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Expectations are low, risk-reward favourable
Valuation near ‘distress’ levels,
ignores growth prospects;
project execution awaited
Action/Valuation: Maintain BUY as risk-reward is favourable
In our view, Lanco's CMP ignores potential value accretion from its project
pipeline beyond FY12; instead it partially reflects the risk of a funding gap
and overhang from unresolved contractual/legal issues. We expect FY11-
13F EBITDA and normalised EPS CAGR at ~70% on the back of higher
contribution from power generation. At 0.7x P/B and 4.5x P/E on FY13F
earnings, multiples are arguably ‘distressed’ and at a discount to its peers.
Maintain BUY; 12-mth TP cut to Rs30 (from Rs51) on reduction in value of
power business (down from INR41 to INR22), higher CoE.
Do our earnings/TP downgrades stop here?
Pushback in project timelines, materially lower near-term realisations and
higher cost of funds largely explain the sharp earnings downgrade. In our
view, earnings sensitivity to these variables entails a fair risk-reward payoff
from our base case; lingering contractual/legal issues remain a risk.
Cashflows just about adequate, but margin of safety is negligible
82% of equity required for its 5.9GW pipeline (ex-renewables, Udupi) is
already invested; Group cash flows would suffice for the balance equity
funding and AUD250mn required for Griffin Coal. Loan disbursals are on
schedule; AUD483mn loan repayable in FY15/16 will require refinancing.
Catalysts: Execution remains key to rebuild investors’ confidence
Commissioning of 1870MW capacity by Mar-12 and operating its 3.9GW
diversified capacity at healthy utilisation levels would restore execution
credibility. Other catalysts – (1) visibility on gas allocation/availability for
KP-III, (2) resolution of project-specific contractual/regulatory/legal issues.
Investment Summary
In our view, Lanco's CMP ignores potential value accretion from its project pipeline
beyond FY12; instead it partially reflects the risk of a funding gap and overhang from
unresolved contractual/legal issues. Our revised earnings forecast for Lanco still pegs
FY11F-13F EBITDA and normalised EPS CAGR at ~70%; at 0.7x P/B and 4.5x P/E on
our FY13F, the risk-reward ratio is favourable over a 12-mth perspective. Maintain BUY,
TP pegged at INR30; execution remains key to rebuild investors’ confidence.
Project execution imperative to rebuild investors’ confidence
We think there are good reasons to de-rate Lanco this year: the stock is down 75% YTD,
repeated earnings disappointment and push back of capacity commissioning timeline
over the past few quarters, a growing list of unresolved contractual/regulatory/legal
issues, debt restructuring and management's aggressiveness to pursue seemingly
low/negative return projects despite Lanco's stretched balance sheet and limited cash
flows. Together with sector-specific concerns on fuel supply, health of SEBs, a tightening
interest rate environment and concern that lenders to the IPPs may look to defer
disbursals to high risk projects, the stock trades below its historical (FY11) book value
Further, there are arguments for the stock price drifting even lower and forward multiples
not looking inexpensive – [1] Griffin Coal may burn cash for a long time; litigation with
Perdaman could endanger viability of operations altogether, [2] coal supply at upcoming
facilities may not be sufficient to enable operations at a profitable utilisation level, [3] the
Gare-Pelma MDO opportunity may drain cashflows, and [4] management may continue
to aggressively pursue new capex-intensive projects (like the Orissa UMPP).
Nevertheless, based on our revised fair value assessment of Lanco’s various business
lines / projects, we believe that at INR16.4/sh, the stock price disregards potential value
accretion from its post-FY12 project pipeline (3.96GW, including Kondapalli-III),
potentially assigning a zero value to Griffin Coal and does not fully value the EPC
business (Fig1). Put another way, if the CMP captures the value of all projects, it implies
that a degree of ‘potential value destruction’ is being priced in as well.
Incorporating pushback in project timelines, materially lower near-term realisations and
higher cost of funds (which largely explain the sharp earnings downgrade), our revised
earnings forecast for Lanco still pegs FY11F-13F EBITDA and normalised EPS CAGR at
~70%. Our calculations indicate that Group cashflows, together with the INR16.6bn cash
at Group level (Mar- 2011) would be just about sufficient to provide equity funding for its
under-construction power projects and pay the balance AUD250mn for Griffin Coal in
FY13/15; however, margin of safety is negligible.
Capturing revised earnings forecast and a higher CoE, our SOTP-based 12-month target
price for Lanco drops by 41% to INR30/sh; implying the stock offers a potential upside of
67% from its CMP. At 0.8x/0.7x FY12F/FY13F price/book, we believe the risk-reward
ratio is favourable over a 12-month perspective. On FY13F, Lanco trades at a significant
discount to its peers on P/Book and P/E multiples.
Why the sharp earnings/TP downgrade – what’s changed?
In our view, pushback in project timelines, materially lower near-term realisations, higher
cost of funds and lower near-term PLF explain the sharp earnings downgrade (Fig 7).
Our revised earnings forecast or Lanco also captures solar EPC/generation business
financials (including capex on solar equipment manufacturing).
Do our earnings/TP downgrades stop here?
We believe our key operating assumptions behind Lanco’s earnings forecast are
arguably conservative. Nevertheless, the risk to our FY13F earnings from any delay in
imminent projects (particularly Udupi and Anpara) remains particularly high as
consolidation of the financials of these two projects is contingent upon start-up of
commercial operations. Timely commissioning and operations of the power projects is
critical for Lanco’s cashflows as well, given its high leverage and significant capex
commitment.
We do note that earnings and TP sensitivity to key variables entails a fair risk-reward
payoff from our base case (Fig 8). For example, back-of-the-envelope calculations
suggest that if Lanco manages to secure Chinese EXIM funding for procurement of
equipment (BTG) for its Amarkantak-II, Babandh and Vidharba projects (aggregate
3960MW), the weighted interest cost of debt for these projects would potentially drop by
~300bps (assuming the Chinese EXIM funding is fully hedged) would raise our SOTPbased
TP for the stock by ~10%.
Takeaways on business financials, valuations and funding
Power generation portfolio valued at INR22/sh
Within the context of fuel supply being a structural risk for upcoming power generation
capacity in India, Lanco’s 7.1GW ex-renewables project pipeline scores fairly high on our
‘milestone risk matrix’. However, pushback in near-term capacity addition timeline and
lower merchant realization prospects, together with higher cost of funds lower our
milestone-risk adjusted FCFE-based value of Lanco's power portfolio from INR41/sh to
INR22/sh (Fig 9).
Solar business to enhance consolidated EBITDA margins
By our calculations, post an inflow from its ex-solar EPC business cashflows in FY12,
Lanco would be in a position to largely fund the equity portion of its solar manufacturing
business (net of expected Government grant of ~2.7bn) and power development
business in FY13-14 via its solar EPC cashflows. Lanco’s solar EPC order book stood at
INR53bn (as of June 2011); we assume an execution over a 2-2.5yrs and a blended
EBITDA margin of 15% (broadly based on the indicative margins outlined by the
company earlier this year).
Griffin Coal – EBITDA positive, but expect break-even only by 2HFY2014
We believe consolidation of Griffin Coal will remain EPS dilutive in FY12F/13F/14F as
production ramp-up would be muted on the back of restrictions on export capacity (at the
Kwinana port) and seemingly tepid outlook on demand for incremental coal in Western
Australia. Near-term KPIs include extent of reduction in cash cost and freight charges
and de-watering related capex; volume ramp-up and export realisations are critical for
self funding/servicing the AUD800mn capex towards capacity expansion and
infrastructure (rail & port) development.
Cashflows & funding status – Just about adequate, negligible margin of safety
Based on our earnings forecast for Lanco, aggregate (including Associates) FCF from
the power and EPC business lines, together with the INR16.6bn (USD369mn) aggregate
cash chest with Lanco as of March 2011 would be just about sufficient to meet the equity
requirement for its under-construction power projects and fund the two-tranche
AUD250mn payable for Griffin Coal in FY13/15 (Fig 20). However, the two-tranche
repayment of the AUD483mn (~AUD100mn in FY15, remainder in FY16) bridge loan
secured to make the down-payment for Griffin Coal, would likely require refinancing;
quantum would depend upon the cashflows of the power and EPC business in FY16.
Valuations – CMP is disregards growth, partially captures risk of value destruction
Based on our SOTP-based valuation for Lanco, we believe that the CMP disregards
potential value accretion from its power project pipeline beyond March 2012 and does
not fully capture the value of the EPC business (Fig 10). Put another way, if the CMP is
pricing in Lanco’s project pipeline, Griffin Coal, and the solar business, the implied value
of these projects/ventures is negative. Our revised earnings forecast for Lanco still pegs
FY11F-13F EBITDA and normalised EPS CAGR at ~70%; at 0.7x P/B and 4.5x P/E on
our FY13F, the risk-reward ratio is favourable over a 12-month perspective.
Key risks to our investment thesis
High dependence on linkage coal/gas supply…
83% of Lanco’s coal fired capacity is dependent on linkage coal supply, wherein a
shortfall is imminent. Although we already assume blending of e-auction/imported coal
for linkage-coal based projects (linkage coal supplying only 50% of total requirement,
rest supplemented with e-auction/imported coal), inability to make-up for the supply
shortfall is a key risk for earnings.
…bulk of its under-construction capacity (coming up post FY12) is untied
45-100% of capacity at Lanco’s big-ticket under-construction projects (AK-II, Babandh,
Vidarbha and KP-III) is not tied up under long-term PPAs; inability to sign PPAs before
start-up timeline can lead to lower than expected PLFs/realizations for these plants.
Growing concern on execution capability
In the backdrop of repeated push-back of commissioning timeline of pipeline projects
over the past few quarters and a growing list of unresolved contractual/regulatory/legal
issues, management’s capability to successfully execute (considering its mega
expansion plans across multiple business lines) is a concern. In tandem, management’s
‘aggressive’ ventures into new business areas/projects/bids at a time when financials are
stretched and there are enough projects on its plate already, is disconcerting – a view
echoed by majority of investors in our discussions on the stock.
High leverage, negligible margin of safety for net cashflows
Our revised earnings forecast for Lanco, which builds in project delays and prospects of
lower merchant tariff realisation, suggests that a funding gap is on the horizon, at best
only to refinance the AUD483mn loan repayment due in FY2015/16. However, in the
backdrop of Lanco’s capex commitments and net-debt to equity rising above set to rise
5x, need to raise equity at the parent or project SPV level is reasonably probable.
Unresolved contractual/legal issues remain an overhang
In our view, unresolved contractual/legal issues, notably the Perdaman lawsuit and PPA
with Haryana SEB (HSEB) for 195MW from Amarkantak Unit-2, are significant overhang
on Lanco’s earnings and stock price performance. While there is no clarity on the
Perdaman lawsuit, we continue to believe that an out-of-court settlement remains a
probable outcome. As regards the PPA with HSEB, we assume the tariff to remain at
Rs2.32/kWh in our base case assumptions; any change in the same would be an upside.
Cashflows – A potential funding gap on the horizon?
In respect of its 7.1GW project pipeline (ex-renewables), Lanco has invested ~82% of its
equity funding requirement as of June 2011 (Fig 18); financial closure for the entire
capacity is in place for the debt funding requirement and as per the management, loan
disbursals by the lenders are as per schedule. As per our calculations based on our
revised earnings forecast for Lanco’s power, EPC, roads and real estate business lines
up to FY15 and deciphering the aggregate cashflows, we infer –
• Investible FCF from the power business (aggregating INR7.5bn during FY12F-15F),
together with the cash on hand as of FY11 (INR7.4bn), will not be sufficient to fund the
INR21bn remaining equity required by the 7.1GW under-construction power projects
(ex-renewables).
• EPC and the solar business will generate FCF (assuming revolving working capital loan
remains available to Lanco) after meeting the funding requirement of the real estate
business (to repay the debt on its books) and solar business (equity investment).
• The resultant combined FCF from the power and EPC business lines (including solar),
together with the INR16.6bn (USD369mn) aggregate cash chest with Lanco as of
March 2011, would be just about sufficient to: [1] meet the equity requirement for its
under-construction power projects and [2] fund the two-tranche AUD250mn payable for
Griffin Coal in FY13/15,
• The two-tranche repayment of the AUD483mn (~AUD100mn in FY15, remainder in
FY16) bridge loan to make the down-payment for Griffin Coal would likely require
refinancing, depending upon the cashflows of the power and EPC business in FY16.
A caveat: fungibility of cash between various power SPVs may not be seamless, but note
that Lanco is moving towards housing all its power projects in a single SPV.
Griffin Coal – capped export capacity suggests break-even only by 2HFY2014
Based on our calculations, Griffin Coal would likely report a positive EBITDA, but net
losses in FY12F/13F/14F as – [1] production ramp-up over this period would be muted,
given the restrictions on Lanco’s export capacity entitlement at the Kwinana port
(currently ~1mtpa), and [2] the AUD800-900mn capacity expansion / infra development
capex gets under way.
Based our earning assumptions for Griffin Coal, resultant cash flows suggests that Griffin
Coal should be able fund the equity portion (D/E: 70:30) of the AUD800mn capex it
needs to incur over the next 4-5 years. However, we note that that production ramp-up,
control over cash costs and export realisations are extremely critical for self funding of
the overall capex. FY15 onwards, as the railway and port infrastructure gets augmented,
we expect production to reach 15mtpa in FY18 (Lanco expects 17mn tons by 2017). Our
long-term cash cost assumption stands at AUD26/ton against management’s guidance
of AUD23-26/ton.
Scenario analysis: What if the US and
Europe slip back into recession?
As the markets have been signaling that risks to our baseline forecasts are on the
downside, our global economics team have considered a bear case economic scenario,
most obviously triggered by a market meltdown, but the fragile state of the advanced
economies leaves them vulnerable to unforeseen shocks or policy errors. For details,
see Global Weekly Economic Monitor, 12 August 2011, and Global market turbulence:
Implications for Asia, 9 August 2011.
The bear case scenario assumes:
• The US and Euro area slip back into recession, with US GDP averaging -1% saar in
2H11 and Euro GDP averaging -3% before recovering to around 2% growth in 2012.
• The CRB commodity price index falls 15% between now and year-end, but starts rising
back again through 2012 reaching current levels by end-2012.
If there is a market meltdown and recessions in the US and euro area, we have no doubt
that initially many economies in the region would be hit hard again in an echo of the
global financial crisis, as non-linear effects start to kick in, notably financial decelerator
effects, multiplier effects of weakening exports on domestic capex and jobs, and capital
flight. However, less disturbing this time around are the two factors that there is less
leverage in the financial system (less room for capital flight) and less chance of Asian
trade finance drying up, as the world’s central banks have most likely learnt the need to
provide ample USD liquidity through FX swap arrangements.
In this scenario, we find Hong Kong, Singapore, Malaysia and Taiwan to be among the
most vulnerable. But, as in 2009, we would expect that, over time, powerful tailwinds
would develop, allowing Asia to bounce back before other regions. These tailwinds
include a likely further decline in commodity prices and the ample room Asia has to ease
monetary and fiscal policies – more so than any other region. In our bear case scenario,
we would expect the Fed to resort to further quantitative easing, which once again would
likely precipitate strong net capital inflows into Asia, attracted by stronger growth,
superior fundamentals and higher interest rates relative to other regions.
What if things get even worse than we can foresee? Although our global economics
team does not see such a situation as plausible at the moment, they have run an
extreme-case scenario analysis to provide some perspective. This extreme scenario
assumes:
• US GDP averaging about -4% saar in 2H11 and Euro GDP averaging -6.5% before
recovering to around 1% growth in 2012.
• CRB commodity price index falls 40% between now and year-end, and stays at the
lower level through 2012.
The table below summarises both the official bear case and the hypothetical extreme
case scenarios.
What does this mean for Lanco?
In the above-mentioned ‘bear case’ and ‘extreme case’ scenarios, we would expect
interest rates and commodity prices to ease which would in fact be beneficial for Lanco
earnings and our target price. Accordingly, we assume a 100 bps decline in interest rates
and a 5% decline in imported coal price in the ‘bear case’ and a 200 bps decline in
interest rates and a 10% fall in imported coal price in the ‘extreme case’.
Ceteris paribus, Lanco’s FY12 and FY13 EPS in the ‘bear case’ should go up by
31%/6% and the TP would rise by 17% to INR35. In the ‘extreme case’ FY12/13 EPS
would increase by 63%/12% and the TP would rise by 33% to INR40.
However, we note that the impact would not be this straightforward –
• In the 2008-09 downturn, the stock price fell sharply due to (1) outflow of capital from
Indian equity markets, and (2) aversion to weak/feeble balance sheets with high
leverage. We note that Lanco continues to be a highly leveraged company and remains
a high beta stock.
• Unlike in 2008-09, Lanco has exposure to Australia via Griffin Coal (5-7% of revenues,
and 1-3% of EBITDA over the next two to three years) and has taken a significant
quantum of foreign currency debt on its book to acquire this asset. Accordingly,
currency fluctuations may play a role in the impact on consolidated earnings.
Interestingly, during the lows of 2008-09, Lanco traded at 1-year forward P/B of 0.8x – it
trades at the same multiple currently, although it did touch a low of 0.6x 1-yr fwd P/B a
few weeks ago.
India Equity Research Reports, IPO and Stock News
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Expectations are low, risk-reward favourable
Valuation near ‘distress’ levels,
ignores growth prospects;
project execution awaited
Action/Valuation: Maintain BUY as risk-reward is favourable
In our view, Lanco's CMP ignores potential value accretion from its project
pipeline beyond FY12; instead it partially reflects the risk of a funding gap
and overhang from unresolved contractual/legal issues. We expect FY11-
13F EBITDA and normalised EPS CAGR at ~70% on the back of higher
contribution from power generation. At 0.7x P/B and 4.5x P/E on FY13F
earnings, multiples are arguably ‘distressed’ and at a discount to its peers.
Maintain BUY; 12-mth TP cut to Rs30 (from Rs51) on reduction in value of
power business (down from INR41 to INR22), higher CoE.
Do our earnings/TP downgrades stop here?
Pushback in project timelines, materially lower near-term realisations and
higher cost of funds largely explain the sharp earnings downgrade. In our
view, earnings sensitivity to these variables entails a fair risk-reward payoff
from our base case; lingering contractual/legal issues remain a risk.
Cashflows just about adequate, but margin of safety is negligible
82% of equity required for its 5.9GW pipeline (ex-renewables, Udupi) is
already invested; Group cash flows would suffice for the balance equity
funding and AUD250mn required for Griffin Coal. Loan disbursals are on
schedule; AUD483mn loan repayable in FY15/16 will require refinancing.
Catalysts: Execution remains key to rebuild investors’ confidence
Commissioning of 1870MW capacity by Mar-12 and operating its 3.9GW
diversified capacity at healthy utilisation levels would restore execution
credibility. Other catalysts – (1) visibility on gas allocation/availability for
KP-III, (2) resolution of project-specific contractual/regulatory/legal issues.
Investment Summary
In our view, Lanco's CMP ignores potential value accretion from its project pipeline
beyond FY12; instead it partially reflects the risk of a funding gap and overhang from
unresolved contractual/legal issues. Our revised earnings forecast for Lanco still pegs
FY11F-13F EBITDA and normalised EPS CAGR at ~70%; at 0.7x P/B and 4.5x P/E on
our FY13F, the risk-reward ratio is favourable over a 12-mth perspective. Maintain BUY,
TP pegged at INR30; execution remains key to rebuild investors’ confidence.
Project execution imperative to rebuild investors’ confidence
We think there are good reasons to de-rate Lanco this year: the stock is down 75% YTD,
repeated earnings disappointment and push back of capacity commissioning timeline
over the past few quarters, a growing list of unresolved contractual/regulatory/legal
issues, debt restructuring and management's aggressiveness to pursue seemingly
low/negative return projects despite Lanco's stretched balance sheet and limited cash
flows. Together with sector-specific concerns on fuel supply, health of SEBs, a tightening
interest rate environment and concern that lenders to the IPPs may look to defer
disbursals to high risk projects, the stock trades below its historical (FY11) book value
Further, there are arguments for the stock price drifting even lower and forward multiples
not looking inexpensive – [1] Griffin Coal may burn cash for a long time; litigation with
Perdaman could endanger viability of operations altogether, [2] coal supply at upcoming
facilities may not be sufficient to enable operations at a profitable utilisation level, [3] the
Gare-Pelma MDO opportunity may drain cashflows, and [4] management may continue
to aggressively pursue new capex-intensive projects (like the Orissa UMPP).
Nevertheless, based on our revised fair value assessment of Lanco’s various business
lines / projects, we believe that at INR16.4/sh, the stock price disregards potential value
accretion from its post-FY12 project pipeline (3.96GW, including Kondapalli-III),
potentially assigning a zero value to Griffin Coal and does not fully value the EPC
business (Fig1). Put another way, if the CMP captures the value of all projects, it implies
that a degree of ‘potential value destruction’ is being priced in as well.
Incorporating pushback in project timelines, materially lower near-term realisations and
higher cost of funds (which largely explain the sharp earnings downgrade), our revised
earnings forecast for Lanco still pegs FY11F-13F EBITDA and normalised EPS CAGR at
~70%. Our calculations indicate that Group cashflows, together with the INR16.6bn cash
at Group level (Mar- 2011) would be just about sufficient to provide equity funding for its
under-construction power projects and pay the balance AUD250mn for Griffin Coal in
FY13/15; however, margin of safety is negligible.
Capturing revised earnings forecast and a higher CoE, our SOTP-based 12-month target
price for Lanco drops by 41% to INR30/sh; implying the stock offers a potential upside of
67% from its CMP. At 0.8x/0.7x FY12F/FY13F price/book, we believe the risk-reward
ratio is favourable over a 12-month perspective. On FY13F, Lanco trades at a significant
discount to its peers on P/Book and P/E multiples.
Why the sharp earnings/TP downgrade – what’s changed?
In our view, pushback in project timelines, materially lower near-term realisations, higher
cost of funds and lower near-term PLF explain the sharp earnings downgrade (Fig 7).
Our revised earnings forecast or Lanco also captures solar EPC/generation business
financials (including capex on solar equipment manufacturing).
Do our earnings/TP downgrades stop here?
We believe our key operating assumptions behind Lanco’s earnings forecast are
arguably conservative. Nevertheless, the risk to our FY13F earnings from any delay in
imminent projects (particularly Udupi and Anpara) remains particularly high as
consolidation of the financials of these two projects is contingent upon start-up of
commercial operations. Timely commissioning and operations of the power projects is
critical for Lanco’s cashflows as well, given its high leverage and significant capex
commitment.
We do note that earnings and TP sensitivity to key variables entails a fair risk-reward
payoff from our base case (Fig 8). For example, back-of-the-envelope calculations
suggest that if Lanco manages to secure Chinese EXIM funding for procurement of
equipment (BTG) for its Amarkantak-II, Babandh and Vidharba projects (aggregate
3960MW), the weighted interest cost of debt for these projects would potentially drop by
~300bps (assuming the Chinese EXIM funding is fully hedged) would raise our SOTPbased
TP for the stock by ~10%.
Takeaways on business financials, valuations and funding
Power generation portfolio valued at INR22/sh
Within the context of fuel supply being a structural risk for upcoming power generation
capacity in India, Lanco’s 7.1GW ex-renewables project pipeline scores fairly high on our
‘milestone risk matrix’. However, pushback in near-term capacity addition timeline and
lower merchant realization prospects, together with higher cost of funds lower our
milestone-risk adjusted FCFE-based value of Lanco's power portfolio from INR41/sh to
INR22/sh (Fig 9).
Solar business to enhance consolidated EBITDA margins
By our calculations, post an inflow from its ex-solar EPC business cashflows in FY12,
Lanco would be in a position to largely fund the equity portion of its solar manufacturing
business (net of expected Government grant of ~2.7bn) and power development
business in FY13-14 via its solar EPC cashflows. Lanco’s solar EPC order book stood at
INR53bn (as of June 2011); we assume an execution over a 2-2.5yrs and a blended
EBITDA margin of 15% (broadly based on the indicative margins outlined by the
company earlier this year).
Griffin Coal – EBITDA positive, but expect break-even only by 2HFY2014
We believe consolidation of Griffin Coal will remain EPS dilutive in FY12F/13F/14F as
production ramp-up would be muted on the back of restrictions on export capacity (at the
Kwinana port) and seemingly tepid outlook on demand for incremental coal in Western
Australia. Near-term KPIs include extent of reduction in cash cost and freight charges
and de-watering related capex; volume ramp-up and export realisations are critical for
self funding/servicing the AUD800mn capex towards capacity expansion and
infrastructure (rail & port) development.
Cashflows & funding status – Just about adequate, negligible margin of safety
Based on our earnings forecast for Lanco, aggregate (including Associates) FCF from
the power and EPC business lines, together with the INR16.6bn (USD369mn) aggregate
cash chest with Lanco as of March 2011 would be just about sufficient to meet the equity
requirement for its under-construction power projects and fund the two-tranche
AUD250mn payable for Griffin Coal in FY13/15 (Fig 20). However, the two-tranche
repayment of the AUD483mn (~AUD100mn in FY15, remainder in FY16) bridge loan
secured to make the down-payment for Griffin Coal, would likely require refinancing;
quantum would depend upon the cashflows of the power and EPC business in FY16.
Valuations – CMP is disregards growth, partially captures risk of value destruction
Based on our SOTP-based valuation for Lanco, we believe that the CMP disregards
potential value accretion from its power project pipeline beyond March 2012 and does
not fully capture the value of the EPC business (Fig 10). Put another way, if the CMP is
pricing in Lanco’s project pipeline, Griffin Coal, and the solar business, the implied value
of these projects/ventures is negative. Our revised earnings forecast for Lanco still pegs
FY11F-13F EBITDA and normalised EPS CAGR at ~70%; at 0.7x P/B and 4.5x P/E on
our FY13F, the risk-reward ratio is favourable over a 12-month perspective.
Key risks to our investment thesis
High dependence on linkage coal/gas supply…
83% of Lanco’s coal fired capacity is dependent on linkage coal supply, wherein a
shortfall is imminent. Although we already assume blending of e-auction/imported coal
for linkage-coal based projects (linkage coal supplying only 50% of total requirement,
rest supplemented with e-auction/imported coal), inability to make-up for the supply
shortfall is a key risk for earnings.
…bulk of its under-construction capacity (coming up post FY12) is untied
45-100% of capacity at Lanco’s big-ticket under-construction projects (AK-II, Babandh,
Vidarbha and KP-III) is not tied up under long-term PPAs; inability to sign PPAs before
start-up timeline can lead to lower than expected PLFs/realizations for these plants.
Growing concern on execution capability
In the backdrop of repeated push-back of commissioning timeline of pipeline projects
over the past few quarters and a growing list of unresolved contractual/regulatory/legal
issues, management’s capability to successfully execute (considering its mega
expansion plans across multiple business lines) is a concern. In tandem, management’s
‘aggressive’ ventures into new business areas/projects/bids at a time when financials are
stretched and there are enough projects on its plate already, is disconcerting – a view
echoed by majority of investors in our discussions on the stock.
High leverage, negligible margin of safety for net cashflows
Our revised earnings forecast for Lanco, which builds in project delays and prospects of
lower merchant tariff realisation, suggests that a funding gap is on the horizon, at best
only to refinance the AUD483mn loan repayment due in FY2015/16. However, in the
backdrop of Lanco’s capex commitments and net-debt to equity rising above set to rise
5x, need to raise equity at the parent or project SPV level is reasonably probable.
Unresolved contractual/legal issues remain an overhang
In our view, unresolved contractual/legal issues, notably the Perdaman lawsuit and PPA
with Haryana SEB (HSEB) for 195MW from Amarkantak Unit-2, are significant overhang
on Lanco’s earnings and stock price performance. While there is no clarity on the
Perdaman lawsuit, we continue to believe that an out-of-court settlement remains a
probable outcome. As regards the PPA with HSEB, we assume the tariff to remain at
Rs2.32/kWh in our base case assumptions; any change in the same would be an upside.
Cashflows – A potential funding gap on the horizon?
In respect of its 7.1GW project pipeline (ex-renewables), Lanco has invested ~82% of its
equity funding requirement as of June 2011 (Fig 18); financial closure for the entire
capacity is in place for the debt funding requirement and as per the management, loan
disbursals by the lenders are as per schedule. As per our calculations based on our
revised earnings forecast for Lanco’s power, EPC, roads and real estate business lines
up to FY15 and deciphering the aggregate cashflows, we infer –
• Investible FCF from the power business (aggregating INR7.5bn during FY12F-15F),
together with the cash on hand as of FY11 (INR7.4bn), will not be sufficient to fund the
INR21bn remaining equity required by the 7.1GW under-construction power projects
(ex-renewables).
• EPC and the solar business will generate FCF (assuming revolving working capital loan
remains available to Lanco) after meeting the funding requirement of the real estate
business (to repay the debt on its books) and solar business (equity investment).
• The resultant combined FCF from the power and EPC business lines (including solar),
together with the INR16.6bn (USD369mn) aggregate cash chest with Lanco as of
March 2011, would be just about sufficient to: [1] meet the equity requirement for its
under-construction power projects and [2] fund the two-tranche AUD250mn payable for
Griffin Coal in FY13/15,
• The two-tranche repayment of the AUD483mn (~AUD100mn in FY15, remainder in
FY16) bridge loan to make the down-payment for Griffin Coal would likely require
refinancing, depending upon the cashflows of the power and EPC business in FY16.
A caveat: fungibility of cash between various power SPVs may not be seamless, but note
that Lanco is moving towards housing all its power projects in a single SPV.
Griffin Coal – capped export capacity suggests break-even only by 2HFY2014
Based on our calculations, Griffin Coal would likely report a positive EBITDA, but net
losses in FY12F/13F/14F as – [1] production ramp-up over this period would be muted,
given the restrictions on Lanco’s export capacity entitlement at the Kwinana port
(currently ~1mtpa), and [2] the AUD800-900mn capacity expansion / infra development
capex gets under way.
Based our earning assumptions for Griffin Coal, resultant cash flows suggests that Griffin
Coal should be able fund the equity portion (D/E: 70:30) of the AUD800mn capex it
needs to incur over the next 4-5 years. However, we note that that production ramp-up,
control over cash costs and export realisations are extremely critical for self funding of
the overall capex. FY15 onwards, as the railway and port infrastructure gets augmented,
we expect production to reach 15mtpa in FY18 (Lanco expects 17mn tons by 2017). Our
long-term cash cost assumption stands at AUD26/ton against management’s guidance
of AUD23-26/ton.
Scenario analysis: What if the US and
Europe slip back into recession?
As the markets have been signaling that risks to our baseline forecasts are on the
downside, our global economics team have considered a bear case economic scenario,
most obviously triggered by a market meltdown, but the fragile state of the advanced
economies leaves them vulnerable to unforeseen shocks or policy errors. For details,
see Global Weekly Economic Monitor, 12 August 2011, and Global market turbulence:
Implications for Asia, 9 August 2011.
The bear case scenario assumes:
• The US and Euro area slip back into recession, with US GDP averaging -1% saar in
2H11 and Euro GDP averaging -3% before recovering to around 2% growth in 2012.
• The CRB commodity price index falls 15% between now and year-end, but starts rising
back again through 2012 reaching current levels by end-2012.
If there is a market meltdown and recessions in the US and euro area, we have no doubt
that initially many economies in the region would be hit hard again in an echo of the
global financial crisis, as non-linear effects start to kick in, notably financial decelerator
effects, multiplier effects of weakening exports on domestic capex and jobs, and capital
flight. However, less disturbing this time around are the two factors that there is less
leverage in the financial system (less room for capital flight) and less chance of Asian
trade finance drying up, as the world’s central banks have most likely learnt the need to
provide ample USD liquidity through FX swap arrangements.
In this scenario, we find Hong Kong, Singapore, Malaysia and Taiwan to be among the
most vulnerable. But, as in 2009, we would expect that, over time, powerful tailwinds
would develop, allowing Asia to bounce back before other regions. These tailwinds
include a likely further decline in commodity prices and the ample room Asia has to ease
monetary and fiscal policies – more so than any other region. In our bear case scenario,
we would expect the Fed to resort to further quantitative easing, which once again would
likely precipitate strong net capital inflows into Asia, attracted by stronger growth,
superior fundamentals and higher interest rates relative to other regions.
What if things get even worse than we can foresee? Although our global economics
team does not see such a situation as plausible at the moment, they have run an
extreme-case scenario analysis to provide some perspective. This extreme scenario
assumes:
• US GDP averaging about -4% saar in 2H11 and Euro GDP averaging -6.5% before
recovering to around 1% growth in 2012.
• CRB commodity price index falls 40% between now and year-end, and stays at the
lower level through 2012.
The table below summarises both the official bear case and the hypothetical extreme
case scenarios.
What does this mean for Lanco?
In the above-mentioned ‘bear case’ and ‘extreme case’ scenarios, we would expect
interest rates and commodity prices to ease which would in fact be beneficial for Lanco
earnings and our target price. Accordingly, we assume a 100 bps decline in interest rates
and a 5% decline in imported coal price in the ‘bear case’ and a 200 bps decline in
interest rates and a 10% fall in imported coal price in the ‘extreme case’.
Ceteris paribus, Lanco’s FY12 and FY13 EPS in the ‘bear case’ should go up by
31%/6% and the TP would rise by 17% to INR35. In the ‘extreme case’ FY12/13 EPS
would increase by 63%/12% and the TP would rise by 33% to INR40.
However, we note that the impact would not be this straightforward –
• In the 2008-09 downturn, the stock price fell sharply due to (1) outflow of capital from
Indian equity markets, and (2) aversion to weak/feeble balance sheets with high
leverage. We note that Lanco continues to be a highly leveraged company and remains
a high beta stock.
• Unlike in 2008-09, Lanco has exposure to Australia via Griffin Coal (5-7% of revenues,
and 1-3% of EBITDA over the next two to three years) and has taken a significant
quantum of foreign currency debt on its book to acquire this asset. Accordingly,
currency fluctuations may play a role in the impact on consolidated earnings.
Interestingly, during the lows of 2008-09, Lanco traded at 1-year forward P/B of 0.8x – it
trades at the same multiple currently, although it did touch a low of 0.6x 1-yr fwd P/B a
few weeks ago.
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