Lodha IPO Analysis by GSN Invest Part 2/2

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The real estate sector is likely to grow slower than historical levels driven by structural changes in the consumer profile. Within RE Tier 1 players will likely grow share driven by pressure on small players from both customers and creditors. Within Tier 1 players, Lodha appears to be a risky company to bet on driven primarily by leverage levels.

For those who want to read the full analysis, here you go!

The broader context- What explains our love for Makaan

Real estate is a dominant asset class in India - before we dive deeper into the sector and the firm, it is important to understand the unique factors of the Indian market that drive this - and how they may likely change over the coming years.

Indian household balance sheets exhibit a set of features that are unusual in the international context - specifically we have a disproportionate amount of our wealth locked up in physical assets (specifically - real estate and gold).

An average Indian household has an overwhelming 77% of its wealth in real estate, 7% in other physical goods and another 11% in gold - which leaves just 5% to be invested in financial assets. We have attached below a chart to demonstrate how we compare with respect to other countries (both developed and developing) on this parameter.

[src: Report of the Household Finance Committee, Jul '17 - This report is an absolute goldmine of information, and we recommend anyone wanting to understand India's financialization story to read it cover to cover]

Understanding the factors that drive this wide discrepancy is critical to developing an understanding of the real estate sector, and therefore any company that may operate in it. Demographic factors like income and age don't seem to explain it - since at every age band and every income quartile, we are overexposed to real estate vs the world. While there is some heterogeneity across states (southern states own more gold, union territories own more financial assets) it is fairly range bound - we are as a country - across age barriers, income barriers, and state barriers - significantly over invested in real estate.

The writers of the report attribute the significant unexplainable differences in India's over allocation to RE to 'India's institutional context'. The only hint they drop us is this - educated Indians invest significantly lower in physical assets - with a potential driver of the difference being more formal work and lower possibilities of tax evasion.

This gives us two broad insights, both counter-intuitive, but both extremely critical - (i) traditional metrics like the spread of housing interest rates over rental yields are marginal not primary drivers of real estate demand - given the true motivation of a majority of the demand is not returns but parking cash (important because the RHP mention the spread as a primary driver of RE growth) (ii) As the economy formalizes - possibilities of tax evasion will begin to get crushed - driving down the attractiveness of RE as an asset class (important because the RHP mentions a growing educated middle class a driver of RE growth)

With that context, lets dig deeper into the sector and the firm.

The real estate context - A few winners take all

Access to abundant and cheap capital is critical for the players in the real estate industry to survive and thrive. But access to easy capital also drives up the supply of real estate in the market - leading to two very negative implications for the real estate developer - (i) There is a downward pressure on price as players compete to sell inventory faster (ii) It takes longer to sell a property - which has implications for your finance costs due to capital locked into the project.

The IL&FS crisis in FY19 severely impacted the flow of funds to NBFCs, making it tougher for the weaker NBFCs to raise funds from banks, thereby tougher for smaller and tier 2 players to raise capital from the market. The credit outflow to developers from banks and NBFCs contracted from 42,000cr in FY19 to 5,000 in FY20, pointing to a drying of funds available for Tier 2 players.

Futher, our discussions with an RE sector expert (IIM Ahmedabad grad) also indicate that consumer propensity to pay before completion has also gone down significantly for non Tier 1 brands - further crushing smaller brands and helping the top players gain share.

The load on Lodha

The Lodha group is a dominant player in the MMR region - which has significantly higher rates per sq ft (10,500+) vs 4000-5500 in the other six top markets in India. Being a branded player, it is able to charge a higher rate (5-20% higher) and able to collect from customers faster. The weaker competition has also be falling away - with 54% of the smaller competitiors leaving the MMR market between 2012 and 2019. That being said the inventory problem still persists, with 202K units of inventory in the MMR region vs 45K-70K houses absorbed every year.

The most pressing issue on the group however - and something that makes it relatively unattractive despite the tailwinds discussed above is the debt on the books of the firm. The firm has a total of 18,662cr of debt on its books including 17,025cr of domestic debt and 1,636cr of overseas debt (linked to the US business). The firm intends to pare this down, driven partially by the majority of the IPO proceeds (1500cr of the 2500cr issue will go towards paring down debt, with the additional inflows from the closure of the UK business used to reduce debt further. It has receivables of ~5000cr and unsold property worth an additional 5000cr, but even if all of that was to be dedicated towards paring down debt, they would still have significant debt on their books at the end of it.

On an annualized basis, the firm pays ~1200cr+ in finance costs, which even in a regular year offers a coverage of less than 2.0x. The inherent volatility in the business, makes having this level of debt on the books an extremely unattractive proposition. At a 21,750cr valuation, the firm will be valued at ~30x FY20 earnings (FY21 earnings will most likely be negative). Given the state of the firms balance sheet, this seems excessively rich.

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You can also read detailed qualitative and financial analysis of 100 top Indian stocks, handpicked and analyzed by an ex-Goldman Sachs, ex-J.P. Morgan analyst here - GSN Invest Edu100

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