The home stretch

For almost all of CY12 I have taken the view that the gloom and doom regarding India’s future is overdone. Just as the wild optimism regarding the country’s future in 2008-09 was unrealistic, so too is the current bout of pessimism. All free market economies move in cycles and, as I see it, we are in the early stages of a modest economic recovery in India that will generate a meaningful rally in the stockmarket (I have been quoted in various forums as saying that the Sensex will touch 23K a year hence).

In a recovery, cyclical sectors usually outperform and a reputed, well-managed, well-capitalised cyclical stock is a reassuringly orthodox way of seeking out-performance in the tricky waters of the Indian stock market. Enter Sobha Developers.  

Founded in 1995, Sobha Developers is one of the leading real estate development companies in India that focuses on residential and contractual projects. The group’s residential projects cater only to the luxury and super-luxury development segments while its contractual business relates predominantly to commercial projects for Infosys. 

Sobha has learnt its lessons over the past five years — it used the proceeds of around ₹270 crore from the IPO in FY07 and ₹1,200 crore of new debt in FY08 to purchase land (equivalent to over 175 msf of saleable area) in Bengaluru, Chennai, Pune, Mysore, Thrissur, Kochi, Coimbatore and Hosur. But the weak operational dynamics of the sector in FY08-09 meant the stress on Sobha’s balance sheet increased considerably with the debt/equity ratio rising to 1.8x in FY08, average debtor days increasing to 173 in FY09 (from 37 in FY07) and operating cash flows at negative ₹1,100 crore in FY08. Thereafter, over FY09-12, Sobha strengthened its balance sheet by focusing on project execution, land monetisation and cash collection from customers, reducing its debt/equity to below 0.57x by FY12.

Our discussions with real estate developers, brokers and bulk buyers of residential and commercial properties in Bengaluru suggest that the key competitive advantages for Sobha can be classified as:

Backward integration: Sobha has achieved this through its state-of-the-art factories spread around an area of 600,000 sq ft that includes: (a) an interiors division engaged in woodwork and manufacturing wood or wood-based products, including doors and windows, wooden floorings, ceilings, panels, pillars, staircases, and custom-built furniture for commercial and residential use; (b) a glazing and metal works division that carries out metal fabrication work such as aluminium windows and doors; and (c) a concrete block-making division that manufactures concrete blocks, pavers, kerbs, water drainage, etc. Our discussions with primary data contacts suggest that this backward-integration model allows Sobha to overcome hurdles such as the shortage of manpower in Bengaluru and supply chain disruptions. That, in turn, helps the group achieve timely execution of its projects while maintaining consistently high quality standards for its projects.

Reputation as a trusted developer: Our primary data checks suggest Sobha ranks alongside Prestige Estates in Bengaluru as the most reputed developer in Bengaluru in terms of quality and execution. Until three-four years ago, Sobha represented 40% of Bengaluru’s residential market and hence has built a strong brand over time (now the 40% has dropped to below 20%).

Strong management team: The founder and promoter, PNC Menon, has been the key driver of Sobha’s overall growth story in India. Along with the Indian operations, Menon also runs a group of construction, engineering and industrial businesses in West Asia, with the oldest one being the Services & Trading Co LLC, founded by him in 1977. Board/managerial compensation has moved in line with Sobha’s earnings over the past three years with managerial remuneration declining by 34% in FY09, broadly in line with earnings shrinkage of 52%. Managerial remuneration increased by 4% in FY10 v/s earnings growth of 25%. The group, largely through Menon, has a strong relationship with Infosys and has consistently been the preferred builder for Infosys’ commercial projects for several years now. Our discussions with primary data contacts suggest that this relationship has been built purely on the basis of Infosys’ view of the quality of Sobha’s construction and hence is a testament to the group’s high operational standards.

With its high quality management team having realised what price it had to pay for uncontrolled aggression towards expansion, Sobha is currently the best placed play in the sector with its operating cash flows being at least 1.5-2.0x its debt servicing related interest outflow and a vast land bank — developable area of 112 msf (saleable area of over 200 msf) valued on its balance sheet at a cost of ₹1,950 crore (or ₹175 psf of developable area). Based on our discussions with real estate brokers, the current value of this land is at least 4x its cost. Project development on this land bank over the next 15 years generates a DCF value of ₹5,720 crore or ₹583/share for the land. However, our base case valuation scenario values this land bank at ₹3,650 crore (₹372 per share), 2.0x its cost. 

Consequently, at a time when most real estate developers in India are finding it hard to service debt on their balance sheet, Sobha is moving into the next stage of growth by focusing on: (a) accelerating annual execution run-rate from approximately 4 msf currently to 8 msf by 2015 and 10 msf by 2017; (b) accelerating monthly run-rate of cash collection from around ₹115 crore currently to around ₹150 crore by FY15; (c) monetising its vast land bank through a combination of 100% owned development projects and through selling whole or part of its stake in some land parcels through joint development agreements, JV or land sales after another two or three years where the land is not ready to be monetised immediately; and (d) expanding its geographical reach to possibly include projects in Hyderabad in the coming years.

Over the longer term, monetisation of the land bank will be carried out in a phased manner to build a sustainable long-term business model with management showing no intention of diversifying away from the real estate business. Adding the ₹372/share of land bank value mentioned above to the projects currently being built and sold by Sobha gives a valuation of ₹462 per share, which is around 22.87% higher than Sobha’s current market price of ₹376 (implying 35% upside).

These are the writer’s personal views. 

This article is not a solicitation to invest in the stock being discussed