As we saw in part 1 of this article that we are at the cusp of a turnaround in the real estate sector in India. We are probably 2-3 years away from a broad-based recovery. If that is so, the next question is – what is the best way to take advantage of this turnaround. From an investment perspective, is there a better way of playing the real estate cycle than buying a house. The answer is yes, we can chose to invest in the stocks of select real estate developer(s). The stocks should provide a better return than the underlying real estate during the upturn in the cycle. The stocks are more volatile than the house prices i.e. they will perform worse in case of a downturn and will give better returns during the recovery period when compared to the underlying house prices. This is because of rampant speculation in the stock market. Anyone with a demat account can start trading in stocks whereas you need a substantial amount of money (as down-payment) to buy a house. During the subprime crisis people were able to buy houses with very little down-payment and we all know now what happened there!!
Financial analysis of select real estate developers
In the remaining part of this article I will try to analyse the financials of some select real estate developers to understand their performance during the past few years (FY2010-16). We will look at their performance from multiple angles – including their P&L, balance sheet and the cash flows to gain a deeper insight into their workings. I have selected the period FY2010-16 as that is the period for which data is readily available for all the companies. We will look at the performance of the following seven real estate developers – Oberoi, Godrej, Sunteck, Prestige, DLF, HDIL and Indiabulls. While this analysis will help to get a broad perspective on the performance of these developers, it cannot be used to form a view towards investing in them. For them a more nuanced and deeper analysis will be required.
With this background let us get started. First of all, we will try to get some idea of the scale of these developers. Figure 1 gives the total assets, operating revenue and asset turnover (operating revenue / total assets) for the selected companies for FY16. While assets and revenues give us an indication of the size of the developer, asset turnover signifies efficiency of the operations. The top three developers in terms of scale from an asset perspective are – DLF, HDIL and Indiabulls; while from a revenue perspective – DLF, Prestige and Godrej. From the chart, Godrej and Prestige stand out for their total asset turnover which means that they are utilizing their assets most efficiently than the others.
Figure 1: Total assets, operating revenues and asset turnover (FY16)
 Except for HDIL, the financials of which are for FY15 as consol financials for FY16 not yet available
The next chart gives a snapshot of the market value of the companies on three parameters, two of which are balance sheet based – price to total assets and price to book and one P&L based – price to earnings. I think a balance sheet based measures give a better perspective on valuation for these companies (at this stage) because their earnings have been quite volatile for the past few years. Further due to the downturn in the real estate cycle their profitability has taken a beating.
The chart is quite revealing and the blue line tells us that market values the assets of only Oberoi (@1.45) more than the value of their total assets while the rest of the companies are selling for less than their total asset values. The second and third place on this parameter is taken by Godrej and Prestige with values of 0.97 and 0.55 respectively. The bottom three are rounded out by Sunteck (0.37), Indiabulls (0.26) and HDIL (0.20).
One reason for this could be excessive debt. The green line takes care of the debt and compares the market value with the book value (or net worth) of respective companies. The most expensive companies on this parameter are again Godrej (3.33), Oberoi (2.12) and Prestige (1.77) with Godrej and Oberoi swapping places for the first and second position. The bottom three are DLF (0.96), Indiabulls (0.56) and HDIL (0.33).
Finally, we take a look at the most famous parameter P/E ratios. Top 3 has one unusual entry and two usual suspects – DLF (56), Godrej (26) and Oberoi (26). Bottom 3 – HDIL (16), Indiabulls (13), Sunteck (10).
The data clearly suggests that market is giving rich valuations to Godrej and Oberoi. On the other hand, Sunteck, DLF, Indiabulls and HDIL’s are being valued cheaply and Prestige is somewhere in the middle. In the remainder of this article we will try to understand that reason in the light of their past performance and see if these developers really deserve their valuations.
Figure 2: Mcap/Total assets (left axis), Mcap/Networth (left axis), Mcap/Earnings (right axis)
Next, we analyze the asset side of the balance sheet to determine the composition and quality of the total assets as depicted in Figure 1. The major categories of assets can broadly be classified into:
Inventory: value of land under construction and the construction cost for which the corresponding revenue is yet to be recognizedwhich has so far not been recognized as revenueies. ied into:
he markets valuation are in line with the performance of the com.
Fixed assets: land bank plus other fixed assets owned by the companies. Other fixed assets would generally include commercial real estate which is owned and on which the developers earn rental income. We can see from the chart that only three companies have a high proportion of fixed assets – DLF (36%), Prestige (26%), and Oberoi (13%). Which also means that these three companies have substantial commercial real estate assets. Indiabulls also comes in this category of developers as we will see below.
Investments: Indiabulls stands out for its highest investment at 33%. I suspect that this is their investment in other Group companies which hold various assets including land bank and commercial real estate. Hence, this should be treated more like a fixed asset instead of investment.
Loans and advances: L&As include advances given to vendors, deposits for projects etc. We see relatively higher L&As in case of Oberoi, HDIL and Prestige. For Oberoi, this is due to L&As to related parties. For HDIL it is due to advances for land purchase and for Prestige it is due to deposits and advances for land purchase.
Others: other assets include trade receivables, goodwill etc. Other assets are higher for DLF and Indiabulls mainly due to high unbilled receivables, and Prestige due to high goodwill and trade receivables.
Figure 3: Composition of total assets (FY16)
In the chart below, I present the corresponding liability side of the balance sheet which shows how the assets have been financed. In general the assets can be financed through three sources; equity, debt and through other liabilities – for the moment lets call all the other liabilities as float. Other liabilities will include customer advances, accounts payable etc. Equity can built up through two sources – 1) equity infusion from outside sources e.g. QIP, IPO, equity warrants etc. (equity dilution in other words) and 2) internal accruals or profits. Broadly all sources of liabilities can broadly be divided into internal and external sources. Real estate developers are forced to raise money from external sources (debt or equity infusion) for completing the ongoing projects or buying new land when internal sources prove inadequate. In general, the lesser the outside sources of liabilities the better the developer. A company which can continue to grow without using too much outside funding is rare. In other words, if a company generates enough cash to fund its operations without utilizing outside funding, there must be something special about it. We might even say the company possesses a moat.
The chart below does not give a breakdown of equity from internal and external sources. However, the data in figure 6 gives a rough indication of that as well. Read together (Figure 4 and 6), let us see what they tell us.
Oberoi clearly stands apart from the entire bunch. They have done 14% equity dilution (Figure 6) during the last 7 years and have managed with only 8% debt (figure 4) translating to roughly 22% outside funding. Which means that Oberoi is able to attract customers who provide it with advances to finance the construction and hence they need minimum outside funding. This must be a measure of the trust they have managed to build with customers over a long period of time. This trust acts as a source of competitive advantage for them.
The second company after Oberoi is Sunteck which has managed with 33% outside funding. Then we have DLF with 41%, HDIL 47%, Prestige 50%, Godrej 54%, and Indiabulls 59%.
The second point to note is that Godrej, Prestige and DLF have the highest amount of leverage at the end of FY16.
Figure 4: Composition of total liabilities (FY16)
So far we have looked at the balance sheet of the companies both from an asset as well as liabilities perspective. From the last figure, we have seen that as of the end of FY2016, Oberoi and Sunteck have used minimal outside funding and have been able to generate cash through internal accruals. At the other end of the spectrum are (surprisingly) Godrej and (not surprisingly) Indiabulls who had to rely on maximum outside funding to take care of their operational needs.
In the next few charts I will look at the cash flows of all the companies during the period FY10-16. Figure 5 simply shows the total cash inflows for the companies during this period.
Figure 5: Total cash inflows (FY10-16)
Next we move on to take a detailed look at the source of cash flows during this period (FY10-16). This figure is similar to Figure 4. The source of cash inflows can be either of the following – equity, debt, revenues (or operations), and others. Any equity cash inflows in this figure refers to external equity infusion. Here again, we would like the developers that are able to generate a majority of cash from operations as opposed to debt or equity.
First things first. As we have seen from our earlier analysis of the source of liabilities, Oberoi is the best and Indiabulls the worst in terms of the cash generated from internal accruals during FY10-16. After Oberoi, the developer with the second highest cash inflows from operations is DLF with 78%. Then we have Prestige, Sunteck and Godrej in that order at more or less similar levels in terms of internal cash generated during this period. HDIL and Indiabulls have been absolutely terrible during this period. HDIL has done a massive 29% equity dilution. Indiabulls has raised external cash with 23% equity dilution and 32% debt.
Figure 4 and 6 combined also tell us something more about the leverage levels of the developers. Godrej, Prestige and DLF have raised moderate amount of debt during the period FY10-16. Despite that they have ended with highest amount of leverage at the end of FY16. Which also tells us that they probably started (FY10) with high amount of leverage.
Figure 6: Source of cash inflows (FY10-16)
Continuing from the previous figure, next we take a look at the utilization of the cash flows during the period FY10-16. Real estate developers utilize the funds towards land purchase and construction expenses and others as shown in Figure 7. We would like to see the maximum funds being utilized towards operating expenses and capex which are the core activities of any developer. It is only when we look at this chart, the amount of mismanagement of funds at DLF and HDIL starts becoming clear. At these two companies more than 20% of the cash inflows were utilized for interest and debt payments, money which might have been utilized more effectively elsewhere.
Another thing to note is that despite Prestige and Godrej also having high amount of leverage, their outflows on amount of interest have been relatively modest at 6% and 1% only. Which means that they have been able to raise debt at much better rates due to some reason.
Figure 7: Utilization of cash (FY10-16)
Finally let us take a look at the profitability of these companies for FY16. I have done a Dupont analysis of profitability in the next two charts. The first chart shows the net profit margin and asset turnover of the companies. The second chart depicts the leverage and the resultant ROE. Whatever way you look at it, DLF, HDIL and Indiabulls clearly stand apart from the rest as the worst performers in terms of profitability as well.
The others also do not display great profitability – the profitability varies from Oberoi at 8% ROE to Godrej at 12.6%. However, both Godrej and Prestige have used high amount of leverage to magnify their returns. However, we should note that the profitability of the entire real estate sector has been dented due to the downturn and is currently at the lowest level. As we move into the upcycle of the sector in the years to come, the profitability numbers should improve.
Figure 8: Net profit margin and asset turnover (FY16)
 Not the same as that in Figure 1. Figure 1 shows total asset turnover while here I have taken assets net of current liabilities
Figure 9: Leverage and return on equity (FY16)
To sum up, Oberoi is an excellent developer and has a lot of credibility among the customers which they have built through good quality product and seamless delivery over a long period. They need little external funding because their customers are willing to fund their operations through advances.
Godrej lags behind others (though not by too much) in terms of cash generated from operations. Also, the amount of external funding in their capital structure is second highest after Indiabulls. In addition, they have the highest leverage amongst all developers. On the positive side, they have displayed with profitability which can be partly attributed to high leverage (bad) and party to high asset turnover (good). Given their ordinary performance, it is difficult for me to justify their premium valuations.
Both Prestige and DLF have generated good amount of cash from operations during FY10-16 (second only to Oberoi). In terms of external funding in their capital structure they are somewhere in the middle with DLF at 41% and Prestige at 50%. Prestige has raised moderate amount of debt as well as equity while DLF has raised low amount of debt and almost no equity during FY10-16. Nevertheless, both have ended up with high amount of leverage at the end of FY16. But the cost of the debt for DLF has been much more onerous than that for Prestige. Additionally, profitability wise also Prestige is ahead of DLF by a wide margin.
Sunteck has required external funding but they have managed through a judicious use of debt and equity. They have shown discipline in their source of funding during the short period of their existence. Their performance has been commendable and they have shown the potential to become a large and profitable developer.
For HDIL and Indiabulls, I don’t have anything positive to say!!!