Sunteck - Real estate consolidation in India due to demonetization

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.