ambit realestate thematic accounting 23apr14

April 2014

REAL ESTATE

Krishnan ASV+91 22 3043 3205

[email protected]

Analyst:

Accounting - at the crossroad

REITsTRANSPARENCY

Company Act 2013TRANSPARENCY

POLICYMAKERS/REGULATORS

Non-uniform

OPACITYAccounting practices

Wilful diversion

OPACITYof funds

Related party

OPACITYtransactions

CUSTOMERS/CAPITAL PROVIDERS

Regulation BillTRANSPARENCY

Thematic:

Real Estate

April 23, 2014 Ambit Capital Pvt. Ltd.

CONTENTS

SECTOR

Executive summary…………………………………………………………………………….. 4

Accounting in real estate - A black box………………………………………………........ 6

Accounting for land - Further latitude………………………………………………………. 7

Revised guidance note (GN) streamlines revenue recognition………………………… 10 yet not watertight

Related party transactions (RPTs) galore…………………………………………………... 14

Category mix and leverage suggest wilful d ivers ion of funds………………………….. 18

Methodology…………………………………………………………………………………... 20

Valuation - a perspective……………………………………………………………………. 25

What can investors look forward to?...................................................................... 27

- Companies Act 2013 - towards greater transparency………………………………. 28 yet onerous on real estate

- Impact of 2014 General Elections - lessons from 2009…………………………..… 30

- Real Estate Regulation Bill - pro-consumer; towards greater disclosures………….31

- Real Estate Investment Trusts (REITs) - limited eligibility;…………………………… 32 unlimited candidates

COMPANIES

Oberoi Realty (BUY): Launch pipeline crucial……………………………………………. 35

Sobha Developers (BUY): Position of relative strength…………………………………. 57

Ambit Capital and / or its affiliates do and seek to do business including investment banking with companies covered in its research reports. As a result, investors should be aware that Ambit Capital may have a conflict of interest that could affect the objectivity of this report. Investors should not consider this report as the only factor in making their investment decision.

Accounting - at the crossroad The real estate sector allows considerable latitude in accounting for revenues and cost (especially land), and thus, it is no surprise that the sector fares the worst on our accounting framework. We argue that fresh funding needs (impending beauty parade for REITs) coupled with recent changes to the accounting and regulatory framework is forcing greater transparency amongst real estate companies. We identify Oberoi Realty, Prestige Estates and Sobha Developers among larger firms and Omaxe and Peninsula Land among smaller firms as more transparent.

Accounting in real estate - too many black boxes

In the absence of sector-specific accounting standards, accounting practices in the real estate sector are non-homogenous, especially around accounting for revenues and land. Key areas that contribute to the sector’s relatively inferior performance on accounting metrics are: (a) arbitrary revenue recognition; (b) weak cash conversion; (c) expense manipulation (lack of prudent provisioning); and (d) many related party transactions.

Revenue recognition harmonised yet not watertight

Whilst the revised guidance note (GN) prescribes a uniform threshold for firms to begin recognising revenues from a project, our discussions with practising auditors suggest that the revised GN is not yet completely watertight. This includes instances such as developers entering into a separate ‘sale of land’ contract (contributing to aggressive revenue recognition), discretion exercised around what constitutes ‘critical approvals’ and ambiguity around JDAs.

Related party transactions (RPTs) - modes of disguised lending

On an average, the top-three categories of RPTs account for c.70% of the total related party transactions. A large proportion of RPTs are only ways of funding group entities, with most categories reversing themselves during the year and not earning any interest. We also argue that a bulk of construction finance (working capital loans raised for under-construction projects) raised by developers for residential projects is diverted towards either land acquisition or stalled projects that are starved for capital (suffering from cost overruns).

Limited investible universe; Oberoi, Prestige - most transparent

Using accounting checks across four categories (P&L misstatement checks, balance sheet misstatement checks, cash pilferage checks, and audit quality checks) on a set of 21 real estate companies, we establish a pecking order of transparency and identify the investible universe of real estate stocks. Based on our analysis, Oberoi, Prestige and Sobha are relatively more transparent.

The road ahead - what can investors look forward to?

Our discussions with senior partners and executives across the Big-4 auditors suggest that developers are gradually undertaking a clean-up operation. Whilst this push towards transparency is partly driven by the impending beauty parade for fresh capital (to become REIT-friendly), experts also attribute this effort to their desire to comply with the revised GN, the Companies Act 2013, and the Real Estate Regulation Bill. We highlight the impending General Elections as a key near-term business catalyst for the sector.

Real Estate NEGATIVE

THEMATIC April 23, 2014

Key Recommendations

Oberoi Realty BUY

Target Price: 290 Upside : 30%

Sobha Developers BUY

Target Price: 491 Upside : 30%

Contingent Liabilities and P/B

Companies CL (% of NW)

FY15 P/B

Large companies - mcap > US$500mn

DLF 26% 0.93

Oberoi Realty 8% 1.46

Prestige Estate Projects 43% 1.71

Unitech 72% 0.37

Godrej Properties 5% 1.82

Phoenix Mills 25% 1.82

Sobha Developers 29% 1.46 Mid-sized companies - mcap between US$200mn and US$500mn Omaxe 32% 1.32

Indiabulls Real Estate 8% 0.35

HDIL 8% 0.27

Anant Raj 4% 0.42

Sunteck Realty 0% 1.79 Mahindra Lifespace Developers 3% 1.07

Puravankara Projects 4% 0.70 Small-sized companies - mcap between US$100mn and US$200mn Parsvnath Developers 9% 0.40

DB Realty 52% 0.51

Peninsula Land 1% 0.66

Hubtown 19% 0.61

Ashiana Housing 1% 1.74

Brigade Enterprises 88% 0.58

Kolte Patil Developers 28% 0.56

Source: Bloomberg, Ambit Capital research; CL denotes contingent liabilities; NW denotes net worth

Analyst Details

Krishnan ASV +91 22 30433205 [email protected]

http://webambit.ambit.co/reports/Ambit_Strategy_AccountingThematic_22Nov2013.pdf

Real Estate


Executive summary The BSE Realty Index has delivered returns in line with the BSE Sensex since the beginning of 2014; however, the Indian realty sector continues to suffer from a high credibility deficit across stakeholders, which is largely attributable to a lack of transparency in reported financials and a lack of like-for-like (LFL) comparable parameters across companies.

To help investors with LFL comparison, we identify 21 real estate firms, categorise them into three separate buckets by market capitalisation and use four categories of accounting metrics (as shown in the exhibit below) to score these firms on their accounting quality.

Exhibit 1: Categories of accounting checks

Category Ratios

P&L misstatement checks (1) CFO/EBITDA, (2) change in depreciation rate, and (3) miscellaneous expenses as a proportion of total expenses

Balance sheet misstatement checks (1) Cash yield, (2) debtors more than six months as a proportion of total debtors, and (3) contingent liability as a proportion of net worth

Cash pilferage checks (1) CWIP to gross block, (2) cost of construction to construction work-in-progress, and (3) cumulative CFO plus CFI to median revenues

Audit quality checks (1) Audit fees as a proportion of standalone revenues, (2) audit fees as a proportion of total auditor remuneration, and (3) unaudited assets as proportion of consolidated assets

Source: Ambit Capital research

Among larger firms, Oberoi Realty, Prestige Estates and Phoenix Mills, and among smaller firms, Omaxe, Peninsula Land and Kolte Patil, are more transparent.

Exhibit 2: The final ‘realty’ check - across accounting metrics

Company P&L checks Balance sheet

checks Cash pilferage checks Audit quality checks Overall score


DLF

Oberoi Realty

Prestige Estate Projects

Unitech

Godrej Properties

Phoenix Mills

Sobha Developers

Mid-sized companies - mcap between US$200mn and US$500mn

Omaxe

Indiabulls Real Estate

Housing Development & Infrastructure

Anant Raj

Sunteck Realty

Mahindra Lifespace Developers

Puravankara Projects

Small-sized companies - mcap between US$100mn and US$200mn

Parsvnath Developers

DB Realty

Peninsula Land

Hubtown

Ashiana Housing

Brigade Enterprises

Kolte Patil Developers

Source: Companies, Ambit Capital research; Note: Strong, Moderate, Weak

Real Estate


We have deliberately refrained from using the full moon ( ) in Exhibit 2 above, given the general lack of transparency around origination and sale transactions in the sector.

Having established a pecking order on accounting quality, we present a valuation approach underpinned by the cash conversion cycle and the adjusted net worth to highlight undervalued stocks. We eliminate four outliers (on cash conversion cycle) and map the remaining real estate developers on the consensus FY14 consolidated P/B multiple (on the X-axis) and the six-year median cash conversion cycle (in number of days) on the Y-axis. The size of the bubble in Exhibit 3 below indicates the contingent liabilities (as a proportion of net worth), customer advances that are yet to go through the P&L, and unbilled revenues.

Exhibit 3: Cash conversion cycle (in number of days) vs P/B multiple - Oberoi and Sobha cheaper than Prestige

Source: Companies, Bloomberg, Ambit Capital research; Note: X-axis denotes consensus FY14 P/B, Y-axis denotes the six-year median cash conversion cycle (in number of days) and the s i ze of the bubble denotes contingent l iabi l i ti e s (as a propor tion of ne t wor th)

Since not all contingent liabilities devolve on the parent entity (some are genuine), we use a conditional adjustment factor on contingent liabilities to arrive at the adjusted net worth. The higher the contingent liabilities, higher the adjustment factor that we use to derive the adjusted net worth.

Exhibit 4: Deriving the adjustment factor for contingent liabilities

CL (% of NW) Deduction from NW

Less than 10% of NW 10% of CL

10% - 30% of NW 20% of CL

Over 30% of NW 30% of CL

Source: Ambit Capital research; CL denotes Contingent Liabilities; NW denotes net worth

The outliers that we have eliminated from Exhibit 3 are Phoenix Mills (significantly negative cash conversion cycle), Indiabulls Real Estate, HDIL and Sunteck Realty (significantly high cash conversion cycle). The largest bubble in Exhibit 3 is equivalent to 75% of net worth (Brigade Enterprises) whilst the smallest bubble is equivalent to 1% of net worth (Peninsula Land and Puravankara Projects). An ideal BUY signal combines a low cash conversion cycle, a relatively attractive valuation and a smaller bubble. On the other hand, the ideal SELL signal combines a high cash conversion cycle, an expensive valuation and a large bubble.

Although the cash conversion cycle (in number of days) is the least common denominator for most of the firms in this analysis, it is worth highlighting that companies with a lean P&L are unduly penalised. Given that the variables in the cash conversion cycle (inventory days, debtor days and creditor days) employ P&L elements (either revenues or cost of sales) in the denominator, the revenue recognition approach, especially the project completion method, disproportionately impacts such firms. We highlight HDIL and Sunteck Realty as outliers on account of the revenue recognition policy (project completion method) and hence, they are not strictly comparable on the cash conversion scale.

Parsvnath

DB RealtyPeninsula Land

Hubtown

Ashiana HousingBrigade Enterprises

Kolte Patil

Oberoi Realty

Anant Raj

Prestige Estates

Sobha Developers

OmaxeMahindra Lifespace

Godrej Properties

DLF

Unitech Puravankara

-200

0

200

400

600

800

1,000

1,200

- 0.5 1.0 1.5 2.0 2.5 3.0

FY15 P/B

Ca

sh c

onve

rsio

n c

ycle

(n

um

ber

of

da

ys)

Cash conversion cycle (in number of days) is the least common denominator for a majority of the firms in this analysis

We identify HDIL and Sunteck Realty as outliers on account of the revenue recognition policy (project completion method) and hence, they are not strictly comparable on the cash conversion scale

Real Estate


Accounting in real estate - A black box As highlighted in our accounting thematic dated November 2013, the ‘realty’ sector fares the worst on our accounting framework, with an average score that is about 20% lower than the average score of the other 350 companies (within the BSE500). Key areas that contribute to the realty sector’s relatively inferior performance on accounting metrics are: (a) arbitrary revenue recognition; (b) weak cash conversion; (c) expense manipulation (inadequate (imprudent) provisioning policies and deferred depreciation); and (d) high cash pilferage. This total lack of credibility has resulted in the realty sector continually being perceived as ‘high risk’ by all stakeholders—capital providers, regulators, policymakers, auditors, property consultants and customers.

Real estate transactions - subjectivity in revenue recognition policies

Accounting practices in the real estate sector are non-homogenous - the industry is characterised with complex arrangements such as agreement to sell, flat-buyer agreements, joint development agreements, area-sharing agreements, revenue or profit-sharing agreements. These agreements assume various forms depending on the nature of agreement between counterparties. One of the most critical areas of subjectivity pertains to revenue recognition in ‘under-construction’ projects.

Real estate transactions - what drives subjectivity in revenue recognition?

In the absence of a specific Accounting Standard (AS) for recognition of income from real estate transactions, the complex nature of real estate transactions led to a wide disparity in revenue recognition across firms in the sector. Issues around revenue recognition arise because real estate developers often enter into agreements for construction/sale of real estate before the construction is completed. The bone of contention in accounting for such transactions is the identification of the applicable accounting standard. Whilst one view suggests that such transactions are construction contracts within the scope of AS7 (Construction Contract) and, hence, revenue should be recognised as construction progresses (under the percentage completion method), the contrary view is that the requirements of AS9 (Revenue Recognition) concerning the sale of goods should be applicable.

Significant divergence in revenue recognition practices

The erstwhile guidance note (GN) mandated real estate companies to use the percentage of completion (POC) method for the purpose of revenue recognition; however, it was silent on how developers should arrive at the POC and revenues thereafter. As a result, there was considerable divergence in the revenue recognition policies followed by different companies across the real estate sector.

Exhibit 5: Revenue recognition policies under the erstwhile GN - wide disparity Threshold

policy Minimum project sale

criteria Minimum collection

Land cost in POC calculation

DLF 30% None No policy Considered Godrej Properties 20% None No policy Considered

HDIL 100% NA NA Considered Indiabulls Real Estate 25% None No policy Not considered

Kolte Patil 20% None No policy Considered Mahindra Lifespaces

25% None Yes Considered

Oberoi Realty 20% None NA Not considered

Omaxe 30% None No policy Considered

Phoenix Mills Not considered

Peninsula Land Considered

Prestige Estates 20-30% None No policy No policy

Sunteck Realty 100% NA NA Considered

Unitech Considered

Source: Companies, Ambit Capital research

Real estate companies exercise subjectivity in revenue recognition

Subjectivity lies in identifying the applicable accounting standard (AS) for real estate transactions - should it be AS7 or AS9?

Earlier, the GN prescribed the Percentage of Completion (POC) method but left the specifics to interpretation

http://webambit.ambit.co/reports/Ambit_Strategy_AccountingThematic_22Nov2013.pdf

Real Estate


Accounting for land - further latitude Another area that contributes to significant accounting disparity amongst real estate companies is around accounting for land. Conventionally, for companies other than those engaged in real estate development, land is a fixed asset and is accounted as such. However, in the case of real estate companies, land is also a raw material, which makes its way gradually from the balance sheet to the P&L statement.

Accounting for land depends on proposed end-use

The accounting for land depends on the proposed end-use - on the one hand, residential projects treat land as inventory (in accordance with AS2) since such land is likely to be sold in the ordinary course of business, but on the other hand, commercial projects (where developers intend to let out the project on a lease) treat land as a fixed asset (in accordance with AS10), flowing through the gross block. Our discussions with auditors suggest that often, companies are undecided about the end-use at the time of land acquisition. Under such circumstances, developers often classify the land so acquired as a fixed asset; however, any subsequent re-classification can only be triggered by an external event. We believe that a bulk of the land acquisition transactions fall in this category (companies undecided on end-use), which translates into companies classifying land as a fixed asset at the time of acquisition and then transferring such land to stock-in-trade (within inventory).

Exhibit 6: Accounting for land across the lifecycle of a real estate project

Stage

Balance sheet entries P&L statement entries

Held for sale Held for lease Mix-use / undecided Held for sale Held for lease

Mix-use / undecided

Land acquisition

Inventory - Construction Work-in-Progress (+ve)

Fixed assets - Capital Work-in-Progress (+ve)

Fixed assets - Capital Work-in-Progress (+ve) Capitalised Capitalised Capitalised

Cash (-ve) Cash (-ve) Cash (-ve)

Development / construction (prior to revenue recognition being triggered)

Inventory - Construction Work-in-Progress (+ve)

Fixed assets - Capital Work-in-Progress (+ve)

Fixed assets - Capital Work-in-Progress (-ve)

Capitalised Capitalised Capitalised Cash (-ve) / Customer advances (+ve)

Cash (-ve) Inventory - Construction Work-in-Progress (+ve)

Cash (-ve)

Development / construction (once revenue recognition is triggered)

Inventory - Construction Work-in-Progress (-ve)

Fixed assets - gross block (+ve)


Cost of Sales - Construction costs

Depreciation Cost of Sales - Construction costs

Cash (+ve) / Debtors (+ve)

Capital Work-in-Progress (-ve)

Cash (+ve) / Debtors (+ve) Revenue Revenue Revenue

Sale is completed (risks and rewards are transferred)


Fixed assets - gross block (+ve)


Cost of Sales - Construction costs

Depreciation Cost of Sales - Construction costs

Cash (+ve) Cash (+ve) Cash (+ve) Revenue


Although developers are not always certain of the end-use at the time of land acquisition, land has two proposed end-uses. When “held for sale”, land is treated as inventory (AS2); when “held for lease”, land is treated as a capital asset (AS10)

Real Estate


Accounting for land as inventory - too many cost categories loaded up

The carrying value of land, when treated as inventory, is lower of cost or the net realisable value (NRV). Given that developers expect to earn a positive return on their operations, the expected NRV is often typically higher than cost. However, there exists wide disparity in cost categories that are loaded up to the carrying cost of inventory on the balance sheet. In most instances, companies are fairly ambiguous about the cost components that are included in the carrying cost of inventory.

Exhibit 7: Accounting for land as inventory - the myriad alternatives in practice

Company Components of cost Method of valuation

Ashiana Housing Ltd. Direct materials, labour and project-specific direct and indirect expenses First-in-First-out

DLF Ltd.

Land (including development rights) acquisition cost, borrowing costs, estimated Internal development costs, external development charges, construction costs, overheads, borrowing cost, development/construction materials

Not disclosed

Godrej Properties Ltd. Cost of land, premium for development rights, construction costs, allocated interest and expenses incidental to the projects undertaken by the company.

Not disclosed

Housing Development & Infrastructure Ltd. Cost of land, land development rights, materials, services, borrowing costs, acquisition of tenancy rights and other related overheads. First-in-First-out

Hubtown Ltd.

Costs incurred upto the completion of the project viz. cost of land/rights, value of floor space index (FSI), materials, services and other expenses (including borrowing costs) attributable to the projects. Cost formula used is average cost.

Average cost

Mahindra Lifespace Developers Ltd. Cost of land, premium for development rights, construction costs and allocated interest and expenses incidental to the projects undertaken by the company.

Weighted average cost

Oberoi Realty Ltd. Cost of land, development rights, rates and taxes, construction costs, borrowing costs, other direct expenditure, allocated overheads and other incidental expenses.

Not disclosed

Omaxe Ltd. Cost of land, materials, construction, services, borrowing costs and other overheads related to projects.

Average cost

Peninsula Land Ltd.

All costs directly related to the project and other expenditure as identified by the management, which are incurred for the purpose of executing and securing the completion of the project (net off incidental recoveries/receipts) up to the date of receipt of occupancy certificate from the relevant authorities.

Not disclosed

Phoenix Mills Ltd. All costs directly related to the project and other expenditure as identified by the management, which are incurred for the purpose of executing and securing the completion of the project (net of incidental recoveries/receipts).

Not disclosed

Prestige Estate Projects Ltd. Aggregate of land cost, materials, contract works, direct expenses, provisions and apportioned borrowing costs (net of material scrap receipts).

Not disclosed

Puravankara Projects Ltd. Cost of land, construction related overhead expenditure, borrowing costs and other net costs incurred during the period of development. Not disclosed

Sobha Developers Ltd. Direct expenditure related to construction activity and other expenditure (including borrowing costs) during the construction period. Not disclosed

Sunteck Realty Ltd. Land acquisition cost (including development rights) and initial development cost and direct expenditure related to construction activity. Not disclosed


Land not meant for self-occupation to be classified as “Investment Property”

It is worth highlighting that real estate developers very rarely report details regarding the movement of inventory in their annual reports (although companies are mandated to report the movement in inventory under the revised Schedule VI balance sheet format). Also, Schedule VI mandates companies to classify land which is not meant for self-occupation (applicable to all real estate companies) under the “Investment Property” category within non-current investments although most developers are not yet following this classification.

Too much ambiguity exists in the categories of costs that are loaded into the cost of land, resulting in over-capitalisation

Real estate companies are mandated to classify land in the “Investment Property” category

Real Estate


Impairment in estimated value of land is not carried out transparently

More importantly, when treated as inventory, any impairment in the estimated costs is not routed through the P&L but adjusted directly against the inventory balance (in projects where revenue recognition is not triggered) or adjusted in the percentage of completion (POC) component for the project (where revenue recognition is triggered).

For instance, if the original cost of a project was estimated at `100 and the actual cumulative cost incurred on the project was at `60, the POC method would imply revenue recognition of 60% of the estimated revenues. However, during the following year, if the cost incurred on the project is `30 (taking the cumulative cost incurred on the project to `90) and the firm believes that a further `60 needs to be incurred to complete the project (implying total project cost at `150), the POC method would imply that revenue recognition remains at 60%.

This is especially the case when unreasonable estimates of unusual cost categories are loaded up to the cost of inventory (cost of land including development rights and cost of construction) that is carried on the balance sheet. It is worth highlighting that firms have often significantly under-estimated as well as over-estimated project costs. For instance, firms often resort to write-offs after having inflated the carrying cost of inventory with unconventional categories of costs. On the contrary, under-estimation of project costs results in aggressive revenue recognition (since the 25% threshold for revenue recognition is achieved earlier on a lower denominator), which is followed by absorption of significant cost escalation thereafter.

Impairment in the carrying value of land is not transparently routed through the P&L but directly adjusted against the balance on the balance sheet

Over-estimating the cost of land results in impairment having to be written off; under-estimating the cost of land results in the firm having to absorb significant cost escalation thereafter

Real Estate


Revised guidance note (GN) streamlines revenue recognition yet not watertight In order to achieve consistency in revenue recognition norms, the Institute of Chartered Accountants of India (ICAI) issued a revised GN in February 2012, which was applicable for all real estate projects commencing after 1 April 2012. Whilst the revised guidance note prescribes a set of uniform threshold criteria for companies to begin recognising revenues from a project, our discussions with several practising auditors suggest that the revised GN is not yet watertight and highlight several transitional issues.

The revised GN applies to all real estate projects commencing after 1 April 2012 and projects in which revenues are being recognised for the first time on or after 1 April 2012. The revised GN covers different types of real estate transactions such as:

Sale of plots of land with or without development;

Utilisation and transfer of development rights;

Redevelopment of existing buildings and structures; and

Joint development agreements (JDAs).

The revised GN prescribes the following conditional criteria for real estate companies to begin recognising revenues from a project under the POC method:

All critical approvals that are necessary for project commencement have beenobtained;

At least 25% of the estimated construction and development cost (excluding thecost of land) has been incurred;

At least 25% of the estimated project revenues has been secured by bindingcontracts; and

At least 10% of the estimated revenues have been realised on each contract as ofthe date of reporting.

Of the above parameters, in practice, obtaining all critical approvals and incurring 25% of the estimated costs are the critical activities within any project, since the other two activities (securing 25% of the estimated project revenues through contracts AND collecting 10% of the estimated revenues) have a ‘total float’.

Still leaves room for subjective judgment

Whilst the revised guidance note is far more elaborate and specific in terms of prescribing a uniform threshold for companies to begin recognising revenue from a project, our discussions with several practising auditors suggest that the revised GN is not yet watertight. For instance, an area where real estate companies tend to exercise subjectivity is around what constitutes ‘critical approvals’. Developers often begin recognising revenues from sale of units on the 10th floor even when they have only obtained a partial commencement certificate (say, 5 floors) in a multi-storeyed tower. This is especially true in properties in the National Capital Region (NCR) and units that are sold to self-funded buyers (buyers who do not opt for a bank loan).

Revised GN a prescription, not mandatory on real estate companies

Whilst most listed real estate companies claim to comply with the revised GN in their FY13 Annual Report, this practice is not being followed across all projects of a listed entity, since a GN is only recommendatory in nature and not an accounting standard by itself. As a result, despite the revised guidance note being in force since 1 April 2012, Sunteck Realty (SRIN) and HDIL, both listed developers, continue to recognise revenues under the project completion method. Similarly, the revised GN prescribes minimum 10% collections on each contract as a pre-condition for revenue recognition; however, companies often aggregate collections from a project and hence, end up recognising revenues aggressively.

The revised GN prescribes four project-related criteria to be fulfilled for revenue recognition to be triggered

Despite the uniform criteria being prescribed, the revised GN is not watertight and still leaves plenty of scope for subjective judgment

Since the revised GN is not yet an Accounting Standard, companies are not mandated to follow it

Real Estate


Exhibit 8: Illustrative example of change in revenue recognition policies since the issuance of the revised guidance note

Company Annual Report - FY12 Annual Report - FY13*

DLF Ltd.

Revenue from constructed properties, other than SEZ projects, is recognised on the percentage of completion method. Total sale consideration as per the duly executed agreement to sell/application forms (containing salient terms of agreement to sell), is recognised as revenue based on the percentage of actual project costs incurred thereon to total estimated project cost, subject to such actual cost incurred being 30% or more of the total estimated project cost. Project cost includes cost of land, cost of development rights, estimated construction and development cost, borrowing cost of such properties.

With effect from April 1, 2012 in accordance with the Revised Guidance Note issued by the Institute of Chartered Accountants of India (ICAI) on “Accounting for Real Estate Transactions (Revised 2012)”, the company revised its Accounting Policy of revenue recognition for all projects commencing on or after April 1, 2012 or project where the revenue is recognised for the first time on or after the above date. As per this Guidance Note, the revenue has been recognised on the percentage of completion method provided all of the following conditions are met at the reporting date. (i) at least 25% of estimated construction and development costs (excluding land cost) has been incurred; (ii) at least 25% of the saleable project area is secured by the Agreements to sell/application forms (containing salient terms of the agreement to sell); and (iii) at least 10% of the total revenue as per agreement to sell are realised in respect of these agreements.

Godrej Properties Ltd.

The company is following the ‘Percentage of Completion Method’ of accounting. As per this method, revenue from sale of properties is recognised in the Statement of Profit and Loss in proportion to the actual cost incurred as against the total estimated cost of projects under execution with the company on transfer of significant risk and rewards to the buyer. If the actual project cost incurred is less than 20% of the total estimated project cost, no income is recognised in respect of that project in the relevant period.

Effective 1 April 2012, in accordance with the ‘Guidance Note on Accounting for Real Estate Transactions (Revised 2012)’ (Guidance Note), all projects commencing on or after the said date or projects which have already commenced, but where the revenue is recognised for the first time on or after the above date, construction revenue on such projects have been recognised on the percentage of completion method provided the following thresholds have been met: (a) All critical approvals necessary for the commencement have been obtained; (b) The expenditure incurred on construction and development costs is not less than 25% of the total estimated construction and development costs; (c) At least 25% of the saleable project area is secured by contracts or agreements with buyers; and (d) At least 10% of the agreement value is realised at the reporting date in respect of such contracts and it is reasonable to expect that the parties to such contracts will comply with the payment terms as defined in the contracts.

Mahindra Lifespace Developers Ltd.

Income from real estate sales is recognised on the transfer of all significant risks and rewards of ownership to the buyers and it is not unreasonable to expect ultimate collection and no significant uncertainty exists regarding the amount of consideration. However if, at the time of transfer substantial acts are yet to be performed under the contract, revenue is recognised on proportionate basis as the acts are performed, i.e. on the percentage of completion basis. Revenues from real estate projects are recognised only when the actual project costs incurred are at least 25 % of the total estimated project costs including land and when at least 10% of the sales consideration is realised.

In accordance with the Guidance Note on Accounting for Real Estate Transactions (Revised 2012), in case of projects commencing on or after 1 April 2012 or in case of projects which have already commenced but where revenue is being recognised for the first time on or after 1 April 2012, revenues will be recognised from these real estate projects only when: (i) the actual construction and development cost incurred is at least 25% of the total construction and development cost (without considering land cost) and (ii) when at least 10% of the sales consideration is realised and (iii) where 25% of the total saleable area of the project is secured by contracts of agreement with buyers.

Oberoi Realty Ltd.

The company follows the percentage of project completion method for its projects. Under this method, the company recognises revenue in proportion to the actual cost incurred as against the total estimated cost of the project under execution subject to completion of construction work to a certain level depending on the type of the project.

(a) Project for which revenue is recognised for the first time on or after 1 April 2012 The Institute of Chartered Accountants of India has issued Guidance Note on Accounting for Real Estate Transactions (Revised 2012) in connection with the revenue recognition for a real estate project which commences on or after 1 April 2012 and also to real estate projects which have already commenced but where revenue is being recognised for the first time on or after 1 April 2012. In this scenario, the company recognises revenue in proportion to the actual project cost incurred (including land cost) as against the total estimated project cost (including land cost), subject to achieving the threshold level of project cost (excluding land cost) as well as area sold, in line with the Guidance Note and depending on the type of project. (b) Project for which revenue recognition has commenced prior to 1 April 2012 In this scenario, the company recognises revenue in proportion to the actual project cost incurred (excluding land cost) as against the total estimated project cost (excluding land cost) subject to completion of construction work to a certain level depending on the type of the project.

Real Estate


Company Annual Report - FY12 Annual Report - FY13*

Parsvnath Developers Ltd.

Revenue from real estate projects including integrated townships is recognised on the ‘Percentage of Completion Method’ of accounting. Revenue is recognised, in relation to the sold areas only, on the basis of percentage of actual cost incurred thereon including land as against the total estimated cost of the project under execution subject to such actual cost being 30% or more of the total estimated cost.

In accordance with Revised Guidance Note issued by the Institute of Chartered Accountants of India (ICAI), on ‘Accounting for Real Estate Transactions (Revised 2012)’, revenue recognition for all real estate projects commencing on or after 1 April 2012 or where the revenue is recognised first time on or after 1 April 2012, revenue is recognised on percentage of completion method if: (a) actual construction and development cost (excluding land cost) incurred is 25% or more of the estimated cost, (b) At least 25% of the saleable project area is secured by contracts or agreements with buyers and (c) At least 10% of the total revenue as per sales agreement or any other legally enforceable document is realised as at the reporting date. However, there was no such project during the year.

Peninsula Land Ltd.

The company is in the business of Property Development. Revenue from sale of properties under construction is recognised on the basis of actual bookings done (provided the significant risks and rewards have been transferred to the buyer and there is reasonable certainty of realisation of the monies) proportionate to the percentage of physical completion of construction/ development work as certified by the architect.

During the year the company adopted the guidelines prescribed by the ‘Guidance note on Accounting Treatment for real estate transactions (Revised 2012)’ issued by the Institute of Chartered Accountants of India, inter alia , with regard to thresholds for commencement of revenue recognition for projects and the basis for determining percentage of completion. The adoption of the said guidelines has no significant effect in the revenues and costs recognised for projects during the year.

Phoenix Mills Ltd.

Revenue from sale of properties under construction is recognised on the basis of Registered Sale Agreements (provided the significant risk and rewards have been transferred to the buyer and there is reasonable certainty of realisation of the monies), on the basis of the percentage completion method, determined based on the physical proportion of the work completed, as certified by the company’s technical personnel after the construction work has progressed significantly.

Revenue from the sale of properties under construction is recognised on the basis of the Sale Agreements (provided the significant risk and rewards have been transferred to the buyer and there is reasonable certainty of realisation of the monies), proportionate to the percentage of physical completion of construction/development work, as certified by the company’s technical personnel.

Prestige Estate Projects Ltd.

Revenue from each Real Estate Developmental Projects related to real estate vested with the company, is recognised based on the ‘Percentage Completion Method’. The percentage completion method is applied on a cumulative basis in each accounting period to the current estimates of contract revenue and contract costs, when the stage of completion of each project reaches a significant level, which is estimated in the range of 20% to 30% of the total estimated costs of the project depending on the size of the project.

Revenue from real estate developmental projects under development is recognised based on the ‘Percentage Completion Method’. The Percentage Completion Method is applied when the stage of completion of the project reaches a reasonable level of development. For projects that commenced on or after 1 April 2012 or where revenue on a project is being recognised for the first time on or after that date, the threshold for ‘reasonable level of development’ is considered to have been met when the criteria specified in the Guidance Note on Accounting for Real Estate Transactions (Revised 2012) issued by the Institute of Chartered Accountants of India are satisfied, i.e., when: (a) All critical approvals necessary for commencement of the project have been obtained. (b) The expenditure incurred on construction and development costs is not less than 25 % of the construction and development costs. (c) At least 25% of the saleable project area is secured by contracts or agreements with buyers. (d) At least 10 % of the total revenue as per the agreements of sale or any other legally enforceable documents are realised at the reporting date in respect of each of the contracts and it is reasonable to expect that the parties to such contracts will comply with the payment terms as defined in the contracts. For projects that commenced prior to 31 March 2012 and where sales have occurred prior to that date ‘reasonable level of development’ is considered to have occurred when the project costs (excluding land cost) incurred is in the range of 20% to 30% of the total estimated costs of the project (excluding land cost). For computation of revenue, the stage of completion is arrived at with reference to the entire project costs incurred including land costs, borrowing costs and construction and development costs as compared to the estimated total costs of the project.

Sunteck Realty Ltd.

The Group follows completed project method of accounting. Direct/Allocable expenses incurred during the year are debited to work-in-progress account. The revenue is accounted for as and when the significant risks and rewards of ownership of the units in real estate are passed or deemed to have passed to the buyer and the projects get completed or substantially completed, to the extent that the economic benefits will flow to the Group and the revenue can be reliably measured.

The Group follows completed project method of accounting. Direct/Allocable expenses incurred during the year are debited to work-in-progress account. The revenue is accounted for as and when the significant risks and rewards of ownership of the units in real estate are passed or deemed to have passed to the buyer and the projects get completed or substantially completed, to the extent that the economic benefits will flow to the Group and the revenue can be reliably measured.

Source: Companies, Ambit Capital research; Note: * in addition to revenue recognition policy disclosed in the respective 2011-12 Annual Reports

Real Estate


Simultaneously employing two accounting policies on revenue recognition

As can be seen from the above exhibit, consequent to the issuance of the revised GN, most real estate companies are currently following two policies simultaneously. The revised GN is applied to all real estate projects that commenced on or after 1 April 2012 and also to projects that have already commenced but where revenue is recognised for the first time on or after 1 April 2012. On the other hand, the erstwhile guidance note is still applied to all the prior projects.

IFRS mandates revenue recognition under project completion method

Given the atypical nature of the industry, whilst the ICAI has already issued Guidance Notes to deal with the accounting policies prevailing in the real estate sector, the international experience on standardised accounting is no different. The International Accounting Standards Board (IASB) issued an interpretation (IFRIC 15), Agreement for Construction of Real Estate, to deal with accounting in real estate companies. In general, the criteria laid down in IFRIC 15 make it difficult to recognise revenues merely based on an agreement to sell.

Dual agreement helps bypass IFRS norms

It is worth highlighting that in the formulation of Indian accounting standards (IND-AS), IFRIC 15 was rejected, as under IFRS, construction contracts were not applicable to real estate developers. As a result, developers (especially those that have a large proportion of overseas funding and hence, need to comply with IFRS norms) enter into two separate contracts—one contract for the sale of land and the other for development on such land—even for residential flats. Under this scenario, income from the first contract (sale of land) is recognised upfront (in line with AS9) whilst the income from the second contract is recognised under the POC method (consistent with AS7).

JDAs – ‘one size fits all’ approach inappropriate

Although the revised GN mentions joint development agreements (JDAs) within its scope, there is no specific guidance or illustration to capture accounting for JDAs. JDAs typically entail the plot owner granting the real estate developer permission to construct a building; in return, the developer is compensated with part-ownership of the building or some other pre-decided form of monetary return. Our discussions with senior executives at the Big-4 as well as practising auditors suggest that every JDA is unique in its structure, terms and conditions. Given the wide diversity of such agreements, a ‘one size fits all’ approach is inappropriate to deal with JDAs.

Most real estate companies are currently following two policies simultaneously

No specific guidance in the revised GN for JDAs

Real Estate


Related party transactions (RPTs) galore The top-three categories of RPTs account for c.70% of the total related party transactions on average. Most categories of RPTs employed by real estate developers are merely ways of funding group entities, a large proportion of which do no earn interest and tend to get reversed during the year, as reflected in the fact that the end-period outstanding balances are typically less than 20% of the maximum outstanding balances.

Most real estate companies are characterised by concentrated ownership, with half of the 21 companies in this analysis having promoter ownership in excess of two-thirds of the total shareholding and only 4 companies having promoter shareholding below 50%. This often manifests itself in complex ownership structures with a labyrinth of layered subsidiaries, joint ventures (JVs) and associate entities.

Real estate developers in India are regulated under the Land Ceiling Act, 1976, which prescribes a ceiling on the area of land that a single company can own, which has spawned the multitude of SPVs for the purpose of land acquisition.

Exhibit 9: Layered entities - number of related parties as of March 2013

Subsidiaries Joint

ventures Associates Other related

parties Remarks

Anant Raj Ltd. 96 11 47 Subsidiaries include 20 step-down subsidiaries

DB Realty Ltd. 20 17 4 37 Other related parties include entities over which key management personnel exercise significant control

DLF Ltd. 266 12 17 110 Other related parties includes entities over which key management personnel exercise significant control

Godrej Properties Ltd. 15 36 5 83 Other related parties include other listed and unlisted entities within the Godrej Group and private equity investment firms

Housing Development & Infrastructure Ltd.

10 2 1 3 Other related parties include enterprises significantly influenced and controlled by key management personnel

Indiabulls Real Estate Ltd. 239 1 2 Other related parties include subsidiaries of associate

Kolte Patil Developers Ltd 14 4 4

Includes limited liability companies and partnership firms

Mahindra Lifespace Developers Ltd. 12 2 1 Includes jointly controlled entities

Oberoi Realty Ltd. 8 5

Joint ventures refer to jointly controlled entities / assets

Omaxe Ltd. 94 1

Parsvnath Developers Ltd. 19 3 4

Subsidiaries include 4 step-down subsidiaries; joint ventures include 1 JV belonging to a step-down subsidiary

Peninsula Land Ltd. 23 3 5 8 Includes 19 step-down subsidiaries; other related parties includes 7 step-down entities

Phoenix Mills Ltd. 21 13 7 Prestige Estate Projects Ltd. 21 4 5 14 Other related parties include partnership firms

Puravankara Projects Ltd. 20 4 8 Sobha Developers Ltd. 10

72 Includes 6 step-down subsidiaries

Sunteck Realty Ltd. 10 10 1

Unitech Ltd. 243 14 2 4 Subsidiaries include 227 wholly-owned subsidiaries; other related parties include entities owned or significantly influenced by key management personnel


RPTs could be used for disproportionate transfer of wealth

One of the most common ownership structures involves pyramids and cross-holding of shares, which contributes to a significant wedge (difference between cash and control rights) between group companies. This presents controlling shareholders with arbitrage opportunities to transfer wealth between group entities (from one in which the controlling shareholder or promoter has lower cash flow rights to another in which the promoters’ rights are higher) through related party transactions (RPTs).

SPVs floated by developers to comply with the Land Ceiling Act

Differences in cash and control rights between group companies provide controlling shareholders (read: promoters) with arbitrage opportunities to move resources

Real Estate


RPTs - occasionally genuine but consistently misused

As captured in our real estate accounting thematic, ‘Mirror, Mirror on the Wall’ dated 26 July 2011, RPTs can take various forms, especially given the number of special purpose vehicles (SPVs) that are floated by real estate companies for the purchase of land from the market (further details on page 26 of this note).

There are many genuine reasons for the existence of related party transactions. A few such reasons are highlighted below:

Project-specific subsidiaries (or SPVs) are floated to segregate the risk-reward dynamics of one project from that of others; this is an especially popular structure with capital providers who prefer funding specific projects rather than taking exposure at a listed entity level.

Prior to a firm listing on the BSE/NSE, transactions are carried out to sell stake in a joint venture to an external party for a specific project to avoid sharing the private group’s consolidated accounts with the JV partner (this is also a manner of funding).

Whilst there are many genuine reasons for group structures and transactions between group companies, there is no denying that group structures have also been used by controlling shareholders to treat minority shareholders inequitably, often resulting in a disproportionate transfer of wealth to the controlling shareholders.

Ideally, the operating cycle in a real estate project (from commencement to transfer of risk) should revolve around a single entity that is responsible for land acquisition, construction, marketing and sale/lease of properties such that cash flows can also be mapped in a straightforward manner, as illustrated in Exhibit 10 below.

Exhibit 10: An ideal real estate operational cycle


However, in the ‘real’ world, the existence of a large number of transactions between a company and its related parties including subsidiaries, JVs and associate companies makes the operating cycle complex and less transparent to analyse.

Exhibit 11: Possible complexities due to related party transactions - inflated costs and balance sheet


Given the evidence that has emerged over the past few years regarding the use (or misuse) of related party transactions to pull cash out of listed entities, investors should be careful about companies with:

Excessive number of related parties (normalised for scale of business);

Excessive funding of related parties (as a percentage of consolidated net worth); and

Excessive funding of related parties (as a percentage of total loans and advances).

At a very basic level, there can be two genuine reasons for related party transactions (RPTs):

(a) isolation of risks; and

(b) isolation of rewards

http://webambit.ambit.co/reports/Ambit_RealEstate_AccountingThematic_26July2011.pdf

Real Estate


Funding of related parties most frequent among RPTs

For the 21 companies in this exercise, we have mapped the three most frequently employed categories of RPTs (maximum contribution to the total RPTs). This analysis is based on the outstanding balance in the particular category as of March 2013.

Exhibit 12: Most prolific categories of related party transactions (RPTs) as of March 2013

RPT 1 RPT 2 RPT 3

Anant Raj Ltd. Loans and advances - subsidiaries Investments in subsidiaries Non-convertible debentures

DB Realty Ltd. Corporate guarantees Advance against purchase of shares

Loans given / deposits placed

DLF Ltd. Loans and interest receivable Advances received under agreement to sell Investments

Godrej Properties Ltd. Sale of units Investment in equity Inter-corporate deposit

HDIL Investment / redemption of debentures Advances for projects Loans / advances paid

Hubtown Ltd. Indiabulls Real Estate Ltd. Other payables Corporate guarantees Debtors

Kolte Patil Developers Ltd Investment in debentures Loans and advances given Preference share capital

Mahindra Lifespace Developers Ltd. Finance given Inter-corporate deposits Oberoi Realty Ltd. Loans given Deposit received Rent income

Omaxe Ltd. Loans and advances receivable Inter-corporate deposits Trade payables

Parsvnath Developers Ltd. Advances for land purchase Borrowings Other payables

Peninsula Land Ltd. Loans to associate companies Investment in debentures

Phoenix Mills Ltd. Loans and advances given Investment in equity shares Deposits given

Prestige Estate Projects Ltd. Inter-corporate deposit payable Loans and advances recoverable Guarantees & collaterals provided

Puravankara Projects Ltd. Guarantees Loans given / advances paid Loans taken / advances received

Sobha Developers Ltd. Land advance Receivables Advances recoverable in cash

Sunteck Realty Ltd. Preference shares Current investment Loans and advances

Unitech Ltd. Investment in debentures Advances received Remuneration paid


It is worth highlighting that the top-three categories of RPTs account for ~70% of the total related party transactions on average. As can be seen from the above exhibit, a bulk of the categories of RPTs employed by real estate developers are merely ways of funding the related party entities. As loans and advances attract significant investor scrutiny, firms have resorted to other modes of providing capital through investment in equity or quasi-equity instruments and tunnelling.

Our analysis shows that a large proportion of RPTs (especially the likes of inter-corporate deposits) does not earn interest and tend to get reversed during the year. From the limited number of companies that disclose details around end-year outstanding balances as well as maximum outstanding balances during the year, we observe that the end-year outstanding balances are less than 20% of the maximum outstanding balances in a majority of the RPTs, implying year-end window dressing.

Going forward, with the notification of over 280 sections under the Companies Act 2013 (more details on pages 27 and 28 of this note), we expect real estate developers to find it progressively difficult to engage in RPTs without an adequate explanation that justifies the rationale for such transactions.

Most RPTs are merely different modes of funding related parties including investments in equity/quasi-equity instruments

Majority of RPTs do not earn interest and reverse themselves during the year, implying year-end window dressing

Real Estate


Category mix and leverage suggest wilful diversion of funds Our analysis of the category mix (asset classes within the real estate sector) and firm-level leverage suggests a significant diversion of debt towards land acquisition. As residential formats account for ~80% of the Indian real estate market and given the self-financing economics of residential real estate (developers can generate pre-sales at the launch/pre-launch stage that should help cover the bulk of the working capital requirements), we find the sector-level leverage intriguing. Hence, we believe that a large proportion of construction finance (working capital loans for under-construction projects) raised by developers for residential projects is diverted towards either land acquisition or stalled projects that are starved for capital.

It is worth highlighting that Indian banks are not allowed to lend to real estate companies for the purpose of land acquisition. However, given the regulatory arbitrage (around exposure limits, extent of scrutiny, and stricter end-user classification) between banks and NBFCs lending to real estate companies, the NBFC route is conveniently exploited. In fact, we argue that a significant proportion of what appears to be non-bank debt to real estate companies is also bank lending to the sector, albeit in an indirect manner.

Exhibit 13: Regulatory arbitrage between bank lending and non-bank lending


Based on our analysis (captured in Exhibit 14), we argue that real estate companies have only two primary sources of funding: banks and High Net-worth Individuals (HNIs and ultra HNIs).

Exhibit 14: Major channels of real estate funding in India

Pre-2005 2005-2007 2008-2009 2010-2011 2012-2013

Offshore listing Offshore listing Offshore listing Offshore listing Offshore listing

IPO IPO IPO IPO IPO

QIP QIP QIP

PE funds PE funds PE funds PE funds

ECBs ECBs ECBs ECBs

NBFC lending NBFC lending NBFC lending NBFC lending NBFC lending

Bank lending Bank lending Bank lending Bank lending Bank lending

Private lending Private lending Private lending Private lending Private lending

Source: JLL publications; Note: Cells highlighted in BOLD indicate very high levels of activity in that channel during the period, cells highlighted in Red indicate average levels of activity in the channel during the period

With residential formats accounting for 80% of India’s real estate market, the reported aggregate sector-level leverage suggests diversion of construction finance towards land acquisition

Construction finance from banks remains the cheapest source of funds for real estate developers; however, relatively greater scrutiny of banks’ exposure limits and end-use monitoring of funds provide NBFCs with a significant regulatory arbitrage

Bank

Real estate company

Bank

Housing finance company (HFC)

Real estate company

Bank

Other NBFC

Real estate company

Sensitive sector - hence, greater regulatory

scrutiny

Relatively lower regulatory scrutiny leads

to arbitrage

Real Estate


As captured in the exhibit above, bank funding (direct) to the real estate sector has been sporadic. On the other hand, the NBFC channel and private lending channel have consistently seen high levels of activity nearly every year. This is reflective of the existing regulatory arbitrage between banks and NBFCs lending to real estate.

Banks are under far greater regulatory scrutiny from the Reserve Bank of India (RBI) on exposure to the real estate sector. In fact, bank exposure to commercial real estate (CRE) is mandatorily classified under sensitive sector exposure as part of banks’ statutory reporting. Another area that contributes to the regulatory arbitrage between banks and NBFCs lending to real estate companies is the prevalent laxity in end-user classification at NBFCs, where exposure to real estate is often camouflaged as MSME (Medium, Small and Micro industries) exposure or unsecured personal lending (whereby HNIs and ultra-HNIs leverage themselves to fund special purpose vehicles).

Given this regulatory arbitrage, banks find it easier to lend to real estate companies through intermediaries like NBFCs, as captured in Exhibit 13. Also, given the NBFC dependence on bank funding (80%), a large proportion of NBFC lending in Exhibit 14 is, in fact, disguised bank lending. It is worth highlighting that growth in bank lending to NBFCs has been consistently north of the headline credit growth being reported by the banking system and also does not undergo as much regulatory scrutiny as bank lending to other end-user industries (like infrastructure).

Exhibit 15: Growth in loan book - reflecting regulatory arbitrage

YoY growth trends (%) 2008-09 2009-10 2010-11 2011-12 2012-13 2013-14*

Non-food credit growth 16.8 21.3 16.6 13.3 14.8

Real estate

-0.3 5.8 15.6 11.9 9.2

Housing

7.7 19.3 12.3 14.0 17.6

Housing (priority sector)

10.5 10.5 10.7 0.3 10.2

NBFCs

14.8 62.3 23.9 12.6 17.6

HDFC Ltd 16.7 15.0 19.6 20.3 20.7 17.0

LIC Housing Finance 26.2 37.6 34.2 23.5 23.4 17.0

Source: RBI, Companies, Ambit Capital research; Note: * 2013-14 indicates YoY growth as of Dec’13

However, it is also worth highlighting that the statutory auditors, in every case, certify the following (or a variant of this version) in the listed companies’ Annual Reports:

In our opinion and according to the information and explanations given to us, the term loans have been applied for the purposes for which they were obtained/secured.

According to the information and explanations given to us and on an overall examination of the balance sheet of the company, we report that no funds raised on short-term basis have been used for long-term investment.

Whilst the first certification amounts to covenant compliance (this is especially critical for banks to monitor whether the borrower is fulfilling the conditions under which the loans were granted), the second certification is a clean chit being given by an auditor to a firm that short-term funding is not being funnelled into creation of long-term assets (presumably land acquisition).

Our discussions with senior chartered accountants suggest that covenant compliance, although mandatory, is only offered in passing reference by banks. Checks around end-use or purpose compliance are nearly non-existent in the system, as auditors tend to treat these as mere check boxes that need to be ticked.

NBFCs are capitalising on regulatory arbitrage and fulfilling most incremental funding needs in the form of ‘last mile funding’

Statutory auditors, in nearly every case, certify purpose compliance and maturity matching (the fact that short-term funds are not being diverted towards creation of long-term assets)

Real Estate


Methodology We identify 21 real estate firms and categorise them into three separate buckets by market capitalisation. We use the following 12 accounting ratios, categorised into four buckets, to score the real estate firms based on their accounting quality.

Exhibit 16: Key categories of accounting checks

Category Ratios

P&L misstatement checks (1) CFO/EBITDA, (2) change in depreciation rate, and (3) miscellaneous expenses as a proportion of total expenses

Balance sheet misstatement checks (1) Cash yield, (2) debtors more than six months as a proportion of total debtors, and (3) contingent liability as a proportion of net worth

Cash pilferage checks (1) CWIP to gross block, (2) Cost of construction to construction work-in-progress, and (3) cumulative CFO plus CFI to median revenues

Audit quality checks (1) Audit fees as a proportion of standalone revenues, (2) audit fees as a proportion of total auditor remuneration, and (3) unaudited assets as proportion of consolidated assets


Whilst we have detailed the accounting ratios under each of these categories over the next few pages, we summarise our observations in Exhibit 17 below.

Exhibit 17: The final ‘realty’ check - across accounting metrics

Company P&L checks Balance sheetchecks

Cash pilferage checks Audit quality checks Overall score


DLF

Oberoi Realty


Unitech

Godrej Properties

Phoenix Mills

Sobha Developers


Omaxe



Anant Raj

Sunteck Realty





DB Realty

Peninsula Land

Hubtown

Ashiana Housing

Brigade Enterprises



Real Estate


I - P&L misstatement checks CFO/EBITDA: This ratio assesses a company’s ability to convert EBITDA (which can be relatively easily manipulated) into operating cash flows (more difficult to manipulate). We evaluate the extent to which these companies are cash-generative based on the ratio of cumulative operating cash flows (post working capital changes) to cumulative EBITDA over the six-year period of FY08-13. We penalise seven companies that have not generated positive operating cash flows even on a cumulative basis over the six-year period. We find that larger companies are significantly better at cash conversion as compared to the mid-sized and smaller real estate companies.

Going forward, with many real estate firms beginning to comply with new revenue recognition norms (in accordance with the revised GN), cash flows from a project are likely to precede the earnings from a project. However, for companies with a portfolio of projects, we believe that this ratio will continue reflecting a firm’s cash-generative ability as long as revenue recognition does not significantly lag cash collections.

Change in depreciation rate: Given the prevalent practice of real estate companies overcapitalising expenses, we calculate change in depreciation rates for each of the past six years (FY08-13). Companies with the smallest change in depreciation rate receive the best score. The rationale is to penalise companies that witness undue volatility in their depreciation rate on a YoY basis, implying volatility in the underlying asset base (this happens on account of over-capitalisation).

Miscellaneous expenditure as proportion of total costs: We use ‘miscellaneous expenses’ as reported by companies (not categorised under specific expense head) in their annual reports as a percentage of their total costs. A high ratio implies that many cost categories are unclassified and get loaded onto ‘miscellaneous expenses’. We use a six-year median for this measure.

Exhibit 18: P&L misstatement checks - small-sized companies better off than mid-sized companies

Company CFO / EBITDA Change in depreciation rate

Miscellaneous expenses (% of total expenses)

Overall score


DLF

Oberoi Realty


Unitech

Godrej Properties

Phoenix Mills

Sobha Developers


Omaxe



Anant Raj

Sunteck Realty





DB Realty

Peninsula Land

Hubtown

Ashiana Housing

Brigade Enterprises



Real Estate


II - Balance sheet misstatement checks Cash yield: This ratio is calculated as the yield earned on cash, investments and deposits. A low ratio could be a cause for concern, as it could mean that either the balance sheet is being inflated or that the cash is being mismanaged. We use a six-year median for this measure.

Debtors greater than six months as a proportion of total debtors: We have conventionally considered provisioning prudence as one of the accounting metrics in our analysis (as measured by provision for doubtful debtors as a proportion of debtors greater than six months). For instance, it is considered prudent to provide completely towards debtors greater than six months (just to put this in perspective, in the banking context, banks are mandated to provide for accounts that are overdue by over three months). However, some real estate companies make a further judgmental distinction within this, between good and doubtful debtors. As a result, real estate companies only provide towards debtor balances that they classify as doubtful within their books of accounts (which is fraught with a subjective bias).

To eliminate this subjective bias, we use an alternate ratio measuring ageing debtor balances (over six months) as a proportion of total debtors. A high ratio raises the spectre of aggressive revenue booking significantly ahead of collections. We use a six-year median for this measure.

Contingent liabilities as a proportion of net worth: This metric measures off-balance-sheet liabilities. A high ratio raises concerns on the balance sheet strength of a firm in the event that the contingent liabilities materialise. Given the nature of capital structures prevalent in the real estate sector (equity infused in step-down subsidiaries with assured returns), we include guarantees and capital commitments whilst arriving at the contingent liabilities. We use a six-year median for this measure.

Exhibit 19: Balance sheet misstatement checks

Company Cash yield Debtors over 6m Contingent liabilities Overall score


DLF

Oberoi Realty


Unitech

Godrej Properties

Phoenix Mills

Sobha Developers


Omaxe



Anant Raj

Sunteck Realty





DB Realty

Peninsula Land

Hubtown

Ashiana Housing

Brigade Enterprises


Source: Companies, Ambit Capital research; Strong, Moderate, Weak

Real Estate


III - Cash pilferage checks CWIP to gross block: We calculate the proportion of capital work-in-progress to gross block for each of the last six years and take a median. A high ratio is penalised; the idea is to punish firms that show consistently high CWIP relative to gross block, as this may indicate either unsubstantiated capital expenditure or deferred depreciation expense. We use a six-year median for this measure.

Cost of construction to construction work-in-progress: As highlighted on pages 7 and 8 of this note (Accounting for land), land held for sale is held as inventory and makes its way through the construction cost line item in the P&L. Using a six-year median, we evaluate how much of construction work-in-progress reflects cost of land (including development rights) and construction costs. A relatively low ratio suggests over-capitalisation of expenses (including estimated internal and external development costs), which should be expensed in the normal course of business. A low ratio also suggests possible direct write-downs (impairment/adjustments) from inventory (on the balance sheet), as a result of which a lower proportion is routed through the P&L statement.

Cumulative CFO plus CFI to median revenues: We compute this ratio by summing up six-year cumulative cash flow from operations and six-year cumulative cash flows from investing activities and normalise this to a firm’s six-year median revenues. Given that a real estate company’s return profile is typically driven by the quality of its investments (or capital employed), this ratio helps assess how efficiently a real estate company is re-deploying its operating cash flows. The idea is to penalise firms, which over such a long period have failed to either generate positive operating cash flows or have significantly stretched themselves by over-investing.

Exhibit 20: Cash pilferage checks

Company CWIP-to-gross block

Construction costs to Inventory (land)

Free cash flows Overall score


DLF

Oberoi Realty


Unitech

Godrej Properties

Phoenix Mills

Sobha Developers


Omaxe



Anant Raj

Sunteck Realty





DB Realty

Peninsula Land

Hubtown

Ashiana Housing

Brigade Enterprises



Real Estate


IV - Audit quality checks Audit fees as a proportion of standalone revenues: We calculate standalone audit fees as a proportion of standalone revenues over FY08-13 and derive the median for this metric. Firms with a lower ratio receive a high score on this metric as we penalise firms that are overpaying their auditors relative to their scale. DLF, Omaxe, Sobha and Prestige rank amongst the best companies on this metric.

Audit fees as a proportion of total auditor’s remuneration: We derive the six-year median to measure the proportion of total auditor remuneration that has been paid out as audit fees. A low proportion suggests that the share of audit in the total business that the auditor derives from the firm is low and the auditor is compensated for services other than statutory audit.

Assets audited by non-statutory auditors as a proportion of total consolidated assets: Multiplicity of related parties and the magnitude of related party transactions portend possible diversion of cash away from the listed entity. We use a three-year median to assess the extent to which an auditor relies on information furnished by the management (auditors outside the statutory auditor and other unaudited financials of entities that are subsequently consolidated). The higher this ratio, the weaker is the audit framework given the extent to which these numbers fall outside the ambit of the audited consolidated numbers.

Exhibit 21: Audit quality checks

Company Audit fees Auditors’ remuneration

Scope of statutory audit Overall score


DLF

Oberoi Realty


Unitech

Godrej Properties

Phoenix Mills

Sobha Developers


Omaxe



Anant Raj

Sunteck Realty





DB Realty

Peninsula Land

Hubtown

Ashiana Housing

Brigade Enterprises



Cumulating scores: We cumulate scores across these 12 parameters to arrive at the final accounting score for each firm. Based on these parameters, we rank 21 firms on accounting quality in this exercise.

Real Estate


Valuation - a perspective Having compared these companies on a range of accounting metrics, we present a valuation approach underpinned on the cash conversion cycle and the adjusted net worth to identify undervalued stocks.

Critical valuation driver 1: Cash conversion cycle

Given that cash generation is the single most critical driver of valuation in real estate firms, we derive the cash conversion cycle for each of the past six years (FY08-13). We then use a six-year median as our first critical driver in this valuation approach. The higher the cash conversion cycle, the longer a developer needs working capital finance. Similarly, lower the cash conversion cycle, lesser the need for working capital finance and lesser the idle capital employed.

Critical valuation driver 2: Adjusted net worth

Given that the P/B multiple-based approach is often used as an alternative to DCF-based valuation (the ideal approach), we argue that it is critical to adjust a firm’s net worth for contingent liabilities, customer advances and unbilled revenues to derive a fair P/B multiple.

Since not all contingent liabilities devolve on the parent entity (some are genuine), we use a conditional adjustment factor on contingent liabilities to arrive at the adjusted net worth. The higher the contingent liabilities, higher the adjustment factor that we use to derive the adjusted net worth.

Exhibit 22: Deriving the adjustment factor for contingent liabilities

CL (% of NW) Adjustment factor (deduction

from NW)

Less than 10% of NW 10% of CL

10% - 30% of NW 20% of CL

Over 30% of NW 30% of CL

Source: Ambit Capital research; CL denotes Contingent Liabilities; NW denotes net worth

Methodology

In Exhibit 22, we eliminate four outliers (on the cash conversion cycle) and map the remaining real estate companies on consensus FY15 consolidated P/B multiple (on the X-axis) and the six-year median cash conversion cycle (in number of days) on the Y-axis. The size of the bubble denotes contingent liabilities (as a proportion of net worth).

Exhibit 23: Cash conversion cycle (in number of days) vs P/B multiple - Oberoi and Sobha cheaper than Prestige

Source: Companies, Bloomberg, Ambit Capital research; Note: X-axis denotes consensus FY14 P/B, Y-axis denotes the six-year median cash conversion cycle (in number of days) and the s i ze of the bubble denotes contingent l iabi l i ti e s (as a propor tion of ne t wor th)

Parsvnath

DB RealtyPeninsula Land

Hubtown


Kolte Patil

Oberoi Realty

Anant Raj

Prestige Estates

Sobha Developers

OmaxeMahindra Lifespace

Godrej Properties

DLF

Unitech Puravankara

-200

0

200

400

600

800

1,000

1,200

- 0.5 1.0 1.5 2.0 2.5 3.0

FY15 P/B

Ca

sh c

onve

rsio

n c

ycle

(n

um

ber

of

da

ys)

Deriving adjusted net worth

Company Adjusted NW (% of reported NW)

Anant Raj 92%

Ashiana Housing 131%

Brigade Enterprises 86%

DB Realty 100%

DLF 80%

Godrej Properties 118%

HDIL 115%

Hubtown 108%

Indiabulls Real Estate 121% Kolte Patil Developers 127%

Mahindra Lifespace Developers 102%

Oberoi Realty 116%

Omaxe 155% Parsvnath Developers 88%

Peninsula Land 99%

Phoenix Mills 105% Prestige Estate Projects 133%

Puravankara Projects 102%

Sobha Developers 97%

Sunteck Realty 426%

Unitech 87%

Source: Ambit Capital research NW denotes Net Worth

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Exhibit 24: Large-sized real estate companies

Source: Companies, Bloomberg, Ambit Capital research; Note: X-axis denotes consensus FY14 P/B, Y-axis denotes the six-year median cash conversion cycle (in number of days) and the size of the bubble denotes the contingent l iabi l i ti e s (as a propor tion of ne t wor th)

Exhibit 25: Mid-sized real estate companies

Source: Companies, Bloomberg, Ambit Capital research; Note: X-axis denotes consensus FY14 P/B, Y-axis denotes the six-year median cash conversion cycle (in number of days) and the s i ze of the bubble denotes the contingent l iabi l i ti e s (as a propor tion of ne t wor th)

Exhibit 26: Small-sized real estate companies

Source: Companies, Bloomberg, Ambit Capital research; Note: X-axis denotes consensus FY14 P/B, Y-axis denotes the six-year median cash conversion cycle (in number of days) and the s i ze of the bubble denotes the contingent l iabi l i ti e s (as a propor tion of ne t wor th)

DLF

Oberoi Realty

Prestige Estates

Unitech Godrej Properties

Phoenix Mills

Sobha Developers

-5,000

-4,000

-3,000

-2,000

-1,000

0

1,000

2,000

(0.50) - 0.50 1.00 1.50 2.00 2.50

FY15 P/B

Ca

sh c

onve

rsio

n c

ycle

(n

um

ber

of

da

ys)

Omaxe

Indiabulls

HDIL

Anant Raj

Sunteck Realty

Mahindra LifePuravankara

-1,000

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

(0.50) - 0.50 1.00 1.50 2.00 2.50

FY15 P/B

Ca

sh c

onve

rsio

n c

ycle

(n

um

ber

of

da

ys)

Parsvnath

DB Realty

Peninsula

Hubtown


Kolte Patil

-200

0

200

400

600

800

1,000

1,200

(0.50) - 0.50 1.00 1.50 2.00 2.50 3.00

FY15 P/B

Ca

sh c

onve

rsio

n c

ycle

(n

um

ber

of

da

ys)

The largest bubble in Exhibit 24 pertains to Unitech (58% of net worth)

The largest bubble in Exhibit 25 pertains to Indiabulls Real Estate (18% of net worth)

The largest bubble in Exhibit 26 pertains to Brigade Enterprises (75% of net worth)

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What can investors look forward to? In the following pages, we highlight the potential impact of key policy developments (likely catalysts) facing the real estate sector over the next 24 months:

Companies Act 2013

2014 General Elections

Real Estate Regulation and Development Bill 2013

Real Estate Investment Trusts (REITs)

Each of these four policy initiatives is likely to drive greater operational transparency in real estate companies. Given the extent of financial duress that a majority of the real estate companies find themselves under and a dangling carrot in the shape of potential fresh funding from REITs, our discussions with senior partners and senior executives across the Big-4 auditors suggest that developers are gradually undertaking a massive clean-up operation. Whilst this push towards transparency is partly driven by the impending beauty parade for fresh capital (to become REIT-friendly), experts also attribute this effort to their desire to comply with the revised guidance note and the Companies Act 2013.

As a result, some of the large developers are beginning to appoint one of the Big-4 in an advisory capacity to help align customer sales/payment contracts with the revised revenue recognition norms. These consulting assignments are aimed at structuring a developer’s payment/sales contracts with its clients so that the cash collections are closely aligned with the revised revenue recognition norms.

We analyse the impact of each of these policy measures on the real estate sector in chronological order (in the order in which these are likely to occur) from page 27 to page 33).

Exhibit 27: Key catalysts for the real estate sector over the next 18 months

Catalysts Key highlights Likely impact

Companies Act 2013

Consolidated financial statements

Likely to introduce greater disclosures and transparency into the sector

Consolidation of land-owning entities

Mandatory rotation of auditors

Restriction on related party transactions

2014 General Elections Streamlining of approvals Will influence supply-side variables ahead of the

demand-side variables Incremental job creation

Real Estate Regulation and Development Bill, 2013

Mandatory project registration Enhances developer accountability and safeguards customer interests

Standard project-related disclosures Ring-fencing of customer advances in escrow account (at least 70% purpose compliance)

Real Estate Investment Trusts (REITs)

Minimum REIT asset size at `10bn

Likely to restrict entry to serious and large players, broad-base the shareholding and enhance price discovery

Mandatory listing of REITs within 18 months of registration At least 90% of the REIT assets to be invested in completed and rent-generating assets At least 90% of the net income to be distributed to unit holders


The impending beauty parade for fresh funding drives a push towards greater transparency

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Companies Act 2013 - towards greater transparency yet onerous on real estate We expect the notification of over 280 sections under the Companies Act 2013 to raise the compliance burden on real estate companies, especially in terms of the nature and scope of related party transactions (RPTs), mandatory rotation of audit firms and layered subsidiaries. Whilst these norms will force greater transparency in the sector (towards better long-term health), we expect the entire sector to feel the impact of higher compliance costs.

The Ministry of Corporate Affairs (MCA) notified 183 sections of the Companies Act 2013 on 26 March 2013. Together with the 98 sections that were notified earlier on 12 September 2013, the MCA has now notified 283 sections of the 470 sections proposed in the Companies Act. The key aspects of the Companies Act 2013 that will have a significant bearing on real estate companies (from a transparency perspective) are the relatively watertight definitions of “control”, “subsidiary”, “independent director” and “related party”. We highlight the following aspects of the Companies Act 2013 that will impose an onerous compliance cost on the real estate sector:

Consolidation of land-owning entities

In India, real estate developers are regulated under the Land Ceiling Act, which prescribes a maximum limit (ceiling) on the area of land that a single company can own. As a result, it is common practice for developers to float multiple special purpose vehicles (SPVs) that purchase land from the market. SPVs are structured in either of the following formats:

Real estate firms own, directly or indirectly, 100% or a majority share in the equity capital in such SPVs and/or have majority representation on the Board of Directors of such SPVs.

Share capital of SPVs, a small quantum in itself, is held by a third party, which also controls the governing body of the SPVs. In such cases, the real estate companies are involved with the SPVs in various other transactions, such as lending, giving exclusive rights to develop land, providing guarantee against funds borrowed by SPVs and guaranteeing a minimum return to capital providers, which may restrict the decision-making powers of the SPV.

The more stringent definitions of “control” and “subsidiary” under the Companies Act 2013 will impact the “related party” disclosure requirement.

Preparation of consolidated financial statements (CFS)

The preparation of CFS has become mandatory for all companies, which operate through subsidiaries, joint ventures or associates. Our discussions with senior executives at the Big-4 auditors suggest that companies that do not operate through subsidiaries but through joint ventures (JVs) and associates may also have to prepare CFS. This compares with the current practice of unlisted companies not having to prepare CFS. Given the structure of a typical real estate firm in India (as explained above), this requirement will impose a higher compliance cost on real estate companies.

Dividend restrictions on companies relying on public deposits

The Companies Act 2013 prescribes that a company cannot declare any dividend if it fails to comply with the provisions related to the acceptance and repayment of deposits. Thus, if a real estate company accepts a deposit and is unable to fulfil the provisions related to the acceptance or repayment of such deposits, the Companies Act 2013 prohibits shareholder payback in the form of dividend. Of the 21 companies in our analysis, we find that Godrej Properties relies heavily on public deposits.

Related party transactions - under greater scrutiny

Although at some deviation from the prevailing AS18, the Companies Act 2013, for the first time, carries a definition of “related party” and “related party transactions”. Instead of the erstwhile practice of securing approval from the Central Government

Real Estate


for entering into related-party transactions (RPTs), companies will now need to pass a special resolution at the general shareholder meeting, wherein interested members will not be entitled to vote on such resolutions. Whilst this provision is likely to ensure closer scrutiny of related-party transactions by shareholders (hence, less possibility of stealth), minority shareholders may continue to be silent spectators if shareholder activism remains weak.

Even assuming arm’s-length related-party transactions, such transactions will need to be referred to in the Board’s report to shareholders alongside an explanation for entering into such transactions. This disclosure requirement is also likely to cover non-cash transactions involving directors, if they are entered with a related party. Against the backdrop of real estate developers increasingly entering into JDAs with land owners, such SPVs also may come within the ambit of “related party” transactions.

Limit imposed on layered subsidiaries (Section 2 Explanation (d) of clause 87)

The definition of “subsidiary” as included in the Companies Act 2013 prohibits certain class or classes of holding company (to be prescribed) from having multiple layers of subsidiaries beyond such numbers as may be prescribed. With such a restrictive section, it appears that a holding company will no longer be able to hold subsidiaries beyond a specified number. In the absence of any specific rules (conditions or sub-clauses), this is likely to have a meaningful implication on real estate developers on account of the multi-layered subsidiaries that are typical of the sector.

Mandatory rotation of auditors/audit firms (Section 139)

The Act mandates rotation of audit firms for all companies (with the exception of small companies and single-person companies). All real estate companies (provided they do not qualify as either small companies or single-person companies) will now have to appoint an audit firm for a term of 5 or 10 years, with a mandatory annual ratification by shareholders. Real estate companies are specifically impacted because of the usual long-term relationship that they enjoy with audit firms, which will now face mandatory rotation.

It is worth highlighting that other than Sobha Developers, none of the other mainstream real estate companies are audited by the Big-4. Whilst this is especially reflective of the well-entrenched nexus between the audit firms and the real estate companies, this is also a damning indictment of the lack of transparency in the sector.

Mandatory debenture redemption reserve (Section 71 clause 4)

The Companies Act 2013 mandates that debenture-issuing companies need to create a debenture redemption reserve (DRR) account out of its available surplus, which can only be used towards redeeming such debentures. The DRR should comply with the following conditions:

Minimum DRR corpus of 50% of the value of debentures issued;

Minimum 15% of the amount of debentures maturing by March of next year (“current portion” of the outstanding debentures) to be invested or deposited in specified securities by April 30 every year

This is especially critical for the real estate sector since most developers have milked non-convertible debentures (NCDs) as an instrument given the difficulties in securing construction finance from banks in recent times. Whilst the minimum DRR corpus will reduce the distributable surplus available to shareholders (for dividend payout), the minimum 15% investment/deposit clause will reduce investible surplus and hence, drag the investment returns for real estate companies. Most real estate developers have a sizeable exposure (in excess of 5% of their net worth) to NCDs, a bulk of which is unsecured and short term in nature. However, developers also carry a DRR on their balance sheet, covering about 20% of the value of the debentures, on an average.

Real Estate


Impact of 2014 General Elections - lessons from 2009 As highlighted in our strategy thematic published on 11 March 2014, a political reset synchronised with a fresh economic ideology has historically driven higher economic growth and higher shareholder returns. As the race for the 2014 General Elections enters its final leg, investors are looking to add beta to their portfolios to benefit from India’s ‘Fourth Wave’. Whilst the real estate sector is an obvious beta play on the economy, we argue that investors should be selective in the exposure that they take within the sector for sustainably high returns.

As captured in the ‘valuation’ section of this note, the core competency for real estate firms emerges from how well a developer capitalises on the factors of production, viz., land, labour and capital. These factors of production can be genuinely exploited as a source of sustainable competitive advantage, as reflected in Exhibit 28.

Exhibit 28: Operating cycle for real estate companies


With opinion polls pointing to an NDA coalition winning the most number of seats in the forthcoming General Elections, the fundamental catalysts are likely to be impacted in the following manner:

Streamlining of approvals (single-window clearances or expedited approvals)

Incremental job creation led by faster economic growth

Between the two catalysts outlined above, the election outcome is likely to have an immediate impact on the supply side (streamlining of approvals), resulting in a further build-up in inventory levels and a medium- to long-term impact on the demand side (faster income generation, better affordability and higher absorption rates). We argue that an improvement in the demand-side variables is more critical to the fundamental performance of the sector, as demonstrated in Exhibit 29.

Exhibit 29: Sales and inventory build-up since 2009 General Elections in top-3 cities

Source: Liases Foras, Bloomberg, Ambit Capital research; Note: Sales denotes quarterly run rate (in million square feet) in India’s top-three cities (Delhi/NCR, Mumbai/MMR and Bengaluru) with the March 2009 observation indexed to 100; Inventory (number of quarters) is scaled to RHS

Ability to generate cash and / or raise capital

Ability to identify viable projects (deployment)

Ability to execute (project development) and launch

Ability to market / sell and collect receivables

Real estate companies that can best exploit the factors of production (land, labour and capital) will have a sustainable competitive advantage over their peers

The election outcome is likely to impact the supply variables ahead of the demand variables

The first few quarters after the 2009 General Elections (May 2009) saw a double-digit QoQ growth in inventory but was offset by a very high absorption rate driven by a revival in sales momentum

http://webambit.ambit.co/reports/Ambit_Economy&Strategy_Thematic_FourthWave_11Mar2014.pdf

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For the purpose of this analysis, we have cumulated the sales and inventory data for India’s top-three real estate markets viz. Delhi (NCR), Mumbai (MMR) and Bengaluru. The sales run rate (the red column in Exhibit 29) has been on a consistently upward curve since the March 2009 quarter. To put this in perspective, the quarterly run rate of sales in these three markets has grown from 20msf during the March 2009 quarter to 49msf during the December 2013 quarter. Put differently, the average quarterly run rate of sales since the March 2009 quarter (between the June 2009 quarter and the December 2013 quarter) is at about 44msf.

Our analysis indicates two things: whilst on the one hand it demonstrates the March 2009 quarter as an outlier (at the lower end), it also proves that the sales momentum has been steady through the past 19 quarters. Hence, we argue that the real estate sector is in a crisis despite steady quarterly sales because of the equally steady rise in inventory and consequently, lower absorption levels, as reflected in the inventory pile-up (black line in Exhibit 29).

Against this backdrop, we argue that the results of the 2014 General Elections are likely to impact the supply-side inventory ahead of the demand-side sales momentum.

The quarterly sales run rate (demand proxy) has increased from 20msf (March 2009 quarter) to 49msf (December 2013 quarter)

However, the inventory build-up (supply proxy) has contributed more to the current crisis for real estate companies

Real Estate


Real Estate Regulation Bill - pro-consumer; towards greater disclosures Like many of its counterparts, the Real Estate Regulation and Development Bill 2013 is primarily aimed at enhancing developer accountability and safeguarding consumer interests. The key clauses of the Bill are as follows:

Mandatory registration of real estate agents

Compulsory registration of projects with a real estate regulatory authority, the absence of which prohibits sale, booking or even offer to sell. Developers will need to disclose standard project details and identify the brokers who will represent the project. Developers can begin sales from a project only after all the necessary approvals are in place and the project has been registered with the authority. The regulatory authority will need to decide on project approvals (clearance or rejection) within 15 days

Developers need to open a separate bank account (escrow account) for each project and will have to ring fence 70% of the customer advances to be used only towards the completion of that particular project

To eliminate inordinate delays in delivery, the Bill empowers buyers to cancel booking and claim the full amount plus interest for project delays

To enhance accountability, the Bill proposes penalties of 5-10% of project cost and imprisonment of up to three years for misrepresentation of facts to customers or non-compliance with regulatory norms

As with many other policy measures that involve Parliament intervention (for approval and passing through both Houses), we expect this Bill to be enacted only once a stable government is in place at the Centre.

Merits of the escrow mechanism

Whilst our discussions with experts suggest heavy lobbying by developers on this Bill, if enacted in its current form, the Real Estate Regulation and Development Bill 2013 is likely to mitigate the risk of diversion of funds (as highlighted on pages 16 and 17, funds borrowed against one project are often deployed in another project). Such ring-fencing would make cash less fungible and result in greater transparency in project cash flows, a welcome development, especially from the perspective of capital providers. Whilst the escrow mechanism benefits capital providers in terms of greater transparency and reduced risk of diversion of funds, it is possible that the lower risk profile is reflected in lower cost of capital for developers.

Demerits of the escrow mechanism

However, the escrow mechanism will pose an impediment for purchase of new land since banks are not permitted to lend towards land acquisition. This is likely to drive a business model shift with developers increasingly leaning on JDAs (joint development agreements) instead of buying land on their own accord.

Although the Bill prescribes 70% of customer advances to be ring-fenced, the precise percentage of customer advances to be set aside for project-specific expenses will be decided by local bodies (within each state). Our discussion with the Big 4 auditors suggests that developers who have already deployed considerable capital in acquisition of land will find the 70% threshold (as prescribed in the Bill) onerous.

Key clauses in the Bill include:

(a) Mandatory project registration;

(b) Standard project-related disclosures; and

(c) Ring-fencing of customer advances in a separate escrow account (minimum 70% purpose compliance)

The escrow mechanism is likely to introduce greater transparency in project cash flows and mitigate the risk of diversion of funds

70% threshold proposed in the Bill is too onerous on developers - hence, local bodies may need to prescribe a lower threshold

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Real Estate Investment Trusts (REITs) - limited eligibility; unlimited candidates As discussed in an earlier section in this note (pages 17 and 18), real estate, being a capital-intensive sector, faces a burgeoning need for capital, especially in the form of long-term institutional capital. During October 2013, given the paucity of institutional sources of funding (aside from banks) for real estate companies in India, the Securities and Exchange Board of India (SEBI), India’s capital markets regulator, published a draft consultation paper on REIT (Real Estate Investment Trust) guidelines.

The global experience with REITs - organised investment vehicles

Globally, REITs are pooled investment entities that predominantly invest in completed, revenue-generating real estate assets and distribute a major portion of the earnings amongst their investors. Typically, a majority of these investments are in completed projects that provide investors with a regular stream of income from rentals derived from such properties. About 30 countries, including most of the developed nations, now have laws governing REITs. REITs globally have recorded a 13% CAGR in market capitalisation from US$300bn (in 2003) to over US$1trn (in 2013).

Exhibit 30: Global REIT landscape – most of the listings are in the US

Country / jurisdiction

Year of introduction of

REITs

Number of REITs (#)

Aggregate market capitalization (US$

mn)

% of global REIT market

Permissible gearing ratio (%)

Profit distribution obligation#

Australia 1985 52 86,169 8.0 Thin capitalisation

rules 100%

Canada 1994 50 48,526 4.5 No restriction 100%*

France 2003 37 68,193 6.3 Thin capitalisation

rules 85% of tax-exempt

profits

Germany 2007 4 1,657 0.2 45% 90% of the net

income

Hong Kong 2003 11 23,925 2.2 45% 90% of audited

annual net income after tax

Japan 2000 41 64,414 6.0 No restriction >90% of distributable

profits

Singapore 1999 32 45,538 4.2 35%-60% 90% of taxable

income

United Kingdom 2007 23 49,007 4.6 Interest cover test 90% of tax-property

rental profits

United States 1960 163 621,924 57.7 No restriction 90% of taxable

ordinary income

Source: EPRA, Ambit Capital research; Note: * Canada imposes full tax on any undistributed surplus - hence, in practice, 100% of the profits get distributed; # the profit distribution obligation is usually imposed on the REIT’s ordinary income (excluding capital gains)

A look at Exhibit 30 suggests that a REIT market needs at least a decade of operations to mature both in terms of market depth (the number of REITs) as well as capturing investor appetite (market capitalisation as a percentage of the global REIT market). With the exception of the United Kingdom, which has seen rapid acceptance of REITs, most other countries gain only about 20-30bps of the global market capitalisation share every year during the evolution stage of REITs.

Globally, REITs typically invest in real estate formats such as business parks, industrial parks, hotels, retail space, office space, serviced apartments (between 80% and 95% of the investible capital is employed in these formats) whilst the residential asset class accounts for less than one-fifth of the REIT assets.

In a move universally welcomed by industry observers, the SEBI published draft REIT guidelines, setting the stage for introduction of REITs over the next 18 months

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REITs in India - draft guidelines broadly borrowed from Singapore

Our analysis of the SEBI’s draft circular suggests that the REIT guidelines are broadly mirrored on the regulations governing REITs in Singapore. We highlight the following key eligibility criteria from the draft REIT guidelines as published by the SEBI:

REITs to be set up as trusts and to register themselves with the SEBI

Mandatory listing within 18 months of registration with the SEBI

Minimum REIT asset size at `10bn

Sponsor to have minimum consolidated net worth of `200mn

Sponsor to have minimum experience of five years in real estate

Sponsor lock-in of 25% for the first three years and 15% thereafter

Following are the key investment criteria:

At least 90% of the REIT assets should be invested in completed (post issuance of occupancy certificate) and rent-generating assets (projects that are at least 75% rented or leased out) in India

Remaining 10% allowed to be invested in developmental properties, government securities, listed or unlisted corporate debt, equity shares of real estate companies

Entire corpus can be invested in one project

Not allowed to invest in vacant land or agricultural land

At least 90% of the net income to be distributed to unit holders

Leverage (gearing ratio) capped at 50%; credit rating from SEBI-registered credit rating agency and approval of unit holders mandatory in case leverage is in excess of 25%

Exhibit 31: SEBI’s draft REIT guidelines - key clauses

Criteria Prescribed value Impact

Minimum initial offer size (` mn) 2,500 Likely to broad-base shareholding and enhance price discovery Minimum public float (%) 25

Minimum subscription size (`) 200,000 Will restrict initial participation to HNIs Minimum value of single REIT unit to be traded (`) 100,000

Minimum asset size under REITs (` mn) 10,000 Will attract only serious and large players

Source: SEBI, Ambit Capital research

Eligibility criteria on minimum REIT asset size will attract only serious and large players

90% of the REIT assets to be invested in completed and rent-generating assets; remaining 10% permitted to be invested in under-construction properties

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Launch pipeline crucial Oberoi Realty emerged as the highest bidder for a 25-acre land parcel in the western suburbs of Mumbai, which has put to rest any concerns around the re-deployment of its surplus capital. We factor in net debt of 0.3x (to fund this land acquisition), and we expect the launch of at least three projects during FY15 to revive Oberoi’s operating cash flows from `1.7bn in FY14E to `9bn by FY15E. Using a project-based DCF approach, we value Oberoi at `290, implying 7.3x FY15E FCFE.

Competitive position: STRONG Changes to this position: POSITIVE

New launches critical for revival in operating cash flows

Excessive cash-guzzling projects (due to the delayed pace of construction) and a deficit of cash-generating assets (due to weak incremental sales and delayed launches) led to negative operating cash flows of `4.2bn during 9MFY14. With cash collections from the existing under-construction projects ahead of the stage of completion, the company’s proposed launches in Worli and Mulund during 1HFY15 are critical to revive operating cash flows.

Accretion to land bank adds crucial growth opportunity

Oberoi has emerged as the highest bidder for 25 acres of land in Borivali that was put on the block by Tata Steel, with a bid of `11.55bn. With 10% of the bid amount already paid out as earnest money deposit (EMD), we expect the balance 90% to be paid out during 1QFY15 (funded by debt of ~`8bn). Our calculations suggest a saleable area of c.4 million square feet (msf), which is a ~50% accretion to Oberoi’s existing inventory of ongoing projects.

Gearing for land acquisition likely to remain comfortable at ~0.3x

We expect Oberoi to have paid the EMD of `1.15bn on the Borivali land from its existing cash balance (of `4.5bn as of December 2013). Given that banks are not allowed to lend towards land acquisition, we expect the balance land cost (`10bn) to be funded through discounting of cash flows from its annuity assets (including two upcoming annuity projects). We expect Oberoi to be cash-positive by end-FY15 on the back of the Worli and Mulund launches.

Valuation at `290/share; we retain BUY

We use a project-based DCF approach to arrive at a valuation of `290/share (revised upwards from `277/share). The upgrade is largely driven by the addition of the Borivali project. Given that Oberoi is likely to restore its cash surplus by end-FY15E on the back of its launch pipeline, we find the stock attractively priced at 7.3x FY15E FCFE, leaving enough room for Oberoi to scout for other opportunistic land acquisitions.

Oberoi Realty BUY

COMPANY INSIGHT OBER IN EQUITY April 23, 2014

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Recommendation Mcap (bn): `74/US$1.2 6M ADV (mn): `46/US$0.8 CMP: `224 TP (12 mths): `290 Upside (%): 30

Flags Accounting: GREEN Predictability: AMBER Earnings Momentum: GREEN

Catalyst

Partial launch of Worli project by 1QFY15

Completion of Borivali land acquisition

Part-launch in Mulund project by 1HFY15

Performance (%)

Source: Bloomberg, Ambit Capital research

Analyst Details

Krishnan ASV +91 22 3043 3205 [email protected]

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Key financials

Year to March FY12 FY13 FY14E FY15E FY16E

Net Revenues (` mn) 8,247 10,476 8,599 11,742 14,370

Operating Profits (` mn) 4,836 6,121 4,218 6,832 8,347

Net Profits (` mn) 4,630 5,048 3,205 4,810 6,540

Diluted EPS (`) 14.1 15.4 9.8 14.7 19.9

RoE (%) 13.6 13.7 7.9 11.0 13.5

P/E (x) 16.0 14.6 23.0 15.4 11.3

P/B (x) 2.1 1.9 1.8 1.6 1.4

Source: Company, Ambit Capital research

Oberoi Realty


Snapshot of company financials Profit and Loss Company Background Year to March (` mn) FY13 FY14E FY15E FY16E

Revenue from residential projects

7,813 5,469 7,110 9,243

Hospitality services 956 1,146 2,336 2,453

Rentals and related income 1,398 1,504 1,798 2,096 Property and project management income

250 330 391 485

Other operating income 58 150 107 92

Total operating Income 10,476 8,599 11,742 14,370

Operating costs (3,715) (3,698) (4,110) (5,029)

Total SG&A (640) (684) (800) (994)

Total operating expenditure (4,355) (4,381) (4,910) (6,023)

EBITDA 6,121 4,218 6,832 8,347

PBT 6,830 4,644 6,972 9,478

PAT 5,048 3,205 4,810 6,540

EPS (`) 15.4 9.8 14.7 19.9

Oberoi currently operates predominantly in Mumbai, with a diverse spread of premium developments including residential, commercial, retail, hospitality and social infrastructure projects. Whilst the group’s promoters have been developing real estate since 1983, the principal business operations of various group entities was consolidated into one group in 2006. The group was listed in 2010 raising `10.3bn through its IPO proceeds. Oberoi has an ongoing project slate of 7.1msf under-construction and a planned project portfolio of 10.4msf, predominantly consisting of residential properties. Whilst the ongoing project portfolio is relatively more concentrated (71% residential; 20% commercial), the portfolio of planned projects is comparatively better diversified (65% residential; 25% commercial).

Balance Sheet Cash flow Year to March (` mn) FY13 FY14E FY15E FY16E

Shareholders’ funds 38,968 41,685 45,763 51,308

Loan funds 0 8,000 8,000 0

Net Fixed assets 10,714 10,423 10,626 12,297

Investments 0 4,000 0 0

Cash 10,725 9,886 6,418 280

Working capital 17,528 25,375 36,719 38,730

Book value per share (`) 118.7 127.0 139.4 156.3

Year to March (` mn) FY14E FY15E FY16E

Total pre-tax CF 2,546 13,049 14,181

Tax (840) (4,306) (4,680)

CFO 1,706 8,743 9,501

FCFE 2,443 10,220 10,961

Changes in WC 7,847 11,344 2,011

Strong launch pipeline to revive operating cash flows Launches to stimulate free cash flow generation

Year / Property Format Area (sft) Likely launch

FY15

Worli Residential 1,783,928 1QFY15

Worli Hospitality 336,375 1QFY15

Mulund Phase I Residential 1,600,690 2QFY15

Splendor Phase III Residential 274,550 4QFY15

Commerz II - Phase I Commercial 725,769 4QFY15

FY16 Splendor Phase IV Residential 118,986 Borivali Residential 1,846,876


5.9%

22.3% 21.4%

32.1%

26.1% 26.8%23.1%

0.0%5.0%

10.0%15.0%20.0%25.0%30.0%35.0%

FY14E FY15E FY16E FY17E FY18E FY19E FY20E

FCFE (% of net worth)

Oberoi Realty


Two new project launches by 1HFY15 Launches to help revive operating cash flows Excessive cash-guzzling projects (due to the delayed pace of construction) and a deficit of cash-generating assets (weak incremental sales and delayed launches) have resulted in Oberoi’s operating cash flows receding by `4bn (about 40% of opening balance) during 9MFY14. With cash collections from the existing under-construction projects running ahead of the pace of progress, the proposed launches in Worli and Mulund during 1HFY15 are critical for a revival in Oberoi’s operating cash flows.

Oberoi Realty’s volume sales and cash collections remained weak during 9MFY14 on account of a combination of limited inventory available for sale in the ongoing projects and lack of new project launches. The limited availability of inventory was driven by:

Delay in obtaining regulatory approvals to resume construction in Oberoi Esquire;

Availability limited to high-ticket-sized inventory in Oberoi Exquisite; and

Inventory exhaustion in completed projects, Splendor and Splendor Grande.

The limited availability of inventory has contributed significantly not only towards weak unit sales (Part A - Exhibit 1) but also towards sluggish cash collections (Part C - Exhibit 1).

Exhibit 1: Quarterly project-wise snapshot - limited inventory contributing to weakness in unit sales during 3QFY14

Project-wise quarterly run rate 4QFY12 1QFY13 2QFY13 3QFY13 4QFY13 1QFY14 2QFY14 3QFY14

PART A: Area sold (sft)

Oberoi Exquisite 27,950 28,600 27,820 39,630 41,600 21,960 16,250 10,790

Oberoi Esquire 74,715 58,065 70,410 52,680 46,095 25,180 22,985 17,560

Oberoi Seven 5,650 5,650 0 5,650 0 0 0 0

Oberoi Splendor Grande 41,860 23,660 20,020 18,200 10,920 1,820 0 0

Oberoi Splendor 20,727 7,896 11,844 7,896 19,740 0 0 0

Oasis Residential# 0 0 0 0 0 0 114,744 0

Total area sold (sft) 170,902 123,871 130,094 124,056 118,355 48,960 153,979 28,350

PART B: Value of area sold (` mn) Oberoi Exquisite 441.9 495.2 488.3 781.2 739.6 477.6 384.7 225.7

Oberoi Esquire 1,036.2 926.6 1,099.5 783.5 780.4 411.0 433.1 348.9

Oberoi Seven 80.0 90.0 0.0 90.0 0.0 0.0 0.0 0.0

Oberoi Splendor Grande 650.6 374.2 345.2 310.7 202.0 36.1 0.0 0.0

Oberoi Splendor 455.9 190.2 287.0 198.5 504.6 0.0 0.0 0.0

Oasis Residential# 0.0 0.0 0.0 0.0 0.0 0.0 3,178.9 0.0

Total area sold (sft) 2,665 2,076 2,220 2,164 2,227 925 3,997 575

PART C: Cash collections (` mn)

Oberoi Exquisite 708.2 660.7 585.9 560.1 1,401.9 848.2 829.8 222.7

Oberoi Esquire 333.6 384.5 325.7 365.8 242.7 81.2 121.5 75.4

Oberoi Seven 80.0 90.0 0.0 90.0 0.0 0.0 0.0 0.0

Oberoi Splendor Grande 414.0 742.5 462.4 363.3 200.2 130.9 91.5 7.0

Oberoi Splendor 259.9 382.0 189.4 294.5 413.2 110.8 0.0 0.0

Oasis Residential# 0.0 0.0 0.0 0.0 0.0 0.0 770.7 0.0

Total cash collections (` mn) 1,796 2,260 1,563 1,674 2,258 1,171 1,814 305

Source: Company, Ambit Capital research; Note: # figures are cumulative until 9MFY14, as per management disclosures and include collections related to transfers from another joint venture (with ICICI Ventures) that were originally sold during 2006-07.

Weak volumes during 9MFY14 on account of limited inventory in ongoing projects and lack of new launches

Oberoi Realty


Too many cash guzzlers; not enough cash generators

Our analysis of project-wise cash flows suggests that cash flows from the completed projects (Seven, Splendor and Splendor Grande) have been exhausted, leaving little headroom for incremental collections in the absence of fresh sales in these projects. All of these three projects are nearly fully sold out, resulting in negligible incremental inflows.

Exhibit 2: Project-wise outstanding collections - cash collections running significantly ahead of project progress

Collections outstanding by project (` mn) 4QFY12 1QFY13 2QFY13 3QFY13 4QFY13 1QFY14 2QFY14 3QFY14

Oberoi Exquisite Cumulative sales (` mn) 10,205.4 10,700.6 11,188.9 11,970.1 12,709.7 13,187.3 13,572.0 13,797.7

Cumulative cash collected (` mn) 7,901.5 8,562.2 9,148.1 9,708.2 11,110.1 11,958.3 12,788.1 13,010.8

Collection outstanding (` mn) 2,303.9 2,138.4 2,040.8 2,261.9 1,599.6 1,229.0 783.9 786.9

Collection (% of sales) 77.4% 80.0% 81.8% 81.1% 87.4% 90.7% 94.2% 94.3%

Percentage of completion (%) 47.1% 51.0% 57.0% 64.0% 71.0% 78.0% 83.0% 88.0%

Oberoi Esquire

Cumulative sales (` mn) 8,537.0 9,463.6 10,563.1 11,346.6 12,127.0 12,538.0 12,971.1 13,320.0


Collection outstanding (` mn) 5,500.9 6,043.0 6,816.8 7,234.5 7,772.2 8,102.0 8,413.6 8,687.1


Percentage of completion (%) BTL BTL BTL BTL BTL BTL BTL BTL

Oberoi Seven

Cumulative sales (` mn) 320.0 410.0 410.0 500.0 500.0 500.0 500.0 500.0

Cumulative cash collected (` mn) 320.0 410.0 410.0 500.0 500.0 500.0 500.0 500.0

Collection outstanding (` mn) 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0



Oberoi Splendor Grande Cumulative sales (` mn) 2,876.6 3,250.8 3,596.0 3,906.7 4,108.7 4,144.8 4,144.8 4,144.8


Collection outstanding (` mn) 729.6 361.3 244.1 191.5 193.3 98.5 7.0 0.0



Oberoi Splendor Cumulative sales (` mn) 14,538.9 14,729.1 15,016.1 15,214.6 15,719.2 15,719.2 15,719.2 15,719.2


Collection outstanding (` mn) 2,807.3 2,615.5 2,713.1 2,617.1 2,708.5 2,597.7 2,597.7 2,597.7



Oasis Residential# Cumulative sales (` mn) 0.0 0.0 0.0 0.0 0.0 0.0 3,178.9 3,178.9

Cumulative cash collected (` mn) 0.0 0.0 0.0 0.0 0.0 0.0 770.7 770.7

Collection outstanding (` mn) 0.0 0.0 0.0 0.0 0.0 0.0 2,408.2 2,408.2

Collection (% of sales) NA NA NA NA NA NA 24.2% 24.2%

Percentage of completion (%) NA NA NA NA NA NA BTL BTL

Source: Company, Ambit Capital research; Note: # figures are cumulative until 9MFY14, as per management disclosures and include collections pertaining to transfers from a joint venture (with ICICI Ventures) that were originally sold during 2006-07; BTL indicates below threshold level

On the other hand, cash collected from under-construction projects (Exquisite, Esquire and Oasis) are running significantly ahead of the progress (percentage of completion) in each of these projects. We expect Exquisite and Esquire to remain net consumers of cash at least until 1QFY15 whilst Oasis is likely to be cash-surplus upon launch.

Inventory exhausted in completed projects; slow-moving ‘under-construction’ projects not yet cash-generative

Oberoi Realty


Strong launch pipeline across formats lends visibility to FY15 cash flows

We expect Oberoi to launch at least three incremental projects (across formats) over the course of FY15. We ascribe a relatively higher probability to the launch of the Worli project and the first phase of the Mulund project by 1HFY15.

Exhibit 3: Launch pipeline - ideal feedstock for the cash flow engine

Year / Property Format Area (sft) Likely launch

FY15

Worli Residential 1,783,928 1QFY15

Worli Hospitality 336,375 1QFY15

Mulund Phase I Residential 1,600,690 2QFY15

Splendor Phase III Residential 274,550 4QFY15

Commerz II - Phase I Commercial 800,000 4QFY15

FY16

Splendor Phase IV Residential 118,986 Borivali Phase I Residential 1,846,876


We expect the launch of Commerz II - Phase I to be contingent upon a revival in the fundamental demand drivers for commercial real estate (largely driven by corporate confidence). Given that FY15 is an election year, we expect Oberoi’s potential clients for Commerz II - Phase I to formalise their lease contracts only during 2HFY15.

Oberoi Realty


Land acquisition a positive catalyst Accretion to land bank adds crucial growth opportunity Oberoi emerged as the highest bidder for 25 acres of land in Borivali (with a bid of `11.55bn), which is likely to add saleable area of c.4msf to its inventory, a ~50% accretion to its existing inventory. With 10% of the bid amount already paid out as earnest money deposit (EMD), we expect the balance 90% to be paid out during 1QFY15 (funded by debt of `8bn). We expect the project to begin generating positive cash flows during FY18 and become cumulative cash flow positive by FY20.

Oberoi has emerged as the highest bidder for 25 acres of land in Borivali that was put on the block by Tata Steel, with a bid of `11.55bn. With 10% of the bid amount already paid out as earnest money deposit (EMD) by end-March 2014, we expect the balance 90% to be paid out during 1QFY15. Assuming that the company maintains a certain quantum of cash on its balance sheet, we expect Oberoi to raise debt of `8bn by discounting lease rentals from its annuity assets.

Pending approvals for transaction completion

For the transaction to go through, Oberoi Realty needs to obtain two major approvals by June 2014. Oberoi needs to obtain the collector’s permission for the sale of the Sanad land which is part of the total property and an NOC (no objection certificate) from the labour authority. If these approvals do not come through within three months, the MOU (Memorandum of Understanding) for the sale of land will stand annulled.

Saleable area of 3.7msf adds crucial inventory pipeline

Our calculations suggest a saleable area of 3.7msf, a sizeable accretion to Oberoi’s growth prospects in terms of addition to inventory.

Exhibit 4: Deriving the total construction area and total saleable area

Particulars Area (sft) Remarks

Land area 1,089,000 Converted from 25 acres

Less: Common amenities area 272,250 25% of the land area

Less: Recreation ground area 81,675 10% of net land area (adjusted for amenities)

Base FSI 735,075 Add: TDR for amenities area 272,250 25% of the original land area

Add: TDR and premium 816,750 Total FSI (before fungible FSI) 1,824,075

Add: Compensatory fungible FSI 638,426 35% of Total FSI

Total FSI (with fungible FSI) 2,462,501 Saleable area 3,693,752 Assuming 50% loading factor

Total construction area 4,432,502 Assuming super built-up area at 20% higher than saleable area


Powerful signalling mechanism

Whilst this acquisition adds crucial saleable area to Oberoi’s inventory pipeline, we read this bid as a powerful signalling mechanism that sets a benchmark for Oberoi’s valuation appetite in land transactions. Oberoi’s bid, at `11.55bn, for a 25-acre plot, implies a land valuation at `4,500 per square feet (on total FSI, inclusive of fungible FSI). From a pricing perspective, the bid provides an insight into Oberoi’s appetite for the acquisition cost of land, especially when the land comes with a clean title, as in this case. Our discussion with senior property consultants suggests that Oberoi’s current bid is significantly north of Oberoi’s earlier bids for such parcels of land and is indicative of a more serious approach towards re-deploying surplus capital, given the relatively greater comfort around the land title.

We expect Oberoi to raise debt of `8bn by discounting lease rentals from its annuity assets

Oberoi Realty


Project likely to be launched in two phases

We expect the Borivali project to be launched in two equal phases (c.1.85msf each), with the first phase likely to be launched during FY16 followed by a second phase launch during FY19. We expect the project to be sold out over 7 years.

Exhibit 5: Assumptions driving the Borivali project - Phase I launch during FY16 and Phase II launch during FY19

Borivali project economics FY14E FY15E FY16E FY17E FY18E FY19E FY20E FY21E FY22E

Revenues

Sales (% of est. saleable area)

0.0% 0.0% 10.0% 15.0% 15.0% 20.0% 15.0% 15.0% 10.0%

Average realisation (`/sft) 15,848 13,000 14,040 15,163 15,921 16,717 17,553 18,431

YoY chg in realisation (%) 8.0% 8.0% 5.0% 5.0% 5.0% 5.0%

Cash collections (%) 0.0% 0.0% 5.0% 10.0% 15.0% 15.0% 20.0% 20.0% 15.0%

Costs

Land cost (% incurred)

10.0% 90.0%

Fungible FSI + TDR costs (% incurred) 5.0% 10.0% 25.0% 25.0% 20.0% 15.0% Percentage of completion (%) 10.0% 20.0% 35.0% 55.0% 75.0% 90.0% 100.0%

Average construction cost (`/sft) 4,097 3,500 3,675 3,859 4,052 4,254 4,467 4,690

YoY chg in construction cost (%)

5.0% 5.0% 5.0% 5.0% 5.0% 5.0%


Project to become cumulative cash flow positive by FY20

Assuming a Phase I launch during FY16, we expect the project to begin generating positive cash flows from FY18 onwards. Assuming a Phase II launch during FY19, we expect the project to become cumulative cash flow positive by FY20.

Exhibit 6: Cash flows from the Borivali project

Borivali project cash flows (` mn) FY14 FY15E FY16E FY17E FY18E FY19E FY20E FY21E FY22E

Inflows (A)

240 1,647 4,408 8,440 12,569 16,668 14,568

Cash collections 240 1,647 4,408 8,440 12,569 16,668 14,568

Outflows (B) (1,125) (10,262) (1,826) (2,316) (3,252) (4,141) (4,184) (2,970) (2,079)

Land cost incurred (1,125) (10,125) Fungible, TDR

(137) (275) (687) (687) (549) (412)

Construction cost incurred

(1,551) (1,629) (2,566) (3,592) (3,771) (2,970) (2,079)

Net cash flow (A-B) (1,125) (10,262) (1,586) (669) 1,155 4,299 8,386 13,698 12,489


Lease rental discounting (LRD) appears to be the best financing option

We expect the net cash outflow (towards earnest money deposit for land acquisition) during FY14 to be funded largely from the existing cash on books as of December 2013. We expect the FY15 payouts (remaining 90% towards cost of land and payments towards development rights and fungible FSI) to be funded partly through internal accruals and debt of `8bn. Our calculations suggest that Oberoi can raise debt by discounting the lease rentals from its annuity assets.

Exhibit 7: Financing project debt for the Borivali land parcel - lease rent discounting (LRD) the best option

Cash flows from annuity assets (` mn) FY15E FY16E FY17E FY18E FY19E FY20E

Free cash flows from operating annuity assets (A) 1,875 1,940 2,024 2,089 2,159 2,167

Free cash flows from upcoming annuity assets (B) 335 623 1,433 1,760 2,020 2,176

Free cash flows from all annuity assets (A+B) 2,209 2,563 3,457 3,850 4,179 4,343


Our channel checks suggest that lenders currently offer lease rental discounting at about 13-13.5%. We believe that Oberoi, on account of its well-capitalised balance sheet, is likely to raise debt at the lower end of this price band.

As demonstrated in Exhibit 7, assuming Oberoi can only discount lease rentals from its existing annuity assets (Commerz I, Westin, Oberoi Mall and Oberoi International

Oberoi Realty


School), Oberoi will need to securitise its receivables for the next six years. On the other hand, if Oberoi is able to discount lease rentals even from the upcoming annuity assets (subject to similarly stable tenancy), receivables from FY15-18 are adequate to finance this debt.

If cash remains fungible (as against a proposal in the Real Estate Regulation Bill that calls for ring-fencing of 70% of cash flows from a project), we expect Oberoi to repay the project debt of `8bn by end-FY16, subject to project launches at Worli and Mulund by 1HFY15.

CARE assigns top rating for `8.5bn facility

As per Oberoi’s recent filings, CARE, a rating agency, has assigned the highest rating for a combination of short-term and long-term facilities for `8.5bn to be availed by Oberoi. The long-term rating has been assigned to Incline Realty Private Limited, a wholly-owned subsidiary of Oberoi Realty, recently floated exclusively for developing the Borivali land parcel.

Exhibit 8: Top ratings secured for facilities worth `8.5bn

Instrument Rating Maturity pattern Amount (` mn)

Commercial paper A1+ Less than 1 year 1,000

Non-convertible debentures AA+ (SO) Long-term (3-5 years) 7,500


Potential for valuation upgrade to Borivali project

Our estimates for the Borivali project build in the following key assumptions:

Saleable area of ~3.7msf

Phase II launch during FY19

Average per square foot realisation of `15,500 through the project life-cycle

Average per square foot construction cost of `4,100 through the project life-cycle

Cost of debt at 13%

Media reports estimate the saleable area on the Borivali land parcel ranging between 3.6msf and 4msf (the upper end of this range is ~8% higher than our saleable area assumptions on this project). Faster-than-anticipated execution of the project (say, a Phase II launch in FY18), higher realisations through the project life-cycle (from better sales velocity) and lower-than-anticipated cost of debt (on account of superior credit profile benefiting from better debt servicing) pose an upside risk to our project cash flow assumptions. Such upside risks would impact our project valuation (excluding land cost) by ~40% and the overall SOTP valuation by ~10% (`29) net of land cost.

Oberoi Realty


Project details Oberoi has an ongoing project slate of 7.1msf under-construction and a planned project portfolio of 10.4msf, predominantly consisting of residential properties. Whilst the ongoing project portfolio (see Exhibit 8) is relatively more concentrated, the portfolio of planned projects (see Exhibit 9) is comparatively better diversified.

Exhibit 9: Under-construction projects (7.1msf)


Exhibit 10: Planned projects (10.4msf)


Residential projects Excluding the Borivali land that was acquired towards the end of March 2014, Oberoi has an ongoing residential project portfolio of about 5.1msf.

Exhibit 11: Key residential projects - approval / launch / completion / sale status

Properties under development Saleable area (sft) Launch

Percentage of completion

(POC)

Clearances / approval status

Time to completion (months)

Unsold inventory (%)

Oberoi Exquisite 1,535,670 October 2009 88% OC for floors 31 to 50 pending 6 months 33%

Oberoi Esquire 1,504,815 February 2011 BTL Partial CC until the 30th floor

36 months 35%

Oasis Residential 1,783,928 Not yet launched BTL 48 months NA

Mulund project (Exotica) 3,201,380 Not yet launched BTL 48 months NA

Borivali project 3,693,752 Land acquired NA NOC from trade union pending

NA

Splendor - Phase III 274,550 Not yet launched

Sangamcity, Pune 773,951 Not yet launched NA

Source: Company, Ambit Capital research; Note: BTL - below threshold level; OC - occupancy certificate; CC - commencement certificate

Although the projects enumerated in Exhibit 10 have relatively greater visibility, other properties (such as Oberoi’s Khar project and Phase IV of Splendor) have relatively lower project-level visibility.

Given our assumptions around area sales run rate and cash collections (detailed separately in the valuation section of this note), we expect the current pipeline of the ongoing residential projects to be completely sold out by FY23E. We expect cash collections from residential projects to peak during FY17E-19E.

Residential, 71.9%

Office space, 23.4%

Hospitality, 4.7%

Residential, 65.2%

Office space, 3.6%

Hospitality, 12.4%

Retail, 2.7%

Social infra, 16.1%

Oberoi Realty


Annuity projects Oberoi currently has four operational annuity assets, which account for 35% of the company’s total operating revenues (during 9MFY14). Although the contribution of annuity assets appears exaggerated on account of the extremely weak residential project launches and sales during 9MFY14, the annuity assets have consistently contributed north of 15% to the company’s operating revenues since FY10. Whilst this is partly on account of the relative maturity of the properties (all of these have been in existence for over five years), the strong fundamentals of these properties are also a function of the company’s strategy to develop residential townships centred on commercial properties.

Exhibit 12: Movement in key metrics in Oberoi’s annuity projects - higher occupancy at the cost of easing rentals

Properties 4QFY12 1QFY13 2QFY13 3QFY13 4QFY13 1QFY14 2QFY14 3QFY14

Office space - Commerz I

Occupancy (%) 79.0% 79.5% 80.7% 80.6% 83.4% 83.4% 85.8% 85.8%

Realisation (`/sft/month) 128 129 129 130 131 132 128 128

EBITDA margin (%) 93.7% 95.8% 97.6% 98.2% 96.7% 97.7% 99.2% 99.8%

Retail property - Oberoi Mall

Occupancy (%) 94.3% 93.5% 94.3% 94.6% 95.1% 99.4% 99.1% 98.0%

Realisation (`/sft/month) 125 128 124 129 125 126 137 137

EBITDA margin (%) 96.0% 96.5% 95.5% 95.9% 94.2% 97.1% 96.0% 94.4%

Hospitality project - Westin Occupancy (%) 72.3% 66.8% 65.1% 67.8% 74.6% 72.5% 76.2% 73.1%

RevPAR (`) 5,886 4,637 4,761 5,606 6,085 5,599 5,659 6,185

EBITDA margin (%) 37.7% 24.6% 21.7% 33.8% 34.1% 30.8% 28.4% 28.5%


Currently, Mumbai’s total office space stock is 101msf, of which 78msf is occupied, resulting in a vacancy level of 23%. Vacancy levels have been increasing consistently since 2009 when they were at 12%, due to the massive influx of nearly 38msf of new supply since 2009.

Against this backdrop, Oberoi, despite its strategy of developing townships around a central commercial property, is likely to be only marginally less vulnerable to the effects of a general economic slowdown. Oberoi, has one operational office-use property (Commerz I, 0.36msf) and is slated to launch another (Phase I Commerz II, 0.7msf) later this year.

Exhibit 13: Office-use projects - key metrics

Commercial properties Estimated area (sft) Launch Occupancy

(%)Lease rent (`/sft/mth)

EBITDA margin (%)

Commerz I 364,888 85.8% 128 99.86%

Commerz II - Phase 1 725,769 4QFY15 NA NA NA

Commerz II - Phase 2 1,661,650 FY16 NA NA NA


Oberoi Realty


Valuation We use a project-based DCF approach to arrive at a valuation of `290/share (revised upwards from `277/share), implying a 33% upside. A little over 70% of this valuation is contributed by residential properties whereas office and retail properties contribute a further 20% to the sum-of-the-parts valuation.

Exhibit 14: FY15 mix of cash inflows (%)


Exhibit 15: FY15 sum-of-the-parts valuation (%)


We use project-specific assumptions (detailed subsequently) to derive the discounted project-specific cash flows to arrive at our sum-of-the-parts (SOTP) valuation. We adjust our SOTP valuation for unallocated overheads that are not apportioned to any specific project and the net cash (debt) position as at end-FY15. We assume the debt of `8bn to be completely repaid during FY16, assuming that cash continues to remain fungible, implying that surplus proceeds from the Mulund and Worli launches will be used to repay the loan borrowed towards the Borivali land acquisition.

Exhibit 16: Sum-of-the-parts (SOTP) valuation for Oberoi Realty (`/share)


Beyond FY15, we expect Oberoi to maintain 15-25% of its balance sheet size in the form of cash with any surplus deployed towards investments that earn the company annual returns of 7.5% on an average. We build in a gradually declining contribution from customer advances, as ongoing projects progress towards completion. We expect Oberoi’s funding of vendors and sub-contractors (through loans and advances on the current assets) to progressively increase as the project moves towards completion.

Residential, 65%Office, 9%

Retail, 16%

Hospitality, 7%

Social infra, 3%

Residential, 71%

Office, 13%

Retail, 7%

Hospitality, 6%

Social infra, 2%

20839

2116 7 2

-5

-50

0

50

100

150

200

250

300

350

Residential Office Retail Hospitality Social infra Otherincome less

SG&A

Net cash

Oberoi Realty


Assumptions around valuation parameters Cost of equity: We have assumed a 15% cost of equity in our calculations. Given that Oberoi has a larger proportion of residential projects in its slate of ongoing and planned projects and since residential projects are typically funded by customer advances, we believe that it is appropriate to use cost of equity to discount cash flows (as against using the weighted average cost of capital).

Since Oberoi is debt-free (aside from the debt that the company will need to raise for the recent Borivali land acquisition), we believe that using cost of equity is a conservative measure to arrive at the net asset value for each individual project.

The two most sensitive project-level variables in our assumptions are: (a) the sales run rate; and (b) the average blended realisations. To put this in perspective, if each of Oberoi’s under-construction residential projects is delayed by 12 months (beyond the delay that we are already building in), our valuation is likely to be dragged by ~15%. More importantly, slower-than-anticipated sales (hence, slower-than-anticipated cash inflows) would potentially translate into Oberoi either having to assume a larger quantum of debt or delaying the construction/launch of some of its projects, all of which are likely to pull the company further into a vicious ‘cash-burn’ cycle.

Oberoi Realty


Residential properties Annual run rate of area sales: For under-construction projects that are yet to

be launched, we build in a period of 8-10 years for a project to move from the ‘launch’ stage to the ‘stock-out’ stage. For projects that are likely to be sold out over 8 years, we assume c.50% of the total saleable area to be sold by Year 3 (from launch) and the remaining 50% to be sold over the next 5 years. For projects that are likely to be sold out over 10 years, we factor in c.50% of the total saleable area to be sold by Year 4 (from the time of launch) and the balance 50% to be sold over the next 6 years. For all projects, the ‘completely sold out’ stage is triggered at least 1-3 years from the time of project completion.

Exhibit 17: Cumulative sales from the time of launch (% of saleable area)


Our assumptions around the sales run rate are consistent with a typical project lifecycle in which sales are high during the initial phase (after the project launch) and gather fresh momentum as the project nears completion (pull factor on account of customers looking for ‘ready-to-move-in’ properties). However, the run rate of sales tapers off in the interim.

Growth in average realisation rates in ongoing projects: For FY15, in the case of ongoing projects, we have benchmarked average realisation rates based on price discovery in recent transactions and anonymous channel checks with Oberoi’s sales team at each project location. In general, we assume c.8% YoY increase in average realisations between FY15E and FY18E followed by 5% YoY increase in average realisations thereafter until the project is completely sold out.

Growth in realisation rates in upcoming projects: For upcoming projects, we have assumed c.8% YoY increase in average realisation for the first two years after the launch followed by a 5% YoY increase in average realisations thereafter until the project is completely sold out. Our base realisation (pricing at the time of launch of such projects) is at a 5-10% discount to the prevailing pricing for comparable projects in the relevant micro-market.

Outflow pertaining to construction costs: For under-construction projects, we have assumed that: (a) construction costs are distributed over the construction period proportionate to the percentage of completion; and (b) the project is delayed by 1-2 years relative to the management’s targeted completion schedule on account of labour shortage.

We have individually projected the construction costs for each residential project from FY14E (or the time of launch, whichever is earlier) until project completion, using the percentage of completion approach. We use an average construction cost (per sft) of `3,500 for Exquisite and Esquire and `7,500 for Oasis (as it is a super-premium project).

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Oberoi Realty


Rise in input costs of construction: For all the under-construction projects, we have assumed an 8% YoY increase in the cost of construction (per sft) during the first 4 years of a project and 5% thereafter until project completion. Our assumptions around YoY cost inflation are based on trends around indexed building construction costs published by the Construction Industry Development Council (CIDC). Our estimates around a rise in input costs are conservative, given that the cost of building construction increased ~4% in Mumbai and ~5% each in Delhi and Bangalore over the past 5 years (between January 2009 and March 2014). Concomitant with our assumptions around growth in blended realisation rates, we believe that Oberoi will recover its pricing power on select projects only post FY18E.

Exhibit 18: YoY movement in building construction costs in major real estate markets

Source: CIDC, Ambit Capital research

Cash collections from upcoming projects: We assume construction-linked cash collections for each of Oberoi’s upcoming projects (ongoing and planned) subject to the following clauses:

(a) 20% down payment at the time of booking for new launches; and

(b) final 5-10% of the consideration payable at the time of possession.

Exhibit 19: Cumulative project-wise cash flows (% of value of area sold)

Cumulative project cash flows FY14E FY15E FY16E Launch Stock-out

Oberoi Exquisite 92% 94% 95% Oct 2009 FY17E

Oberoi Esquire 34% 77% 94% Feb 2011 FY17E

Oasis Residential 24% 36% 47% FY15E FY22E

Mulund project 0% 20% 35% FY15E FY23E

Borivali project 0% 0% 40% FY16E FY23E


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Oberoi Realty


Commercial / retail / hospitality projects Rental rates for annuity projects: Currently, Mumbai’s total office space stock

is 101msf, of which 78msf is occupied, resulting in a vacancy level of 23%. Vacancy levels have been increasing consistently since 2009 when they were at 12%, due to the massive influx of nearly 38msf of new supply since 2009.

Exhibit 20: Movement in lease rentals and absorption levels in Mumbai

Source: Knight Frank Office Traction November 2013, Ambit Capital research

Lease rentals in Mumbai have either been steady or declining over the past few quarters (dotted line in Exhibit 20) although absorption levels have remained healthy (the red column in Exhibit 20). Although the blended lease rentals in Mumbai are at sub-`100 levels, Oberoi’s incremental office inventory is being added in Goregaon, which corresponds to SBD West.

Exhibit 21: Business district-wise lease rent in Mumbai (`/sft/month)

Business district 1QCY12 3QCY12 4QCY12 1QCY13 3QCY13 Average

CBD & Off CBD 250 240 245 240 218 239

ABD 245 275 260 265 265 262

Central Mumbai 128 175 135 139 165 148

SBD West 89 110 90 92 102 97

SBD Central 90 90 92 90 85 89

PBD 44 50 44 42 48 46

Source: Knight Frank Office Traction November 2013, Ambit Capital research; Note: CBD & Off CBD corresponds to Nariman Point, Cuffe Parade, Ballard Estate, Fort, Mahalaxmi, Worli micro-markets; ABD corresponds to BKC, Bandra (E), Kalanagar and Kalina micro-markets; Central Mumbai consists of Parel, Lower Parel, Dadar and Prabhadevi micro-markets; SBD West consists of Andheri, Jogeshwari, Goregaon and Malad micro-markets; SBD Central corresponds to Chembur, Kurla, Ghatkopar, Vikhroli, Kanjurmarg, Powai and Bhandup micro-markets; PBD consists of Thane, Airoli, Vashi and Belapur micro-markets

A typical lease rental agreement on Oberoi’s commercial projects lasts for 5-7 years embedded with a rent reset clause every three years. However, given the ongoing sluggishness in the broader economic environment and supply outstripping demand for commercial properties (reflected in rising vacancies), we assume a 1% YoY decline in lease rental rates for all of Oberoi’s office projects. Any recovery in the office space segment, with a potential turnaround in absorption levels, poses an upside risk to our estimates on lease rent.

We assume a 3% YoY rise in the average rentals for Oberoi Mall (retail property) and a 5% YoY rise in RevPAR (revenue per available room), the key operating metric for the company’s hospitality projects (Westin and Oasis).

Occupancy rates for retail/commercial/hospitality projects: Given the continued weakness in the broader economic environment, we expect the demand for commercial office space to remain sluggish over the near term. Therefore, for upcoming office-use projects, we assume occupancy levels at 25% during Year 1, 50% during Year 2, 75% during Year 3 and gradually plateauing at a steady-state 85% over the next 10 years. Although the overall vacancy levels

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Oberoi Realty


in Mumbai are at an all-time high of over 20%, our analysis suggests that SBD West, the micro-market corresponding with Oberoi’s upcoming office space projects, consistently absorbs about one-third of the inventory every quarter (see Exhibit 22).

Exhibit 22: Business district-wise absorption in Mumbai (%)

Business district 1QCY12 3QCY12 4QCY12 1QCY13 2QCY13 3QCY13

CBD & Off CBD 1% 2% 4% 0% 3% 1%

ABD 6% 14% 3% 3% 6% 16%

Central Mumbai 17% 43% 29% 4% 34% 7%

SBD West 30% 13% 47% 47% 31% 32%

SBD Central 28% 18% 2% 15% 4% 14%

PBD 18% 10% 15% 31% 22% 30%

Source: Knight Frank Office Traction November 2013, Ambit Capital research; Note: CBD & Off CBD corresponds to Nariman Point, Cuffe Parade, Ballard Estate, Fort, Mahalaxmi, Worli micro-markets; ABD corresponds to BKC, Bandra (E), Kalanagar and Kalina micro-markets; Central Mumbai consists of Parel, Lower Parel, Dadar and Prabhadevi micro-markets; SBD West consists of Andheri, Jogeshwari, Goregaon and Malad micro-markets; SBD Central corresponds to Chembur, Kurla, Ghatkopar, Vikhroli, Kanjurmarg, Powai and Bhandup micro-markets; PBD consists of Thane, Airoli, Vashi and Belapur micro-markets

We assume occupancy rates for retail projects (Oberoi Mall) to continue at 99%. For hospitality projects, we assume an average occupancy rate of 75% for the Westin project (FY15E-19E) and 25-50% for the Worli project, due to the higher supply of five-star hotels in Worli as compared to a scarcity premium for such hotels in Goregaon.

Exhibit 23: Assumptions around occupancy levels (%) in Oberoi’s non-residential projects

Occupancy levels (%) FY14E FY15E FY16E FY17E FY18E FY19E FY20E FY21E FY22E FY23E FY24E FY25E FY26E

Office space Commerz I 85% 85% 85% 88% 88% 88% 90% 90% 90% 93% 93% 93% 95%

Commerz II - Phase 1 25% 50% 75% 80% 85% 85% 85% 85% 85% 85% 85% 85%

Commerz II - Phase II

0% 0% 25% 35% 45% 50% 55% 60% 65% 70% 75% 80%

Retail property

Oberoi Mall 99% 99% 99% 99% 99% 99% 99% 99% 99% 99% 99% 99% 99%

Hospitality projects Westin 75% 75% 75% 75% 75% 75% 80% 80% 80% 80% 80% 80% 80%

Oasis Hospitality

25% 35% 45% 55% 65% 70% 75% 75% 75% 75% 75% 75%


EBITDA margin in non-residential projects: Given that a typical office space lease agreement mandates the lessee to incur most of the maintenance expenses, we build in higher EBITDA margins in the office space segment.

Exhibit 24: EBITDA margin (%) assumptions for Oberoi’s non-residential projects

EBITDA margin (%) FY14E FY15E FY16E FY17E FY18E FY19E FY20E FY21E FY22E FY23E FY24E FY25E FY26E

Office space

Commerz I 99% 99% 99% 99% 99% 99% 99% 99% 99% 99% 99% 99% 99%

Commerz II - Phase 1 90% 90% 90% 90% 90% 90% 90% 90% 90% 90% 90% 90%

Commerz II - Phase II 90% 90% 90% 90% 90% 90% 90% 90% 90% 90%

Retail property

Oberoi Mall 95% 95% 95% 95% 95% 95% 95% 95% 95% 95% 95% 95% 95%

Hospitality project Westin 29% 30% 30% 30% 30% 30% 25% 25% 25% 25% 25% 25% 25%

Oasis Hospitality 10% 15% 20% 25% 25% 25% 25% 25% 25% 25% 25% 25%


Oberoi Realty


For the hospitality projects, we assume a maintenance cost of 10% (of operating revenues) on the Westin project and 15% (of operating revenues) on the Worli project (in line with the branded residency theme), undertaken in the form of construction expenditure. Taken alongside our EBITDA margin assumptions, this would imply that 10% of the operating revenues from the Westin project and 15% of the operating revenues from the Worli project are being re-invested in the respective projects every year.

Ancillary revenues from hospitality projects: We factor in a meaningful contribution of ancillary revenues to the overall revenues from both of Oberoi’s hospitality projects. We have assumed that the Worli (Oasis) hospitality project, on account of its competitive positioning, will take about 10 years to match the ancillary revenue contribution of the Westin project.

Exhibit 25: Ancillary revenue (% of total revenue) assumptions for Oberoi’s hospitality projects

Ancillary revenues (%) FY14E FY15E FY16E FY17E FY18E FY19E FY20E FY21E FY22E FY23E FY24E FY25E FY26E

Hospitality project Westin 50% 50% 50% 50% 50% 50% 50% 50% 50% 50% 50% 50% 50%

Oasis Hospitality

40% 40% 40% 40% 40% 40% 45% 45% 45% 45% 45% 50%


Oberoi Realty


Catalysts for our BUY stance Launch of Worli project by 1QFY15: We expect Oberoi to launch Oasis, its mixed-use Worli project, by 1QFY15. Oasis, proposed as a branded residency, consists of 1.8msf (million square feet) of residential and ~0.3msf of hospitality area.

Completion of Borivali land acquisition: For the Borivali 25-acre land acquisition transaction to go through, Oberoi Realty needs to obtain two major approvals by June 2014. Oberoi needs to obtain the collector’s permission for the sale of the Sanad land that forms a part of the total property and an NOC (no objection certificate) from the labour authority. If these approvals do not come through within three months, the MOU (Memorandum of Understanding) for the sale of land will stand annulled. Any potential annulment of this MoU, on any grounds, will be a significant negative for the visibility on Oberoi’s growth prospects.

Launch of Mulund project by 1HFY15: As highlighted in this note, timely launches are critical to reviving Oberoi’s sales run rate and consequently, its cash generation. The company secured the Supreme Court’s permission to begin construction, and thus, we expect the first phase of the Mulund project (1.6msf) to be launched by 2QFY15.

Risks to our BUY stance and our estimates Delayed launches: We have assumed project launches during each of the first two quarters of FY15. A delay of one quarter in launching the residential projects at Worli and Mulund will significantly drag the company’s cash flows on account of a larger portfolio of assets continuing to guzzle cash and an inadequate portfolio of annuity assets generating cash.

Borivali land acquisition falling through: Oberoi’s bid for the Borivali land has not only enhanced Oberoi’s growth prospects but has also acted as a powerful signal of Oberoi’s intent to deploy its cash meaningfully in accumulating inventory. Whilst timely launches are crucial to revive the company’s operating cash flows, these cash flows are meaningless without a pipeline of inventory. In fact, timely launches without any new land acquisition would further compound Oberoi’s problems by generating surplus cash without any avenue for re-deployment.

Forensic accounting flags Exhibit 26: Explanation for our forensic accounting flags on the front page

Segment Score Comment

Accounting GREEN Despite a sluggish 9MFY14 (in terms of fresh sales and cash flows), Oberoi boasts of a superior cash conversion ratio relative to its peers as well as a very strong balance sheet (zero leverage).

Predictability AMBER

Although Oberoi’s two key projects (Worli and Mulund) have been subject to exogenous factors (litigation and regulatory bottlenecks), resulting in inordinate delays in the launch of both properties. The company has been unable to guide investors realistically and it has made inadequate documented disclosures around the status of approvals and clearances.

Earnings momentum GREEN Oberoi recently emerged as the highest bidder for the Borivali land (put on the block by Tata Steel); the stock has witnessed sharp upgrades to its earnings contingent on the land acquisition transaction going through.


Oberoi Realty


Revision in estimates Exhibit 27: Revision in FY14E/FY15E/FY16E estimates

FY14E FY15E FY16E

Changes in estimates Old New % change Old New % change Old New % change

Operating income 10,221 8,599 -15.9% 11,800 11,742 -0.5% 15,074 14,370 -4.7%

EBITDA (` mn) 5,699 4,218 -26.0% 6,846 6,832 -0.2% 8,844 8,347 -5.6%

Net profit (` mn) 4,231 3,184 -24.7% 5,526 4,733 -14.3% 7,404 6,371 -14.0%

EPS (`) 12.9 9.7 -24.8% 16.8 14.4 -14.2% 22.6 19.4 -14.1%

BVPS (`) 129.2 126.9 -1.7% 142.5 139.2 -2.3% 161.5 155.6 -3.6%


Changes to FY14E estimates Our estimates for FY14E have undergone a sharp downward revision on account of a combination of limited inventory available for the sale in ongoing projects and lack of new project launches. The limited availability of inventory was driven by:

Delay in obtaining regulatory approvals to resume construction in Oberoi Esquire;

Availability limited to high-ticket-sized inventory in Oberoi Exquisite; and

Inventory exhaustion in completed projects - Splendor and Splendor Grande

Given Oberoi’s high operating leverage and zero leverage, the downward revision in our revenue estimates translates directly to a relatively sharper downgrade to our FY14E earnings estimates.

Changes to FY15E / FY16E estimates Our revenue estimates for FY15E/FY16E have been revised downwards (though not pulled down as sharply as our FY14E forecasts) as a result of our relatively conservative assumptions around project sales run rate and lower growth in realisation rates for the upcoming projects. The spill-over of project launches from FY14 into FY15E partially offsets this downward revision. However, our FY15E/ FY16E earnings estimates are more sharply impacted due to the interest burden from the debt that Oberoi would need to raise to fund the Borivali land acquisition.

Oberoi Realty


SWOT analysis Exhibit 28: Oberoi Realty - SWOT analysis Strengths Weaknesses

Strong brand with a reputation for reliable execution in Mumbai

Net cash of `5bn as of December 2013 as against the average gearing of 0.6x-0.7x for its closest peers (Sobha and Prestige)

Strong pipeline of ongoing (7.1msf) and planned projects (10.4msf) across formats (excluding the recent land acquisition at Borivali)

Best-in-class construction / architectural tie-ups with Samsung C&T, L&T and KPF

Stable stream of cash flows from annuity assets (commercial and hospitality segments), contributing north of 25% to operating income

High project concentration risk with 90% of projects exposed to Mumbai

Inability to adhere to launch timelines on account of regulatory delays (at least three projects stuck in litigation)

Opportunities Threats

Deployment of surplus cash towards opportunistic land acquisition such as the recent Borivali land acquisition

Strategic flexibility to bid for land parcels on the back of negligible leverage

Further delay in launches that drain surplus cash from the balance sheet

Desperation to generate returns may force the company towards acquiring land at unviable prices


Oberoi Realty


Balance Sheet

Year to March (` mn) FY12 FY13 FY14E FY15E FY16E

Shareholders’ funds 34,688 38,968 41,685 45,763 51,308

Loan funds 0 0 8,000 8,000 0

Net Fixed assets 9,850 10,714 10,423 10,626 12,297

Investments 0 0 4,000 0 0

Cash 12,934 10,725 9,886 6,418 280

Working capital 11,904 17,528 25,375 36,719 38,730

Book value per share (`) 105.7 118.7 127.0 139.4 156.3


Income statement


Revenue from residential projects 5,768 7,813 5,469 7,110 9,243

Hospitality services 897 956 1,146 2,336 2,453

Rentals and related income 1,289 1,398 1,504 1,798 2,096

Property and project management income 229 250 330 391 485

Other operating income 63 58 150 107 92

Total operating Income 8,247 10,476 8,599 11,742 14,370

Operating costs (2,958) (3,715) (3,698) (4,110) (5,029)

Total SG&A (452) (640) (684) (800) (994)

Total operating expenditure (3,411) (4,355) (4,381) (4,910) (6,023)

EBITDA 4,836 6,121 4,218 6,832 8,347

PBT 6,060 6,830 4,644 6,972 9,478

PAT 4,630 5,048 3,205 4,810 6,540

EPS (`) 14.1 15.4 9.8 14.7 19.9


Cash Flow statement

Year to March (` mn) FY14E FY15E FY16E

Total pre-tax CF 2,546 13,049 14,181

Tax (840) (4,306) (4,680)

CFO 1,706 8,743 9,501

FCFE 2,443 10,220 10,961

Changes in WC 7,847 11,344 2,011

Source: Company, Ambit Capital research, Note: All financials pertain to IFRS consolidated accounts

Ratio Analysis


P/E (x) 16.0 14.6 23.0 15.4 11.3

P/BV (x) 2.1 1.9 1.8 1.6 1.4

P/FCF

43.4 8.5 7.8

P/FCFE 30.3 7.2 6.8

ROE % 13.6 13.7 7.9 11.0 13.5

Net Debt/equity -0.37 -0.28 -0.14 0.03 -0.01

EBITDA margin (%) 58.6 58.4 49.1 58.2 58.1

Net margin % 47.5 44.0 34.3 36.4 41.3

Dividend yield % 1.0 1.0 0.7 1.0 1.3


Oberoi Realty


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Position of relative strength With a growing diversified presence across key southern geographies, especially in NRI-rich cities, Sobha has gradually positioned itself in a sweet spot. The company is focused on further penetrating the southern markets beyond Bangalore (its primary market). In addition, it has a tight collection system. Thus, we expect a quarterly launch run rate of 2msf to translate into a strong pre-sales run rate in excess of 4msf in FY15E/FY16E. We are BUYers with a sum-of-the-parts valuation of `490, implying 9.6x FY15E P/FCFE.

Competitive position: STRONG Changes to this position: POSITIVE

FY14 guidance disappointment transitory; well poised for FY15

During FY14, Sobha disappointed on its guidance with volume sales at 3.6msf (vs guidance of 4.2msf) and value sales at `23.4bn (vs guidance of `26bn) primarily due to delayed launches. However, with a 20% QoQ increase in pre-sales during 4QFY14, unrecognised revenues from sold units at `23bn (100% of its December 2013 net worth) and three large projects launched towards end-March 2014, we expect Sobha to regain its sales momentum in FY15.

Cash inflows (net of interest payout) strong; FY15 refinancing crucial

Sobha generated a steady stream of cash inflows from its real estate segment (quarterly run rate of `4.5bn) and its contracted projects (quarterly run rate of `1.7bn) during 9MFY14. During 9MFY14, Sobha averaged `0.7bn-0.8bn of quarterly net cash from operations (CFO), net of interest payouts. With net debt to equity at 0.6x, Sobha is exposed to a manageable refinancing risk with over `8.5bn (0.3x net worth) due for repayment during FY15.

Backward integration and strong launch pipeline imply sweet spot

Sobha’s backward-integrated business model has consistently helped achieve timely execution of projects (annual development run rate of over 6msf since FY08) whilst maintaining the highest quality standards for contracted projects as well as its own projects. Concomitant with its backward-integrated business model, a visible pick-up in sales momentum, steady cash conversion and a strong launch pipeline, Sobha is in a sweet spot.

Valuation at `490/share; remain BUYers

We use a project-based DCF approach to arrive at a valuation of `490/share, implying a 30% upside, valuing the company at 9.6x FY15E FCFE. As Sobha predominantly operates through joint development agreements (JDAs), a capital-light business model, P/FCFE is an ideal measure for valuing a stable-debt Sobha. A higher-than-expected interest rate environment and lower-than-anticipated cash inflows are key risks to our BUY stance.

Sobha Developers BUY

COMPANY INSIGHT SOBHA IN EQUITY April 23, 2014

Key financials


Net Revenues (` mn) 14,079 18,645 20,931 24,500 29,765

Operating Profits (` mn) 4,666 5,483 5,905 7,300 8,995

Net Profits (` mn) 2,060 2,172 2,245 2,845 3,675

Diluted EPS (`) 21.0 22.1 22.9 29.0 37.5

RoE (%) 10.7 10.5 10.5 12.7 14.7

P/E (x) 17.8 16.8 16.3 12.9 9.9

P/B (x) 1.8 1.7 1.6 1.5 1.3


Real Estate

Recommendation Mcap (bn): `37/US$0.6 6M ADV (mn): `83/US$1.4 CMP: `376 TP (12 mths): `490 Upside (%): 30

Flags Accounting: AMBER Predictability: AMBER Earnings Momentum: GREEN

Catalyst

OMR (Chennai) project launch in 1HFY15

Gurgaon project launch during 1HFY15

Launch of APMC project in Bangalore

Performance (%)


Analyst Details

Krishnan ASV +91 22 3043 3205 [email protected]

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Sobha Developers


Snapshot of Company Financials Profit and Loss Company Background Year to March FY13 FY14E FY15E FY16E Revenues from property development 13,092 15,762 17,984 21,754

Revenues from sale of land & TDR

1,020 0 0 0

Revenue from sale of manufactured products 1,477 1,725 2,187 2,766

Revenues from contractual projects

3,013 3,390 4,261 5,160

Other operating income 43 54 67 84

Total income 18,645 20,931 24,500 29,765

Operating costs (9,103) (10,252) (12,356) (14,957)

Total SG&A (incl. employee costs) (4,060) (4,101) (4,942) (5,983)

EBITDA 5,483 5,905 7,300 8,995

PBT 3,239 3,257 4,312 5,376

PAT 2,172 2,245 2,845 3,675

EPS (`) 22.1 22.9 29.0 37.5

Sobha Developers (Sobha), one of India’s foremost real estate developers, is focused on residential formats (c.40%) and contractual projects (c.60%) with a sizeable exposure (90% of 61msf in completed projects) to the relatively stable south Indian market. Sobha has an ongoing real estate project slate of 18.9msf under construction (55% in Bangalore) and a contract portfolio of 9.5msf (60% contracted by Infosys). Whilst the portfolio of ongoing real estate projects is relatively more concentrated in Bangalore (56%), the portfolio of contracts is comparatively better-diversified (32% exposure to Bangalore). With its backward-integrated business model and an under-construction area of ~36msf likely to act as feedstock for a steady stream of launches, we expect a quarterly launch run rate of 2msf to translate into a strong pre-sales run rate in excess of 4msf in FY15E/FY16E.

Balance Sheet Cash flow Year to March FY13 FY14E FY15E FY16E

Shareholder’s fund 21,234 22,819 24,948 27,793

Debt 13,787 14,787 15,787 16,787

Minority interest 102 102 102 102

Net Fixed Assets 3,169 2,634 2,127 1,644

Investments 2 2 2 2

Cash & bank balance 670 4,086 7,631 12,920

Working capital 31,283 30,986 31,078 30,115

Book value per share (`) 216.5 231.4 252.8 279.7

Year to March FY14E FY15E FY16E

Total pre-tax CF 6,558 7,710 10,582

Tax (1,141) (1,496) (1,906)

CFO 5,417 6,214 8,677

FCFE 3,203 3,773 5,875

Changes in WC 297 (92) 963

Pre-sales (` mn) - 4QFY14 witnessing an uptick Cost of debt benefiting from rating upgrades


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Sobha Developers


FY14 - guidance miss but exit on a high 4QFY14 signals meaningful sequential turnaround Sobha delivered FY14 volume sales at 3.6msf (guidance: 4.2msf) and value sales at `23.4bn (guidance: `26bn). However, with a 20% QoQ increase in pre-sales during 4QFY14, unrecognised revenues from sold units at `23bn (100% of its December 2013 net worth) and strong demand for large projects launched towards the end of March 2014, we expect Sobha to regain its sales momentum during FY15.

Despite falling short of its FY14 volume and value sales guidance, Sobha saw a visible turnaround in sales momentum by end-FY14, as reflected in a 20% sequential pick-up in pre-sales during 4QFY14 (at `6bn) as compared to a sub-par 3QFY14 (at `5bn). The recovery comes on the back of 3.6msf of launches in south India during the March quarter that garnered strong demand after a sluggish 3QFY14 (when sales volumes dipped to a ten-quarter low of 0.74msf).

Exhibit 1: Pre-sales (` mn) - turnaround during 4QFY14


Exhibit 2: Area sold (sft) - 4QFY14 witnessing an uptick


We attribute the sales momentum to Sobha’s strategy of focusing on lower ticket sizes in the `7.5mn-15mn price bracket that continues to see stable demand. Given the strong reception to its recent project launches, we believe that Sobha will be able to deliver volume sales north of 4msf in FY15/FY16E on the back of a relatively strong pipeline of launches in south India.

Reducing concentration risk; benefiting from diversified presence

At the end of March 2014, Sobha has a real estate presence in 9 cities (up from 4 as of March 2011). Sobha’s primary market remains Bangalore (accounting for c.68% of volumes and 73% of value sales on an average), which ranks extremely high on the employment creation and affordability metrics. By FY16, we expect the contribution of Bangalore to Sobha’s volume sales to decline to c.60%.

Exhibit 3: Contribution of newly added locations to overall volumes (% of total sft)

Location Launch debut Average contribution to area sold (%)

Mysore 1QFY12 1.9%

NCR 2QFY12 9.6%

Chennai 4QFY12 8.2%

Kozhikode 2QFY14 4.9%

Cochin 4QFY14 1.8%


0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

1Q12

2Q12

3Q12

4Q12

1Q13

2Q13

3Q13

4Q13

1Q14

2Q14

3Q14

4Q14

0

200,000

400,000

600,000

800,000

1,000,000

1,200,000

1Q12

2Q12

3Q12

4Q12

1Q13

2Q13

3Q13

4Q13

1Q14

2Q14

3Q14

4Q14

Volume recovery during 4QFY14 on the back of launches in south India and more affordable units in Bangalore

Sobha Developers


Our discussion with the management team suggests that the company is looking to nearly double its new sales volume from ~3.6msf (as of FY14) to ~7msf over the next five years (FY19), with the contribution of Bangalore likely to drift lower to 50%. Even within Bangalore, Sobha is focused on gradually moving towards smaller-sized units (from 3BHK formats of 1,800sft-2,000sft to 2BHK formats of 1,350sft) to reduce the unitary ticket size and enhance its offerings in the affordable segment.

Exhibit 4: Location-wise breakdown of volume sales (sft) - growing contribution from NRI-rich locations

1Q13 2Q13 3Q13 4Q13 1Q14 2Q14 3Q14 4Q14

Bangalore 520,080 590,438 591,216 682,629 603,055 674,622 503,708 630,947

Thrissur 44,096 118,306 88,407 93,034 149,194 103,270 49,064 58,458

Coimbatore 26,005 10,631 19,574 7,160 0 15,871 17,124 40,171

Pune 30,639 38,621 23,124 45,324 22,912 12,716 24,433 23,395

NCR 135,721 137,600 103,098 132,732 36,255 30,892 23,522 38,114

Chennai 72,083 42,323 67,350 106,377 99,963 86,869 53,523 62,195

Mysore 6,975 8,209 9,881 4,015 9,300 22,128 26,538 19,547

Cochin NP NP NP NP NP NP NP 16,252

Kozhikode NP NP NP NP NP 56,661 42,293 32,193

Total 835,599 946,128 902,650 1,071,271 920,679 1,003,029 740,205 921,272

Source: Company, Ambit Capital research; Note: NP indicates no projects on offer in the city during that quarter

Sobha’s volume sales, although a function of the exogenous economic environment, are also a function of increasing penetration into newer cities as well as a stronger launch pipeline in its traditional markets.

Exhibit 5: New geographies - contribution from Bangalore likely to decline further


Our discussions with the management team and independent consultants suggest that Sobha is actively scouting for land parcels in the southern city of Hyderabad (either outright acquisition or through the joint development agreement route) to add to its slate of 9 locations.

4

5

6

7

8

9

10

60.0%

62.0%

64.0%

66.0%

68.0%

70.0%

72.0%

74.0%

1Q12 2Q12 3Q12 4Q12 1Q13 2Q13 3Q13 4Q13 1Q14 2Q14 3Q14 4Q14

Number of cities (RHS) Area sold in Bangalore (% of total sft)

Sobha Developers


Strong cash conversion to be tested Cash inflows (net of interest payouts) to pick up pace Net of interest payouts, Sobha has averaged `0.7bn-0.8bn of quarterly net cash from operations (CFO) during 9MFY14, aided by a steady stream of cash inflows from its real estate operations (quarterly run rate of `4.5bn) as well as its contracted projects (quarterly run rate of `1.7bn). Net debt-to-equity is comfortable at 0.6x, with the average cost of debt at 12.7%, gaining from an improving credit profile (on the back of timely repayments and steady cash flows). However, Sobha is exposed to high refinancing risk with over `8.5bn (0.3x December 2013 net worth) due for repayment during FY15.

Although Sobha’s net debt-to-equity has been stable at 0.6x over the past eight quarters, the cost of debt has been trending lower during the corresponding period (in an increasing interest rate environment), primarily on the back of upgrades from rating agencies (ICRA and Brickworks) during FY14.

Exhibit 6: Net debt-to-equity stable at 0.6x


Exhibit 7: Cost of debt benefiting from rating upgrades


Our discussion with rating agencies suggests that the upgrades were primarily driven by steady cash flows on the back of healthy sales velocity in its ongoing projects and periodic repayments of its existing debt, with the 3QFY14 volume print an exception to the trend. Sobha’s improving credit profile has been driven by a healthy mix of recurring cash flows from its contractual projects (~26% of total cash inflows from operations as of 9MFY14).

Exhibit 8: Segmental cash collections - stable, recurring cash flows from contracts


0.52

0.54

0.56

0.58

0.6

0.62

0.64

10.0

10.5

11.0

11.5

12.0

12.5

13.0

13.5

1Q12

2Q12

3Q12

4Q12

1Q13

2Q13

3Q13

4Q13

1Q14

2Q14

3Q14

Net debt (Rs bn) Net debt-to-equity (x) (RHS)

13.5%

13.9%14.1%

13.9%13.7%

13.6%13.6%

13.5%

12.9%

12.7% 12.7%

12.0%

12.5%

13.0%

13.5%

14.0%

14.5%

420

440

460

480

500

520

540

1Q12

2Q12

3Q12

4Q12

1Q13

2Q13

3Q13

4Q13

1Q14

2Q14

3Q14

Finance cost (Rs mn)

Blended cost of debt (annualized) (%) (RHS)

3,249 3,687 3,8835,293 4,923 4,552 4,445

764798

1,495

1,037 1,230 1,788 2,111

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

1Q13 2Q13 3Q13 4Q13 1Q14 2Q14 3Q14

Real estate Contracts Monetization of land

Cost of debt down by ~80bps in the past eight quarters, benefiting from rating upgrades by ICRA and Brickworks during FY14

Rising contribution of operating cash inflows from recurring cash flows (contract projects)

Sobha Developers


Over `8.5bn (over 50% of outstanding debt) up for repayment during FY15

Our discussion with rating agencies suggests that debt of `8.5bn (of the overall net debt of `13bn) is up for repayment during FY15. Although Sobha has matching undrawn sanctioned limits for its ongoing and planned projects, the disbursement of incremental debt is contingent upon the timely launch and progress of these projects. Also, one of Sobha’s proposed launches over the next four quarters is the development of a commercial project awarded by APMC (Agricultural Produce Market Committee), which is likely to result in increased funding requirements.

High but manageable refinancing risk during FY15

Hence, Sobha is exposed to high refinancing risk in a high interest rate environment (our Macro team expects a further 25-50bps hike in repo rate during 1HFY15). The refinancing risk (potentially higher cost of debt) is further exacerbated by the fact that the debt repayment is to be made out of customer collections, which depends on the timing and success of its recent as well as upcoming launches.

As a result, we expect Sobha to expedite the pace of launches and front-load some of its proposed launches (residential) during the early part of FY15 to stimulate its cash inflows and manage the refinancing risk better.

Exhibit 9: Format-wise proposed launches during April-December 2014

Format Sobha's share of saleable area (sft)

Residential 3,323,893

Bangalore 682,143

Gurgaon (NCR) 102,420

Chennai 1,984,850

Coimbatore 206,000

Thrissur 348,480

Commercial 2,063,252

Bangalore 2,063,252

TOTAL 5,387,145


We expect Sobha to launch its commercial project during 2HFY15 to manage its cash flows better (operating cash inflows are likely to be relatively slower from the commercial project vis-à-vis the residential properties). During the early part of FY15, we believe Sobha will be more aggressive on its residential launches, especially in Gurgaon (offers higher realisations) and Chennai (offers relatively higher volume).

Going forward, the quantum of undrawn sanctioned limits that Sobha needs to draw upon as well as the cost of incremental debt will be influenced by:

Sales velocity in recently-launched and upcoming residential projects;

Ability to maintain collection efficiency;

Pace of execution of new launches; and

Recurring cash flows from contracts (cash inflows).

Debt of `8.5bn (of the overall net debt of `13bn) is up for repayment during FY15; Sobha is exposed to high but manageable refinancing risk in a high interest rate environment

We expect the commercial project launch to be back-ended during FY15 for Sobha to better manage its cash flows

Sobha Developers


Project details Sobha has an ongoing real estate project slate of 18.9msf under construction (55% in Bangalore) and a contract portfolio of 9.5msf (60% contracted by Infosys). Whilst the portfolio of ongoing real estate projects (see Exhibit 10) is relatively more concentrated in Bangalore, the portfolio of contracts (see Exhibit 11) is comparatively better-diversified.

Exhibit 10: Location mix of ongoing projects (18.9msf)


Exhibit 11: City mix of ongoing contract projects (9.5msf)


Real estate projects Aside from its ‘under-construction’ projects, Sobha has an undeveloped land bank of over 2,500 acres (translating into saleable area of 227msf), with a majority of its land bank in IT/ITeS-centric cities. Sobha’s land bank is well diversified in IT/ITeS-driven locations that contribute 80% to the company’s land bank and 81% to its discounted cash flow (DCF) (see Exhibit 12).

Exhibit 12: City-wise land bank - demand and valuation drivers

Location % of land bank % contribution to DCF Key buyer segments

Bangalore 38.2% 41.0% IT/ITeS

Chennai 17.0% 19.0% IT/ITeS

Coimbatore 2.7% 2.1% IT/ITeS

Gurgaon 0.0% 3.0% BPO/KPO/IT/ITeS

Hosur 15.4% 11.0% IT/ITeS

Kochi 21.3% 14.0% NRI

Kozhikode 0.2% 0.2% NRI

Mysore 0.3% 0.3% IT/ITeS

Pune 2.3% 7.0% IT/ITeS

Thrissur 2.5% 2.4% NRI


Bangalore56%

Gurgaon22%

Thrissur8%

Chennai5%

Kozhikode3%

Others6%

Bangalore32%

Hyderabad17%Trivandrum

15%

Mangalore10%

Pune7%

Jaipur6%

Others13%

Sobha Developers


Valuation We use a sum-of-the-parts (SOTP) approach and arrive at a valuation of `490/share (marginal upward revision from our earlier valuation of `486/share), implying a 30% upside. We value the real estate business at `441/share (using a DCF approach) and the contracts business at `49/share.

Exhibit 13: Sum-of-the-parts valuation (`/share)

Real estate projects valuation (` mn) 43,413

Real estate projects (`/shr) 442

Contracts business valuation (` mn) 4,800

Contracts business (`/shr) 49

Total valuation (` mn) 48,213

SOTP Valuation (`/shr) 491


Exhibit 14: Valuation of real estate business (`/share)

Real estate projects (` mn) 59,317

Less: Unpaid land bank (` mn) 1,250

Less: Net debt (March 2015) (` mn) 14,654

Net valuation (` mn) 43,413

No. of shares (mn) 98.2

Net valuation (`/shr) 442


Assumptions around valuation parameters Target leverage: We assume long-term target gearing at 0.7x - this compares

to 0.6x net debt-to-equity that the company has been maintaining over the past 8 quarters.

Weighted average cost of capital: Assuming cost of equity at 18%, we arrive at a weighted average cost of capital of 14.3%. Cost of equity at 18% is higher than the 15% that we assume for Oberoi Realty. On the other hand, we assume cost of debt at 14%, ~125bps higher than Sobha’s current cost of debt (12.7% as of December 2013).

Real estate projects Given Sobha’s discontinued disclosures around project-wise sales and project-level progress, we cumulate the city-wise pre-sales based on management guidance and inputs from independent consultants.

Annual run rate of sales: For under-construction projects that are yet to be launched, we build in about 50% of the total sales to be achieved by Year 1 after launch and 80% of cumulative sales by Year 3. For all projects, we assume the ‘stock out’ stage is triggered about 12-18 months after project completion. For all the upcoming projects, we build in a delay of 12-18 months in project completion. Although Sobha claims to complete its residential projects over a period of 2.5 years to 3.5 years, our assumptions around delays are conservative, given the usual issues around labour shortage.

Our assumptions around sales run rate are consistent with a typical project life-cycle in which sales are high during the initial phase (after the project launch) and gather fresh momentum as the project nears completion (pull factor on account of customers looking for ‘ready-to-move-in’ properties). However, the run rate of sales tapers off during the interim.

Growth in average realisation rates in ongoing projects: For FY15, in the case of ongoing projects, we have benchmarked average realisation rates based on our discussion with independent consultants. In general, we assume c.8% YoY increase in average realisations between FY15E and FY18E followed by 5% YoY increase in average realisations thereafter until the project is completely sold out.

Growth in realisation rates in upcoming projects: For the upcoming projects, we have assumed c.8% YoY increase in average realisation for the first two years after launch followed by 5% YoY increase in average realisations thereafter until the project is completely sold out. Our base realisation (pricing at the time of launch of such projects) is at a 5-10% discount to the prevailing pricing for comparable projects in the relevant micro-market.

Sobha Developers


Outflow pertaining to construction costs: For projects under construction, we have assumed that: (a) construction costs are distributed over the construction period proportionate to the percentage of completion; and (b) project is delayed by 1-2 years relative to the management’s targeted completion schedule on account of labour shortage.

We have individually projected the construction costs for each residential project from FY14E (or the time of launch, whichever is earlier) until project completion, using the percentage of completion approach. We use an average construction cost (per sft) of `3,000-3,600 for premium projects and `1,500-2,000 for Sobha’s lower price band projects and projects in the smaller cities.

Rise in input costs of construction: For all projects under construction, we have assumed 8% YoY increase in cost of construction (per sft) during the first four years of a project and 5% thereafter until project completion. Our assumptions around YoY cost inflation are based on trends around indexed building construction costs published by the Construction Industry Development Council (CIDC). Our estimates around rise in input costs are conservative given the fact that the cost of building construction increased ~4% in Mumbai and ~5% each in Delhi and Bangalore over the past five years (between January 2009 and March 2014). Concomitant with our assumptions around growth in blended realisation rates, we believe that Sobha’s pricing power is only restored on select projects post FY18E.

Exhibit 15: YoY movement in building construction costs in major real estate markets

Source: CIDC, Ambit Capital research

Exhibit 16: Key assumptions

FY14E FY15E FY16E Remarks

Volumes (msf) Residential 3.59 3.91 4.37 We expect residential sales to record a 9% YoY growth during FY15E and a

12% YoY growth during FY16E

Contractual sales 3.41 3.98 4.53 Given the contractual nature of projects (with relatively higher visibility), we build in a 17% YoY growth in contract volumes during FY15E and 14% YoY growth during FY16E

Realization rates (`/sft) Residential 6,534 6,926 7,342 We build in 6% YoY blended rise in realisation rates during FY15E and FY16E

Contracts 1,500 1,620 1,750 We build in 8% YoY rise in blended realisations during FY15E and FY16E

Pre-sales value (` mn) Residential sales 23,457 27,081 32,085

The pre-sales value is driven by 9-12% rise in volumes and a 6% rise in realisation rates

Contracts 5,115 6,448 7,926

Construction cost (`/sft) 1,900 2,050 2,200 We assume rise in input costs at around 8% for FY15E and 7% for FY16E

Average cost of debt (%) 12.75% 14% 14% We assume a 125bps increase in cost of debt during FY15E and FY16E


0%2%4%6%8%

10%12%14%16%18%

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Mumbai Delhi Bangalore

Sobha Developers


Catalysts for our BUY stance Launch of residential project in Chennai: We expect Sobha’s residential project launch in Chennai during 1HFY15 to improve the company’s net cash reserves prior to the principal repayment cycle.

Launch of residential project in Gurgaon: Whilst the Chennai projects are likely to drive volume sales, the residential project launch in Gurgaon is likely to contribute towards better realisations (higher unitary ticket size).

Launch of commercial project during 2HFY15: We expect Sobha to launch its commercial project at Bangalore during 2HFY15 to better manage its cash flows and principal repayment during the year.

Risks to our BUY stance and our estimates Delayed launches: We have assumed project launches during each of the first two quarters of FY15 and a front-loading of residential projects in Chennai and Gurgaon. A delay of one quarter in launching the residential projects at Chennai and Gurgaon will significantly drag Sobha’s cash inflows and raise its net debt-to-equity position.

Weak sales velocity in recently launched projects: As highlighted earlier, a weak sales velocity in its recent and upcoming launches coupled with a fall in pricing power (for Sobha) will further accentuate the need for refinancing.

Premature launch of commercial project at Bangalore: We have assumed that Sobha would launch its commercial project at Bangalore during 2HFY15. An earlier launch of the commercial project would imply greater strain on the expected pace of cash inflows, which might have to be offset by higher debt at the wrong end of the interest rate cycle.

Risk of refinancing: We have assumed that Sobha can refinance its debt maturing during FY15 at 14% (higher than Sobha’s current cost of debt by ~120bps). A higher-than-anticipated interest rate environment and lower-than-anticipated cash inflows (resulting in tighter liquidity) are risks to our BUY stance.

Forensic accounting flags Exhibit 17: Explanation for our forensic accounting flags on the front page

Segment Score Comment

Accounting AMBER

Despite an improving cash conversion over the past three years (FY11-13), Sobha ranks behind its other A-grade peers such as Oberoi Realty; relatively low cash yield; elevated contingent liabilities as a proportion of net worth; extremely low audit fees (as proportion of auditor remuneration).

Predictability AMBER Instances of missed guidance despite exercising relatively better control over the supply chain.

Earnings momentum GREEN The company launched four new projects (Bangalore, Kozhikode and Cochin) during 4QFY14, and thus, the stock has seen upgrades to its FY15E earnings.


Sobha Developers


Revision in estimates Exhibit 18: Revision in FY14E/FY15E/FY16E estimates

FY14E FY15E FY16E

Changes in estimates Old New % change Old New % change Old New % change

Operating income 20,559 20,931 1.8% 24,779 24,500 -1.1% 29,998 29,765 -0.8%

EBITDA (` mn) 6,205 5,905 -4.8% 7,481 7,300 -2.4% 9,058 8,995 -0.7%

Net profit (` mn) 2,318 2,245 -3.1% 3,038 2,845 -6.4% 3,870 3,675 -5.0%

EPS (`) 23.6 22.9 -3.0% 31.0 29.0 -6.4% 39.5 37.5 -5.2%

BVPS (`) 232.7 231.4 -0.6% 254.4 252.8 -0.6% 283.4 279.7 -1.3%


Changes to FY14E estimates Our earnings estimates for FY14E have undergone a marginal downward revision due to lower-than-anticipated pre-sales volume and lower EBITDA margin during FY14 on account of:

One-time write-off of `63mn on account of one-time settlement on a contract;

Weak demand fundamentals in the Gurgaon and Pune markets; and

Delayed launches in the southern Indian markets.

Changes to FY15E / FY16E estimates Our revenue estimates for FY15E/FY16E have been revised marginally downwards as a result of relatively conservative assumptions around project sales run rate and lower growth in realisation rates in ongoing projects. However, our FY15E/ FY16E earnings estimates are more sharply impacted on account of the higher cost of debt that we have assumed for Sobha during FY15.

Sobha Developers


SWOT Analysis Exhibit 19: Sobha Developers - SWOT analysis Strengths Weaknesses

Well-located land bank in IT/ITeS-dominated cities such as Bangalore, its primary market, Gurgaon, Chennai and Pune, accounting for over 80% of the company’s saleable area

Sizeable presence in Kerala markets with relatively high proportion of NRI diaspora

Diversified presence in 9 cities (real estate projects) with contribution from Bangalore, its primary market, gradually reducing from over 75% to about 65%

Infosys’ partner of choice for civil contracts (own buildings)

Backward-integrated business model with subsidiaries engaged in metalwork manufacturing (0.3msf), woodwork manufacturing (0.8msf), giving Sobha better control on the supply chain

High concentration risk in the contracts business with 60% of orders from

Infosys

High refinancing risk with about `8.5bn up for principal repayment during FY15

Opportunities Threats

Expansion into formats other than residential such as commercial (office and retail)

Expansion into newer geographies to reduce dependence on Bangalore, its primary market

Fixed-margin contract business with high client concentration

Rise in net debt-to-equity in case of lower sales velocity from recently launched projects or delayed launches


Sobha Developers


Balance Sheet


Shareholder’s fund 19,956 21,234 22,819 24,948 27,793

Debt 12,440 13,787 14,787 15,787 16,787

Minority interest 355 102 102 102 102

Net Fixed Assets 2,810 3,169 2,634 2,127 1,644

Investments 0 2 2 2 2

Cash & bank balance 588 670 4,086 7,631 12,920

Working capital 29,352 31,283 30,986 31,078 30,115

Book value per share (`) 203.5 216.5 231.4 252.8 279.7


Income statement


Revenues from property development 8,948 13,092 15,762 17,984 21,754

Revenues from sale of land & TDR 1,365 1,020 0 0 0 Revenue from sale of manufactured products

1,393 1,477 1,725 2,187 2,766

Revenues from contractual projects 2,348 3,013 3,390 4,261 5,160

Other operating income 25 43 54 67 84

Total income 14,079 18,645 20,931 24,500 29,765

Operating costs (4,447) (9,103) (10,252) (12,356) (14,957)

Total SG&A (incl. employee costs) (4,967) (4,060) (4,101) (4,942) (5,983)

EBITDA 4,666 5,483 5,905 7,300 8,995

PBT 3,177 3,239 3,257 4,312 5,376

PAT 2,060 2,172 2,245 2,845 3,675

EPS (`) 21.0 22.1 22.9 29.0 37.5


Cash Flow statement

Year to March FY14E FY15E FY16E

Total pre-tax CF 6,558 7,710 10,582

Tax (1,141) (1,496) (1,906)

CFO 5,417 6,214 8,677

FCFE 3,203 3,773 5,875

Changes in WC 297 (92) 963

Source: Company, Ambit Capital research, Note: All financials pertain to IFRS consolidated accounts

Ratio Analysis


P/E (x) 17.8 16.8 16.3 12.9 9.9

P/BV (x) 1.8 1.7 1.6 1.5 1.3

P/FCF 5.5 4.8 3.5

P/FCFE 9.4 8.0 5.1

ROE % 10.7 10.5 10.5 12.7 14.7

Debt/equity 0.62 0.65 0.65 0.63 0.60

EBITDA margin % 33.1 29.4 30.2 30.2 30.2

Net margin % 14.6 11.6 11.2 12.1 12.7

Dividend yield % 1.6 2.3 2.4 3.0 3.4


Sobha Developers


Institutional Equities Team

Saurabh Mukherjea, CFA CEO, Institutional Equities (022) 30433174 [email protected]

Research

Analysts Industry Sectors Desk-Phone E-mail

Aadesh Mehta Banking & Financial Services (022) 30433239 [email protected]

Achint Bhagat Cement / Infrastructure (022) 30433178 [email protected]

Aditya Khemka Healthcare (022) 30433272 [email protected]

Akshay Wadhwa Banking & Financial Services (022) 30433005 [email protected] Ankur Rudra, CFA Technology / Telecom / Media (022) 30433211 [email protected]

Ashvin Shetty, CFA Automobile (022) 30433285 [email protected]

Bhargav Buddhadev Power / Capital Goods (022) 30433252 [email protected]

Dayanand Mittal, CFA Oil & Gas / Metals & Mining (022) 30433202 [email protected]

Deepesh Agarwal Power / Capital Goods (022) 30433275 [email protected] Gaurav Mehta, CFA Strategy / Derivatives Research (022) 30433255 [email protected]

Karan Khanna Strategy (022) 30433251 [email protected]

Krishnan ASV Real Estate (022) 30433205 [email protected]

Nitin Bhasin E&C / Infrastructure / Cement (022) 30433241 [email protected]

Nitin Jain Technology (022) 30433291 [email protected]

Pankaj Agarwal, CFA Banking & Financial Services (022) 30433206 [email protected]

Pratik Singhania Real Estate / Retail (022) 30433264 [email protected]

Parita Ashar Metals & Mining / Oil & Gas (022) 30433223 [email protected]

Rakshit Ranjan, CFA Consumer / Real Estate / Retail (022) 30433201 [email protected]

Ravi Singh Banking & Financial Services (022) 30433181 [email protected]

Ritika Mankar Mukherjee, CFA Economy / Strategy (022) 30433175 [email protected]

Ritu Modi Automobile (022) 30433292 [email protected]

Tanuj Mukhija, CFA E&C / Infrastructure (022) 30433203 [email protected]

Sales

Name Regions Desk-Phone E-mail

Deepak Sawhney India / Asia (022) 30433295 [email protected]

Dharmen Shah India / Asia (022) 30433289 [email protected]

Dipti Mehta India / USA (022) 30433053 [email protected]

Nityam Shah, CFA USA / Europe (022) 30433259 [email protected]

Parees Purohit, CFA UK / USA (022) 30433169 [email protected]

Praveena Pattabiraman India / Asia (022) 30433268 [email protected]

Sarojini Ramachandran UK +44 (0) 20 7614 8374 [email protected]

Production

Sajid Merchant Production (022) 30433247 [email protected]

Sharoz G Hussain Production (022) 30433183 [email protected]

Joel Pereira Editor (022) 30433284 [email protected]

Nikhil Pillai Database (022) 30433265 [email protected]

E&C = Engineering & Construction

Sobha Developers


Explanation of Investment Rating Investment Rating Expected return

(over 12-month period from date of initial rating)

Buy >5%

Sell <5%

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Additional Disclaimer for U.S. Persons

20. The research report is solely a product of AMBIT Capital 21. AMBIT Capital is the employer of the research analyst(s) who has prepared the research report 22. Any subsequent transactions in securities discussed in the research reports should be effected through J.P.P. Euro-Securities, Inc. (“JPP”). 23. JPP does not accept or receive any compensation of any kind for the dissemination of the AMBIT Capital research reports. 24. The research analyst(s) preparing the research report is resident outside the United States and is/are not associated persons of any U.S. regulated broker-dealer and that therefore the

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