Sunday 17 February 2008

IPO Analysis - Rural Electrification

Investors can subscribe to the initial public offering of shares by Rural Electrification Corporation (REC) at the cut-off price. REC’s business is sharply focussed and the company has a robust financial profile despite difficult clients such as State electricity boards (SEB) and other power utilities.

Importantly, at Rs 90-105, the offer is priced attractively and leaves enough on the table for investors in the medium term. Investors should not subscribe in anticipation of listing returns.
Funding electrification

REC’s original mandate was to enable electrification of Rural India through financing of transmission and distribution (T&D) projects and the energisation of agricultural pumpsets.

However, the company has now evolved to finance all segments of the power sector throughout the country, including generation projects.

The company’s clients are predominantly SEBs and state power utilities. Loan sanctions and disbursements have been growing at a good clip; in the last five years, they grew at a compounded annual rate of 28.37 and 13.51 per cent respectively.

The government has set an objective of ‘power for all’ by 2012 which will require massive investment in generation and T&D infrastructure. The company has a tremendous opportunity given its long experience in funding the sector and its position as a prime intermediary for development schemes.

REC is the nodal agency for the Rajiv Gandhi Grameen Vidyutikaran Yojana (RGGVY) whose objective is to electrify all villages in the country. Under RGGVY, the government provides 90 per cent funding for projects in the form of grants that are channelled through REC; the latter funds the balance 10 per cent in the form of long-term loans. Such loans typically account for less than 5 per cent of REC’s total sanctions and disbursements in any financial year.

REC is also the nodal agency for two “build, own and operate” transmission projects that have been allotted for tariff-based competitive bidding.

The company will be required to take all preliminary steps for these two projects and administer them till they are handed over to the winning bidders. This is similar to the role of Power Finance Corporation in the case of ultra mega power projects.
Robust financial profile

Though it services clients who are known to delay or even default on their loan obligations, REC has managed to keep its finances insulated and healthy.

The company has a well-structured model to protect itself from defaults ranging from State government guarantees to escrow accounts in addition to the normal charge on assets.

Gross non-performing assets are well under control at 2.39 per cent of outstanding loan assets but the point to note here is that the company is not subject to RBI’s prudential norms for income recognition and classification of assets.

REC has devised its own prudential norms, much like its peer, Power Finance Corporation (PFC), which is also not governed by RBI norms. There is some ambiguity on the subject nevertheless with RBI asking REC (and PFC) to prepare a “road map” for compliance and the issue is still under discussion between the regulator and the government.

REC boasts of a healthy net interest margin of 3.30 per cent (2006-07) which compares with the best in banking and financial services. This is almost on a par with PFC’s net interest margin of 3.52 per cent in the same period. REC has mainly the government to thank for this.

Just under half of its funding comes from cheap sources such as capital gains bonds issued under the Income Tax Act. Given the tax benefit that subscribers to these bonds enjoy, the interest payable is very low.

For instance, the average cost of such bonds issued by REC was 5.48 per cent only as of September 30, 2007.

Besides this, REC also issues taxable bonds which had a weighted average cost of 7.56 per cent as of the same date. The company has also been able to secure long-term loans from banks and financial institutions at an average rate of 7.58 per cent only.

The point is that given its character of a government company promoting rural development, REC enjoys access to cheap funds. Its average cost of funds was just 6.55 per cent in the first half of this fiscal when interest rates were on the boil.
Attractive valuation

REC’s offer is attractively valued when compared to its peer PFC. The profiles of the two companies are similar with REC’s business having a rural tilt given its history. REC is smaller compared to PFC in terms of the size of its business but it appears to be more profitable. Its return on net worth of 21 per cent in 2006-07 is almost double that of PFC’s in the same period.

REC had outstanding loan assets of Rs 31,974 crore as of March 31, 2007 compared to PFC’s Rs 43,902 crore.

At the offer price band of Rs 90-105, REC is valued 9-11 times based on its 2006-07 earnings. In comparison, PFC, at the current price of Rs 184, is valued around 19 times its 2006-07 earnings.

If the annualised first half 2007-08 earnings is considered, the picture is even more favourable for REC which is valued between 7-8 times on its price band compared to PFC’s multiple of 18 times.

REC will have equity of Rs 858.66 crore, post-offer, which is significantly lower than PFC’s Rs 1,147.76 crore and the public float of the former at 18.18 per cent of outstanding shares will also be higher than that of the latter at 10.22 per cent.

The higher public float will enable better price discovery of REC’s shares in the market.
What to watch out for

There are three main risks to our recommendation. First, continued access to cheap funds through the tax-free capital gains bonds scheme. This is important as it enables REC to price its loan products competitively.

The government annually reviews the tax exemption on these bonds and any change in its policy will have an adverse effect on REC’s cost of capital.

Besides, the high reliance on this mode of finance could lead to asset-liability mismatches; while these bonds are typically three-year instruments, REC on-lends such funds for terms of up to 20 years. The company may be forced to cover up a possible term mismatch by borrowing higher cost funds which will affect its net interest margin.

Second, REC lends to some troubled borrowers such as SEBs and rural electricity cooperatives. Though it takes adequate protection, a delay in payments can affect the company’s cash flows, leading to a mismatch in funds.

Finally, the ambiguity over whether RBI’s prudential norms apply to REC is a nagging risk.

Assuming that the regulator’s norms become applicable, it is unclear as to how the complexion of REC’s financial statements will change.

Issue details: REC is offering 15.61 crore shares in the price band of Rs 90-105, half of which is an offer for sale from the government and the balance fresh issue of equity.

The total issue size is Rs 1,405-1,639 crore and the company will have a market cap of Rs 9,015 crore at the upper end of the price band. The issue is lead-managed by ILFS Investsmart and ICICI Securities.