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Akruti Nirman IPO: Our view - Views on News from Equitymaster

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Akruti Nirman IPO: Our view
Jan 15, 2007

Akruti Nirman Limited (ANL), one of the leading players in the Mumbai slum rehabilitation and real estate market, will launch its initial public offering today. The company is putting on offer 6.7 m shares and the offer price is in the range of Rs 475 to Rs 540 per share. At the higher price level, the company will be collecting Rs 3.6 bn from this IPO. The issue will close on January 19, 2007. Here is a brief analysis of the issue. We shall put up a detailed review shortly.

Company background
Akruti Nirman Limited (ANL) is a Mumbai-centric real estate company involved in the development of commercial and residential properties. On the commercial front, the company builds, leases and sells office space for IT and ITES companies. In its residential business, it develops multi-unit apartments. As part of the newly launched retail business, ANL is currently developing six shopping malls.

ANL commenced its real estate development work in 1989 and has been a major player in the slum rehabilitation scheme of the Government of Maharashtra (GoM). In this business, in return for constructing new residential buildings for slum dwellers, the GoM grants the company either the right to develop a portion of the former slum land for its own purpose, or grants its Transferable Development Rights (TDRs), which permits it (ANL) to develop land in certain parts of Mumbai that are outside the relevant slum area. In fact, since 1989, of the 5 million square feet (m sq ft) of building area developed by ANL, almost 4.8 m sq ft has been developed on land made available for development through the company’s participation in slum rehabilitation projects.

ANL has seen some good times in the past and its performance over the last five years vindicates the same. During the period FY02 to FY06, the company has grown its sales and net profits at compounded rates of 50% and 45% respectively, which is commendable considering the company’s business concentration in just a single location, i.e., Mumbai. Also, what is more noticeable, over these years, ANL has outperformed its peers like Parsvnath, DLF, Unitech and DS Kulkarni when it comes to profitability. Against an industry range of 10% to 25%, ANL has earned average operating margins of over 35% during the period FY02 to FY06. In fact, during the latest period of April to November 2006, ANL’s operating margins stood at a stupendous 46%. This is largely due to the ‘free’ developmental land that the company acquires from the government in return for constructing new residential buildings for slum dwellers under the GoM’s slum rehabilitation scheme.

As of November 30, 2006, ANL held development rights over 11.7 m sq ft of land, primarily located in Mumbai. The management has indicated that it will take the company around 3 to 5 years to complete its ongoing and currently planned projects. Also, as part of its growth strategy, ANL has commenced plans to expand into Pune and Bangalore.

Reasons to apply
Not really a ‘land bank’ story: Going by the history of ANL as well its projects that it is currently working upon, it is not a pure play land bank story that has otherwise being ‘built’ around real estate companies, thus justifying their superfluously high valuations. Rather, the company has been a major player in the slum rehabilitation scheme of the Government of Maharashtra (GoM), wherein, in return for constructing new residential buildings for slum dwellers, the GoM grants the company either the right to develop a portion of the former slum land for its own purpose, or grants its Transferable Development Rights (TDRs), which permits it (ANL) to develop land in certain parts of Mumbai that are outside the relevant slum area. In fact, since its incorporation, of the 5 million square feet (m sq ft) of building area developed by ANL, almost 4.8 m sq ft has been developed on land made available for development through the company’s participation in slum rehabilitation projects.

Further, it is expected that the GoM will open bidding for resettlement in Dharavi, a vast Mumbai shantytown with hundreds of thousands of residents that is one of the world’s largest. Apart from local developers like ANL, foreign companies like ETA-Ascon of Dubai have expressed serious interest in this project considering that the size of the rehabilitation project could be in the range of US$ 200 m for each of five 107-acre plots at Dharavi.

So profitable is resettlement becoming that companies like ANL have built their businesses around slums. Typically, land and construction costs of slum resettlement amount to roughly a third of the total project cost. But because builders usually get the land free or at a big discount, the effective cost per acre works out to much less than the market price of the land. Moreover, ANL’s redevelopment of slum lands provides it the right to also develop its own real estate developments for sale or lease to third parties on lands freed by the company’s slum rehabilitation efforts. In this manner, it obtains developable, urban land for its projects in Mumbai primarily through the rehabilitation of slum lands. This sounds a great opportunity for developers like ANL.

As of November 30, 2006, ANL held development rights over 11.7 m sq ft of land, primarily located in Mumbai. Of this area, over 8 m sq ft represents slum rehabilitation land owned by the applicable slum rehabilitation authorities and 3.7 m sq ft were acquired or leased by ANL from third parties. The company’s management has indicated that it will take it around 3 to 5 years to complete its ongoing and currently planned projects. Also, as part of its growth strategy, ANL has commenced plans to expand into Pune and Bangalore.

Financial advantages of slum rehabilitation: The principal financial advantage for ANL from developing land as part of slum rehabilitation schemes is that the company is not liable to pay substantial, one-off land purchase costs at the beginning of each project in order to acquire the use of such land. The cost incurred by the company for building an additional building to house slum dwellers tends to be significantly less than the purchase costs for comparable land that it would have otherwise incurred by purchasing land from third parties. Secondly, ANL’s financial exposure in respect of slum lands is also reduced against the risk that a planned development does not proceed for any reason, as the company does do not incur land acquisition costs at the outset of slum rehabilitation projects. Thirdly, the use of slum rehabilitation projects to procure buildable land also provides ANL the benefit of protection against future increases in land purchase prices.

These financial benefits are clearly visible in the company’s profitability, as indicated by its superior operating margins vis-à-vis its peers in the real estate development industry. Against an industry range of 10% to 25%, ANL has earned average operating margins of over 35% during the period FY02 to FY06. In fact, during the latest period of April to November 2006, ANL’s operating margins stood at a stupendous 46%.

Reasons not to apply
Political hurdles: The biggest obstacle in the path of successful rehabilitation of slum-dwellers in Mumbai is the growing tendency to politicise the entire process. There have been numerous instances in the past when politicians have opted for a myopic approach by stalling demolition of slums to garner votes instead of working for long-term rehabilitation. In fact, as per a report, thousands of slum-dwellers residing in some prominent Mumbai slums that were demolished as early as 2001, were left homeless, and created slums elsewhere! In one such glaring case, while the hutments surrounding the Mumbai airport have always been viewed as a security threat to key installations, nothing has yet been done to clear the same, mainly owing to ‘political compulsions’. These instances can stall the growth of companies like ANL, which have in fact built their entire businesses around slum rehabilitation and consequent grant of TDRs. We see this as a major risk to investment in ANL.

‘Mumbai’ risks: Compared to its other listed peers from the real estate development industry, ANL is the smallest player and is also the only one with a single location presence (Mumbai). The city has seen a stupendous rise in property rates in past 2-3 years. While it might seem logical that there should be land scarcity in a crowded megapolis like Mumbai (that leads to high asset prices in times of high demand), the truth is that the scarcity is mostly the result of faulty policy. All the land occupied by dead textile mills in central Mumbai has been locked out of the market for decades, and is being unlocked only now in slow, small steps. What makes the issue more serious is the fact that exceptionally high real estate prices exist with poor civic infrastructure and services. This is partly because property taxes are not levied very sensibly, and then not collected very efficiently.

The result is that cities like Mumbai are usually too broke to offer even rudimentary services to their citizens-like assured water supply, electricity, an effective law and order machinery, and an efficient public transport system. These factors make the entire real estate inflation in the city look like a bubble waiting to explode. This is a major risk to ANL, considering that the company follows a different model (of acquiring TDRs from slum rehabilitation authorities) of real estate development. The edge that ANL has against is peers is due to the fact that the cost incurred by the company for building an additional building to house slum dwellers tends to be significantly less than the purchase costs for comparable land that it would have otherwise incurred by purchasing land from third parties. In case of any reduction in this cost differential, the performance of ANL might be negatively impacted in the future.

Comparative Valuations & Comments
Latest statistics made available by the World Bank reveal that almost 54% of Mumbaikars live in slums today. Another 25% to 30% per cent live in chawls and footpaths, which leaves just around 10% to 15% living in buildings, bungalows or high-rises. Further, it projects that in 20 years, factors like the halt to the slum demolition scheme, the unhindered migration into the city, antiquated housing laws and sky-rocketing real estate prices, will see slums overtake the Mumbai skyline!

Already 67% of the city works in the informal sector. If the World Bank estimate of the city reaching a population of nearly 23 m by 2025 is true, slums will be everywhere. It is also estimated that 100 to 300 new families come to Mumbai every day and most land up in a slum colony or just erect a shanty on the nearest available footpath. In such a situation, we believe that rehabilitation shall be a big draw to get rid of slums. And with this, companies like ANL that have built their entire businesses around slums, are likely to be big beneficiaries. However, political concerns and single location risks, as mentioned above, as also the scams that have been unearthed in the past with respect to slum rehabilitation land allotments, might be key dampeners to growth for the company.

Despite its differential business model, we have compared ANL with the recently listed Parsvnath Developers (PDL) and Sobha Developers, and DLF, Unitech and DS Kulkarni. Our analysis shows that the company has had a lower compounded annual growth rate in revenues and net profits during the period FY02 and FY06, relative to its peers (see table below). This is largely due to the single location dependence of the company. However, as we have mentioned above, on the back of leverage that slum rehabilitation and consequent TDRs provide, the company has outperformed everyone else when it comes to profitability, as represented by operating and net profit margins. Even ANL’s ‘return on equity’ is remarkably higher than its peers.

Comparative evaluation
Particulars ANL PDL Sobha DS Kulkarni DLF Unitech
Land bank (m sq ft) 11.7 108.6 117.3 NA 574.0 NA
FY06 Sales (Rs m) 2,033 726 6,284 1,330 11,450 8,928
FY06 PAT (Rs m) 633 146 892 176 2,274 877
Averages/CAGR (FY02-FY06, %)            
Sales CAGR 50.4 120.5 48.3 45.3 34.5 45.3
PAT CAGR 45.1 138.7 97.1 57.4 61.5 101.4
Avg. OPM 38.5 19.5 11.6 5.9 23.4 7.9
Avg. NPM 25.3 16.7 6.5 7.1 12.0 5.3
Avg. RoE 38.8 52.2 108.5 18.6 14.3 14.2
P/E* 56.9 128.3 73.5 45.5 NA 403.7
* For ANL, higher price of Rs 540 is considered. EPS for all companies is for FY06

As far as ANL’s valuations are concerned, despite looking ‘cheaper’ on a relative basis, these are still stupendous. In fact, if one were to annualise the company’s eight month earnings (April-November 2006), the P/E that the issue is valued at stands at 165 times!

Due to the fact that the real estate sector is over-heated, investment at these high prices is bound to be risky. We believe that the stockmarkets are fancying these stocks because most of the real estate companies are sitting on ‘land banks’ in major metros. However, it is important to understand that such land is valued at today's inflated prices. Should the bubble burst, real estate investments might be worth a fraction of what they are today! Even if, as some experts say, there is no bubble, real estate stocks have to establish their credentials in the stock markets. Investors have had very little of long-term exposure to these stocks.

The remarks of Mr. Deepak Parekh, Chairman of the housing finance major, HDFC also need to be carefully considered – “Real estate in India has to do with affordability whether it is for residences, offices or even malls, and affordability is the key to viability. The boom in the commercial space is due to the demand from the IT and ITES sectors where most companies do not buy space. Almost 90% of it is rented. Companies cannot afford to pay rents of Rs 30-35 per sq foot because the wage structure is increasing. If you do not want to lose business to China or Vietnam, rents have to stay in check. How many malls can afford to pay Rs 100-150 or Rs 200 per sq foot? Look what happened to Crossroads. Only restaurants are left because food sells and the Piramals have sold out. The same thing is going to happen to other malls. There are many international brands, but they too cannot afford to be present in every mall.”

Our subscribers, who would have earlier applied to the IPOs of PDL and Sobha on our advice, have already seen their investments return them 40% and 70% respectively. Thus, considering the broader factors with respect to ANL (as outlined above), and also giving due respect to equity diversification, wherein it is not recommended to have a portfolio skewed towards a particular sector (especially one with higher risks, like real estate), we advise investors to ‘AVOID’ this issue.

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