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Monday, July 31, 2006

GMR Infrastructure: Avoid

nvestors can avoid the initial public offer of GMR Infrastructure (GMR) for now. The offer is stiffly priced; lack of visibility in earnings growth from the current revenue model, which is dominated by power, and the risks involved in relatively new ventures such as airport and road projects, outweigh the positives of being a unique infrastructure developer.

GMR develops, owns and operates infrastructure projects through a number of special purpose vehicles, some wholly-owned and others joint-ventures. The company's primary business segments are power, road and airport. The IPO proceeds of Rs 800-950 crore are to be used to fund road and airport projects and pay a promoter group company towards acquisition of GVL Investments, which holds a 9 per cent stake in Delhi International Airport Ltd (DIAL). The offer price band of Rs 210-250 is at a price earnings multiple (PEM) of 75-89 times the consolidated, fully-diluted, FY-06 earnings.

While international players in the concession business such as Cintra of Spain command a PEM of close to 150, their business model cannot be directly equated to that of GMR, as the latter, even after considering the road projects on hand, would remain mainly a power generation company.

Challenged by power

The power and road construction businesses accounted for 83 per cent and 14 per cent respectively of sales for the year-ended March 2006. In the power segment, all the revenues are now generated by two projects — the 220-MW Chennai power plant and the 200-MW Mangalore unit — both of which are suffering from low utilisation because of the high tariff brought about by oil-based fuels.

The current power purchase agreements (PPA) ensure that the fixed costs along with a fixed return on equity are recovered from the respective State electricity boards. However, the PPA for the Mangalore project expires in 2008 and the terms of its renewal are clouded in uncertainty.Further, the company's third power project at Vemagiri, Andhra Pradesh, based on natural gas, is unlikely to generate power in the near term for want of adequate gas supply. GAIL, the gas supplier, will supply only on "best efforts" basis as enough gas is not available in the region now to service the needs of all the customers.The picture may not improve until gas discovered in the Krishna-Godavari basin is brought to shore in the next three-four years.

Given the uncertainty over the Vemagiri plant's commercial operation, the company is re-negotiating the terms of the present PPA. GMR has also planned some hydropower projects but they are long gestation ones and, hence, do not add any immediate revenue visibility. The growth prospects for the power business are, therefore, likely to remain stunted.

Paving the way

GMR has quickly strengthened its position in the road segment with two annuity projects and four more, which will commence operation by 2008-09.

The road segment is likely to attain balance with 50 per cent of its revenues coming as they would from annuity projects. The rest would accrue from high-risk, high-return toll-based projects. GMR is, however, not a construction player and will be outsourcing much of the building work. It may, thus, lose the edge in terms of margins compared to the engineering procurement and construction (EPC) players in the field.

GMR has agreed to transfer the right to receive 73 per cent and 68 per cent of the receivables from its current two annuity roads projects to a consortium of banks and financial institutions for 15 years from May 2005 against secured loans received.

This means the present revenues from the road segment would not directly fill the company's coffers. The road segment is, nevertheless, likely to drive volumes on the back of the huge investment plans of the Centre and the States.

Take-off yes, but...

The success of the concession for the Hyderabad Airport, which is likely to be operational by August 2008, would depend on the actual traffic that the airport is able to attract. As of now, Mumbai and New Delhi remain the primary transit hubs in the country. The lease for this project, however, provides the right to develop hotels, resorts, and so on, in conjunction with the airport within the 5,500 acres of total land provided.

This leaves considerable scope for commercial revenue generation, if the Hyderabad airport consortium is able to plan and develop such area.

While the operation management and development agreement of the Delhi airport has commenced, the agreement is still under legal contention from one of the unsuccessful bidders.

Further, about 46 per cent of the gross revenues from the Delhi airport (unlike a 4 per cent concession fee and annual lease rent on a deferred basis in the case of Hyderabad airport) would be shared with the Airport Authority of India for the entire duration of the concession. This takes the sheen away from the seemingly lucrative project.

The key to ramping up revenues in airports may lie in increasing the proportion of non-aero revenues which, in turn, depend on passenger traffic.

The current mix of aero-to-non-aero revenues of 70:30 in Indian airports may have to undergo a drastic change. Singapore's Changi Airport started with a 60:40 mix in 1981, but that ratio has now reversed in favour of commercial revenues.

While we are positive about the potential from the airport infrastructure segment, the above issue appears to cloud the medium-term earnings visibility.

The structuring of the group that involves complex cross-holdings among group companies and promoter outfits does not add to the comfort levels on the offer.

Offer details: The offer will be open from July 31 to August 4. Enam and JM Morgan Stanley are among the book running lead managers. Retails investors will get a discount of 5 per cent on the issue price.

Tech Mahindra: Invest at cut-off

Investors with an appetite for risk can participate in the book-built public offering from Tech Mahindra. Bidding at the cut-off price,which has been fixed between Rs 315 and Rs 365 per share, would be appropriate. While this will involve an upfront payment of Rs 365 per share, investors will be eligible to invest even if the final price is fixed lower.

As a software services company focussed on the telecom vertical, Tech Mahindra represents a good choice for investors seeking to diversify their IT portfolio. At the proposed price band, the price-earnings multiple works out to 15.5-18 times the consolidated 2005-06 earnings on an expanded equity base. At these levels, the stock is reasonably priced relative to its domestic frontline software peers.

However, investors will have to moderate their returns expectations from this offer, as a plethora of choices are available (practically all companies in the Nasscom Top 20 are listed entities).


Slowly but steadily, global companies in the telecom space are investing in `next generation' converged networks, which carry both voice and data to replace legacy voice networks.

While fixed-line telecom service providers are investing in convergent IP networks to offer services such as Voice over Internet Protocol, mobile companies are deploying data intensive 3G (third generation) mobile services to make up for the slowing revenues from voice.

Global telecom companies are investing enormous resources in developing innovative value-added services to stay competitive in a mobile market where the Average Revenue Per User will remain under pressure, or in fixed-line telephony where volumes will continue to shrink.

As the telecom industry enters this new phase, companies with specialised focus on select verticals will be better placed to grab a bigger slice of business volumes and will be preferred over generic second rung players. Tech Mahindra, with its exclusive focus on the telecom sector, will stand to gain from this trend in the medium term. With its expertise in the Telecom Service Provider (TSP) segment, the company can either offer a range of high value data and content services or use business intelligence/billing optimisation tools to reduce overall costs.

From being a player predominantly focussed on the TSP segment, the company has expanded its presence to the Telecom Equipment Manufacturers (TEM) segment with its acquisition of Axes Technologies in November 2005. The Axes acquisition has brought in Alcatel, North America, as its key client, with significant business in the area of product engineering services. This acquisition is also expected to help open doors in the highly competitive TEM space consisting of players such as Siemens, Motorola, Nokia, Cisco Systems and Ericsson.

Its established client relationships, especially the likes of British Telecom or Alcatel are expected to help widen its base and expand its geographic footprint. At the same time, the company is also well placed to deepen its existing client relationships by offering a much wider range of services.

After a highly turbulent phase in 2003-04, the financials of Tech Mahindra has improved significantly. In the latest year ended March 31, 2006, the company clocked a revenue growth of 31 per cent to Rs 1,242.6 crore and a two-fold rise in post-tax earnings to Rs 235.4 crore.

The operating profit margin, which had touched a low of 10 per cent in 2003-04, has jumped to 21.5 per cent in 2005-06. The company has sustained the OPM in the first quarter ended June 30.This, however, is considerably lower than the 31-35 per cent OPM logged between 2001 and 2003.

Risks and challenges

British Telecom (BT), one of the controlling shareholders of Tech Mahindra, holding about 36.2 per cent of its equity, is also its key client. As its top client, BT accounted for 69 per cent of Tech Mahindra's revenues for the year ended March 31, 2006. This engagement with BT, recently renewed for three years, is expected to lend stability to Tech Mahindra's overall earnings stream. On the flip side, it also leaves the company vulnerable to any delay or freeze in spending (say, in 21st Century Network, BT's large transformation initiative involving the development of a converged network to carry voice and data) or downturn in overall IT spending on telecom projects.

The proportion of revenues accruing from the top five clients at 85 per cent is also quite high. Tech Mahindra has indicated that BT, Alcatel and AT&T are its three key clients, with whom it has entered into long-term agreements.

The offer document states that Alcatel recently announced a merger agreement with Lucent Technologies. The impact of this acquisition on Tech Mahindra's relationship with Alcatel is not clear at the time of the offer. Tech Mahindra is likely to face heightened competition from domestic frontline peers such as TCS, Infosys and Wipro, or global players such as Accenture, HP and IBM. For these players, telecom happens to be one of the segments in a de-risked portfolio of verticals ranging from financial services to manufacturing.

Unlike these players, since Tech Mahindra derives all its revenues from telecom, it remains exposed to a potential downturn in business, greater billing rate pressure from select clients, and volatile quarterly performance.

Finally, the principal risk remains an unanticipated downturn or slowdown in the telecom sector. Since telecom growth is linked strongly to the spending plans of Fortune 500/Global 1000 customers, any economic/sectoral slowdown can impact the company adversely.

Offer details: Tech Mahindra is coming out with a book-built public offer of 1.27 crore equity shares in the price band of Rs 315 to Rs 365 per share. The offer consists of a fresh issue of 31.8 lakh shares and an offer for sale of 95.5 lakh shares by Mahindra and Mahindra, and British Telecom.

Part of the fresh issue proceeds is to be used for enhancing the delivery infrastructure in Pune. The book running lead managers are Kotak Mahindra Capital and ABN Amro Securities. The stock will be listed on the NSE and the BSE. The offer opens on August 1, and closes on August 4.

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