No gain without pain

A retail investor is generally advised to stick to investments in reasonably-valued, successful, dividend-paying companies that have demonstrated steady, profitable growth in sectors that track the underlying medium to long term growth opportunities in the economy. Some of the leading companies in the banking, housing finance, consumer goods and services, and pharma space generally meet these characteristics and should be able to reward investors with a “nominal GDP growth plus” rate of return. Though such investments are not meant to bring about spectacular returns in the short to medium term, investment advisers find it safe to recommend such investments for retail investors since they are advised to look only for steady long term returns.

Contrary to standard practice, my pick is a rather unconventional, high-risk but potentially high-return stock that is certainly not for the faint-hearted. Lanco Infratech is a large infrastructure developer that is currently saddled with high financial leverage, raw material bottlenecks, sticky receivables and multiple litigations. Investors would be normally well advised to stay clear of such scrips and this is reflected in Lanco’s price performance. For the slightly adventurous investor, however, here lies a chance to generate supernormal returns by assuming some calculated risks.

Most of the company’s problems require policy action by the government and it is encouraging that there is some movement in the right direction over the last few months. Whether it is trying to make available contracted coal and natural gas supplies or revamp the finances of the state electricity corporations or softening interest rates, the outlook now appears a bit less gloomy, with the government perhaps realising it can hardly be a silent spectator when frequent blackouts bear testimony to the demand-supply mismatch in power. 

The buy case for Lanco rests entirely on the faith that the government is motivated to address these issues in the runup to the 2014 election. With a 72% stake in the company, the promoters certainly have their skin in the game and as long as their dominant interest continues, there is some comfort for the potential investor. 

Inside story

With a 4,500 MW power generating capacity on the ground, Lanco Infratech is already one of the largest power generators in the private sector with operations in 12 states. And it is all set to double its generation capacity by March 2015. Being one of the first private sector power companies to supply to state discoms, the company has been having some trouble relating to off take of electricity at remunerative prices even when the power purchase agreements allow for some cost pass-throughs. In what could be a harbinger of happy times, the long-pending dispute relating to the Madhya Pradesh discom’s purchase of 300 MW from the Amarkantak I project has been amicably resolved. With most states effecting hikes in retail power tariffs, there is a renewed thrust on fast tracking contentious issues with power producers to tackle endemic power shortages, which augurs well for the company.

The projects under construction and development are progressing well and with the recent $2-billion financing commitment by the state-controlled Chinese Development Bank, the projects are well funded. The company has a significant EPC business with an order book of over $6 billion, as of March 2012, covering internal and external projects at good margins. It owns thermal coal mines in Australia. The company also has a sizeable infra business with 163 km of highway toll roads near Bengaluru and another 283 km of toll roads being developed in UP. In addition, Lanco has smaller businesses in non-conventional energy, power trading and real estate.  

Feeling the blues

One of the main concerns of investors in Lanco has been the rather stretched balance sheet with a debt equity ratio of seven, especially with the problems of raw material supplies and receivables keeping capacity utilisation and profitability levels subdued. While the resolution of raw material and receivables problems is being accorded priority, Lanco is taking steps to rectify the high financial leverage. 

Divestment of the non-core businesses is being actively pursued, which could release significant amounts of cash to improve the capital structure of the company. With some progress on the policy front in tackling issues relating to coal/gas supplies and state electricity corporations, Lanco’s efforts in bringing in serious long-term strategic investors at the power holding company level appear to be nearing fruition. The market price of the company has been falling steeply since mid-2011 from the ₹65 level consequent to a lawsuit by a potential Australian coal buyer (Perdaman Chemicals) claiming $3.5 billion in damages from Lanco following the buyout of Griffin Coal.

The company has filed a countersuit and appears to be confident of a favourable resolution in the Q1CY13. Currently, Griffin Coal produces some 3 million tonne of coal and has plans to ramp it up to 18 million tonne per annum. It also has a port that is less than 100 km away. As per my assumption, 18 million tonne should fetch the company around $500 million in profits every year from 2015. Currently, the entire market cap of Lanco Pis just over $500 million. So, that is the sort of value in this company.

The reaction from the market is that Lanco has already lost the case and it will have to pay the damages sought. Hence, a successful outcome from these events has the potential to re-rate the company given that, at current costs, the equity value of just a 9,000 MW power producer with reasonable financial leverage would be thrice the current market cap. The point to be mentioned here is that Lanco has spent less than ₹4 crore/MW for its power project, whereas at today’s costs new projects would cost not less than ₹6 crore/MW.  

On balance, Lanco, which is quoting 0.6 times book, should not be a dominant holding in an investor’s portfolio given its risk profile. At the current price of ₹13, it may be worth allocating a small portion of the portfolio to the scrip in the hope that the risks do not play out to the extent the market has priced them.