R e l i a n c e P o w e r

Isn’t it high time to wake up ?

F O O L I N G A R O U N D

A right royal abuse of power

The most awaited event of the Indian primary market calendar is here. Reliance Power may have priced its IPO in the Rs 415-450 band but the active grey market price is Rs 900. This gives Reliance Power a potential listing market capitalisation of Rs 2,00,000 crore. With zero installed capacity today, expected generation capacity of 6,000 megawatts by 2011 and 26,000 MW by 2016. NTPC, in itself a richly valued stock, has an installed capacity of 27,000 MW and commands a similar market cap. The market has simply taken an eight year leap and priced it in the Reliance Power stock today. I find that staggering.

A look at the ratios look even more mind numbing. This IPO money is being raised to execute about 7,000 MW of capacity. That should be done by 2012. That year, if all goes perfectly, Reliance Power will have revenues of Rs 7,700 crore, EPS of under Rs 8 and a book value of Rs 70. At the listing price of Rs 900, the stock would be trading at a 2012 price-earning ratio of 110, a price to book value ratio of 13 and a market cap to sales ratio of 26. These are four-year forward ratios, remember. The ratios moderate somewhat for 2016 but by then much further dilution would have happened to finance the additional capacity so the market cap would balloon substantially.

This is madness. While many explanations abound on how such valuations could be justified, this is so similar to the 100-plus PEs the market gave freely to information technology stocks back in 2000. While all of us know how that story finally ended, we should also remember how long that madness continued. The power madness, too, will end, sector tailwind notwithstanding, but it may continue longer than we think it can before fizzling out. While it lasts, the most expensive stock in the sector will become the valuation benchmark and will pull the others into the clouds.

Just remember the old adage:

“Those who forget history are doomed to repeat it”

The NANO Revolution!

Rumblings continue on the Nano, the Rs 1 lakh car introduced by Mr. Ratan Tata last week, as environmentalists fear that the 'people's car' will lead to a faster deterioration of the environment. It has been seen that people often criticise something that is making waves everywhere. This has also been the case with Tata Nano. Competitors, safety regulators and environmentalists are busy conjuring up the problems that India will face, when such a car is available (by the second half of this year). Interestingly, as far as competitors are concerned, they have moved on from saying that "this car couldn't be produced" to "this car shouldn't be produced". What a change in thoughts that a puny Nano has brought about!

Imagine, the Rs 1 lakh that you would have otherwise used to apply to that 'another' IPO, you could now use to buy a 'C-A-R'!

Hail Tata!

BPOs: Opportunity not worth missing

The Indian BPO services sector was under severe pressure in 2007 largely due to the rupee’s appreciation against the US dollar. This is because BPO companies earn a substantial part of their revenues in US dollar terms (almost over 95%) and the cost is entirely in rupee terms. With appreciating rupee, while BPO companies are no doubt growing in US dollar terms, the growth in rupee terms has taken a beating. Over that, there is pressure on margins on account of wage hikes and higher service tax on lease rentals.

The returns on stocks of pure BPO players have been poor. The price of Allsec Technologies, a BPO registered in Chennai, came down from Rs 370 in Jan 2007 to Rs 135 in December. Same is the case with Firstsource Solutions, which has not moved from the IPO price since its listing in Feb last year. But are the private equity (PE) investors thinking on the same line as investors in stock market?

First things first, these BPO companies are here to do business. They will not close down their business just because the rupee has appreciated and margins are declining due to it. The Software Technology Park (STPI) scheme is expiring in March 2009 as a result of which the BPO companies will cease to avail tax benefits, which will put additional burden on their margins. To counter this issue, BPO companies have come out with three strategies. Firstly, they are trying to locate and are opening more delivery centres abroad to serve those markets. Secondly they are trying to win more business from the domestic market. More domestic business would mean that the facilities could be used during the daytime as well, increasing seat utilisation. Thirdly, these companies are spreading to Tier II and III cities thereby cutting their operational costs by about 15%.

The PE investors perhaps are not thinking the same way as investors in the secondary markets. As per media reports, almost US$ 200 m came into the BPO sector in 2007 in companies, which are in very early stages of their growth. Currently, the US mortgage industry is troubled by sub-prime crisis. But in the long run, the outsourcing is only likely to increase rapidly when troubled firms resort to cost cutting.

So, for BPOs operating in the mortgage vertical, it translates into a huge opportunity. How? Mortgage processing job is around 5% of the outstanding loan amount (almost US$ 2 trillion), which can be offshored and translates to business worth US$ 100 bn. If only 10% of this US$ 100 bn is offshored to India (the percentage actually is higher) this translates to business of US$ 10 bn. And to the surprise, the revenues of the BPO companies from the mortgage vertical are just US$ 200 m. So the potential upside is almost 50 times.

Perhaps the Tier I IT companies are fast to tap this opportunity. TCS has made many acquisitions in platform based transactional BPO, while staying away from low margin voice-based business. It acquired Comnicron in Chile, which facilitated its entry into global pensions BPO. Then it formed Dilegenta in CY07 in which it owns 76% by entering into a JV with Pearl Group's BPO division in UK for £486 m. And at the fag end of the year it took controlling stake in Swiss banking software and services specialist TKS-Teknosoft. Infosys also on its part has entered into a US$ 250 m multi-year contract with Philips to provide Finance & Accounting (F&A) services and the processing of purchasing orders and has acquired three-shared service centers located in India, Poland and Thailand from Philips.

The opportunities are huge in this space, the only problem being that of supply (skilled labour).

Software: Things looking up?

The BSE IT index was the worst performer in 2007 down 14% over its 2006 closing levels. Perhaps, on the part of the investors (retail as well as institutional), I believe that deserting IT stocks just because of appreciating rupee was bit premature. While investors may contest that when sectors such as power, engineering and capital goods are giving such high returns then why stick to sectors like software and pharma, which are giving negative returns. Point taken.

But then what triggers downturn in a stock? The answer is ‘return of sanity’. Warren Buffet once said, “The stock market is the most peculiar place in the world. Here people are more relaxed after they have bought an overpriced security and have sold an undervalued one”. This sentence was not just for saying but this actually works in stock markets.

The point I want to make here is that when investors started deserting IT stocks, I believed that the fears were largely exaggerated. The contention given was that with rupee appreciating, the margins of IT companies will come down, and so will the return ratios like ROE and ROIC.

The rupee was trading at 44.11 to dollar on 31st December 2006 and yesterday it ended at 39.42 to a dollar thereby appreciating by 10.6% in CY07. Every 1% change in rupee impact operating margins of companies by around 0.4% and thus liquidating the holdings in this sector seemed valid. However, had that been the case, Infosys’ operating margins would have come down to 27.4% by the end of September 2007, from 31.6% in December 2006. But over the last 9 months (3Q results are yet to be declared), Infosys margins’ have come down by just 1% indicating company’s ability to deliver even in adverse circumstances.

TCS for instance has recorded a margin decline of only 0.2%, which is quite commendable. Wipro’s margins should have been around 18.9% and Satyam’s margins should have been around 20%. Wipro margins have come down mainly because of the string of acquisitions it has made in the low margin segment. It is quite clear that the margins have not fallen in the proportion of the appreciation of rupee and steep wage hikes affected to counter the talent crunch problem. These companies have been able to achieve this by higher volume growth, better pricing environment and improving the product mix.

What to expect? The IT companies again emerged as the leader in hiring people in 2007. This indicates that the demand pipeline is still very strong as indicated by all these companies. On the supply side, the only worry is the high attrition levels. With the rupee stabilising around the 39.5 to 40 mark and the wage hikes being already affected by these companies, I expect stable margins with a slight negative bias going forward. While this may please the stocks markets on a quarterly basis, in the long run the companies need to spend heavily in R&D because this shall help them achieve breakthroughs in productivity.