HDIL-time to invest at rockbottom values? SOTP Valuation included!

In my earlier post detailing why realty companies are trading at record low valuations(http://specialsituationsindia.blogspot.com/2011/12/why-do-indian-real-estate-companies.html)  I'd given a laundry list of factors and promised to give a SOTP valuation of HDIL. I chose the company due to its apparently low valuation, and seemingly good corporate governance record/information availability. The company trades at a P/BV to 0.37. And even after going through the notes to accounts, I realized that the company does seem having a good margin of safety, even after accounting for doubtful assets like promoter receivables, disputed loans etc.


But as the past 1yr data shows(broken into 6 month intervals), the equity has gone up, but the quality of assets has fallen,. Cash/non current investments have risen much slower than the project investments.





My SOTP valuation estimates the project value around Rs 12,000 crores.I estimated the percentage completion from the data in the investor presentations, and the market rate from websites like magicbricks, for project bookings presently. The riskier assumptions are in percentage completion, but I've tried to be conservative. As the breakup would show, bulk of value comes from SRA projects, whcih are inherently riskier given the dependence on TDR, and the expected release of land in Mumbai which would lower the prevalent rates. Unfortunately, the company does not reveal much data on their SRA projects, so I'd to be much more conservative. Those of you wishing to use different assumptions and see the rates, please modify the spreadsheet and check. Note-all area below only reflects the share of HDIL in the project, not the total project area.
HDIL SOTP Valuation Jan12
On the governance front, there are apprehensions about the tax demands. After the widely reported Sep09 raid on them by the Income Tax authorities, they offered Rs 350crore of previously undisclosed income to tax(potential tax impact of 30%-100% of that amount after factoring in penalty & interest). While that sum is accounted for in the books, the previous year assessments will be reopened, and thus the tax risk is a hanging sword.
Conclusion After reducing the debt worth Rs 4400 crore, it leaves around Rs 7600 crores equity on the table, is a good upside of 150% from the present market cap. Of course, with other stocks out there, it is an open question as to why would someone ditch a Piramal Holdings/Reliance Industries(both cash rich companies with similar risk/return ratios for such risky companies). But if someone wants to invest in the realty sector, then this seems one of the better stocks given management reputation for execution, good governance(despite tax issues) etc.

Why do indian real estate companies trade at low price to book(P/BV) multiples?

A Mint article today caught my attention when it pointed out several stocks trading at price to book multiples of <0.5. More of these stocks belong to the infrastructure sector, more especially realty.
The graph to the left shows what  took place in the sector, which saw dotcom like P/BVs only to see them dissipated later on.


 

But is this only a general market phenomenon? Not really.  The graph above shows that ever since the CNX Realty price to book dipped below 10 in June-08, it has steadily gone downhill till then, while the general market has recovered. Why is this so? Why do investors distrust the sector to the extent of not even wanting to pay for book value, while the reality of land shortages, housing requirement and rising housing prices exists? To understand this, the points below may help

1. Depends on the target market-Commercial or Realty(basic or luxury). While realty IS in under supply, the same cannot be said for commercial real estate, where over supply does exist.
2. Location Location Location! Two projects in the same city may have drastically different rates. Hence to value the project, investors need market intelligence or reliable rates, both of which are missing in the Indian markets. Peter Lynch's dictum of investing in what you know, could not be more relevant than in realty where there is little substitute for inspecting the project site!
3. Volatility+Leverage=Dynamite:-The real estate sector takes on high debt, and is subject to regulatory volatility(permits, FSI, planning). Also, most purchases today are financed by bank loans, and therefore the bank policies of credit both to builder and flat buyer, makes a difference. Given that past 13 interest rate hikes by RBI and fears of stagflation, prospective flat buyers are not willing(or able for that matter!) to get adequate debt
4. Sticky housing prices:-While Economics 101 would advocate reducing the house prices to ensure swifter offtake, builders do not wish to destroy their future market. Also, given the amount of bribes given to secure the site, they also cannot lower prices beyond a point, although construction costs may be just around Rs 1200/acre. 
5. Persistent debt:-When you have low housing purchases and prices are not dramatically lowered, then one incurs interest while still holding the inventory. And from Mar-11 to Sep-11, India Inc has not materially lowered the debt(with maybe exceptions of DB Corp/DLF). 
6. Governance Issues/Political Linkages:-The sector is associated with politicians and the mafia, and that taint applies to nearly all companies. Hence, when a good governance crackdown occurs like Lokpal, these companies would be caught in the cross hairs
7. Peculiar organizational structure:-The use of partnership firms/JVs/LLPs is an industry practice to derisk balance sheet/allow SPV lending/purchase land w/o alerting others, but that leads to murky consolidation issues and lack of oversight on those JVs.
8. Related Party transactions:-Promoters often have their HUFs/partnership firms/raw material supplying firms as group companies, with which listed companies transact. Naturally, that is not a good recipe for corporate governance.
9. Industry practices on loans and deposits
1. Mobilization Advance:This is given to the EPC contractors as an advance for starting work. if the project is held up for any reason, this advance is difficult to get back, more so if the ongoing relationship with vendor is not there
2. Interest Free performance deposit:-For land purchase deals, an industry practice is to give  an advance termed as 'interest free performance deposit'. Like author advances in the publishing industry, this is ostensibly an asset but not if the worst case happens-then years of arbitration are needed to get it back. Lesson to be learnt-be wary of both above.
10. Land title issues & subsequent litigation:-There being no land bank in India, title is presumptive not conclusive, and challenges can hold up the project, as also claims of inadequate land acquisition/forged title deeds. The most recent example of it is farmers demanding their land back in Greater Noida
11. Accounting:-The percentage completion method links revenue recognition to a complex formula depending on customer advances received and/or construction costs incurred. For reasons other than receiving progress payments on time, revenue recognition can be boosted by
12. Non diversifiable risks:-Unlike other companies which can diversify their product portfolio and markets, doing so in realty does not bring any advantages. In fact, the loss of local knowledge/expertise/contacts may make that geographic diversification increase overall risks! That is why companies are mostly localized.

A longish list, but very few new factors(most of these are industry specific). Then why this dislike towards the industry? One can single out #3,#4,#5,#6,#11 as key factors in the limelight now, which makes investors push for flight to safety. In another post, I'll examine the valuation complexity with the case of HDIL.