ILFS Transportation IPO Review

Investors with a high-risk appetite can consider the initial public offer of road developer and operator, IL&FS Transportation Networks (IL&FS Transport). A portfolio of eight roads in operation and 11 more under development (totalling to 9400 km), a strong parent in IL&FS and a foreign acquisition which holds potential to offer superior technology for road operation and maintenance in the domestic market are key positives for the company.

Nevertheless, uncertainties linked to the long term and the differentiated nature of projects; high debt and risk of the foreign subsidiary pulling down margins make this investment risky. These risks may stand mitigated after two-three years, when new projects, once commercialised, could de-risk the existing portfolio.

The offer price of Rs 242-258 discounts the annualised consolidated per share earnings for FY-10 by 20-21 times, post-issue. Its price-to-book value (relevant here given that it holds roads as assets) of three is not way off valuations of international toll operators such as Abertis.

Despite holding a larger portfolio of roads, IL&FS Transport's valuation is a tad lower than its most comparable peer, IRB Infrastructure Developers and perhaps rightly so, given the superior profitability and return on equity of IRB at present. IL&FS Transport, nevertheless holds potential to more than double its revenues over the next couple of years, if it is able to successfully implement its projects on time.

Business and offer

The company is in the business of developing and operating roads by entering into long-term concession agreements. Apart from revenue received for construction, the group generates toll/annuity revenues and revenues from operation and maintenance of roads. For the half-year ended September 2009, the company's consolidated revenues were Rs 957 crore (Rs 1225 crore for FY-09) and net profits for the six months stood at Rs 118 crore (Rs 27 crore in FY-09).

This offer is a combination of fresh issue of shares and offer for sale. At the offer price band, the company (net of offer for sale) would raise Rs 589-596 crore. The offer proceeds would primarily be used to repay some of the debt.

Unique features

IL&FS Transport's primary business stands out for certain differentiated and ‘ahead of market' strategy adopted by it.

Toll auction: For one, the company, having been in the toll business ahead of peers, has moved up the learning curve, hurting itself initially on estimation of toll traffic and rates.

It has, therefore, adopted the toll auction model for some of its projects; wherein it earns a fixed sum in return for allowing the toll collector to enjoy revenues or bear the volatility in toll collections as the case may be.

While it may seem that the company is capping its toll revenue growth by entering into such arrangements, the short-term nature of such contracts (maximum of 12 months) allow the company to revert to own toll collection if they are found to be lucrative.

For instance, the company could on initial periods of sluggish traffic adopt this strategy and then shift to own toll collection once traffic picks up thusreducing the volatility present in toll projects but enjoying higher revenues if the toll project promises to be lucrative.

Acquisition: IL&FS Transport's profit margins crashed in FY-09 as a result of its acquisition of the Spanish road operator, Elsamex (in March 2008). In what was perhaps a distress sale, valued at Rs 77 crore, the Spanish company's high fixed costs and interest costs evidently dragged IL&FS Transport's net profit margins to a meagre 2.2 per cent in FY-09. The acquisition may, however, have to be viewed in the following context: One, Elsamex, although in distress, generates close to 40 per cent of IL&FS Transport's consolidated revenues and with experience of operating over 21,000 km of roads internationally, is clearly a player equipped with experience and technology.

Two, Elsamex's technology can be effectively used to operate and maintain Indian roads. Besides, a good number of the NHAI road contracts that were initially given on cash-contract basis and maintained by NHAI, may come up for O&M contracts, providing huge opportunity for companies such as IL&FS Transport. If so, the relatively lucrative Indian market could provide the much-needed profit margin boost to this Spanish company. Elsamex's presence in South American countries could also help combat the European slowdown.

Beneficial interest: The third strategy of IL&FS Transport is to hold ‘beneficial interest' in some projects by way of warrants and call options; the warrants entitled to earn dividends from projects; typically at a much later stage. Revenues from these projects would come to IL&FS Transport's books only on conversion of these instruments into shares. The conversion of these warrants can be expected over a three-year time-frame when some of the projects may break even.

However, this does pose risk to revenue visibility if conversion is delayed and dividend flow is insignificant. At least three of the 11 upcoming projects come under such beneficial holding, besides call options on three of the eight operating roads. However, since the parent holds much of the interestthe above risk may not be too high.

Financials

IL&FS Transport's revenues have grown six-fold over two years to FY-09 as a result of acquisitions and stake increases. Consolidated earnings though, halved over this period, merely on account of the acquisition.

The six-month earnings for FY-10 though have picked up pace and at Rs 118 crore, is over double that of earnings in FY-09. Operating profit margins for the half year, at 35 per cent, although not superior to IRB, is in line with industry average.

The company's debt equity ratio could come down to 1.5 times, post-issue, after repayment of debt. This leverage nevertheless appears high; the consoling factor though would be that all new projects, being SPVs would leverage in their independent capacity and the present debt level would provide some leeway to allow borrowing by IL&FS Transport for its equity contribution.

via BL