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Background of Hancock acquisition
GVK Coal Developers (Singapore) Pte (GVKCDPL), a step-down subsidiary of GVK Natural Resources Pte
(GVKNRPL), (a GVK promoter group company), in a joint venture with GVK Power and Infrastructure
(GVKPIL, the listed company) will acquire certain affiliated entities of Hancock Prospecting Pty for a total
consideration of USD1.26b (refer to Exhibit 1 for details of assets). GVKNRPL will hold a 90% stake and
GVKPIL will hold a 10% stake. USD500m will be paid at the time of deal closure followed by USD200m after
one year of the closure. The remaining USD560m will be paid when financial closure is achieved or within
three years of closing, whichever is earlier. About USD1.0b debt will be raised from a consortium of banks
(at 3-month LIBOR + 500bp). GVKPIL (the listed entity) has the option to increase its stake to 49% at a
discount to market value. Total planned capex in the first phase is around USD10b (USD5b for the mines +
USD5b for the railway line and port).
Funding the acquisition cost
The acquisition cost of USD1.26b will be funded through USD1b of debt and USD260m of equity. Repayment
of the debt is to start after 5½ year: interest will have to be paid meanwhile at LIBOR + 5.0% (approximately
8.5% pa interest including hedging costs). The security for the loan consists of the acquired assets and
guarantees by GVKNRPL and GVKPIL. GVKNRPL will guarantee 51% of the outstanding facility and GVKPIL
will provide a corporate guarantee for 49% of the outstanding facility. GVKPIL will also pledge the shares of
GVK Energy Ltd and GVK Transportation Ltd to secure the equity requirements of the project including debt
service requirements. In addition, GVK Energy Ltd, GVK Airport Developers Private Ltd and GVK
Transportation Private Ltd, subsidiaries of GVKPIL, intend to provide undertakings in relation to acquisition
financing to be availed by GVKCDPL. Essentially almost all businesses of GVKPIL will provide back-up for
raising debt required for the acquisition.
Unfavourable balance of risk for GVKPIL minority shareholders
Essentially GVKPIL is only a 10% owner of the acquired asset, but has guaranteed 49% of the debt required
for the acquisition. Although GVKPIL has an option to increase its stake to 49%, we believe the additional
stake will not be acquired for free. The company also has an option to purchase 20m tonnes per annum of
coal to fuel its thermal power generation capacity. This assurance depends on the success of the project
coming in on a timely basis, which in our view is a highly optimistic assumption.
Option value
Fuel availability has been a major hurdle in setting up of thermal power plants in the current environment.
With a successful development of its coal mines, GVK could remove this hurdle with a view to expand its
power portfolio. We are expecting the first year of production to be in 2016 with 10m tonnes, gradually
ramping up to a full capacity of 84m tonnes by 2022. GVK has an option to enter into a long-term contract
for 20m tonnes per annum that could support 7,500MW of generation.
Is the coal acquisition viable?
The viability of the coal business itself depends on international coal prices. The current market price for
coal of similar quality is USD110/tonne. Assuming USD63/tonne of operational expenditure, long-term
inflation of 2.5% and timely execution and funding of capex, the project would break-even at a long-term
coal price of USD82/tonne. Our house estimates for the long-term coal price is USD95/tonne, which results
in a contribution of INR9 per GVKPIL share for its 10% stake.
Financing and execution, two key factors of success
The success of the transaction depends on two major factors – financing and execution:
GVKCDPL must arrange for financial investors on a timely basis. Key parameters to be watched for are what
percentage of stake gets sold and at what valuation.
GVKCDPL does not have the proven expertise in executing projects of such nature or magnitude. The project
not only involves development of mines, but also development of related infrastructure to make the coal
marketable. Essentially, the company has to develop a rail link to port and develop the port to handle coal
shipments.
Two extreme scenarios
Worst case: In our worst case scenario, we assume GVKCDPL will not be able to find a suitable financial
partner to fund its developmental capex. The lenders of the acquisition debt, in that case are likely to
access the security for the USD1b of debt. GVKPIL has essentially offered almost all its assets as security to
guarantee USD490m of debt. As the current market cap of GVKPIL is less than USD490m, it is very likely
that the minority shareholders would lose all their rights to the lenders. In this scenario, our valuation for
GVKPIL’s share is zero.
Best case: In our best case scenario, we assume that GVKPIL successfully infuses funds required for
development of the assets by tapping a suitable financial partner. In this case, the value of assets depends
on long-term coal price assumptions. We estimate that the project requires long-term coal prices of
USD82/tonne to break-even: our house view of long-term coal prices is USD95/tonne. Assuming a long-term
coal price of USD95/tonne, the NPV of the project is INR9 per share for GVKPIL’s share. In this case, the
catalyst for the stock will be successful partnering with a financial investor.
Cash flows
In terms of cash flows, GVKPIL has to fund 10% of the required funds for the acquisition. Management
indicated that they are close to raising USD1b, which leaves them with USD260m of equity financing to
secure. GVKPIL will have to arrange for 10% of its share, i.e., USD26m over the next three years or financial
closure (of USD10b), whichever is earlier. Based on their existing cash flows, GVKPIL should be able to
support funding the USD26m. However, if the company is able to finance the USD10b developmental capex
in 70:30 debt-to-equity ratio, they will need to finance 10% of 30% of the USD10b, i.e., USD300m over the
developmental period, let’s say, up to 2017. These calculations assume that GVKPIL will not raise their
equity in the JV to 49%. In case they do, their equity commitment increases to USD127.4m at the time of
acquisition and USD1.5b during developmental period up to 2017, which their cash flows from existing
assets cannot support.
However, we believe that the company would structure its deal with its financial partners similar to
dilution in its power plants. Essentially, the company would issue additional shares to the financial
investors that would dilute their own stake in such a manner that the capital infused will be sufficient to
fund the entire USD3b of equity required for developmental capex.
Equity stake sale to financial investors
GVKPIL is likely to bring in a financial investor to reduce the burden of equity investment in its acquisition.
The company has successfully done such a deal in its power portfolio to support its equity commitment in
its power plants under development. The magnitude of the sale and the structure of the deal will determine
the direction stock prices take. In our view, GVKPIL is likely to sell stakes in small batches (as opposed to
one chunk) sufficient to support near-to-mid-term equity requirements. At the end of the development,
assuming that GVKCDPL would not pitch-in any equity, GVKPIL needs to raise USD3b of equity financing to
develop the assets. Assuming that they sell a 75% stake in the asset to financial investors for USD3b (i.e.
value of the total asset should be USD4b), the long-term coal price required to support such a valuation
should be USD97/tonne, which is close our estimate of USD95/tonne. At a USD4b valuation for the asset,
assuming that the promoter entity allows GVK to raise its stake to 49% within GVKCDPL for no material
consideration, accretion of value from this asset to GVKPIL should be INR13 per share post stake sale of
75%. If we assume no such sale, GVKPIL’s share would get diluted by 75% to 2.5% and value accrued to
GVKPIL shareholders would be only INR2 per share.
Interest burden in any case
Since the acquisition is by GVKCDPL, of which GVKPIL owns 10%, they will have to bear the interest burden
starting from the first draw-down. GVKCDPL will draw USD500m immediately, USD200m after one year,
and USD560m by the end of three years. Assuming an interest rate of 8.5%, the interest cost burden works
out as 2%, 6% and 54% of PBT estimates for GVKPIL during FY12-14E. Net, cash outflows from FY12-17E
would be substantial with no visibility of cash inflows from the acquisition.
Management bandwidth gets stretched
Management bandwidth has shifted to managing and executing this transaction, which leaves its other
businesses – power, highways and airports (including real estate) – with less management attention. GVK
has Mumbai airport, Goindwal Sahib thermal plant and related mines, Alaknanda Hydro Power plant and
three highways under development which require substantial management bandwidth for successful
execution.
What is the stock pricing in?
Assuming our best and worst case valuations of zero and INR40 (including positive NPV from Hancock),
implies that markets are assigning roughly two-thirds probability of a failure of the venture and one-third
probability of a successful execution. In terms of book value, we believe the stock is trading at about a 21%
discount to adjusted consolidated book value as of 31 March 2011
Catalyst: What happens when GVKPIL ropes in a financial investor?
We believe GVKPIL is likely to tap financial investors on a piece meal basis. As a result, it would not sell
more than a 25% stake in the first batch. As mentioned above, markets are already factoring in a 33%
chance of success. Therefore, we recommend investors to use this opportunity to exit the stock even if the
stock reacts positively. We believe the time difference between the first and second batch of stake sales is
likely to be sufficient to show some execution on-ground, where GVKPIL could show some value add to the
project so that they could fetch higher valuations for the assets. Hence, we believe investors should not get
optimistic when the first stake sale takes place.
Valuation
We have adopted a weighted average approach to arrive at our valuation of INR10 as our TP. As mentioned
above, markets are currently factoring in a 33% chance of success. However, we believe the probability of
success is less than 33% at this time. Consequently, we are making a subjective assumption of 25%
probability of success and resulting valuation of INR40 per share. On the other hand, we assign a zero value
and a 75% chance to our worst case.
Key risks
Funding of the acquisition and related capex is a key concern. Additionally, the development of the railroad
and port facilities simultaneously with the mine development will be necessary. Lastly, only letters of
intent for off take of 45m tpa has been signed. Concrete off take agreements would provide more visibility
to future cash flows. Another key concern is that although GVKPIL has only a 10% economic interest, 49% of
the debt for the acquisition is guaranteed by the various highways, energy and airport assets of the listed
company. Separately, several of its projects in the existing portfolio are still under execution; with this
acquisition there is a risk of inadequate attention by management on the execution of these projects.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
Background of Hancock acquisition
GVK Coal Developers (Singapore) Pte (GVKCDPL), a step-down subsidiary of GVK Natural Resources Pte
(GVKNRPL), (a GVK promoter group company), in a joint venture with GVK Power and Infrastructure
(GVKPIL, the listed company) will acquire certain affiliated entities of Hancock Prospecting Pty for a total
consideration of USD1.26b (refer to Exhibit 1 for details of assets). GVKNRPL will hold a 90% stake and
GVKPIL will hold a 10% stake. USD500m will be paid at the time of deal closure followed by USD200m after
one year of the closure. The remaining USD560m will be paid when financial closure is achieved or within
three years of closing, whichever is earlier. About USD1.0b debt will be raised from a consortium of banks
(at 3-month LIBOR + 500bp). GVKPIL (the listed entity) has the option to increase its stake to 49% at a
discount to market value. Total planned capex in the first phase is around USD10b (USD5b for the mines +
USD5b for the railway line and port).
Funding the acquisition cost
The acquisition cost of USD1.26b will be funded through USD1b of debt and USD260m of equity. Repayment
of the debt is to start after 5½ year: interest will have to be paid meanwhile at LIBOR + 5.0% (approximately
8.5% pa interest including hedging costs). The security for the loan consists of the acquired assets and
guarantees by GVKNRPL and GVKPIL. GVKNRPL will guarantee 51% of the outstanding facility and GVKPIL
will provide a corporate guarantee for 49% of the outstanding facility. GVKPIL will also pledge the shares of
GVK Energy Ltd and GVK Transportation Ltd to secure the equity requirements of the project including debt
service requirements. In addition, GVK Energy Ltd, GVK Airport Developers Private Ltd and GVK
Transportation Private Ltd, subsidiaries of GVKPIL, intend to provide undertakings in relation to acquisition
financing to be availed by GVKCDPL. Essentially almost all businesses of GVKPIL will provide back-up for
raising debt required for the acquisition.
Unfavourable balance of risk for GVKPIL minority shareholders
Essentially GVKPIL is only a 10% owner of the acquired asset, but has guaranteed 49% of the debt required
for the acquisition. Although GVKPIL has an option to increase its stake to 49%, we believe the additional
stake will not be acquired for free. The company also has an option to purchase 20m tonnes per annum of
coal to fuel its thermal power generation capacity. This assurance depends on the success of the project
coming in on a timely basis, which in our view is a highly optimistic assumption.
Option value
Fuel availability has been a major hurdle in setting up of thermal power plants in the current environment.
With a successful development of its coal mines, GVK could remove this hurdle with a view to expand its
power portfolio. We are expecting the first year of production to be in 2016 with 10m tonnes, gradually
ramping up to a full capacity of 84m tonnes by 2022. GVK has an option to enter into a long-term contract
for 20m tonnes per annum that could support 7,500MW of generation.
Is the coal acquisition viable?
The viability of the coal business itself depends on international coal prices. The current market price for
coal of similar quality is USD110/tonne. Assuming USD63/tonne of operational expenditure, long-term
inflation of 2.5% and timely execution and funding of capex, the project would break-even at a long-term
coal price of USD82/tonne. Our house estimates for the long-term coal price is USD95/tonne, which results
in a contribution of INR9 per GVKPIL share for its 10% stake.
Financing and execution, two key factors of success
The success of the transaction depends on two major factors – financing and execution:
GVKCDPL must arrange for financial investors on a timely basis. Key parameters to be watched for are what
percentage of stake gets sold and at what valuation.
GVKCDPL does not have the proven expertise in executing projects of such nature or magnitude. The project
not only involves development of mines, but also development of related infrastructure to make the coal
marketable. Essentially, the company has to develop a rail link to port and develop the port to handle coal
shipments.
Two extreme scenarios
Worst case: In our worst case scenario, we assume GVKCDPL will not be able to find a suitable financial
partner to fund its developmental capex. The lenders of the acquisition debt, in that case are likely to
access the security for the USD1b of debt. GVKPIL has essentially offered almost all its assets as security to
guarantee USD490m of debt. As the current market cap of GVKPIL is less than USD490m, it is very likely
that the minority shareholders would lose all their rights to the lenders. In this scenario, our valuation for
GVKPIL’s share is zero.
Best case: In our best case scenario, we assume that GVKPIL successfully infuses funds required for
development of the assets by tapping a suitable financial partner. In this case, the value of assets depends
on long-term coal price assumptions. We estimate that the project requires long-term coal prices of
USD82/tonne to break-even: our house view of long-term coal prices is USD95/tonne. Assuming a long-term
coal price of USD95/tonne, the NPV of the project is INR9 per share for GVKPIL’s share. In this case, the
catalyst for the stock will be successful partnering with a financial investor.
Cash flows
In terms of cash flows, GVKPIL has to fund 10% of the required funds for the acquisition. Management
indicated that they are close to raising USD1b, which leaves them with USD260m of equity financing to
secure. GVKPIL will have to arrange for 10% of its share, i.e., USD26m over the next three years or financial
closure (of USD10b), whichever is earlier. Based on their existing cash flows, GVKPIL should be able to
support funding the USD26m. However, if the company is able to finance the USD10b developmental capex
in 70:30 debt-to-equity ratio, they will need to finance 10% of 30% of the USD10b, i.e., USD300m over the
developmental period, let’s say, up to 2017. These calculations assume that GVKPIL will not raise their
equity in the JV to 49%. In case they do, their equity commitment increases to USD127.4m at the time of
acquisition and USD1.5b during developmental period up to 2017, which their cash flows from existing
assets cannot support.
However, we believe that the company would structure its deal with its financial partners similar to
dilution in its power plants. Essentially, the company would issue additional shares to the financial
investors that would dilute their own stake in such a manner that the capital infused will be sufficient to
fund the entire USD3b of equity required for developmental capex.
Equity stake sale to financial investors
GVKPIL is likely to bring in a financial investor to reduce the burden of equity investment in its acquisition.
The company has successfully done such a deal in its power portfolio to support its equity commitment in
its power plants under development. The magnitude of the sale and the structure of the deal will determine
the direction stock prices take. In our view, GVKPIL is likely to sell stakes in small batches (as opposed to
one chunk) sufficient to support near-to-mid-term equity requirements. At the end of the development,
assuming that GVKCDPL would not pitch-in any equity, GVKPIL needs to raise USD3b of equity financing to
develop the assets. Assuming that they sell a 75% stake in the asset to financial investors for USD3b (i.e.
value of the total asset should be USD4b), the long-term coal price required to support such a valuation
should be USD97/tonne, which is close our estimate of USD95/tonne. At a USD4b valuation for the asset,
assuming that the promoter entity allows GVK to raise its stake to 49% within GVKCDPL for no material
consideration, accretion of value from this asset to GVKPIL should be INR13 per share post stake sale of
75%. If we assume no such sale, GVKPIL’s share would get diluted by 75% to 2.5% and value accrued to
GVKPIL shareholders would be only INR2 per share.
Interest burden in any case
Since the acquisition is by GVKCDPL, of which GVKPIL owns 10%, they will have to bear the interest burden
starting from the first draw-down. GVKCDPL will draw USD500m immediately, USD200m after one year,
and USD560m by the end of three years. Assuming an interest rate of 8.5%, the interest cost burden works
out as 2%, 6% and 54% of PBT estimates for GVKPIL during FY12-14E. Net, cash outflows from FY12-17E
would be substantial with no visibility of cash inflows from the acquisition.
Management bandwidth gets stretched
Management bandwidth has shifted to managing and executing this transaction, which leaves its other
businesses – power, highways and airports (including real estate) – with less management attention. GVK
has Mumbai airport, Goindwal Sahib thermal plant and related mines, Alaknanda Hydro Power plant and
three highways under development which require substantial management bandwidth for successful
execution.
What is the stock pricing in?
Assuming our best and worst case valuations of zero and INR40 (including positive NPV from Hancock),
implies that markets are assigning roughly two-thirds probability of a failure of the venture and one-third
probability of a successful execution. In terms of book value, we believe the stock is trading at about a 21%
discount to adjusted consolidated book value as of 31 March 2011
Catalyst: What happens when GVKPIL ropes in a financial investor?
We believe GVKPIL is likely to tap financial investors on a piece meal basis. As a result, it would not sell
more than a 25% stake in the first batch. As mentioned above, markets are already factoring in a 33%
chance of success. Therefore, we recommend investors to use this opportunity to exit the stock even if the
stock reacts positively. We believe the time difference between the first and second batch of stake sales is
likely to be sufficient to show some execution on-ground, where GVKPIL could show some value add to the
project so that they could fetch higher valuations for the assets. Hence, we believe investors should not get
optimistic when the first stake sale takes place.
Valuation
We have adopted a weighted average approach to arrive at our valuation of INR10 as our TP. As mentioned
above, markets are currently factoring in a 33% chance of success. However, we believe the probability of
success is less than 33% at this time. Consequently, we are making a subjective assumption of 25%
probability of success and resulting valuation of INR40 per share. On the other hand, we assign a zero value
and a 75% chance to our worst case.
Key risks
Funding of the acquisition and related capex is a key concern. Additionally, the development of the railroad
and port facilities simultaneously with the mine development will be necessary. Lastly, only letters of
intent for off take of 45m tpa has been signed. Concrete off take agreements would provide more visibility
to future cash flows. Another key concern is that although GVKPIL has only a 10% economic interest, 49% of
the debt for the acquisition is guaranteed by the various highways, energy and airport assets of the listed
company. Separately, several of its projects in the existing portfolio are still under execution; with this
acquisition there is a risk of inadequate attention by management on the execution of these projects.
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