Angel Broking has come out with research report on Rural Electrification Corporation (REC) IPO. They have recommended subscribing to the issue. REC, one of the leading public financial institutions in Indian power infrastructure, proposes to enter the capital markets on February 19, 2008 with a public issue of 156,120,000 equity shares of Rs 10 each through 100% book building process.
Angel Broking report on Rural Electrification Corporation IPO
Substantial funds requirement for Indian Power sector
Rural Electrification Corporation is a leading public financial institution exclusively focused on extending finance to the Indian Power Sector, which, going by the government’s stated intentions, is slated for tremendous growth during the Eleventh Five-year Plan (2007-2012). It is estimated that Rs 10.3 lakh crore of capital would be required to set up the power infrastructure targeted to be added by 2012. Within the available funding sources, the government envisages REC’s share at Rs 59,150 crore at least.
Accordingly, we expect REC to deliver a CAGR growth of 25% in Advances over FY2008-10E. Importantly, REC’s mandate has evolved over the years and it now finances all segments of the Power sector throughout the country. REC’s changing sanction mix corroborates this viz., the private sector borrowers and generation projects comprise an increasing share of sanctions, in line with the present dynamics of the Power sector.
Clear-cut, Profitable business model
REC’s primary source of revenue is interest Income from Power sector lending. Low-cost ‘54EC Bonds’ comprise 45% of its borrowings. REC is expected to deliver NIMs of 3.2-3.4% over FY2008-10E. Given its lean organisational structure, inherently low credit risk and Tax benefit u/s 36(1)(viii), RoAs should sustain at 2% levels.
REC’s leverage cannot exceed 8-9x to maintain AAA credit rating (critical for cost competitiveness). Accordingly, it is expected to deliver RoE of around 16% by FY2010E, which should increase to around 18% at optimum leverage (post FY2010E).
Tax benefits and treatment of deferred tax liability (DTL)
REC is eligible for tax benefit u/s 36(1) (viii) of IT Act, 1961 by creating a special reserve of upto 20% of profits. The company has created DTL in respect of this tax benefit – however, we believe the tax liability is unlikely to crystallize and consider it appropriate to treat the DTL so created (and to be created) as part of equity. Accordingly, we have increased book value by Rs 9.5 (and have assumed the effective Tax rate for FY2008-10E to be 27% for the same reason).
Outlook and Valuation
In the past few months, the Power Sector (on which REC is an indirect play) has seen valuations reaching frothy levels, only to come off recently. Against this backdrop, we believe the REC Issue comes at a reasonable price based on fundamental value, considering the high visibility of credit demand in the Power Finance sector, REC’s strong positioning in the same and its reasonably strong financial performance.
At the upper end of the price band of Rs 105, the stock is available at 1.3x FY2009E Adjusted Book Value of Rs 80.7 and 1.2x FY2010E Adjusted Book Value of Rs 90.5. The valuations compare favorably with its closest peer, PFC, which is trading at 1.8x FY2009E Adjusted Book Value of Rs 104 and 1.6x FY2010E Adjusted Book Value of Rs 117 at the CMP of Rs 185. We believe REC can command upto 1.5x 1-year Forward Adjusted Book Value, implying reasonable upside even at the upper end of the price band. Hence, we recommend subscribe to the issue.
Concerns
Credit offtake falling short of estimates
In the past, the government has often fallen short of targeted capacity addition in its Five-year Plans. The Ninth Plan had targeted a capacity addition of 40,245MW, of which only 47.8% was actually added during the Plan. Similarly, in the Tenth Plan, only 51.5% of the targeted capacity addition of 41,110MW was actually achieved.
The Eleventh Plan has an ambitious targeted capacity addition of 78,577MW, of which 13.7% (10,760MW) is expected to be in the Private sector. Various factors such as delays in environmental clearance, land acquisition, financial closure (on the Equity or Debt front) may result in shortfall in targeted capacity addition, as a result of which loan disbursements for REC may fall short of estimates.
Nonetheless, the environment is more enabling during the Eleventh Plan, driven by Power Sector reforms including enabling regulations such as the Electricity Act, which provide a framework for the private sector to expand viably and for the SEBs to be restructured and corporatised.
Moreover, greater competition from banks or development of deeper bond markets could result in a deteriorating NIM-credit growth trade-off for REC. This may be exacerbated by improving financial profile of Power Sector entities, with greater share of capacity addition moving to the private sector.
Withdrawal of Tax benefits
Withdrawal of capital gains exemption u/s 54EC Income Tax Act will result in REC’s cost of funds gradually increasing by around 100bp as the existing Bonds mature. However, REC does pass on part of the benefit to borrowers by charging concessional rate of interest, which we expect will be discontinued if the section is withdrawn.
Withdrawal of tax exemption u/s 36 (1) (viii) of the Income Tax Act will result in REC’s effective tax rate going up by 6-7%, potentially bringing down sustainable RoEs from about 18% to about 16.5%.
Increase in borrowing / credit (NPA) costs
Competitive pressures may force REC’s spreads below projected levels. Due to the concentrated nature of its Asset Book, major systemic problems in the Power Sector may increase its NPA levels and drastically impact its profits.
Source: Moneycontrol.com
Monday, February 18, 2008
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