Description
Mohnish Pabrai’s significant (9.99%) investment in a high-end
property developer in India— Sunteck Realty, caught my eye. Sunteck’s strategy
remains focused on Mumbai Metropolitan Region with more than 60% of the land
acquired in Mumbai.
This is a breakdown of why this is a good investment, since the
stock dropped from 438 rupees per share on January 10, 2020 back to a low point
of 185 on July 31, 2020 due to the corona virus and other demonetization
policies (described later in the thesis). A decline in total income from 890
crore in the previous year to 631 crore and a 91% decline for 2020’s June
quarter in respect to 2019’s earnings provide a cheap price for an outstanding
company.
Sunteck’s management has consistently increased their
shareholding by buying shares in the open market from 65% in 2010 to more than
73% in 2016. During
2014 and 2015 managers and Sunteck’s founder, Kamal Khetan, voluntarily decided
not to take any dividend— dividend was only distributed only to shareholders—
managers voluntarily waived their right to get the dividend which amounted to
4.65 crores.
Background:
Currently, Sunteck has 26 projects aggregating to development
potential of around 30 million ft2, of which about 72% is in residential
segment and the rest a balance of commercial & retail with 4 rented assets
providing annual income.
Out of the said development potential, Sunteck has an economic
interest approximately 12 million ft2 of developable area. This scale of
development portfolio has been achieved within a short span since Sunteck’s
foray into real estate development business in 2005.
Sunteck is to create a suburban rental portfolio of
approximately 2,700m Rupees (USD36M) per annum for SRL. 2.6M ft2 in the
location of ODC, Goregaon (W) in Mumbai for back-office and mid-office. Rental
yields range from 5-9%.
Residential property, which is to be developed and sold over the
next 2-5 years, brings in 34 billion rupees (USD450M) of revenue. The new
parcel purchased in Vasai ensures sufficient for development over the next 5-7
years.
Below are 6 reasons why Sunteck will prosper in the long term:
1. Demonetization and regulation
(RERA, GST) leads to consolidation of real estate players
India has been fighting
corruption and would like to bring transparency to the real estate sector. In
2016, demonetization was implemented, and 85% of the existing currency was
wiped out. Sunteck has always done
things the right way— they have insisted in all of their transactions being
paid in forms other than cash—cheque, TT, etc.
In 2016, after
demonetization, the Indian government (coupled with RERA implementation) wiped
out illegal cash transactions— eliminating tax evasion and money laundering.
This wiped out 60-80% of existing developers, leaving only a dozen developers
to compete. In the next decade, combine
demonetization, with GST (one per cent for affordable housing and five per cent
for others) and RERA (Real Estate Regulation and Development Act)— 80-90% of
competitors are gone.
In Mumbai around 10% of the
developers are doing well, 10-15% are trying to survive, while the rest are
dying.
- RERA
With RERA, everything is formalized
and reported to the government— 53,700 real estate projects and 41,200 real
estate agents, are registered under RERA across the country. The real estate
authority has disposed of a little over 48,700 cases in the country, causing
the real estate sector to experience reorganization and consolidation.
This creates opportunities to
acquire distressed projects and leaves a gap for reputable developers to
thrive. All
agents, transactions, require transparency and registration. In earnings calls,
Sunteck Chairman and founder, Kamal Khetan has stated that even pre-RERA,
Sunteck had already kept accurate and separate recordings for each of its
projects.
- GST
The launch of GST forces
developers to be organized and introduces tax credits. GST on affordable
housing is levied at rate of 1%, while completed apartments are levied at 5%.
Usually, the customer normally pays the entire 12% GST— with Sunteck, they bear
some of the rate. For a 6.5% or 5%
benefit Sunteck receives from tax input credits, this rate is applied to the
customer to reduce the rate he or she effectively pays. The customer
practically pays 6.5% on 12% of GST.
- Consolidation (only a few serious contenders)
A few real estate developers
– Oberoi, Godrej, Brigade, Sunteck, Prestige, DLF, HDIL and Indiabulls are
still in the game. But in terms of capital allocation and generating value,
only 4 players, bring a high return on equity and asset turnover relative to
the debt and shares issued. Competitor
Oberoi is one of the more established developers and has a lot of credibility
among the customers, requiring little external funding due to advance deposits.
Both Prestige and DLF have
generated good amount of cash from operations for the last decade using a high
amount of leverage. Prestige has raised moderate amount of debt as well as
equity while DLF has raised low amount of equity and debt. Despite this both
have ended up with high amount of leverage. In terms of profit margins,
Prestige leads DLF, whereas Sunteck is in a mid-tier range at 25-35%. With
increased regulation and difficulty in obtaining financing, there are high
barriers to entry in becoming a developer in Mumbai.
2. RERA and conservative
percentage completion accounting hiding true cash flow – ROIC will be high
double digits long term
- High ROIC is not discovered
and realized by investors due to conservative project completion accounting and
RERA recognition inhibiting cash flow short term
- Assume Sunteck has 28B book,
10B in short term borrowings and long term debt. To make things easy, assume
38B of capital deployed in a year.
- Sunteck adheres to the
project completion method for their accounting, with revenue recognition linked
to 40% of construction costs incurred, 25% of salable land secured and legally
enforceable by contract. There has been a lot of volatility and lower than
desire results reported in the financials since Sunteck doesn’t use the more
commonly used percentage completion method.
- True owner’s earnings is
easily understated. 1-2 billion rupees (USD100-200M) of free cash flow could
easily be 3-5 billion rupees (USD300-500M) per annum due to the recognition
method.
- Due to RERA, when 20-30% of
customers start registration, Sunteck can’t immediately collect the money until
the stamp duty and registration has exceeded 10%. Until the customer pays the
stamp duty and registers, volumes and cash flows won’t be realized. These cash
flows will be realized, it is just a question of when.
- Sunteck already obtains its
occupation permit faster than other developers and usually within a year. Once
presales and collections grow, Sunteck will see an appreciation in cash flows.
- Sunteck on the other hand
does not treat the land as an asset but as an inventory. All the land owned by
Sunteck is under development and in this way they are able to churn their
assets quickly and earn better return on their capital.
- The cost of acquisition of
land for Sunteck has extremely attractive. Sunteck on the other hand has a
contrarian approach and have been buying land at distressed levels in the
current downturn from other real estate companies who are forced to sell to
bring down their debt.
3. India, in particular, Mumbai
as a fertile ground for development
In terms of population
density, Mumbai ranks in the top 3 cities. With a population of 20 million over
Mumbai’s area of 603 km2, the population density is 32,303/km2. This density
ranks higher than Manhattan, with a population growth rate of 1% annually,
demand will always exist.
Although Sunteck has presence
outside Mumbai, such as Goa, and Nagpur— their core focus will remain in
Mumbai. While a lot of people tend to believe that Mumbai real estate market is
saturated with so much development happening, it is actually just scratching
the surface.
The landscape of Mumbai will
be transformed over the next 10-15 years. In Mumbai, people live in very
expensive housing lacking quality. Most of this will be torn down and rebuilt.
Mumbai is developing with multiple centers (such as BKC, Goregaon) which
contain mixed commercial and residential developments. Indian citizens will
have a greater disposable income, with India’s GDP per capita currently at USD
2000 and rising.
4. Partnerships & asset
light model coupled with low cost financing for land acquisitions
Sunteck’s partnership model,
allows them to assume the least risk in the industry while producing large
returns. For example, with the Piramal
Group their faith with a J.V (using a 26% topline sharing model) and Ajay
Piramal personally investing a 3.5% stake in Sunteck in March 2014 and later
increasing stakes to 4.63% by March 2015.
In this situation, Sunteck
will partner with a landlord where 25-27% of the top line is contributed, and
anything over and above, Sunteck deducts 5% as a brand and marketing fee. Financing in India for parcels of land has
historically been through private equity and partnerships instead of through
banks. Bank financing for land acquisition is uncommon, and a lot of financiers
got burnt by backing developers in 2005. In 2012, Kotak realty fund invested in
Sunteck for development of the ODC land parcel, and by 2016, the completed
project yielded 22% IRR. Partnerships with KKR, Aditya Birla, Ajay Piramal, has
been fruitful.
Sunteck defers approval to
their landlord partners and focuses on sales, marketing, and execution. Should
there be any delays or problems in obtaining approval, Sunteck always puts in a
clause which allows them to step in and take control to get those approvals.
This also mitigates the risk
if there is litigation or if cash flows get affected in the project. Once the
project is finished and receivables are collected by Sunteck, redistributed and
filed with RERA, and then the remaining balance is given to the partnering
landlord or developer as per agreement.
Partnership with SBI bank to
provide loans and financing for customers will soon be launched and smaller
ticket developments like the affordable housing Sunteck is developing in Vasai
will have a lower GST (5 vs 1%). This will help sales.
5. A healthy balance sheet
As a lightly levered builder,
Sunteck does not hold onto large ticket sales. As real estate is cyclical,
Sunteck is also prepared to weather a downturn— a modest amount of building
ensures that there isn’t a lot of unsold property requiring large inventory
write downs.
CEO Kamal has also enforced a
policy of making sure that the company always has a healthy balance sheet to
take advantage of real estate cycles. He wants:
- The debt to equity to always
be at a consistently near 21% (LT debt now 1.5B rupees), impact of QIP and
promoter preferential issues in our balance sheet, the net debt to equity
stands at about 13%
- Many real estate companies
purchase and maintain large land banks for future development. In the meantime
they show the land as an asset on the balance sheet. When a company does that,
their capital in the form of land does not earn any returns which depresses the
return on capital.
- A shift from high ticket
sales to low ticket sales. In 2020 sales of 12.2B rupees (USD 163M) generated
by lower ticket size sales in regions such as Oshiwara and Naigaon, while
moderating large ticket sales such as BKC (22% of NAV).
- The ticket size for the
completed high margin Bandra Kurla Complex (BKC) has a ticket size in excess of
Rs200mn/unit. The realization from BKC is approximately Rs50,000/ sq ft.
Whereas newer projects have lower realizations with ODC, Goregaon at Rs15,000/
sq ft. and Naigaon at Rs 5000/ sq ft
- Asset light model via JVs
& Jointly developed acquisitions only in greenfield projects and land as an
inventory-- other than BKC and ODC – most other projects either smaller in size
or under the asset-light JV/JDA model.
- When doing commercial
property, Sunteck does not want to take and exposure of more than 200-300
crores for certain projects, which would place unnecessary stress on the
balance sheet.
6. Development of new land
Sunteck has signed a package
to develop a large 50 Acre land parcel in Vasai, with 4.5 million ft2 (FSI ~2)
of developable area in the western suburb of Mumbai over 7 years. If the
company executes well, hopefully, within next couple of years, we could see the
sales breach the 1000 cr mark.
Vasai west will generate 5000
crores or USD670M through a 5-7 year time frame (1 year for approvals) and a
revenue potential of 5,000 crores. The 4.5 million square feet of area to will
be sold at an approximate price of 10,000 per square feet. (compare this with
Sunteck’s project in Naigaon, it comes down to 8650/ft2.
As this is a JV project, the
landlord will bring in the land parcel and development rights and Sunteck will
offer 25% of total revenue. So given the sales projection of 5,000 cr, Sunteck
share of revenue is likely to be Rs 4,000 cr, translating to about 600 - 650 cr
per year, considering a 6 year project timeline.
Construction costs are pegged
at about Rs 2,000 cr. With a large township project, the total built up area
including non-FSI area could be close to about 6,300,000. At a construction
cost of about 2,800 per sq ft (including all expenses and overheads), the total
construction cost of the project would be about 1764 cr. Considering
inflation over next 6 to 7 years, the cost is likely to be in the range of
2,100 - 2250 cr.
Though it is densely
populated area, Vasai is not a very affluent area, so apartment sizes are
typically small. Hence a significant volume of the apartments in this location
could qualify under the affordable housing criteria As per GST council’s
revised ruling; GST on affordable housing is levied at rate of 1%. GST of
completed apartments is levied at 5%. Assuming a blended GST rate of even 5%,
the revenue net of GST is likely to be in range of 3800 cr.
So the gross margin from the
project would be in the range of about 1550 cr, at 40%, spread over 6 years. If
margins hold up, we could see profits after tax in excess 200 - 250 Cr range With
the existing large ODC project in Goregaon, existing township project in
Naigaon, and this new one in Vasai, the project pipeline is definitely
strengthening.
Risks:
-- Real Estate follows
population, GDP growth per capita and income per capita: People continue to
need homes to live in. The process of
building a home has not changed materially.
1.
Regulations & Litigation
- If the benefits on lower GST on affordable housing and the interest subsidies
under government schemes are withdrawn or reduced, it could also have adverse
impact on housing demand. there is a zoning which are already defined by MMRDA,
so there is a commercial zone, there is a residential zone, and there is a
restrictions like within the residual zone you can do certain percentage of
commercial and not more than that and certain percentage of residential that
you can do. And similarly, in the commercial zone, you have to do like 50% let
us say commercial or then you can do residential. But for the commercial whatever we do commercial, there is a big
advantage like obviously we get four FSI and the residential we get only 3
FSI plus the fungible. So 4 FSI plus fungible makes it almost 4.8 whereas
residential you will get 3 FSI and the fungible that will make you almost
close to 4.5., so the mix used
will get the maximum benefit to the company and will create a maximum value for
the company as well for the buyers for the buyers of residential as well as the
commercial apartments.
2.
Drop in price and big ticket
loans & purchases
- Real-estate has been on the down cycle for past 6-7
years, demand as well as prices have been subdued, with one mega event after
other impacting the sentiment. If the real-estate market remains subdued for
next 3-4 years, the realization per sq ft may be lower, thus hitting the
margins adversely. With a downturn and Covid-19 people would be more opposed to
taking big-ticket loans for purchase of properties.
Valuation:
At a market cap of 25 billion rupees (190 Rupees per share) and
enterprise value of 29B rupees (USD 380M), I believe with progress, Sunteck is
at least worth triple, or 75-80B rupees (USD 1 billion). Oberoi, Sunteck’s
competitor, has a tangible book of 86B, compared to Sunteck’s 28B, and I think
Sunteck can reach their size, which means that a valuation of 150B rupees (USD
2 billion) is not out of reach.
Receivables = 4 billion Rupees for sales completed
Inventory = Rs 27 billion
Pending Approval Cost = 795M
Total Debt = 7B
Book value per share is approximately Rs 200/share
Book value has grown from 14B rupees in 2015 to 28B rupees in
2020
Shares Outstanding = 140M
If judge by book value alone, we have 28B, if we add the total
for projects unrealized at a substantial discount, at least 15-20B is not
placed on the books. A double in 5 years is about 15% growth per year; this is
great despite a bad economy coupled with covid-19, for real estate.
How much more would a good and recovering economy bring?
Sunteck can be bought with safety and below liquidation, with 26
projects which span 31M sq ft with 60 finished apartments in Mumbai. Some
projects are worth 500M to 1B rupees—but that’s not the point and not the right
way to value Sunteck.
Neither is looking at the multiples the right way to value
Sunteck. Price to tangible book is 1.5x, and Total Enterprise value to leading
twelve months EBITDA is 13x. The point
is that the cash flows generated over the next decade will be ridiculous. There
is a long run way for compounding ahead. As mentioned earlier, in Mumbai,
people live in expensive, but terrible housing which needs to be rebuilt.
Couple this with barriers to entry and only 10 or less
developers due to weeding out from demonetization, the headwinds look great
over the next decade. Also remember due to the project completion method, not
all revenues and profits are marked on the books. Due to the project completion
method, there is an unrealized surplus of approximately 10-20B for both completed
projects and on-going projects.
Catalyst
There is temporary stress on cash flows – a lot of presales
numbers have not come into effect due to conservative accounting, and 600
crores or 80 million worth of sales are not realized. Sunteck has not collected
more than 10% of certain projects. 20-30% more will come due to the delay of
RERA.
An asset light model will help company and opportunistic
acquisitions through J.V financing and cooperation will generate long term
shareholder value. In addition, the credible management of Kamal Khatan and his
team brings make this a stock to consider.
Demonetization will remove 90% of competition and provide cheap
land acquisitions.
