GMR Infrastructure Annual Report analysis 2015-16

GMR Infrastructure is the poster child of what ails infrastructure in India, and why equity investors often get the short end of the stick despite a well intentioned management. With a family trust resolving succession issues, reputed board members and iconic projects some even being the subject of case studies such as Delhi Airport/Kishangadh highway etc, GMR Infrastructure does command valuation premiums even basis reported numbers, while it trades at a P/BV of 1.6(negative PE multiple). However, it has been mired in regulatory issues(delays in gas linkages to power plants, court ordered delays in hydel plants, Maldives airport nationalization, Kishangadh highway bid cancellation due to 'force majure', CAG audit report claiming undue benefit to DIAL operator and power tariff regulators delayed acceptance of force majure to permit fuel price hike pass through), Some of these have reflected in the audit report with the management refusing to write down asset balances which are clearly doubtful,

The below table indicates that if the audit adjustments were given effect to, the company's reported loss would increase by 74%-172%, while the reported networth will erode by 53%-96%. This shows the importance of perusing the audit report and not just going by reported numbers

Little wonder then, that whenever there are regulatory announcement, the stock price oscillates like crazy. And with a F&O lot size >10,000, it is quite risky for speculators without insider information

Now, GMR is by no means alone as these links indicate. However, it is one of the most detailed and complex cases, therefore prompting me to write a blog post.
http://www.capitalmarket.com/CmEdit/story11-43.asp?SNo=869509
http://www.business-standard.com/article/pti-stories/sebi-exchanges-ask-75-firms-to-restate-a-c-on-audit-red-flags-115070500259_1.html

The Indian power sector should wait before celebrating the CERC order on PPA tariff revision

Two days ago, the order of the CERC made headlines nationally when it agreed to the demand of Adani Power for escalation in tariffs, to compensate for the 'unexpected' increase in imported coal prices after the Indonesian Government passed a law forbidding miners from selling coal below a benchmark price(so that its its revenue based royalty would not reduce due to transfer pricing by coal mining companies selling at lower rates to their parent/group companies). The favourable order can be read here  http://www.cercind.gov.in/2013/orders/SOSJ.pdf and the dissent can be read here http://www.cercind.gov.in/2013/orders/SOALL.pdf Both orders agree that the 'change in law' should only apply to Indian law, and that unexpected price rise does not constitute force majure. However, what they differ on is the regulator's power to intervene in the pricing mechanism of fixed price contracts. For some background, let me reproduce the  main facts below, and my views on it

1. The power procurers i.e State electricity boards had sought bids for long term power supply. The bids had left room for the bidders to quote escalation based on fuel, foreign currency fluctuation etc. Adani Power, "relying on the Govt of India policy and its coal supply LOAs" in its infinite commercial wisdom, chose to quote a fixed rate, and then won the contract. While the procurers had initially satisfied themselves about the coal linkage, this was entirely the power company's responsibility.
2. The Adani parent company Adani Enterprises owned 74% of the Indonesian coal company which supplied coal to Adani Power UMPP. Hence, most of the coal price hike went to the parent company. yet, instead of merging the coal company into the power project like how Tata Power did, Adani Power preferred to pocket the coal profits, but pass on the increase to the power purchasers

While the CERC agreed that Adani Power did not have any contractual case for compensation, it interpreted its regulatory power widely under Section 79 to state that since power sector investments were to be encouraged, it could not allow the power project to become sick. It also stated that since the replacement cost of the project(and resultant tariffs) would far exceed even the requested tariff increase, it was in the overall sectoral interest to increase the tariffs. It is with this interpretation that I have the following issues

1. Suppose the coal prices had fallen instead of rising, and power procurers had sued Adani Power asking for discounts, then it would have cried foul about policy changes/nationalization etc. Why should only the downside be borne by shareholders?
2. If there was a commercial mistake by Adani Power, let the plant turn bankrupt, and the proceeds be distributed amongst the utilities which can then run the plant themselves using imported coal. 
3. The bidders who quoted variable price linked escalations related to coal, and who lost for their being realistic, should not be prejudiced. 
4. Unlike the infamous 2G spectrum allotment which was an opaque process, the results of transparent power procurement by bidding should not be adversely shifted by regulators.
5. Assuming the parent company guaranteed the power project performance, then encash all possible securities/performance guarantee then only ask consumers to pay more. 

 The ruling has already been appealed, and I hope that the courts will be saner. Also, what persuaded the CERC was the chance of project turning sick. Now, for financially stable companies like Reliance Power, Tata Power etc, especially where parent companies have given guarantees, turning sick would mean even larger monetary losses, or may not be required after considering overall parent resources. Hence, there is a case even before the CERC, to differentiate their case from Adani's.

Verifying DIAL financial model used in tariff-AERA use of consultants apt?

GMRs demand for 6x-8x tariff increase for Delhi Airport,  made for severe media and interest group scrutiny, as people were mentally reluctant to accept this tariff shock. Hence, the aviation regulator AERA thought it fit to have extensive consultations etc, and released a consultation paper in Jan12 inviting comments by Feb29,2012. While reading that consultation paper(CP-No.32/2011-12-Determination of Aeronautical Tariff –IGI Airport, New Delhi, read it http://aera.gov.in/writereaddata/consultation/116.pdf) I noticed a very interesting section from para 21 onwards which stated that in order to analyse, review and advise on the financial model used by DIAL as a part of their tariff application, the Authority appointed Consultants. The scope of the assignment included

1. Review and assessment of the models' arithmetic accuracy:-independent cell-by-cell  inspection and sheet-bysheet review of the arithmetic accuracy of formulae and calculations contained in the model including tracing items through the various interlinked sheets and calculations back to the input data and verifying the correct application of addition, subtraction, multiplication and division based on standard business and financial logic
2. Check for logical and calculation integrity of the models verifying that the links within the model are working accurately; assessing that any macros that govern calculations in the model are running as intended; assessing that the model is logically constructed, internally consistent with respect to calculations and formulae and is fit for the purpose of undertaking analyses of relevant  aspects for tariff determination by the Authority; assessing that assumptions in the Financial Model are at one place and that there are no hard coded numbers in calculations in the Financial Model that might influence calculation results in unexpected ways and checking whether the assumptions listed in the assumption sheet are getting correctly reflected in the various sheets of the financial model.  
3. Consistency check with key agreements/documents:- Further, the Consultants were also required to ensure that the Financial Model accurately reflects the concession offered by the Central Government with respect to the key agreement(s), and financial documents as also the provisions in the Act. The tasks here included consistency check for incorporation of provisions from key agreements related to various Building Blocks into the financial model.
4. Assistance in undertaking certain sensitivity analyses. The Consultants were further required to provide assistance to the Authority in identifying such elements that may need to be certified from auditors /Chartered Accountants of DIAL of key aspects/ assumptions taken from the key / concession agreement(s) and also assist the Authority in reviewing the implications/change in results through sensitivity analysis of various factors like growth rate in traffic, inflation etc., to be conducted with respect to specific changes to assumptions for a factor or even reviewing the drivers and projection bases for such factors. 

I agree that financial modelling is not easy, in fact there are entire specialized courses on the subject and that the very complex issues in this(as opposed to power/roads/ports) may have prompted the authority to seek external help. But while the first two aspects could have warranted taking a consultant's help for Excel alone, the consistency checks and sensitivity analyses surely comes within the expected circle of competence of the regulator. Maybe they did not want to risk mistakes in such an important case and so they engaged consultants. Also to be fair, even other regulators do engage consultants to advice on tariffs petition process(but they are not explicitly acknowledged in the orders), so maybe I'm just shooting the messenger(AERA) who was upfront in admitting this, even if for the purpose of protecting themselves against subsequent judicial review. But for anyone in the infrastructure finance field either as preparer, auditor or banker, the above process used by AERA is quite instructive

Debt financing with equity risks-infrastructure finance, film funding, SME lending

One may be surprised how can debt financing carry equity risks. But in each of the examples mentioned above, even debt financing is quasi equity as explained below

1. Infrastructure finance:-The RBI Deputy Governor Harun R Khan delivered a speech on  'Infrastructure financing-progress and prospects'  at the  Diamond Jubilee International Conference on Frontiers of Infrastructure Finance 2011, held at IIT Kharagpur. In that speech(http://rbi.org.in/scripts/BS_SpeechesView.aspx?Id=655), he pointed out the manifold risks ranging from financial closure to operating/political risk. Not all these risks are random, thus making it difficult to trade them off against return. For instance, political risks/legal force majure/land title etc are risks which are quasi equity and yet lenders are heavily exposed to it in the infra space
2. Film Funding:-As I understanding during the 2nd year elective on 'Contemporary Film Industry' taught by Kandaswamy Bharathan, film funding is fully backed by intangible assets, and the market for the final product is not clear. Even with the promoter having skin in the game, that does not ensure a success. While the no-guarantee of success argument holds even in other fields, it may so happen that even big budget productions with stars and no cost overruns, still come up dud at the box office. Unlike other areas of business, 'professionalizing' the process does not increase the success unless creative talent is not impaired in the process. 
3. SME lending:-To meet the public policy requirement of inclusive growth, SMEs are classed under the priority sector, eligible for collateral-light loans, directed lending and interest rate subvention. Yet, smaller enterprises do have a higher failure rate, and the banks are often not comfortable with the accounts/audit/governance-even appointing auditors does not remove that problem totally. Hence, banks can legitimately grouse about unsecured lending to SMEs, where they are exposed to risks like PEs are, but without the manifold upside.

The above post was just a humble effort at connecting the dots, comments welcome.

Converting Capex to Opex-can infrastructure lessons work in finance?

During my Transport Infrastructure(TI) classes here at IIM-A, Prof G Raghuram introduced the class to a framework of analyzing infrastructure as three distinct segments, each with its own risk-return tradeoffs, competition characteristics and investment rationale. They are Terminals/Right of way/Rolling stock. This is further elaborated below(note that essentially they have the principle that specialist operators take over capex headache, and charge opex to the users).

1. Right of way:- Getting the license to lay cables/fly airlines/build towers. Typically, this involves liasons with regulators/local authorities/government. Usually a legal monopoly, and if a private sector player gets it, it becomes a natural monopoly due to the poor economics of duplication.
2. Terminals:- These are the fixed departure/termination points between which rolling stock(vehicles etc) moves. They supply all the operating infrastructure and deftly schedule competitors. 
3. Rolling Stock:- Planes, buses, coaches, wagons, ships fall in this class. They are the actual revenue earning assets, which depend on the first 2 segments for being able to operate. There is no voluntary open access at all here, and maximum customization/differentiation is possible. Usually unregulated(wrt returns) and the sweet spot for private players due to low cost of entry, low entry barriers etc. 

 The above framework applies to nearly all infrastructure sectors whether it be telecom(laying wires/towers/handsets-spectrum), rail(tracks/stations/coaches), ships(flags/ports/ships). The underlying principle at play is that asset ownership/operation, and asset utilization require drastically different competencies. While fixed asset management would need maximum utilization(open access), efficient cheap service etc; its utilization would depend on competitive dynamics and the ease of entry for market players. Earlier, regulators used to bundle the license('right of way') with the necessity to set up one's own physical infrastructure('terminals'/'rolling stock'), but now the realization has set in that operating the asset may not need physical assets-sharing agreements can take care of that. Hence we have toll collection companies, MVNOs etc, who bring their expert skills to get the best out of the infrastructure.

In case of banking/finance, this paradigm is slowly getting in place. Take the following examples:-

1. Hedge funds can now use their intellectual capital('rolling stock') to access the prime broking infrastructure of their investment banking competitors
2. Insurance companies/mutual funds can piggyback on their banking partners to sell products, instead of taking the pain to set up branches. 
3. For expanding the access of retail banking, RBI suggests bank agnostic banking correspondents, who will have machines able to operate any bank's account.
4. The idea of intraprenuers within organizations/financial supermarket in a retail bank branch, hinges on the idea that creative ideas/cross selling can best utilize the infrastructure already in place. 
5. ATMs('terminals') are now nearly open access due to the number of free transactions(5/month) for ALL banking customers. Hence, new banks(aka 'rolling stock'!) can devote less resources to this aspect and focus on customer service and innovation
6. Incubation centres/Industrial parks/business centres/single window clearances(presently non banking scenario only) focus on this same principle of relieving headache of the formalities/heavy investments. 
7. Outsourcing trend seen in financial services(IT/Manpower/office space/accounting) and elsewhere, is reflective of this trend,\

This post IS a bit random but should hopefully spark some thinking

Deep pockets a substitute for relevant qualifying experience? Naya Raipur Development Authority thinks so.

While browsing some tenders where IL&FS is the project consultant, I noticed an unusual condition in a bid for a logistics hub at Naya Raipur(Chhatisgarh). As per the bid document(http://www.ilfsindia.com/tenders/LHUB_Bid_Summary.pdf), the project cost is Rs 100 crore(approx) on a BOOT basis.  While the usual experience criteria mentioned is completion of Rs 50 crore projects(Rs 150 crore if within other related sectors) in 3yrs, this is dropped for bidders with net worth of Rs 100crore+ as on 31st March 2011.
Exception to High Net-worth Bidders: If a Bidder (Sole – Bidder/Lead member of consortium) is having
a minimum Net-worth of Rs. 100 Cr. as on 31st March 2011,  then the Bidder need not meet the Experience Criteria for qualification/ eligibility.

This defeats the very purpose of imposing that restriction, and is not logical. Just having a net worth=project cost(presumable inference that one can absorb that loss!) does not give a license to relax the experience criteria, which would increase project execution risk.

Tirupati theme park Swiss challenge-is it fair to other bidders?

 The public sector does not have monopoly on creative ideas. Often, the private sector creatively suggests PPP ideas/projects, and then the public sector appoints consultants to prepare the bid documents, design the entire bidding process etc. But in the case of developing a mythological theme park at Tirupati, the Andhra pradesh tourism department has taken an innovative approach of swiss challenge, where the original proponent has the Right of First Refusal(ROFR) to match the winning bid.

The facts are as follows. IL&FS suo-motu proposed this theme park to the AP Govt, which had to put it up for public bidding. However, AP Govt decided to allow IL&FS to eat its own cooking viz the winning bidder(if any) would pay the project design/consultancy fee of Rs 15 million, otherwise if IL&FS itself won, it would not get any such fee. The bid document summary gives the key conditions(http://www.ilfsindia.com/tenders/bid_sum_temples_130511.pdf) that

1. Bidders must quote the NPV they offer to the Govt
2. IL&FS(original project proponent) can match this bid, without further negotiations. 
3. If IL&FS is not the winner, then the winner pays the bid cost(Rs 15 million) to IL&FS. 

Now, this is a risk free process for the Andhra Pradesh Govt. Even if there are no other bidders, it shows that IL&FS is the best. And if other bidders emerge due to the public bid, then it will only improve the price. And waste is avoided(IL&FS would have conducted its due diligence before proposing the bid, so the Govt essentially piggybacks on that, throws the data open to the private sector).

However, the other private sector bidders will have serious reservations about bidding since the risk of winner's curse is more. If IL&FS declines its right of first refusal, it means that the winning bid is probably negative NPV. And if they exercise it, then the winning bidder wastes its efforts and sees a positive NPV project slip out of its hands.

For saving Rs 150lakhs(we can argue this is wrong because AP Govt could have imposed some bid fees and absorbed the rest as costs), AP Govt has actually lowered the private sector(non IL&FS) incentives to bid. IL&FS gets a free option of ROFR without any risk(given that it would be anyway paid-either from the project OR from the winning bidders). One may view this as a 'finders fee' for IL&FS, in which case it would seem more equitable.