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Look beyond group concerns
CHANGE
Group companies’ overhang continues to drag down the stock
Despite positive catalysts in its regulated businesses, Reliance
Infrastructure has underperformed the broader markets mainly due to
overhang of allegations against group companies in the telecom business.
It is difficult to quantify the risk from an unfavourable outcome, but we
believe fundamental risks in its core businesses are adequately priced in.
CATALYST
2G resolution, earnings momentum key catalysts
Any resolution of the 2G allegations would be a catalyst for the stock. The
company recently renewed its distribution licence for Mumbai for 25
years. The regulators have allowed Reliance Infrastructure to collect
arrears and cross-subsidy in Mumbai, and to hike tariffs by 22% in Delhi.
These positives should provide earnings momentum.
VALUATION
SoTP-based TP implies healthy upside
We have revised our SoTP-based TP to INR723, from INR1,077, of which
the standalone business contributes INR256. We have used our Utilities
team’s valuation for its associate R-Power (38% ownership), which now
contributes INR223 (down from INR391). All other infrastructure assets
contribute INR224.
Key developments and stock performance
Reliance Infrastructure (R-Infra) has underperformed the Sensex by approximately 36% YTD, predominantly
on allegations against its group companies in 2G spectrum allocation.
We believe the markets have completely ignored certain positive developments in the fundamentals of the
company.
1. Its distribution licence in Mumbai has been renewed for 25 years. This is the best case scenario we
highlighted in our note, One for the believers (15 April 2011).
2. Regulators have allowed R-Infra to collect INR23.16b in Mumbai licence area from its regulated assets.
3. The company has been allowed to collect cross-subsidy from customers who migrated to competitors.
4. R-Infra has also received approval for a 22% rate hike in its Delhi distribution area.
5. Cash balance parked in the form of inter-corporate deposits has substantially reduced from INR28b in
FY10 to INR8b (to third parties) now. Cash parked in overseas investment vehicles as preference shares
for making vendor payments (for its EPC business) has also reduced from INR23b to INR16b. Nondisclosure of third parties has been an overhang on the stock.
On the negative side,
1. Allegations against group companies in 2G spectrum allocation have been a major overhang on the
stock.
2. Slow execution of R-Power’s power plants due to high coal prices or unavailability of gas.
3. R-Infra has been repeatedly delaying the commissioning date of its Mumbai Metro 1 project.
4. Its Western Freeway Sealink project (Bandra-Worli Sealink and the extension thereof) is facing the risk
of being cancelled, according to media reports.
5. Overhang of disclosures – business-wise financial details are not made available, which makes it
difficult to forecast business performance.
Positive developments
Mumbai transmission and distribution licence has been renewed for 25 years
After inviting applications from various interested parties, the Maharashtra Electricity Regulatory
Commission (MERC) finally extended R-Infra’s transmission and distribution licence for an additional 25
years, ending 15 August 2036. The regulator not only extended the licence, but also expanded its coverage
area. Therefore, we continue to value this business as a going concern at INR126/share (INR199/share
including its generation assets).
Cost recovery of INR23.16b approved
The MERC has approved the recovery of INR23.16b revenue shortfall, or regulated assets. R-Infra will also
be allowed to collect the carrying cost on this amount at SBI’s PLR pertaining to the respective years of the
shortfall. This amount will be collected through higher tariffs as and when the company files for truing up
of its rates through the Annual Revenue Requirement (ARR) filing. We believe this amount will be collected
over a period of 3-5 years.
Cross-subsidy to be recovered from migrated customers
Around 159,000 customers have migrated from R-Infra to Tata Power (TPWR IN, not rated), with around
154,000 of these customers continuing to use R-Infra’s distribution network. R-Infra’s petition to the MERC
claims that it lost about 208MU of sales in FY09-10 and will lose 1,278MU in FY10-11 from these customer
migrations. The loss of customers is significant, as these are industrial and commercial consumers who, by
way of their higher consumption of electricity, subsidize the domestic category of consumers. Consequently,
there is a need to collect cross-subsidy from these consumers to mitigate a sudden and significant increase
in tariffs for the domestic category. Separately, the migrated consumers that are still on R-Infra’s
transmission infrastructure will also have to bear the recovery charges for the regulator assets discussed
above. These additional charges, in our view, create barriers for consumers from migrating to competitors’
networks and signify the monopolistic nature of this business. R-Infra will start collecting cross-subsidy
when the MERC approves it upon filing of ARR for FY11-12.
Rate hike (22%) in its Delhi distribution area
The Delhi Electricity Regulatory Commission (DERC) has allowed a 22% tariff hike to recover a part of the
accumulated INR22b losses. Further, there remains a revenue gap after this rate hike, which means that RInfra has the right to recover these amounts if and when the regulator allows it to make collections. At
BYPL (one of the two distribution areas in Delhi), the regulator has identified a revenue gap of INR5.45b for
FY11-12 after considering the 22% tariff hike. Similarly, at BRPL, the revenue gap is INR6.18b for FY11-12
after considering the rate hike. The revenue gap for FY10-11 has not been calculated yet. The regulatory
asset balance for BYPL as of 31 March 2011 was INR15.87b and that for BRPL it was INR29.19b. These
amounts would be recovered in future ARR filings.
Reduced inter-corporate deposits (ICDs)
Investors have been concerned about the inter-corporate deposits (ICDs) because of lack of details
regarding the companies with which such deposits have been made. In our view, there are two factors that
reveal that the risk of R-Infra losing these deposits is not as high as perceived. One, the company has
reduced its ICD balance from the peak of INR52.4 in FY08 to deploy in assets under development. Two, the
returns that these deposits are generating are satisfactory; we calculate that the returns from these
deposits in the form of interest should have been in the range of 12-17% for FY11. The current balance of
ICDs is INR17.92b on the standalone balance sheet (of which INR9.97b is due from Subsidiaries) and
INR7.98b on the consolidated balance sheet.
Negative developments
2G Spectrum allocation investigation, a major overhang
R-Infra’s group companies including some senior executives have been allegedly involved in dealings that
have been questioned by authorities and enforcement agencies. Media reports state that there has been no
evidence against the group Chairman’s involvement in the dealings. However, until these proceedings are
completed, we believe the overhang will persist. We are not in a position to quantify the financial impact of
the risk out of these allegations.
Execution concerns on its power plants
There have been media reports on R-Power, R-Infra’s associate (38% ownership), unwilling to continue with
the execution of some of its major power projects (Krishnapatnam UMPP) without renegotiating its PPA.
Slowdown in execution of power projects could have a two-fold impact on R-Infra’s valuation: 1) its EPC
arm, which is executing these projects, would report lower earnings, and 2) a decline in attributable value
to R-Infra from R-Power due to a reduction in valuation of power projects. Our utilities analyst has taken
these risks into account while assigning INR69/share as the fair value of R-Power. We further ascribe a 20%
holding company discount to INR69 while calculating R-Power’s contribution to R-Infra’s fair value.
Execution concerns on its Metro project
Apart from its power projects mentioned above, R-Infra has been consistently postponing the commission
date of its Mumbai Metro 1 project. Although, the reasons for the delay (land acquisition, right of way,
approval from railways, etc) have been beyond the control of R-Infra’s management, in our view, the real
execution capabilities lie in their anticipation of such bottlenecks and working with the required
government agencies to get these issues sorted. Instead, management has been repeatedly postponing the
timeline for commissioning the project, which could be perceived as misguidance by certain investors.
However, the overall value attributable by this project to R-Infra’s valuation is only INR29 or 4% of our
revised TP of INR723/share.
Risk of project cancellation
The company was awarded the Western Freeway Sealink Project (11.5kms), which includes operation and
maintenance of Bandra-Worli Sealink and development of Worli-Haji Ali Sealink. Management estimates
the cost of the project is INR45.5b, which includes upfront payment of INR16.34b to MSRDC, the awarder of
the project. The company is also entitled to INR13.9b of viability gap funding, to be received in three equal
annual instalments. The concession period is for 40 years including construction period; the company can
continue to toll the existing stretch of Bandra to Worli. The concession agreement was signed in July 2010,
but the project has not been handed over to R-Infra yet. Further, there has been no transfer of funds on
either side. However, there have been media reports that the State (Maharashtra) government is
contemplating an alternate coastal road along the alignment of this project and not continuing with the
execution of the Sealink. As there has been no official handover of the project and no money exchanged,
we have not considered this project in our estimates and valuations.
Insufficient disclosures
The company reports consolidated numbers on a quarterly and annual basis, without discussing
contributions from its major assets. For instance, income from the electricity business includes
transmission and distribution income from both its Mumbai and Delhi distribution businesses, electricity
trading income, income from sale of electricity from its power plants, and income generated from its
transmission projects. Worse, there has been material volatility in the earnings generated by the electricity
business. Similarly, the company does not share collections/revenue by road individually. In the absence of
asset-wise disclosures, it is difficult to assess the performance of its investment decisions. We have
estimated earnings and assigned valuations by collecting information from various sources including the
company.
Estimate changes
Our FY12-13 revenue estimates increase by 3% and 15%, respectively. Our EPC revenue estimate has
increased primarily due to the strong performance of the segment during 1QFY12. Mumbai distribution
revenue has been adjusted for 1QFY12 results and our estimate of the power supply for the remainder of
the year. Delhi Distribution revenue increases 32% and 29% in FY12E and FY13E respectively to factor in the
22% tariff increase allowed by the DERC and an increase in our estimate of the total number of units sold.
The decline in revenue from the Others segment is primarily due to a decline in our estimates for Delhi
Metro and no contribution from Mumbai Metro I in FY12. Additionally, we now estimate that the WRSS
transmission project will not contribute materially to our FY12 revenue estimate. Based on the energy
traded in 1QFY12, we are also lowering our estimate of the total energy traded in FY12; this is the largest
contributor to the decline in revenue from Others. Separately, we are introducing FY14 estimates.
The change in our EBITDA estimates is a function of the change in the revenue estimates. In EPC, we have by
and large maintained our EBITDA margin assumptions. In the distribution businesses, we have lowered the
cost of power purchase. We are lowering our depreciation estimate to factor in the estimated delay in
commissioning of various projects. Interest expense has increased primarily due to the increase in interest
rates.
The contribution from R-Power, the associate, increases 94% and 12% in FY12E and FY13E, respectively, due
to the change in estimates of R-Power by our utilities team.
We are lowering our TP to INR723 from INR1,077, a 33% decline primarily on adjustment in cash and
R-Power’s valuation. The standalone company is now valued at INR256 (INR467 earlier). We believe any
unfavourable decision in the 2G case could impact the company’s deposits with other companies or
investments in preference shares in the overseas entity. Consequently, we are not valuing ICDs and
preference shares any longer as part of the cash balance; our net cash per share declines to INR3 (INR169
earlier) and is a major contributor to the decline in the standalone company’s valuation. The EPC business
now contributes INR54 (INR69 earlier) due to a lower EV/EBIT multiple of 3x (7x earlier). We have lowered
our target multiple to factor in project execution risk in its existing order book. Our multiple is in line with
the lower end of the range of multiples that we ascribe to other construction businesses in our coverage.
The stake in R-Power now contributes only INR223 (INR391 earlier). This decline incorporates the lower TP
for R-Power by our utilities team.
The other assets’ contribution has been tweaked to adjust for the performance of 1QFY12 and latest
updates from the company (e.g. latest traffic estimates for roads, Delhi Metro and expected commissioning
date for Mumbai Metro I). We have used 13.5% COE across our asset valuations in our DCF assumptions.
Key risks to our TP and rating include adverse outcome for its group companies in 2G allegations and a
significant financial impact on R-Infra, lower-than-expected EPC revenue or margins, delays in recovery of
regulated assets in its Mumbai and Delhi distribution areas, and delays in commissioning of its
infrastructure projects
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
Look beyond group concerns
CHANGE
Group companies’ overhang continues to drag down the stock
Despite positive catalysts in its regulated businesses, Reliance
Infrastructure has underperformed the broader markets mainly due to
overhang of allegations against group companies in the telecom business.
It is difficult to quantify the risk from an unfavourable outcome, but we
believe fundamental risks in its core businesses are adequately priced in.
CATALYST
2G resolution, earnings momentum key catalysts
Any resolution of the 2G allegations would be a catalyst for the stock. The
company recently renewed its distribution licence for Mumbai for 25
years. The regulators have allowed Reliance Infrastructure to collect
arrears and cross-subsidy in Mumbai, and to hike tariffs by 22% in Delhi.
These positives should provide earnings momentum.
VALUATION
SoTP-based TP implies healthy upside
We have revised our SoTP-based TP to INR723, from INR1,077, of which
the standalone business contributes INR256. We have used our Utilities
team’s valuation for its associate R-Power (38% ownership), which now
contributes INR223 (down from INR391). All other infrastructure assets
contribute INR224.
Key developments and stock performance
Reliance Infrastructure (R-Infra) has underperformed the Sensex by approximately 36% YTD, predominantly
on allegations against its group companies in 2G spectrum allocation.
We believe the markets have completely ignored certain positive developments in the fundamentals of the
company.
1. Its distribution licence in Mumbai has been renewed for 25 years. This is the best case scenario we
highlighted in our note, One for the believers (15 April 2011).
2. Regulators have allowed R-Infra to collect INR23.16b in Mumbai licence area from its regulated assets.
3. The company has been allowed to collect cross-subsidy from customers who migrated to competitors.
4. R-Infra has also received approval for a 22% rate hike in its Delhi distribution area.
5. Cash balance parked in the form of inter-corporate deposits has substantially reduced from INR28b in
FY10 to INR8b (to third parties) now. Cash parked in overseas investment vehicles as preference shares
for making vendor payments (for its EPC business) has also reduced from INR23b to INR16b. Nondisclosure of third parties has been an overhang on the stock.
On the negative side,
1. Allegations against group companies in 2G spectrum allocation have been a major overhang on the
stock.
2. Slow execution of R-Power’s power plants due to high coal prices or unavailability of gas.
3. R-Infra has been repeatedly delaying the commissioning date of its Mumbai Metro 1 project.
4. Its Western Freeway Sealink project (Bandra-Worli Sealink and the extension thereof) is facing the risk
of being cancelled, according to media reports.
5. Overhang of disclosures – business-wise financial details are not made available, which makes it
difficult to forecast business performance.
Positive developments
Mumbai transmission and distribution licence has been renewed for 25 years
After inviting applications from various interested parties, the Maharashtra Electricity Regulatory
Commission (MERC) finally extended R-Infra’s transmission and distribution licence for an additional 25
years, ending 15 August 2036. The regulator not only extended the licence, but also expanded its coverage
area. Therefore, we continue to value this business as a going concern at INR126/share (INR199/share
including its generation assets).
Cost recovery of INR23.16b approved
The MERC has approved the recovery of INR23.16b revenue shortfall, or regulated assets. R-Infra will also
be allowed to collect the carrying cost on this amount at SBI’s PLR pertaining to the respective years of the
shortfall. This amount will be collected through higher tariffs as and when the company files for truing up
of its rates through the Annual Revenue Requirement (ARR) filing. We believe this amount will be collected
over a period of 3-5 years.
Cross-subsidy to be recovered from migrated customers
Around 159,000 customers have migrated from R-Infra to Tata Power (TPWR IN, not rated), with around
154,000 of these customers continuing to use R-Infra’s distribution network. R-Infra’s petition to the MERC
claims that it lost about 208MU of sales in FY09-10 and will lose 1,278MU in FY10-11 from these customer
migrations. The loss of customers is significant, as these are industrial and commercial consumers who, by
way of their higher consumption of electricity, subsidize the domestic category of consumers. Consequently,
there is a need to collect cross-subsidy from these consumers to mitigate a sudden and significant increase
in tariffs for the domestic category. Separately, the migrated consumers that are still on R-Infra’s
transmission infrastructure will also have to bear the recovery charges for the regulator assets discussed
above. These additional charges, in our view, create barriers for consumers from migrating to competitors’
networks and signify the monopolistic nature of this business. R-Infra will start collecting cross-subsidy
when the MERC approves it upon filing of ARR for FY11-12.
Rate hike (22%) in its Delhi distribution area
The Delhi Electricity Regulatory Commission (DERC) has allowed a 22% tariff hike to recover a part of the
accumulated INR22b losses. Further, there remains a revenue gap after this rate hike, which means that RInfra has the right to recover these amounts if and when the regulator allows it to make collections. At
BYPL (one of the two distribution areas in Delhi), the regulator has identified a revenue gap of INR5.45b for
FY11-12 after considering the 22% tariff hike. Similarly, at BRPL, the revenue gap is INR6.18b for FY11-12
after considering the rate hike. The revenue gap for FY10-11 has not been calculated yet. The regulatory
asset balance for BYPL as of 31 March 2011 was INR15.87b and that for BRPL it was INR29.19b. These
amounts would be recovered in future ARR filings.
Reduced inter-corporate deposits (ICDs)
Investors have been concerned about the inter-corporate deposits (ICDs) because of lack of details
regarding the companies with which such deposits have been made. In our view, there are two factors that
reveal that the risk of R-Infra losing these deposits is not as high as perceived. One, the company has
reduced its ICD balance from the peak of INR52.4 in FY08 to deploy in assets under development. Two, the
returns that these deposits are generating are satisfactory; we calculate that the returns from these
deposits in the form of interest should have been in the range of 12-17% for FY11. The current balance of
ICDs is INR17.92b on the standalone balance sheet (of which INR9.97b is due from Subsidiaries) and
INR7.98b on the consolidated balance sheet.
Negative developments
2G Spectrum allocation investigation, a major overhang
R-Infra’s group companies including some senior executives have been allegedly involved in dealings that
have been questioned by authorities and enforcement agencies. Media reports state that there has been no
evidence against the group Chairman’s involvement in the dealings. However, until these proceedings are
completed, we believe the overhang will persist. We are not in a position to quantify the financial impact of
the risk out of these allegations.
Execution concerns on its power plants
There have been media reports on R-Power, R-Infra’s associate (38% ownership), unwilling to continue with
the execution of some of its major power projects (Krishnapatnam UMPP) without renegotiating its PPA.
Slowdown in execution of power projects could have a two-fold impact on R-Infra’s valuation: 1) its EPC
arm, which is executing these projects, would report lower earnings, and 2) a decline in attributable value
to R-Infra from R-Power due to a reduction in valuation of power projects. Our utilities analyst has taken
these risks into account while assigning INR69/share as the fair value of R-Power. We further ascribe a 20%
holding company discount to INR69 while calculating R-Power’s contribution to R-Infra’s fair value.
Execution concerns on its Metro project
Apart from its power projects mentioned above, R-Infra has been consistently postponing the commission
date of its Mumbai Metro 1 project. Although, the reasons for the delay (land acquisition, right of way,
approval from railways, etc) have been beyond the control of R-Infra’s management, in our view, the real
execution capabilities lie in their anticipation of such bottlenecks and working with the required
government agencies to get these issues sorted. Instead, management has been repeatedly postponing the
timeline for commissioning the project, which could be perceived as misguidance by certain investors.
However, the overall value attributable by this project to R-Infra’s valuation is only INR29 or 4% of our
revised TP of INR723/share.
Risk of project cancellation
The company was awarded the Western Freeway Sealink Project (11.5kms), which includes operation and
maintenance of Bandra-Worli Sealink and development of Worli-Haji Ali Sealink. Management estimates
the cost of the project is INR45.5b, which includes upfront payment of INR16.34b to MSRDC, the awarder of
the project. The company is also entitled to INR13.9b of viability gap funding, to be received in three equal
annual instalments. The concession period is for 40 years including construction period; the company can
continue to toll the existing stretch of Bandra to Worli. The concession agreement was signed in July 2010,
but the project has not been handed over to R-Infra yet. Further, there has been no transfer of funds on
either side. However, there have been media reports that the State (Maharashtra) government is
contemplating an alternate coastal road along the alignment of this project and not continuing with the
execution of the Sealink. As there has been no official handover of the project and no money exchanged,
we have not considered this project in our estimates and valuations.
Insufficient disclosures
The company reports consolidated numbers on a quarterly and annual basis, without discussing
contributions from its major assets. For instance, income from the electricity business includes
transmission and distribution income from both its Mumbai and Delhi distribution businesses, electricity
trading income, income from sale of electricity from its power plants, and income generated from its
transmission projects. Worse, there has been material volatility in the earnings generated by the electricity
business. Similarly, the company does not share collections/revenue by road individually. In the absence of
asset-wise disclosures, it is difficult to assess the performance of its investment decisions. We have
estimated earnings and assigned valuations by collecting information from various sources including the
company.
Estimate changes
Our FY12-13 revenue estimates increase by 3% and 15%, respectively. Our EPC revenue estimate has
increased primarily due to the strong performance of the segment during 1QFY12. Mumbai distribution
revenue has been adjusted for 1QFY12 results and our estimate of the power supply for the remainder of
the year. Delhi Distribution revenue increases 32% and 29% in FY12E and FY13E respectively to factor in the
22% tariff increase allowed by the DERC and an increase in our estimate of the total number of units sold.
The decline in revenue from the Others segment is primarily due to a decline in our estimates for Delhi
Metro and no contribution from Mumbai Metro I in FY12. Additionally, we now estimate that the WRSS
transmission project will not contribute materially to our FY12 revenue estimate. Based on the energy
traded in 1QFY12, we are also lowering our estimate of the total energy traded in FY12; this is the largest
contributor to the decline in revenue from Others. Separately, we are introducing FY14 estimates.
The change in our EBITDA estimates is a function of the change in the revenue estimates. In EPC, we have by
and large maintained our EBITDA margin assumptions. In the distribution businesses, we have lowered the
cost of power purchase. We are lowering our depreciation estimate to factor in the estimated delay in
commissioning of various projects. Interest expense has increased primarily due to the increase in interest
rates.
The contribution from R-Power, the associate, increases 94% and 12% in FY12E and FY13E, respectively, due
to the change in estimates of R-Power by our utilities team.
We are lowering our TP to INR723 from INR1,077, a 33% decline primarily on adjustment in cash and
R-Power’s valuation. The standalone company is now valued at INR256 (INR467 earlier). We believe any
unfavourable decision in the 2G case could impact the company’s deposits with other companies or
investments in preference shares in the overseas entity. Consequently, we are not valuing ICDs and
preference shares any longer as part of the cash balance; our net cash per share declines to INR3 (INR169
earlier) and is a major contributor to the decline in the standalone company’s valuation. The EPC business
now contributes INR54 (INR69 earlier) due to a lower EV/EBIT multiple of 3x (7x earlier). We have lowered
our target multiple to factor in project execution risk in its existing order book. Our multiple is in line with
the lower end of the range of multiples that we ascribe to other construction businesses in our coverage.
The stake in R-Power now contributes only INR223 (INR391 earlier). This decline incorporates the lower TP
for R-Power by our utilities team.
The other assets’ contribution has been tweaked to adjust for the performance of 1QFY12 and latest
updates from the company (e.g. latest traffic estimates for roads, Delhi Metro and expected commissioning
date for Mumbai Metro I). We have used 13.5% COE across our asset valuations in our DCF assumptions.
Key risks to our TP and rating include adverse outcome for its group companies in 2G allegations and a
significant financial impact on R-Infra, lower-than-expected EPC revenue or margins, delays in recovery of
regulated assets in its Mumbai and Delhi distribution areas, and delays in commissioning of its
infrastructure projects
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