Even after the 82% fall in 2008 (with 30% underperformance), the sector fell another 4%
(101%) and has been the largest underperformer since January 2009.
Despite better fundamentals, significant underperformance….
While fundamentals (macro and sector) are much better vis-à-vis 2008…
Unlike 2008, global accommodative monetary policies have supported growth. Similarly,
accommodative monetary policies in early 2009 by the RBI helped GDP growth rise to
8%+ in FY10-11 as against 7% in FY09.
Since 2009, developers have slashed land banks and significantly improved gearing (to
47% from the high of 126% seen in March 2009) – a key source of investor concern.
Developers are refocusing on the cash-flow-generating mid-end residential vertical rather
than on margin-driven high-end office space, where we see continuing oversupply.
…sector records sizeable and consistent fall
Improving fundamentals were immediately reflected in the Sensex and partly reflected in
the India Property financials in FY10-11 (i.e. with a lag).
While the BSEREAL fell 82% in 2008 (32% underperformance), it has been down 4%
since then, underperforming the Sensex by 100%. Even in the past six and twelve
months, it recorded 20% and 39% underperformance, respectively.
Stocks now trade at trough valuations, at a 30%+ discount to NAV (sector’s c.39%
discount to NAV is the highest in Asia), with most trading at a discount to their book
value.
…and near-term catalysts; hence we upgrade to overweight
High-beta sector appears to have stabilised since January 2011.
The perceived peaking of rate hikes by the RBI (after 250bps in the past 15 months) and
price cuts by developers in the next six months could be the long-awaited catalysts for
the sector. This was seen in 2009, with BSEREAL rising by c.190% and outperforming
Sensex by c.113% from March to September 2009.
With risk-reward now looking favourable, we upgrade:
The sector to Outperform (from Underperform)
DLF, the market leader by far, to Buy (from Hold)
Unitech to Hold (from Sell)
What’s new here?
While sizeable risks are known, sector characteristics favour developers
Detailed sector characterisation indicates the following:
There is significant potential given the demographics, increasing incomes and availability
of retail finance. However, high unit prices, transaction costs and unaccounted wealth
(due to limited institutional funding) make it a shallow and translucent market.
Multiple (and increasing) number of approvals and approval agencies coupled with lack
of clear processes and timelines further delay the long delivery schedules for real estate.
While supply is fragmented, demand is even more so. Like banking, property is a
localised sector with limited threat from global players.
Hence, the sector, in its early life cycle stage, will likely continue to be driven by supply,
leading to profit focus and weak corporate governance by developers.
Unlike the Street, we believe the office vertical will remain under pressure for four to
six quarters
In line with the Street, we believe residential demand will remain weak across almost all
cities. Bengaluru, driven by the continual robust outlook for the key IT sector, a late
pickup in demand (from end-CY09, unlike mid-CY09 in almost all other cities) and minimal
price hikes, continues to support demand.
Our detailed macro and micro analyses indicate that supply for the office vertical will
likely remain ahead of demand, with glut expected to continue for another six quarters.
This is despite developers trying to restrict supply by continually rolling over project
execution schedules.
Our proprietary analysis of developers’ varying accounting policies suggests that DCF
is the only independent valuation tool
Considering the shortcomings of DCF-based valuations, investors are looking to use
other valuation methodologies.
As developers launch projects optimising between cash flow and profits, cash flow from
operations is not an independent variable to be used as a valuation tool.
Our proprietary analysis indicates that each company uses its unique revenue recognition
(RR) policy, with differences in defining the threshold and in including land in RR, with
DLF and Sobha following the most aggressive policy. Hence, using an unadjusted P/E
multiple for valuation is erroneous.
Even the simple debtor recognition policy varies significantly. Despite its conservative
revenue recognition, Unitech’s debtor days are high and rising.
We can calculate DCF-based NAV with relative ease using a common set of valuation
assumptions for all companies, as it is independent of accounting policies.
Cut estimates and target price
FY11 financials were poor, especially the significant drop in 4Q margins driven by the
inferior product mix, spike in costs and increase in budgeted costs. We anticipate a delay
in projects and change in product mix and cut revenues by up to 30%. High inflation and
poor product mix result in EBIDTA and PAT being cut by up to 50% each.
We continue using DCF-based valuation methodology. Delaying projects by 1.5-3 years,
raising construction costs, WACC and discount to GAV, we cut target prices by up to
40%.
Despite better fundamentals,
significant underperformance;
upgrading to overweight
Key themes – risk-reward now looks favourable
Fundamentals (macro and sector) are much better now as compared with 2008. This is
partly reflected in the India Property financials and in the Sensex.
While the BSEREAL fell 82% in 2008 (32% underperformance), it has been down 4%
since then, underperforming the Sensex by 100%. Even in the past six and twelve
months, it recorded 23% and 40% underperformance, respectively.
Stocks now trade at trough valuations, at a 30%+ discount to NAV (highest in Asia), with
most trading at a discount to their book value.
The high-beta sector has stabilised since January 2011. The perceived peaking of rate
hikes by the RBI and price cuts by developers in near term could be the long-awaited
catalysts. This was seen in 2009, with BSEREAL rising by c.190% and outperforming
Sensex by c.113% from March to September 2009.
With limited downside, the risk-reward now looks favourable. Hence, we upgrade the
sector to Outperform (from Underperform), DLF to Buy (Hold) and Unitech to Hold (Sell).
While known sizeable risks,
sector characteristics favour
developers
Key themes
There is significant potential given demographics, increasing incomes and the availability
of retail finance. However, high unit prices, transaction costs and unaccounted wealth
(due to limited institutional funding) make it a shallow and translucent market.
The multiple (and increasing) number of approvals and approval agencies, coupled with a
lack of clear processes and timelines, further delay the long delivery schedules for real
estate.
The sector, in its early life cycle stage, is driven by supply, leading to a profit focus and
weak corporate governance by developers
Credible data is a handicap
for any significant analysis
Key themes
The lack of a common regulator or industry association and classification differences in
collating mortgage data from banks/ NBFCs result in there being no organised sectorwide
data base.
Even the office vertical, with organised stakeholders (large corporate end-users, large
tier-1 developers and property consultants), and shorter demand-supply cycles, has
significant data inconsistency.
As India lacks reliable data over a period of >3 years, significant analysis is irrelevant.
Hence, we refrain from any significant analysis.
Lack of organised sector data
No common regulator or strong industry association at the national/state/city level
Data for most industries is released by companies (auto, cement, telecom, etc.), or , industry
associations (auto, cement, IT, telecom, etc.) or with organised data providers (FMCG, the
media, etc.) or by regulators (banks, telecom, etc.). While data from these sources may not
be completely accurate or fully reliable, it can be used for trend analysis. Real estate is one of
the few sectors where there is no such data bank.
Though stamp duty accounts for a chunk of state government revenues, it is not well
collated
While stamp duty and registration account for 10-20% of the revenues of local bodies and
state governments, this data is not collated over time by region for conducting any analysis.
Even data on mortgages from banks/NBFCs is not welI collated
Surprisingly, even data on mortgages is not well collated, as banks are governed by RBI,
while housing finance companies (HFCs) like HDFC, LIC Housing Finance, and ICICI Home
Finance are governed by National Housing Bank (NHB). Classification differences, constant
changes in classification criteria and different reporting dates make comparisons difficult.
While large, listed developers provide quarterly data, it may not be relevant
While almost all large, listed developers provide basic operational data on a quarterly basis:
these large, listed developers form only a small proportion of the market in each of the
major metro areas and an even smaller proportion at a national level
each developer has its own unique way of classification (defining metros, cities, etc.),
and these classification techniques are continually changing
the reliability of this data may be questioned given the weak corporate governance in the
sector.
Thus, data from listed developers may not be relevant for any significant analysis.
Even office, an easier vertical to analyse, has data inconsistency
Office, a vertical with largely organised stakeholders,…
While residential vertical accounts for c.80%+ of the Indian property sector, it is
fragmented and unorganised. Many factors associated with the sector (suppliers,
buyers, peers, etc.) are also significantly fragmented.
Fortunately, commercial (c.10%+ of Indian property sector) is much better organised:
The top seven Indian cities account for c.90% of this vertical, most of which are tier-
1 properties.
A significant portion of the market (c.85%) is accounted for by corporate end-users.
There are fewer suppliers of tier-1 properties.
This vertical is supported by a few global property consultants/brokers (e.g. JLL,
Knight Frank, Cushman, etc.), who collate primary data on the sector, analyse it and
publish it as a free service.
Thus, this commercial vertical is similar to a wholesale market in that it is not only easier to
track but also offers reliable industry data.
…and shorter demand-supply cycles…
Industry nature constraints speculative demand as:
A significant portion (c.75%+) of the market (by value) is accounted for by
multinational companies, which prefer leasing to purchase.
Furthermore, leasing is generally concluded in the last phase of construction. With
little sub-leasing, demand is almost entirely end-user driven with limited speculative
demand.
Even if there is pre-leasing by larger tenants, there is limited upfront payment.
…while funding constraints speculative construction
In the residential vertical, developers pre-launch even before getting all approvals
and commencing construction, in order to raise resources. This is not possible in the
commercial vertical. Thus, commercial projects tend to be “cash guzzlers”. Only
after the developer exits with the sale of a majority stake, which is largely possible
only after completion and leasing.
With the REIT market yet to develop in India and no other alternate market offering
significant exit options (London-based AIMs, Singapore-based REITs, etc.) for Indian
commercial projects, complete exit for tier-1 commercial projects is almost
impossible. Even strata sales are not possible for tier-1 properties or SEZs.
Coupled with shorter gestation cycles, this dilemma could lead to shorter demandsupply
cycles. With large floor plates (allowing for easy design and automation in
construction) and limited internal construction, commercial projects can be completed in
18-36 months as compared to 24-60 months for residential projects. We believe this
leads to shorter demand-supply cycles as compared to those in the residential vertical.
…has significant data inconsistency
We analysed the commercial office space data available from premier global property
consultants like Jones Lang LaSalle (JLLM), Cushman & Wakefield (C&W) and DTZ research.
We observed that JLLM reports a lower stock compared to Cushman and DTZ in each year.
Similarly, the JLLM yearly supply and absorption data is comparatively lower than its peers.
Some of the reasons for the significant variance could be:
The coverage area for each city may be different.
While all the data is for office properties that are Grade-A or in prime CBD locations, each
consultant may have a different interpretation of these classification types.
The depth of coverage in any location by different consultants may vary.
Glut in office space likely to
continue
Key themes
Robust GDP growth drove demand for office space from CY01-07. But, global liquidity
crisis squeezed demand, leading to a spike in vacancies despite a plunge in rentals.
Despite robust economic growth, attractive rentals and a plunge in supply, analysis of
macro data indicates that recovery in absorption and rentals will likely be slower than
expected (the glut sustaining for a couple of years).
An analysis of the data from major office developers presents an even more bearish
picture (lacklustre leasing and most ongoing projects getting pushed out further).
Macro data on office indicates glut likely to sustain despite
supply delays
We focus on the top seven cities in India
As per global real estate advisors/brokers, commercial real estate in India largely centres
around seven cities (NCR, Bengaluru, Mumbai, Chennai, Hyderabad, Pune and Kolkata).
While Bengaluru comprises c.26% of the existing office space across these cities,
significant glut in 2009 constrained 2010 supply, resulting in its share in new supply
falling to c.13%.
Robust GDP growth and low base drove demand for office space
Robust economic growth (4%+ until FY03 and c.8% thereafter) and a low base of office
stock resulted in CAGR of 38% in supply of office space from CY01-07 (Figure 22)
We believe that as India was a supply-constrained economy at that time, most of this
supply was largely absorbed, as was seen in the period CY05-07 (Figure 22).
Thus, despite the robust increase in supply, rents spiked (Figure 23) and vacancies
bottomed at 5% in CY07 (Figure 22). Thus, while in locations with large stock like
Bengaluru (Figure 20), rents increased by 65% from CY04 to CY08, this figure spiked
320% in low-stock, supply-constrained Mumbai
Ex-Bengaluru, residential
volumes face resistance
Key themes
A spike in property prices in Mumbai leading to unaffordability has resulted in volumes
plummeting. This, coupled with excess supply in central Mumbai, is forcing developers
to delay projects.
Analysis of quarterly pre-sales data suggests that, ex-Bengaluru, volumes remain weak.
Robust outlook for IT sector; Bengaluru developers’ focus on execution and minimal
price hikes lead to robust demand in Bengaluru. This augurs well for Sobha, our top pick.
Regulatory bodies indicate a slowdown in housing loan off-take
Despite a significant ramp up in pre-sales in FY10 and FY11 for most developers as also in
property prices:
RBI’s (a regulatory body for banks) outstanding bank credit for housing data has grown at
only 15% in FY11. While this is an increase from 8% in FY10, it is significantly below the
levels recorded from FY05-07 (Figure 35)
NHB (National Housing Bank, a regulatory body for Housing Finance Companies, HFCs)
indicates that growth in housing finance has declined to <17% in FY11 as against c.19%
in FY10 and a c.25% CAGR from FY05-09.
Unique accounting policies
inadvertently affect valuation
Key themes –prefer the independent DCF-based valuation tool
Considering the shortcomings of DCF-based valuations, investors are looking to use
other valuation methodologies.
Our proprietary analysis indicates that each company uses its own unique revenue
recognition policy, with DLF following the most aggressive policy. Hence, using an
unadjusted P/E multiple for valuation is erroneous.
Even the ‘simple’ debtor recognition policy varies significantly for any ratio comparison.
Despite its conservative revenue recognition, Unitech’s debtor days are high and rising.
As developers launch projects optimising between cash flow and profits, cash flow from
operations is not an independent variable to be used as a valuation tool.
We can relatively easily calculate DCF-based NAV using a common set of valuation
assumptions for all companies as it is independent of accounting policies.
Accounting policies significantly impact valuations
Accounting policies not only impact financials, but also valuations
While everyone realises the impact that accounting policies could have on financials, we
believe their impact on valuations is not really understood by the markets.
Hence a proprietary analysis of accounting policies and its impact on P&L and BS items
While DCF-based NAV is the most relevant valuation tool for the sector and is
significantly agnostic to accounting policies, it has significant shortcomings:
Developers offer little clarity on their vast land bank, land titles, etc.
A sizeable part of the valuation of developers accrues in the medium to long term,
which is not so relevant given (a) the poor corporate governance in the sector, and
(b) current tight liquidity in the system, particularly in the property sector.
Investors have started focusing on P&L (P/E) and cash flow-based valuations (price to
FCF). However, we believe that these valuation methodologies are significantly
influenced by the accounting policies of each company. Hence, in this section, we do a
detailed study on the accounting policies of most developers and their impact on their
P&L and B/S.
We select leading developers by market cap, but exclude HDIL, IBREL and Sunteck
We have selected major developers by market cap to analyse their accounting policies.
We look at DLF, HDIL, IBREL, Oberoi, Prestige, Puravankara, Sobha, Sunteck and
Unitech for this analysis.
However we exclude HDIL, IBREL, Sunteck from this analysis as:
HDIL and Sunteck follow a conservative revenue recognition policy, resulting in
project revenues coming at the end of a project, meaning they cannot be compared
with peers.
As the first few projects from IBREL have just started to flow into its financials,
analysis of its historical financials is not relevant compared to peers.
Significant difference in revenue recognition policy among peers
Major factors driving the variations in revenue recognition policy
In India, the Institute of Chartered Accountants of India (ICAI) publishes accounting standards
(AS) and guidance notes to provide rules and guidance regarding revenue recognition. While
AS provides complete guidance about revenue recognition for most industries, there remain
wide gaps for quite a few sectors, including real estate.
The first and foremost variance arises from the fact that AS allows real estate developers
to follow either (a) a percentage of completion method (PoCM) or (b) project completion
method (PCM).
Under PoCM, revenues are recognised at every stage, based on costs actually
incurred as a percentage of total estimated costs of the project. This policy offers
the following benefits: (a) it stabilises revenues, as these are recognised in
proportion to actual costs incurred; and (b) it helps analysis of ratios and comparison
between peers. Most industry players follow this method.
Under PCM, revenues are recognised only at the completion of the project. Until
then, all costs incurred towards the project are treated as inventory and payments
received from customers are treated as ‘advances from customers’. The advantages
of this policy include (a) deferment of payment of direct tax to government, and (b)
recognising revenues only after transferring the entire project ownership to the
customer post delivery of the project. This being the most conservative revenue
recognition policy, only a few listed developers (HDIL, Sunteck Realty, etc.) follow it.
While most follow PoCM, the similarities end there
AS does not provide any rule/guidance regarding any minimum threshold (if any) for
project completion, for it to become eligible for revenue recognition. While most
developers following PoCM do have a minimum threshold, this varies among the
developers, with Oberoi and Unitech at a 20% threshold and DLF and Prestige at 30%
thresholds. Further, Puravankara does not have any minimum threshold for revenue
recognition.
Among the players that use a threshold, the industry is divided on whether land cost
should be included in ‘costs incurred’ to compute the threshold.
Finally, the industry is divided on another key question: Should land cost be taken as part
of ‘costs incurred’ to compute the percentage of revenues that will be recognised in the
financials?
Even the ‘simple’ debtor recognition policy diverges significantly
Considering that there are quite a few gaps in AS regarding revenue recognition policies and
the minimum threshold to be applied in case of long-term construction/contractual projects,
we are not surprised to witness a diversion for this. However, the policy for recognising
debtors, a rather straightforward one, also varies significantly across our cross-section of
selected developers.
Elucidating the linkage/process of pre-sales, collection and accounting/financials
To understand the diverse debtors recognition policies (DRP) followed by the developers, we
describe presales, collection and accounting policies for Indian developers.
Step 1 – Pre-sales: Residential projects in India are pre-launched (launched without
construction being completed) and the buyer needs to pay c.10%+ at the time of
booking the unit. This upfront booking amount is recorded as ‘customer advances’ (CA)
under ‘current liabilities (CL) in the B/S.
Step 2 – Billing: The buyer then has to pay the remaining amount in milestone or timebased
instalments. Hence, as and when the instalment becomes due, the buyer is
invoiced for his dues.
Step 3 – Collection and Accounting: When the customer makes a payment, it is
recorded as ‘customer advances’ under ‘current liabilities’ in the B/S.
DRP 1 – Debtor recognition being linked to customer invoicing
In this case, the company follows an ‘accrual method’ of accounting in its ‘true spirit’ and
recognises debtors when the invoice is raised and until the buyer makes the payment.
The dues received from the buyer are reflected as cash in the assets in B/S, matched by
an equal amount being added to CL in the B/S.
However, if the dues are not received, it would be recorded as debtors in the B/S, with
an equal amount being added to CL.
Among the companies analysed above, Unitech, Puravankara and Oberoi follow this
method of recognising debtors in the B/S.
In the case study analysed above, we have assumed 30% invoicing to customer, but
collections of only 25%. Hence, in Figure 48, all three companies (Unitech, Puravankara
and Oberoi) reflect INR5 as debtors, and INR10 as CA (total CA of INR30 is reduced by
INR20 being booked in revenues).
DRP 2 – Debtors’ recognition being linked to revenue recognition in P&L
In this case, the developer follows the ‘conventional’ method of recognising debtors.
When the invoice is raised, it does not get reported anywhere in the B/S.
The dues received from the buyer are reflected as cash in the assets in B/S, matched by
an equal amount being added to CL in the B/S.
After recognition of revenues, CL would be reduced by that amount.
Debtors are recognised only in the case and to the extent of CL being lower than
revenues recognised.
Among the companies analysed above, Sobha and Prestige follow this method of debtor
recognition.
Hence, in the case study analysed above, Prestige would record CA of INR25 (as it is yet
to recognise revenues), while Sobha would not reflect anything in its B/S as its CA of
INR25 (amount received from buyers) is matched by revenues of INR25 (Figure 48).
DRP 3 – Unbilled revenues/debtors
Our discussions with managements indicate that different companies follow different policies
regarding ‘unbilled revenues’ (UR) and their representation in B/S. We take a look at the
policy adopted by each company in this regard:
DLF: As seen in Figure 48-45, DLF is the most aggressive in terms of recognising
revenues in its P&L. However, its invoicing policy would be much slower than this
revenue recognition policy. The balance amount is then treated as UR.
In our case study (Figure 48), we assume only 30% invoicing to buyer, whereas it
would have recognised 52% of revenues. In such a case, it recognises the
remaining 22% as UR.
Unlike peers, DLF’s UR is not considered as debtors, but as a part of ‘other current
assets’ in the B/S.
Unitech: As Unitech does not follow aggressive revenue recognition policy, its revenues
usually lag invoicing to customers. Hence, UR is insignificant for Unitech and is clubbed
with debtors.
In our case study (Figure 48), Unitech would not have any UR, as its invoicing to
customers precedes its revenue recognition.
Puravankara: Follows a policy similar to that of Unitech - hence insignificant UR.
Oberoi: Follows a policy similar to that of Unitech - hence insignificant UR.
Sobha: follows unique policy. In a footnote in its annual report, it reports a large part of
debtors being UR for ongoing projects.
Prestige: Prestige prefers to pre-launch only a small portion of a project with subsequent
launches as the project advances. As the company is not strapped for cash it optimises
on margins by boosting average realisations. The buyers for these late-stage projects are
given c.3-6m for their dues payable at that stage of construction. Thus, these new presales
cross even the high threshold of 30% revenue recognition, right at the start.
Hence, the gap between revenues recognised and invoices sent to customers is treated
as UR.
DCF-based NAV, an independent valuation tool, is relevant
Shortcoming of P/E-based valuation
As explained in previous sections, revenues, costs and profits are all significantly
influenced by accounting policies.
With no two companies following largely similar accounting policies, we believe that
unadjusted P/E-based valuation process is irrelevant.
Given the limited data on each of the companies, it is almost impossible to arrive at
adjusted profits/P/E for each company to make it comparable to peers.
Shortcoming of cash flow-based valuation
Developers launch projects not on their development capability or the market absorption
capability, but based on their own cash flow/profit optimisation strategies.
After the liquidity crisis, developers launched projects only to generate some cash flow
from operations.
We believe that cash flow from operations may not be reflective of the actual operations
to be used as a valuation tool.
DCF based NAV for each company can be independently derived and hence relevant
DCF-based NAV valuation has the following shortcomings:
Little clarity on the entire land bank of most developers
Limited clarity on the time taken to commercialise such land banks
Nevertheless, we believe it is still a useful accounting tool due to the following.
We can estimate DCF-based NAV for every company based on an independent set of
industry assumptions
Such a valuation is not significantly impacted by accounting policies
Lowering our estimates and
target prices
Key themes
FY11 financials were poor, especially the significant drop in 4Q margins driven by an
inferior product mix, a spike in costs and increase in budgeted costs. We delay projects,
change the product mix and cut revenues by up to 30%. High inflation and poor product
mix result in EBIDTA and PAT being cut by up to 50% each.
We continue to use a DCF-based valuation methodology. Delaying projects by 1.5-3
years, raising construction costs, WACC and discount to GAV, we cut target prices by up
to 40%.
Post a poor FY11, especially the 4Q margins…,
While DLF saw robust yoy revenue growth, peers recorded stagnant revenues…
Driven by a launch and pre-sales of plots as well as its aggressive accounting policy, DLF was
able to record robust yoy growth (Figure 52). Peers (mainly Unitech), have shown a
significant fall in growth in the past six quarters, driven by:
Weak pre-sales due to the spike in prices
Delay in getting approvals
Weaker execution due to shortage of labour, sand, etc.
…and a collapse in margins in 4Q…
While margins have been under pressure, 4Q recorded a collapse in margins due to:
Inferior product mix (pre-sales in CY09 at attractive prices is now flowing into P&L)
Spike in costs and increase in budgeted costs for some (which constrain revenue
recognition and increase costs)
…and a collapse in PAT
Weak revenue growth was aggravated by operating leverage and increase in interest costs
with a collapse in PAT for all the companies the sector
…and sluggish demand, we cut our projections by up to 50%
Sluggish demand and weaker execution
High property prices and an expected increase in mortgage rates in the next two
quarters would further constrain residential demand
A delay in approvals and tightening liquidity would delay the execution
With an expected glut of office space for the next three years, developers are delaying
commercial projects
Hence, we delay new launches and project execution for all developers by c.2-3 years.
Cutting our revenue estimates by up to c.30%...
Poor product-mix – a higher proportion of new launches are lower value added plots that
will likely constrain revenues as they flow into P&L
After the re-budgeting of costs, revenue recognition will likely remain slow for another 2-
3 quarters
With demand growth remaining weaker than expected, fresh pre-leasing and lease
revenues likely will be much slower than expected
Hence, we cut our revenue estimates for developers by up to c.30%.
…and EBITDA and PAT estimates by up to c.50% due to falling margins
Projects launched in mid-CY09 at attractive prices are now flowing into P&L and will
likely constrain margins
Considering the high inflation, we further raise cost of construction by 10%
Developers’ propensity to drive cash flow is resulting in a higher proportion of lower
gestation and lower margin plots
Lower–than-expected revenue growth aggravates high operating and financial leverage
We expect margins to stabilise in FY13E and then increase in FY14E. We believe it would
be impossible to reach the margins of the FY08-09 peaks
Interest rates have hardened and will likely harden further in the next 2-3 quarters.
Hence, we cut our EBTDA and PAT estimates by up to c.50%.
Valuation methodology and assumptions
DCF-based NAV valuation is the most suitable
We believe that a P/E-based valuation tool is not suitable because:
It is influenced by the accounting policies and strategies of each company (in optimising
current cash flows and profits compared with long-term returns)
It does not capture the value of the land bank – the sector’s most critical resource
Near-term future profits are determined by real estate prices of the recent past
Hence, we continue to prefer a DCF-based NAV approach as each company can be valued
independently on a common set of assumptions without being influenced by varied
accounting policies adopted by developers.
…we believe that it still understates the value of developers
We believe that the DCF-based NAV valuation tool is better suited as it addresses most of
the above shortcomings. However, it still understates the actual value of the company as:
Terminal value is not captured: Developers continue to add to their large land banks.
Efficient use of capital: Developers sell stakes in unfinished projects to improve cash
flows. With cap rate (c.10%) < than discounting rate (c.15%+), DCF is understated.
Considering the risk factors, our target prices are at a discount to DCF-based NAV
Considering that (a) we have little clarity on its land bank (in terms of location, size, clear land
titles, etc.) and (b) there are execution issues, our target prices are at a discount to DCFbased
NAV. Regional valuations (Figure 8) also indicate that developers across the region
(except Japan) now trade at a discount (-3 to 39%) to their NAVs.
This discount is based on company-specific factors such as:
Positives (size of company, brand equity and execution capability)
Negatives (concentration risk on any geography/vertical and other risks, including
gearing)
Valuation process
Using our valuations assumptions (Figure 58) regarding
Number of years for projects’ completion
WACC, cap rates and tax rates
Constant property prices and costs
We arrive at a DCF-based GAV for our coverage stock.
Then we exclude the net debt and payable for land bank and add the value of other
business to arrive at DCF-based NAV.
We use a discount to GAV, based on company-specific factors as mentioned above, to
arrive at our target price for the stock.
Cut target prices by up to 40% across coverage universe
We delay execution for all players due to continuing demand-supply imbalance
Considering the sector headwinds and company-specific issues, we delay overall
completion of projects on current land bank by c.2-3 years across our coverage universe.
DLF achieved only 10msf of presales (largely plotted development) against its
guidance of c.12msf for FY11. With 10msf of the 12msf to be launched in FY12E
being lower-value added plots, we change product-mix and delay DLF’s projects by
c.1.5 years.
Unitech has launched projects of c.35msf during the past two years. We are worried
that the current liquidity crunch may constrain its execution capabilities and hence
delay its projects by about three years.
Similarly, projects for Sobha and Puravankara have been delayed by c.two years.
Considering significant delay in MIAL due to continual delay in identification of
eligible slum dwellers by state government, we now delay the completion of MIAL
project by about two years for HDIL.
There have been few project approvals in Mumbai in the past six months. Hence,
despite IBREL’s proven execution capabilities, we delay its projects by c.two years.
We increase construction costs by 10%
Considering the spike in construction costs in the past three quarters, we raise the cost of
construction by 10% for all companies and all projects.
Tightening liquidity and rising interest rates force us to raise WACC and discount to
GAV
Considering (a) policy interest rates have increased by 250bps from February 2010, (b)
sticky higher inflation is expected to lead to a further increase in interest rates (we
estimate c.75bps by December 2011e), and (c) tightening liquidity for the sector, we
have increased our WACC for coverage universe by <1.5%
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Underperformance despite fundamentals offers favourable risk-reward
After the sector’s near-100% underperformance (worst-performing sector) since
Jan'09, we believe pessimism is overdone, even discounting further short-term
macroeconomic deterioration. With risk-return turning favourable after a long gap,
we upgrade the sector to Outperform. A peaking interest rate cycle (we expect a
75bps increase after the 250bps hike in the past 15 months) and property price
cuts, which will bring back demand, should be key sector catalysts (as in 2009).
We upgrade DLF to Buy and Unitech to Hold; we prefer Sobha, a low-beta stock.
A sense of déjà-vu – sector awaiting catalysts for a bounce-back, à la 2009
We see a repeat of 2009, when the sector saw sharp recovery (outperforming the
Sensex by 113% between March and September 2009) after the liquidity crisis.
Outperformance was driven by: (a) rate cuts of 425bps between September 2008
and April 2009, (b) counter-intuitive c.20% cut in property prices to kick-start
demand and (c) equity dilutions. Despite improving fundamentals, most stocks
trade below book value, and at a >30% discount to DCF-based NAV, higher than
the region. Having stabilized since January 2011, this high-beta sector, is awaiting
catalysts, which can be perceived peaking of rate hikes by the RBI (after 250bps in
the past 15 months) and price cuts by developers in the next six months.
Sector fundamentals have improved dramatically since 2009
Since 2009, companies have slashed land banks and significantly improved
gearing, a key source of investor concern. Gearing levels are down to 47% from
the high of 126% seen in March 2009. Developers are refocusing on the cash–
flow-generating mid-end residential vertical rather than on margin-driven high-end
office space, where we see continuing oversupply.
While sizeable risks are known, sector characteristics favour developers
Robust GDP growth, rising disposable incomes, attractive demographics and
finance availability remain long-term growth drivers. However, opaque approval
processes by multiple regulators, non-transparent markets, long delivery
schedules and high transaction costs have constrained supply, favouring
developers. However, pricing remains the key to demand returning. We concede
that corporate governance in a few companies will likely remain an overhang.
Analysis suggests DCF is the most independent valuation tool
The shortcomings of DCF (lack of clarity on land banks) force investors to use
other valuation tools. Our proprietary analysis (pages 34-42) of the varying
accounting policies of developers suggests that P/E is significantly influenced by
the definition of the threshold and in including land in revenue recognition (RR).
Thus, RR is quicker for DLF and Puravankara and higher for DLF and Sobha, but
then normalises. Hence, we prefer DCF, an independent valuation tool.
P&L, a trailing indicator, getting constrained; cut estimates and target price
Data from property consultants indicate that the supply of office space will likely
run ahead of demand for more than three years. Despite developers delaying such
projects, we expect rentals to remain suppressed for about six quarters, unlike the
Street. Data from listed developers indicate a slowdown in residential presales.
This, coupled with high inflation and aggressive accounting policies, constrains
revenues and margins, which are lag indicators. We cut estimates and DCF-based
target prices by up to 52% and 40%, respectively.
Investment summary
The bear market story so far
Real estate sector hit by Murphy’s Law – anything that could go wrong, has gone
wrong:
Deteriorating corporate governance, especially in a few companies
Significant slowdown in demand coupled with spiking prices and rising interest rates
This, coupled with approval and execution delays, is constraining cash inflows, while the
spike in inflation is constraining profitability, aggravating operating leverage.
Developers are facing difficulty in raising funds in a tight liquidity environment, thus
raising solvency risks.
Even after the 82% fall in 2008 (with 30% underperformance), the sector fell another 4%
(101%) and has been the largest underperformer since January 2009.
Despite better fundamentals, significant underperformance….
While fundamentals (macro and sector) are much better vis-à-vis 2008…
Unlike 2008, global accommodative monetary policies have supported growth. Similarly,
accommodative monetary policies in early 2009 by the RBI helped GDP growth rise to
8%+ in FY10-11 as against 7% in FY09.
Since 2009, developers have slashed land banks and significantly improved gearing (to
47% from the high of 126% seen in March 2009) – a key source of investor concern.
Developers are refocusing on the cash-flow-generating mid-end residential vertical rather
than on margin-driven high-end office space, where we see continuing oversupply.
…sector records sizeable and consistent fall
Improving fundamentals were immediately reflected in the Sensex and partly reflected in
the India Property financials in FY10-11 (i.e. with a lag).
While the BSEREAL fell 82% in 2008 (32% underperformance), it has been down 4%
since then, underperforming the Sensex by 100%. Even in the past six and twelve
months, it recorded 20% and 39% underperformance, respectively.
Stocks now trade at trough valuations, at a 30%+ discount to NAV (sector’s c.39%
discount to NAV is the highest in Asia), with most trading at a discount to their book
value.
…and near-term catalysts; hence we upgrade to overweight
High-beta sector appears to have stabilised since January 2011.
The perceived peaking of rate hikes by the RBI (after 250bps in the past 15 months) and
price cuts by developers in the next six months could be the long-awaited catalysts for
the sector. This was seen in 2009, with BSEREAL rising by c.190% and outperforming
Sensex by c.113% from March to September 2009.
With risk-reward now looking favourable, we upgrade:
The sector to Outperform (from Underperform)
DLF, the market leader by far, to Buy (from Hold)
Unitech to Hold (from Sell)
What’s new here?
While sizeable risks are known, sector characteristics favour developers
Detailed sector characterisation indicates the following:
There is significant potential given the demographics, increasing incomes and availability
of retail finance. However, high unit prices, transaction costs and unaccounted wealth
(due to limited institutional funding) make it a shallow and translucent market.
Multiple (and increasing) number of approvals and approval agencies coupled with lack
of clear processes and timelines further delay the long delivery schedules for real estate.
While supply is fragmented, demand is even more so. Like banking, property is a
localised sector with limited threat from global players.
Hence, the sector, in its early life cycle stage, will likely continue to be driven by supply,
leading to profit focus and weak corporate governance by developers.
Unlike the Street, we believe the office vertical will remain under pressure for four to
six quarters
In line with the Street, we believe residential demand will remain weak across almost all
cities. Bengaluru, driven by the continual robust outlook for the key IT sector, a late
pickup in demand (from end-CY09, unlike mid-CY09 in almost all other cities) and minimal
price hikes, continues to support demand.
Our detailed macro and micro analyses indicate that supply for the office vertical will
likely remain ahead of demand, with glut expected to continue for another six quarters.
This is despite developers trying to restrict supply by continually rolling over project
execution schedules.
Our proprietary analysis of developers’ varying accounting policies suggests that DCF
is the only independent valuation tool
Considering the shortcomings of DCF-based valuations, investors are looking to use
other valuation methodologies.
As developers launch projects optimising between cash flow and profits, cash flow from
operations is not an independent variable to be used as a valuation tool.
Our proprietary analysis indicates that each company uses its unique revenue recognition
(RR) policy, with differences in defining the threshold and in including land in RR, with
DLF and Sobha following the most aggressive policy. Hence, using an unadjusted P/E
multiple for valuation is erroneous.
Even the simple debtor recognition policy varies significantly. Despite its conservative
revenue recognition, Unitech’s debtor days are high and rising.
We can calculate DCF-based NAV with relative ease using a common set of valuation
assumptions for all companies, as it is independent of accounting policies.
Cut estimates and target price
FY11 financials were poor, especially the significant drop in 4Q margins driven by the
inferior product mix, spike in costs and increase in budgeted costs. We anticipate a delay
in projects and change in product mix and cut revenues by up to 30%. High inflation and
poor product mix result in EBIDTA and PAT being cut by up to 50% each.
We continue using DCF-based valuation methodology. Delaying projects by 1.5-3 years,
raising construction costs, WACC and discount to GAV, we cut target prices by up to
40%.
Despite better fundamentals,
significant underperformance;
upgrading to overweight
Key themes – risk-reward now looks favourable
Fundamentals (macro and sector) are much better now as compared with 2008. This is
partly reflected in the India Property financials and in the Sensex.
While the BSEREAL fell 82% in 2008 (32% underperformance), it has been down 4%
since then, underperforming the Sensex by 100%. Even in the past six and twelve
months, it recorded 23% and 40% underperformance, respectively.
Stocks now trade at trough valuations, at a 30%+ discount to NAV (highest in Asia), with
most trading at a discount to their book value.
The high-beta sector has stabilised since January 2011. The perceived peaking of rate
hikes by the RBI and price cuts by developers in near term could be the long-awaited
catalysts. This was seen in 2009, with BSEREAL rising by c.190% and outperforming
Sensex by c.113% from March to September 2009.
With limited downside, the risk-reward now looks favourable. Hence, we upgrade the
sector to Outperform (from Underperform), DLF to Buy (Hold) and Unitech to Hold (Sell).
While known sizeable risks,
sector characteristics favour
developers
Key themes
There is significant potential given demographics, increasing incomes and the availability
of retail finance. However, high unit prices, transaction costs and unaccounted wealth
(due to limited institutional funding) make it a shallow and translucent market.
The multiple (and increasing) number of approvals and approval agencies, coupled with a
lack of clear processes and timelines, further delay the long delivery schedules for real
estate.
The sector, in its early life cycle stage, is driven by supply, leading to a profit focus and
weak corporate governance by developers
Credible data is a handicap
for any significant analysis
Key themes
The lack of a common regulator or industry association and classification differences in
collating mortgage data from banks/ NBFCs result in there being no organised sectorwide
data base.
Even the office vertical, with organised stakeholders (large corporate end-users, large
tier-1 developers and property consultants), and shorter demand-supply cycles, has
significant data inconsistency.
As India lacks reliable data over a period of >3 years, significant analysis is irrelevant.
Hence, we refrain from any significant analysis.
Lack of organised sector data
No common regulator or strong industry association at the national/state/city level
Data for most industries is released by companies (auto, cement, telecom, etc.), or , industry
associations (auto, cement, IT, telecom, etc.) or with organised data providers (FMCG, the
media, etc.) or by regulators (banks, telecom, etc.). While data from these sources may not
be completely accurate or fully reliable, it can be used for trend analysis. Real estate is one of
the few sectors where there is no such data bank.
Though stamp duty accounts for a chunk of state government revenues, it is not well
collated
While stamp duty and registration account for 10-20% of the revenues of local bodies and
state governments, this data is not collated over time by region for conducting any analysis.
Even data on mortgages from banks/NBFCs is not welI collated
Surprisingly, even data on mortgages is not well collated, as banks are governed by RBI,
while housing finance companies (HFCs) like HDFC, LIC Housing Finance, and ICICI Home
Finance are governed by National Housing Bank (NHB). Classification differences, constant
changes in classification criteria and different reporting dates make comparisons difficult.
While large, listed developers provide quarterly data, it may not be relevant
While almost all large, listed developers provide basic operational data on a quarterly basis:
these large, listed developers form only a small proportion of the market in each of the
major metro areas and an even smaller proportion at a national level
each developer has its own unique way of classification (defining metros, cities, etc.),
and these classification techniques are continually changing
the reliability of this data may be questioned given the weak corporate governance in the
sector.
Thus, data from listed developers may not be relevant for any significant analysis.
Even office, an easier vertical to analyse, has data inconsistency
Office, a vertical with largely organised stakeholders,…
While residential vertical accounts for c.80%+ of the Indian property sector, it is
fragmented and unorganised. Many factors associated with the sector (suppliers,
buyers, peers, etc.) are also significantly fragmented.
Fortunately, commercial (c.10%+ of Indian property sector) is much better organised:
The top seven Indian cities account for c.90% of this vertical, most of which are tier-
1 properties.
A significant portion of the market (c.85%) is accounted for by corporate end-users.
There are fewer suppliers of tier-1 properties.
This vertical is supported by a few global property consultants/brokers (e.g. JLL,
Knight Frank, Cushman, etc.), who collate primary data on the sector, analyse it and
publish it as a free service.
Thus, this commercial vertical is similar to a wholesale market in that it is not only easier to
track but also offers reliable industry data.
…and shorter demand-supply cycles…
Industry nature constraints speculative demand as:
A significant portion (c.75%+) of the market (by value) is accounted for by
multinational companies, which prefer leasing to purchase.
Furthermore, leasing is generally concluded in the last phase of construction. With
little sub-leasing, demand is almost entirely end-user driven with limited speculative
demand.
Even if there is pre-leasing by larger tenants, there is limited upfront payment.
…while funding constraints speculative construction
In the residential vertical, developers pre-launch even before getting all approvals
and commencing construction, in order to raise resources. This is not possible in the
commercial vertical. Thus, commercial projects tend to be “cash guzzlers”. Only
after the developer exits with the sale of a majority stake, which is largely possible
only after completion and leasing.
With the REIT market yet to develop in India and no other alternate market offering
significant exit options (London-based AIMs, Singapore-based REITs, etc.) for Indian
commercial projects, complete exit for tier-1 commercial projects is almost
impossible. Even strata sales are not possible for tier-1 properties or SEZs.
Coupled with shorter gestation cycles, this dilemma could lead to shorter demandsupply
cycles. With large floor plates (allowing for easy design and automation in
construction) and limited internal construction, commercial projects can be completed in
18-36 months as compared to 24-60 months for residential projects. We believe this
leads to shorter demand-supply cycles as compared to those in the residential vertical.
…has significant data inconsistency
We analysed the commercial office space data available from premier global property
consultants like Jones Lang LaSalle (JLLM), Cushman & Wakefield (C&W) and DTZ research.
We observed that JLLM reports a lower stock compared to Cushman and DTZ in each year.
Similarly, the JLLM yearly supply and absorption data is comparatively lower than its peers.
Some of the reasons for the significant variance could be:
The coverage area for each city may be different.
While all the data is for office properties that are Grade-A or in prime CBD locations, each
consultant may have a different interpretation of these classification types.
The depth of coverage in any location by different consultants may vary.
Glut in office space likely to
continue
Key themes
Robust GDP growth drove demand for office space from CY01-07. But, global liquidity
crisis squeezed demand, leading to a spike in vacancies despite a plunge in rentals.
Despite robust economic growth, attractive rentals and a plunge in supply, analysis of
macro data indicates that recovery in absorption and rentals will likely be slower than
expected (the glut sustaining for a couple of years).
An analysis of the data from major office developers presents an even more bearish
picture (lacklustre leasing and most ongoing projects getting pushed out further).
Macro data on office indicates glut likely to sustain despite
supply delays
We focus on the top seven cities in India
As per global real estate advisors/brokers, commercial real estate in India largely centres
around seven cities (NCR, Bengaluru, Mumbai, Chennai, Hyderabad, Pune and Kolkata).
While Bengaluru comprises c.26% of the existing office space across these cities,
significant glut in 2009 constrained 2010 supply, resulting in its share in new supply
falling to c.13%.
Robust GDP growth and low base drove demand for office space
Robust economic growth (4%+ until FY03 and c.8% thereafter) and a low base of office
stock resulted in CAGR of 38% in supply of office space from CY01-07 (Figure 22)
We believe that as India was a supply-constrained economy at that time, most of this
supply was largely absorbed, as was seen in the period CY05-07 (Figure 22).
Thus, despite the robust increase in supply, rents spiked (Figure 23) and vacancies
bottomed at 5% in CY07 (Figure 22). Thus, while in locations with large stock like
Bengaluru (Figure 20), rents increased by 65% from CY04 to CY08, this figure spiked
320% in low-stock, supply-constrained Mumbai
Ex-Bengaluru, residential
volumes face resistance
Key themes
A spike in property prices in Mumbai leading to unaffordability has resulted in volumes
plummeting. This, coupled with excess supply in central Mumbai, is forcing developers
to delay projects.
Analysis of quarterly pre-sales data suggests that, ex-Bengaluru, volumes remain weak.
Robust outlook for IT sector; Bengaluru developers’ focus on execution and minimal
price hikes lead to robust demand in Bengaluru. This augurs well for Sobha, our top pick.
Regulatory bodies indicate a slowdown in housing loan off-take
Despite a significant ramp up in pre-sales in FY10 and FY11 for most developers as also in
property prices:
RBI’s (a regulatory body for banks) outstanding bank credit for housing data has grown at
only 15% in FY11. While this is an increase from 8% in FY10, it is significantly below the
levels recorded from FY05-07 (Figure 35)
NHB (National Housing Bank, a regulatory body for Housing Finance Companies, HFCs)
indicates that growth in housing finance has declined to <17% in FY11 as against c.19%
in FY10 and a c.25% CAGR from FY05-09.
Unique accounting policies
inadvertently affect valuation
Key themes –prefer the independent DCF-based valuation tool
Considering the shortcomings of DCF-based valuations, investors are looking to use
other valuation methodologies.
Our proprietary analysis indicates that each company uses its own unique revenue
recognition policy, with DLF following the most aggressive policy. Hence, using an
unadjusted P/E multiple for valuation is erroneous.
Even the ‘simple’ debtor recognition policy varies significantly for any ratio comparison.
Despite its conservative revenue recognition, Unitech’s debtor days are high and rising.
As developers launch projects optimising between cash flow and profits, cash flow from
operations is not an independent variable to be used as a valuation tool.
We can relatively easily calculate DCF-based NAV using a common set of valuation
assumptions for all companies as it is independent of accounting policies.
Accounting policies significantly impact valuations
Accounting policies not only impact financials, but also valuations
While everyone realises the impact that accounting policies could have on financials, we
believe their impact on valuations is not really understood by the markets.
Hence a proprietary analysis of accounting policies and its impact on P&L and BS items
While DCF-based NAV is the most relevant valuation tool for the sector and is
significantly agnostic to accounting policies, it has significant shortcomings:
Developers offer little clarity on their vast land bank, land titles, etc.
A sizeable part of the valuation of developers accrues in the medium to long term,
which is not so relevant given (a) the poor corporate governance in the sector, and
(b) current tight liquidity in the system, particularly in the property sector.
Investors have started focusing on P&L (P/E) and cash flow-based valuations (price to
FCF). However, we believe that these valuation methodologies are significantly
influenced by the accounting policies of each company. Hence, in this section, we do a
detailed study on the accounting policies of most developers and their impact on their
P&L and B/S.
We select leading developers by market cap, but exclude HDIL, IBREL and Sunteck
We have selected major developers by market cap to analyse their accounting policies.
We look at DLF, HDIL, IBREL, Oberoi, Prestige, Puravankara, Sobha, Sunteck and
Unitech for this analysis.
However we exclude HDIL, IBREL, Sunteck from this analysis as:
HDIL and Sunteck follow a conservative revenue recognition policy, resulting in
project revenues coming at the end of a project, meaning they cannot be compared
with peers.
As the first few projects from IBREL have just started to flow into its financials,
analysis of its historical financials is not relevant compared to peers.
Significant difference in revenue recognition policy among peers
Major factors driving the variations in revenue recognition policy
In India, the Institute of Chartered Accountants of India (ICAI) publishes accounting standards
(AS) and guidance notes to provide rules and guidance regarding revenue recognition. While
AS provides complete guidance about revenue recognition for most industries, there remain
wide gaps for quite a few sectors, including real estate.
The first and foremost variance arises from the fact that AS allows real estate developers
to follow either (a) a percentage of completion method (PoCM) or (b) project completion
method (PCM).
Under PoCM, revenues are recognised at every stage, based on costs actually
incurred as a percentage of total estimated costs of the project. This policy offers
the following benefits: (a) it stabilises revenues, as these are recognised in
proportion to actual costs incurred; and (b) it helps analysis of ratios and comparison
between peers. Most industry players follow this method.
Under PCM, revenues are recognised only at the completion of the project. Until
then, all costs incurred towards the project are treated as inventory and payments
received from customers are treated as ‘advances from customers’. The advantages
of this policy include (a) deferment of payment of direct tax to government, and (b)
recognising revenues only after transferring the entire project ownership to the
customer post delivery of the project. This being the most conservative revenue
recognition policy, only a few listed developers (HDIL, Sunteck Realty, etc.) follow it.
While most follow PoCM, the similarities end there
AS does not provide any rule/guidance regarding any minimum threshold (if any) for
project completion, for it to become eligible for revenue recognition. While most
developers following PoCM do have a minimum threshold, this varies among the
developers, with Oberoi and Unitech at a 20% threshold and DLF and Prestige at 30%
thresholds. Further, Puravankara does not have any minimum threshold for revenue
recognition.
Among the players that use a threshold, the industry is divided on whether land cost
should be included in ‘costs incurred’ to compute the threshold.
Finally, the industry is divided on another key question: Should land cost be taken as part
of ‘costs incurred’ to compute the percentage of revenues that will be recognised in the
financials?
Even the ‘simple’ debtor recognition policy diverges significantly
Considering that there are quite a few gaps in AS regarding revenue recognition policies and
the minimum threshold to be applied in case of long-term construction/contractual projects,
we are not surprised to witness a diversion for this. However, the policy for recognising
debtors, a rather straightforward one, also varies significantly across our cross-section of
selected developers.
Elucidating the linkage/process of pre-sales, collection and accounting/financials
To understand the diverse debtors recognition policies (DRP) followed by the developers, we
describe presales, collection and accounting policies for Indian developers.
Step 1 – Pre-sales: Residential projects in India are pre-launched (launched without
construction being completed) and the buyer needs to pay c.10%+ at the time of
booking the unit. This upfront booking amount is recorded as ‘customer advances’ (CA)
under ‘current liabilities (CL) in the B/S.
Step 2 – Billing: The buyer then has to pay the remaining amount in milestone or timebased
instalments. Hence, as and when the instalment becomes due, the buyer is
invoiced for his dues.
Step 3 – Collection and Accounting: When the customer makes a payment, it is
recorded as ‘customer advances’ under ‘current liabilities’ in the B/S.
DRP 1 – Debtor recognition being linked to customer invoicing
In this case, the company follows an ‘accrual method’ of accounting in its ‘true spirit’ and
recognises debtors when the invoice is raised and until the buyer makes the payment.
The dues received from the buyer are reflected as cash in the assets in B/S, matched by
an equal amount being added to CL in the B/S.
However, if the dues are not received, it would be recorded as debtors in the B/S, with
an equal amount being added to CL.
Among the companies analysed above, Unitech, Puravankara and Oberoi follow this
method of recognising debtors in the B/S.
In the case study analysed above, we have assumed 30% invoicing to customer, but
collections of only 25%. Hence, in Figure 48, all three companies (Unitech, Puravankara
and Oberoi) reflect INR5 as debtors, and INR10 as CA (total CA of INR30 is reduced by
INR20 being booked in revenues).
DRP 2 – Debtors’ recognition being linked to revenue recognition in P&L
In this case, the developer follows the ‘conventional’ method of recognising debtors.
When the invoice is raised, it does not get reported anywhere in the B/S.
The dues received from the buyer are reflected as cash in the assets in B/S, matched by
an equal amount being added to CL in the B/S.
After recognition of revenues, CL would be reduced by that amount.
Debtors are recognised only in the case and to the extent of CL being lower than
revenues recognised.
Among the companies analysed above, Sobha and Prestige follow this method of debtor
recognition.
Hence, in the case study analysed above, Prestige would record CA of INR25 (as it is yet
to recognise revenues), while Sobha would not reflect anything in its B/S as its CA of
INR25 (amount received from buyers) is matched by revenues of INR25 (Figure 48).
DRP 3 – Unbilled revenues/debtors
Our discussions with managements indicate that different companies follow different policies
regarding ‘unbilled revenues’ (UR) and their representation in B/S. We take a look at the
policy adopted by each company in this regard:
DLF: As seen in Figure 48-45, DLF is the most aggressive in terms of recognising
revenues in its P&L. However, its invoicing policy would be much slower than this
revenue recognition policy. The balance amount is then treated as UR.
In our case study (Figure 48), we assume only 30% invoicing to buyer, whereas it
would have recognised 52% of revenues. In such a case, it recognises the
remaining 22% as UR.
Unlike peers, DLF’s UR is not considered as debtors, but as a part of ‘other current
assets’ in the B/S.
Unitech: As Unitech does not follow aggressive revenue recognition policy, its revenues
usually lag invoicing to customers. Hence, UR is insignificant for Unitech and is clubbed
with debtors.
In our case study (Figure 48), Unitech would not have any UR, as its invoicing to
customers precedes its revenue recognition.
Puravankara: Follows a policy similar to that of Unitech - hence insignificant UR.
Oberoi: Follows a policy similar to that of Unitech - hence insignificant UR.
Sobha: follows unique policy. In a footnote in its annual report, it reports a large part of
debtors being UR for ongoing projects.
Prestige: Prestige prefers to pre-launch only a small portion of a project with subsequent
launches as the project advances. As the company is not strapped for cash it optimises
on margins by boosting average realisations. The buyers for these late-stage projects are
given c.3-6m for their dues payable at that stage of construction. Thus, these new presales
cross even the high threshold of 30% revenue recognition, right at the start.
Hence, the gap between revenues recognised and invoices sent to customers is treated
as UR.
DCF-based NAV, an independent valuation tool, is relevant
Shortcoming of P/E-based valuation
As explained in previous sections, revenues, costs and profits are all significantly
influenced by accounting policies.
With no two companies following largely similar accounting policies, we believe that
unadjusted P/E-based valuation process is irrelevant.
Given the limited data on each of the companies, it is almost impossible to arrive at
adjusted profits/P/E for each company to make it comparable to peers.
Shortcoming of cash flow-based valuation
Developers launch projects not on their development capability or the market absorption
capability, but based on their own cash flow/profit optimisation strategies.
After the liquidity crisis, developers launched projects only to generate some cash flow
from operations.
We believe that cash flow from operations may not be reflective of the actual operations
to be used as a valuation tool.
DCF based NAV for each company can be independently derived and hence relevant
DCF-based NAV valuation has the following shortcomings:
Little clarity on the entire land bank of most developers
Limited clarity on the time taken to commercialise such land banks
Nevertheless, we believe it is still a useful accounting tool due to the following.
We can estimate DCF-based NAV for every company based on an independent set of
industry assumptions
Such a valuation is not significantly impacted by accounting policies
Lowering our estimates and
target prices
Key themes
FY11 financials were poor, especially the significant drop in 4Q margins driven by an
inferior product mix, a spike in costs and increase in budgeted costs. We delay projects,
change the product mix and cut revenues by up to 30%. High inflation and poor product
mix result in EBIDTA and PAT being cut by up to 50% each.
We continue to use a DCF-based valuation methodology. Delaying projects by 1.5-3
years, raising construction costs, WACC and discount to GAV, we cut target prices by up
to 40%.
Post a poor FY11, especially the 4Q margins…,
While DLF saw robust yoy revenue growth, peers recorded stagnant revenues…
Driven by a launch and pre-sales of plots as well as its aggressive accounting policy, DLF was
able to record robust yoy growth (Figure 52). Peers (mainly Unitech), have shown a
significant fall in growth in the past six quarters, driven by:
Weak pre-sales due to the spike in prices
Delay in getting approvals
Weaker execution due to shortage of labour, sand, etc.
…and a collapse in margins in 4Q…
While margins have been under pressure, 4Q recorded a collapse in margins due to:
Inferior product mix (pre-sales in CY09 at attractive prices is now flowing into P&L)
Spike in costs and increase in budgeted costs for some (which constrain revenue
recognition and increase costs)
…and a collapse in PAT
Weak revenue growth was aggravated by operating leverage and increase in interest costs
with a collapse in PAT for all the companies the sector
…and sluggish demand, we cut our projections by up to 50%
Sluggish demand and weaker execution
High property prices and an expected increase in mortgage rates in the next two
quarters would further constrain residential demand
A delay in approvals and tightening liquidity would delay the execution
With an expected glut of office space for the next three years, developers are delaying
commercial projects
Hence, we delay new launches and project execution for all developers by c.2-3 years.
Cutting our revenue estimates by up to c.30%...
Poor product-mix – a higher proportion of new launches are lower value added plots that
will likely constrain revenues as they flow into P&L
After the re-budgeting of costs, revenue recognition will likely remain slow for another 2-
3 quarters
With demand growth remaining weaker than expected, fresh pre-leasing and lease
revenues likely will be much slower than expected
Hence, we cut our revenue estimates for developers by up to c.30%.
…and EBITDA and PAT estimates by up to c.50% due to falling margins
Projects launched in mid-CY09 at attractive prices are now flowing into P&L and will
likely constrain margins
Considering the high inflation, we further raise cost of construction by 10%
Developers’ propensity to drive cash flow is resulting in a higher proportion of lower
gestation and lower margin plots
Lower–than-expected revenue growth aggravates high operating and financial leverage
We expect margins to stabilise in FY13E and then increase in FY14E. We believe it would
be impossible to reach the margins of the FY08-09 peaks
Interest rates have hardened and will likely harden further in the next 2-3 quarters.
Hence, we cut our EBTDA and PAT estimates by up to c.50%.
Valuation methodology and assumptions
DCF-based NAV valuation is the most suitable
We believe that a P/E-based valuation tool is not suitable because:
It is influenced by the accounting policies and strategies of each company (in optimising
current cash flows and profits compared with long-term returns)
It does not capture the value of the land bank – the sector’s most critical resource
Near-term future profits are determined by real estate prices of the recent past
Hence, we continue to prefer a DCF-based NAV approach as each company can be valued
independently on a common set of assumptions without being influenced by varied
accounting policies adopted by developers.
…we believe that it still understates the value of developers
We believe that the DCF-based NAV valuation tool is better suited as it addresses most of
the above shortcomings. However, it still understates the actual value of the company as:
Terminal value is not captured: Developers continue to add to their large land banks.
Efficient use of capital: Developers sell stakes in unfinished projects to improve cash
flows. With cap rate (c.10%) < than discounting rate (c.15%+), DCF is understated.
Considering the risk factors, our target prices are at a discount to DCF-based NAV
Considering that (a) we have little clarity on its land bank (in terms of location, size, clear land
titles, etc.) and (b) there are execution issues, our target prices are at a discount to DCFbased
NAV. Regional valuations (Figure 8) also indicate that developers across the region
(except Japan) now trade at a discount (-3 to 39%) to their NAVs.
This discount is based on company-specific factors such as:
Positives (size of company, brand equity and execution capability)
Negatives (concentration risk on any geography/vertical and other risks, including
gearing)
Valuation process
Using our valuations assumptions (Figure 58) regarding
Number of years for projects’ completion
WACC, cap rates and tax rates
Constant property prices and costs
We arrive at a DCF-based GAV for our coverage stock.
Then we exclude the net debt and payable for land bank and add the value of other
business to arrive at DCF-based NAV.
We use a discount to GAV, based on company-specific factors as mentioned above, to
arrive at our target price for the stock.
Cut target prices by up to 40% across coverage universe
We delay execution for all players due to continuing demand-supply imbalance
Considering the sector headwinds and company-specific issues, we delay overall
completion of projects on current land bank by c.2-3 years across our coverage universe.
DLF achieved only 10msf of presales (largely plotted development) against its
guidance of c.12msf for FY11. With 10msf of the 12msf to be launched in FY12E
being lower-value added plots, we change product-mix and delay DLF’s projects by
c.1.5 years.
Unitech has launched projects of c.35msf during the past two years. We are worried
that the current liquidity crunch may constrain its execution capabilities and hence
delay its projects by about three years.
Similarly, projects for Sobha and Puravankara have been delayed by c.two years.
Considering significant delay in MIAL due to continual delay in identification of
eligible slum dwellers by state government, we now delay the completion of MIAL
project by about two years for HDIL.
There have been few project approvals in Mumbai in the past six months. Hence,
despite IBREL’s proven execution capabilities, we delay its projects by c.two years.
We increase construction costs by 10%
Considering the spike in construction costs in the past three quarters, we raise the cost of
construction by 10% for all companies and all projects.
Tightening liquidity and rising interest rates force us to raise WACC and discount to
GAV
Considering (a) policy interest rates have increased by 250bps from February 2010, (b)
sticky higher inflation is expected to lead to a further increase in interest rates (we
estimate c.75bps by December 2011e), and (c) tightening liquidity for the sector, we
have increased our WACC for coverage universe by <1.5%
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