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Sobha Developers IPO: Our view - Views on News from Equitymaster
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Sobha Developers IPO: Our view
Nov 23, 2006

Sobha Developers Limited (SDL), a Bangalore-based real estate developer, is issuing 8.9 m shares as part of its initial public offering, which begins today and will be remain open for subscription till November 29 2006. The company has priced its offering at Rs 550 to Rs 640 per share. At the higher price band, it expects to raise Rs 5.7 bn from the issue, which will be towards funding its land acquisition and construction initiatives. Here is a brief snapshot of the issue.

Company background
Bangalore based Sobha Developers Limited (SDL) is involved into construction and development of residential and commercial projects. It also undertakes construction of projects on a contractual basis. It has till date successfully executed 75 projects, spanning 8.4 m sq ft of super built up area and 21 residential projects spanning 2.9 m sq ft of super built up area. The company has successfully transformed itself and diversified its portfolio, from being a contractual construction company, to one where it has a well-balanced portfolio of residential and commercial projects, and construction of contractual projects. Apart from Bangalore, SDL now envisages to tap other major cities like Chennai and Pune. Its total land reserves and land arrangements in these two cities combined stand at 3983 acres. Also, as a part of its growth and diversification strategy, SDL plans to foray into the development of hotels, SEZs, integrated townships, residential complexes, and commercial properties such as malls, multiplexes and shopping complexes and plot development.

Reasons to apply
Unique backward integration model: The execution of real estate development projects requires a lot of agencies to work in tandem with each other. Often, mismanagement and lack of co-ordination amongst these agencies leads to poor delivery timing and quality. Various contractors also indulge in blame game leading to lack of accountability. SDL, however, has developed a differentiated model to real estate development. The company has put in place a backward integration model, whereby it has its own in-house design studios, interiors, glazing and metal works and planning department. This not only ensures better coordination and control over various aspects of the construction and development work, but also ensures good quality and timely completion of projects. We believe that such a model has its merits, especially when the company is planning to make a wider geographical foray.

Derisking business: In the past, SDL has executed contractual projects for prestigious clients like Infosys, which used to contribute a significant portion to the former’s total revenues. However, considering the changing dynamics of the industry, where competition is on the rise and there is a need to have a diversified revenue base, the company is derisking its revenues from Infosys and is targeting other contractual contracts. This is amply evident form the fact that the share of Infosys’ contracts in SDL’s total revenues has reduced over the years (26% in FY06, from 52% in FY04).

Also, while the company has been mainly involved in development of residential and contractual projects till now, post this issue, it envisage diversification in development of hotels, integrated townships (it has already signed a MoU with Reliance Energy for a project in Hyderabad), malls, multiplexes, shopping complexes and plot development. Also, the contribution of residential projects in the company’s total revenues has been on rise, which has effectively reduced the burden on its capital requirements. Investors must note that most of the residential real estate developers, like SDL, follow a ‘build and sell’ model, which often works on negative working capital. Higher share of such business will thus reduce working capital requirements for the company going forward.

Reasons not to apply
‘Banglored’: While this term is used by the Americans to refer to outsourcing of work from the US to low cost markets like India (specifically the country’s silicon valley, Bangalore), it has a somewhat negative connotation for SDL, especially considering that the company is heavy reliant for growth, at least for the next few years, on its projects in Bangalore. Real estate is a highly localized industry, with unorganised players dominating businesses across particular regions. There are no major real estate developers in the country that has a diversified pan-India presence. Most of the real estate companies that are raising funds currently (including SDL) plan to do so in order to diversify their base across regions. While this can be a long term positive, it has significant risks (like local competition) attached to it in the medium term. Risks might be in the form of difficulties in land mass acquisition, absence of business infrastructure to market new projects at new locations, wide number of approvals to be obtained from various local civic bodies, and long gestation periods. Also, any slowdown in demand in Bangalore, considering the much talked about poor infrastructure condition in the city, might be a big dampener on the company’s growth.

Rising cost of operations: The real estate sector is dependent on a number of commodities, like cement, steel, bricks, wood, sand, gravel, and paints. Prices of most of these commodities have shown a firm upward trend over the past two years. Coping with such price escalations and being able to pass them to their clients, is one of the big challenges facing real estate developers today. And SDL is no exception.

Comparative valuation and comments
We have compared SDL with Parsvnath Developers (PDL), DLF, Unitech and DS Kulkarni. Our analysis shows that the company is neither the best nor the worst performers from among its peers. Across most of the parameters, the company occupies the mid position. As far as valuations are concerned, the stock is offered at almost the ‘cheapest’ valuations among peers (see P/E comparison below).

Comparative evaluation
Particulars SDL PDL DLF Unitech DS Kulkarni
Land bank (m sq ft) 117.3 108.6 215.1 NA NA
FY06 Sales (Rs m) 6,284 2,004 11,450 8,928 1,330
FY06 PAT (Rs m) 892 318 2,274 877 176
Averages/CAGR (FY02-FY06, %)          
Sales CAGR 48.3 120.5 34.5 45.3 45.3
PAT CAGR 97.1 138.7 61.5 101.4 57.4
Avg. OPM 11.6 19.5 23.4 7.9 5.9
Avg. NPM 6.5 16.7 12 5.3 7.1
Avg. RoE 108.5 52.2 14.3 14.2 18.6
P/E* 43.2 51.8 NA 472.2 42.5
* For SDL, higher price of Rs 640 is considered. EPS for SDL and PDL is annualised for 1HFY07. For others, it is the FY06 figure.

We are particularly enthused by the company’s strong relationships with large clients like Infosys. The latter’s world-class development centres across India (most of them built by SDL) are indicative of the quality of development and construction of the latter. Though the company is working towards reducing its share of revenues from the Bangalore market (by targeting other cities like Chennai and Pune), it still has a long way to go. This is considering that these cities already have set players, and there might be issues for SDL in establishing its presence, at least in the medium term.

Considering all parameters of past performance, and the company’s future growth strategies, we recommend ‘Apply’ to the issue, though strictly for long-term investors with high-risk appetite.

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