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Investment thesis
Price correction is a key catalyst for the sector -- - ahead of interest rate cuts
We have compared volume trends in the Mumbai and Bengaluru markets to the BSE Realty index
performance. The BSE Realty index has moved in tandem with the volume trend in these two markets for
seven out of the last nine quarters (see Exhibits 1 & 2), implying volume is a key indicator for the sector.
Based on the affordability metrics, price correction is the most effective variable (interest rates and wages
are other variables which take time to change) for volumes to recover. We forecast real estate prices will
correct about 20% across India over the next three-to-six months, based on our affordability calculation
(refer to the section ‘Assessing the extent of price correction -- - expect a 20% decline in prices’ on page 7).
If prices correct 20% and volumes increase only 20% (historically the quantum of increase has been much
more), the net impact on gross profit across price segments could range from 14% to 23%. If we incorporate
a similar scenario to our target prices, our calculations suggest about 6% downside potential from current
levels.
Office sector: Bengaluru remains better placed, vacancies in Mumbai to increase due to upcoming supply
The office sector contributes about 45% to the total gross asset value (GAV) of the major listed developers.
DLF, Prestige (PEPL) and Anant Raj (ARCP) are the most geared to the office sector, as it represents more
than 50% of their GAV.
In 2011, we expect total absorption of around 35m sqft across the top seven cities (Mumbai, NCR, Chennai,
Bengaluru, Hyderabad, Kolkata and Pune) in India, which is close to the last five years’ average of 34m sqft.
We estimate supply in the seven key cities will increase 24% in 2011. A majority of the upcoming supply is
concentrated in the Mumbai region, thus we expect vacancies to continue to increase in Mumbai. Bengaluru
remains relatively better placed due to limited upcoming supply and stable demand.
Asset sales to continue, dilution and refinancing are other options to meet funding shortfall
We assess the funding situation of the developers under our coverage based on their debt service coverage
ratios (DSCR) including capex, which effectively = (EBITDA -- - minimum alternative tax) divided by (interest +
debt repayment + capex) and net funding shortfall (debt repayment + interest obligation + capex on office
or retail assets -- - cash flow from operations). DSCR is used to evaluate a company’s ability to meet its debt
repayment and servicing obligations.
Our analysis shows that DLF, Unitech, PEPL and Sobha are likely to face funding shortfall in the near term.
Asset sales, dilution and refinancing are the potential options to offset this eventually. We believe
developers with huge debt burden (DLF) will likely to continue with asset sales and possibly dilute equity.
Sobha and PEPL can meet their funding shortfall through refinancing since their gearing ratios are still
within the acceptable range (0.5-0.7x). Unitech is likely to see a mix of asset sales and refinancing.
Prefer a valuation methodology which factors in both efficiency and asset base of the developer
For the last four years investors have been debating about the appropriate way of valuing Indian
developers. Some old-school investors believe a P/BV multiple (captures efficiency) is the best way to value
developers, which effectively implies using the formula: ((long-term sustainable ROE -- - long-term growth
rate)/(long-term cost of equity)) -- - long-term growth rate. Some investors believe a DCF-based NAV
(captures asset base) approach captures the actual value of the large land banks.
We believe the true value lies somewhere in between which captures both efficiency and the asset base of a
firm, so we use the average of these two valuations to derive target prices for our property coverage
universe.
Oberoi and Sobha remain our top picks; downgrade DLF to a REDUCE, from Hold
We prefer developers with high revenue visibility, consistent execution track records, good corporate
governance, and simpler business models. Oberoi and Sobha emerge top rankers on most of these
parameters and remain our top picks in the sector.
We downgrade DLF to REDUCE, from Hold. Key reasons for the downgrade are: 1) projected asset sales are
unlikely to generate any significant value and would just about meet DLF’s cash requirement; 2) high
dilution risk persists; 3) 2QFY12 operational metrics should remain weak; and 4) an unfavourable
judgement on the Competition Commission of India (CCI) penalty could further strain cash flows.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
Investment thesis
Price correction is a key catalyst for the sector -- - ahead of interest rate cuts
We have compared volume trends in the Mumbai and Bengaluru markets to the BSE Realty index
performance. The BSE Realty index has moved in tandem with the volume trend in these two markets for
seven out of the last nine quarters (see Exhibits 1 & 2), implying volume is a key indicator for the sector.
Based on the affordability metrics, price correction is the most effective variable (interest rates and wages
are other variables which take time to change) for volumes to recover. We forecast real estate prices will
correct about 20% across India over the next three-to-six months, based on our affordability calculation
(refer to the section ‘Assessing the extent of price correction -- - expect a 20% decline in prices’ on page 7).
If prices correct 20% and volumes increase only 20% (historically the quantum of increase has been much
more), the net impact on gross profit across price segments could range from 14% to 23%. If we incorporate
a similar scenario to our target prices, our calculations suggest about 6% downside potential from current
levels.
Office sector: Bengaluru remains better placed, vacancies in Mumbai to increase due to upcoming supply
The office sector contributes about 45% to the total gross asset value (GAV) of the major listed developers.
DLF, Prestige (PEPL) and Anant Raj (ARCP) are the most geared to the office sector, as it represents more
than 50% of their GAV.
In 2011, we expect total absorption of around 35m sqft across the top seven cities (Mumbai, NCR, Chennai,
Bengaluru, Hyderabad, Kolkata and Pune) in India, which is close to the last five years’ average of 34m sqft.
We estimate supply in the seven key cities will increase 24% in 2011. A majority of the upcoming supply is
concentrated in the Mumbai region, thus we expect vacancies to continue to increase in Mumbai. Bengaluru
remains relatively better placed due to limited upcoming supply and stable demand.
Asset sales to continue, dilution and refinancing are other options to meet funding shortfall
We assess the funding situation of the developers under our coverage based on their debt service coverage
ratios (DSCR) including capex, which effectively = (EBITDA -- - minimum alternative tax) divided by (interest +
debt repayment + capex) and net funding shortfall (debt repayment + interest obligation + capex on office
or retail assets -- - cash flow from operations). DSCR is used to evaluate a company’s ability to meet its debt
repayment and servicing obligations.
Our analysis shows that DLF, Unitech, PEPL and Sobha are likely to face funding shortfall in the near term.
Asset sales, dilution and refinancing are the potential options to offset this eventually. We believe
developers with huge debt burden (DLF) will likely to continue with asset sales and possibly dilute equity.
Sobha and PEPL can meet their funding shortfall through refinancing since their gearing ratios are still
within the acceptable range (0.5-0.7x). Unitech is likely to see a mix of asset sales and refinancing.
Prefer a valuation methodology which factors in both efficiency and asset base of the developer
For the last four years investors have been debating about the appropriate way of valuing Indian
developers. Some old-school investors believe a P/BV multiple (captures efficiency) is the best way to value
developers, which effectively implies using the formula: ((long-term sustainable ROE -- - long-term growth
rate)/(long-term cost of equity)) -- - long-term growth rate. Some investors believe a DCF-based NAV
(captures asset base) approach captures the actual value of the large land banks.
We believe the true value lies somewhere in between which captures both efficiency and the asset base of a
firm, so we use the average of these two valuations to derive target prices for our property coverage
universe.
Oberoi and Sobha remain our top picks; downgrade DLF to a REDUCE, from Hold
We prefer developers with high revenue visibility, consistent execution track records, good corporate
governance, and simpler business models. Oberoi and Sobha emerge top rankers on most of these
parameters and remain our top picks in the sector.
We downgrade DLF to REDUCE, from Hold. Key reasons for the downgrade are: 1) projected asset sales are
unlikely to generate any significant value and would just about meet DLF’s cash requirement; 2) high
dilution risk persists; 3) 2QFY12 operational metrics should remain weak; and 4) an unfavourable
judgement on the Competition Commission of India (CCI) penalty could further strain cash flows.
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