Indiabulls Real Estate Ltd’s investment of $150 million (Rs592.5 crore) in the power sector has appreciated by 567% in a period of less than six months.
The company announced a private placement to two companies associated with Farallon Capital Management Llc. and L.N. Mittal and family, which values its stake at $1 billion. The two investors have brought in $400 million for a 28.6% stake, so the equity of the entire firm has been valued at $1.4 billion. Well, if you’re confounded by the absurdity of power sector valuations, consider this: Indiabulls’ power business is valued at a fraction of Reliance Power Ltd’s.
The power business, which will be housed under an entity called Sophia Power Co. Ltd, is building power projects with about 4,000MW capacity. This means its equity has been valued at $350 million for every 1,000MW of capacity. And Indiabulls is said to have submitted bids for many more projects with a cumulative capacity of over 11,000MW.
Despite Reliance Power’s sharp correction since listing, it still gets a valuation of $775 million for every 1,000MW of capacity.
Typically, the debt-equity ratio for funding large power projects is 30:70, so the enterprise value of these firms would be roughly $1.17 billion and $2.58 billion for every 1,000MW of capacity.
The cost of constructing a power plant is roughly $1 billion per 1,000MW, so Indiabulls’ valuation seems much closer to reality. (This is a crude form of analysis, because what matters ultimately is the estimates of tariffs and when cash flows will be first generated, which will differ for each project.)
It’s highly likely that Indiabulls Power will ultimately make an initial public offering (IPO) to “unlock value”, but it’s unlikely that public investors will get to participate at similar valuations. The deal with Farallon and L.N. Mittal should not be seen as the typical pre-IPO deal, which acts as a benchmark for IPO pricing.
They are more likely to be portrayed as early investors who brought in risk capital, which will be rewarded at the time of the IPO. It’ll be surprising if Indiabulls makes an IPO at a valuation much cheaper than listed peers.
Talking of power valuations, investors would do well to note that while power projects, such as those launched by Reliance Power, have a chance of earning higher returns than projects constrained by regulated returns, there is also the risk of lower returns.
This is because costs have risen, but there may not be enough leeway with pricing, since large capacities are coming up across the country. The current high valuations for companies that are yet to generate cash flow suggest that such risks have been completely ignored.
Short Indian banks, go long on Chinese: JP Morgan
During the recent market meltdown, the banking sector has often been touted as a relatively safe place to hide from the storm. That, however, hasn’t really been true. While the Sensex is now down 14.6% from its January highs, the Bombay Stock Exchange (BSE) Bankex is down 14%, not much of a difference.
Nevertheless, the pundits have continued to recommend the public sector banks (PSBs), on the basis of their being a proxy for economic growth on the one hand and being relatively inexpensive on the other. For instance, broking firm Enam Research says in its review of banking results for the December quarter, “Going ahead, we believe that continued expansion in NIM (net interest margins), robust credit growth and stable asset quality will help PSBs to get further re-rated.”
What about the Chinese banking sector? Well, some of their banks have been hit by the fallout of the subprime crisis. More importantly, the perception of these banks, at least in India, has been that they’re in far worse shape than Indian banks, with questionable asset quality and state-directed lending.
However, a recent report by JP Morgan recommends a strategy of going long Chinese banks while shorting Indian financials. JP Morgan analyst Sunil Garg says that Chinese banks trade at a lower price-earnings multiple compared with Indian banks, while they have higher earnings growth. His computations show that Indian bank’s price-earnings multiple is 15.5 times 2008 earnings, while Chinese banks trade at a multiple of 13.8.
On the other hand, earnings growth is expected to be 22.4% in 2008 for Indian banks and 36.3% for Chinese banks. Garg also draws attention to the large equity dilutions by Indian banks and to rising non-performing assets (NPAs).
Others point out, however, that while the net NPAs of the Chinese banks is more, 6%, that for Indian banks is only slightly higher than 2%.
And surely there’s a reason why Indian banks have given the best returns in the region in the last six months?
The JP Morgan report says that’s precisely why they are bearish on Indian banks, because while they face more or less the same headwinds that banks face in China, the markets aren’t discounting that fact.
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