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The insane pricing of IPOs

Any management that has a long-term view of its business and wants to raise further capital should prefer to err on the ‘cheaper’ side while pricing its IPO.

Dipen Sheth | Print Edition: October 2009

Dipen Sheth
Dipen Sheth

Taking a business to the public via an initial public offering (IPO) is not merely a fund-raising event. It’s for the first time that shareholders from the public become stakeholders and the management becomes accountable to this group.

Pricing such a transaction has long-term implications; if a company rubs shareholders the wrong way, it severely reduces its long-term capability to raise further capital. So any management that has a long-term view should prefer to err on the ‘cheaper’ side while pricing its IPO.

Sadly, this does not seem to have been the case with the two recently concluded IPOs—Adani Power at Rs 100 a share and NHPC at Rs 36. Both were high-visibility events that took place during the rediscovered bull mode in the markets. It would have made eminent sense for both the promoters, Adani Group for Adani Power and the Government of India for NHPC, to leave substantial value on the table for investors, trigger massive over-subscription (which did happen) and possibly hatch substantial gains on the listing day (this certainly did not pan out).

Instead, both stocks have hardly moved even weeks after the listing. There can be many reasons for this, but none is as compelling as the mis-pricing argument. On taking a closer look at the financials of the two companies, I felt distinctly uneasy. Adani Power has diluted 13.8% stake at Rs 100 a share, while the promoters’ historical cost per share is under Rs 6. This, for a company that has switched on about 5% of its power capacity so far, and will take at least another three years to go live with the rest. Yes, a number of private investors like 3i and Capital Trade have invested at prices higher than the promoters in the recent past, from Rs 26 a share to Rs 111 a share, but why should I take solace from this fact?

Adani Power’s ambitions are going to be driven by Chinese equipment, which is largely untested in Indian conditions but has worked wonders in China so far. A positive aspect is that about 70% of its power generation is pre-sold for 25 years to a number of state-level utilities. Its coal supplies are secured with its parent company, Adani Enterprises, which is going to mine the coal from its newly acquired Bunyu Island mines in Indonesia. The pricing dynamics are not particularly clear. Note that the coal price determines profitability in the power generation business.

The case of NHPC seems no better, although the promoter/shareholder is the Government of India. Setting up hydropower plants is very time-consuming due to the difficulty of executing a project in harsh terrain. This has acted as a dampener on the overall returns posted by the company as much of its capital is perennially blocked in unproductive capital work-inprogress (WIP).

Although power producers work in a regulated environment in which they are allowed to earn about 14% a year return on invested capital, NHPC has earned only around 6% annually in the recent past. Unfortunately, Indian power companies are not allowed by law to earn a return on capital WIP, unlike in some other countries. This is likely to keep RoEs low as NHPC rolls out 4,622 MW capacity against the currently installed 5,175 MW over the next four-five years.

My back-of-the-envelope calculations suggest that at the offer price, NHPC is available for around 26 times the 2010-11 earnings, which translates to an earnings yield of under 4% for two-year forward earnings. This is really steep for a company which struggles to earn even a 6% return on shareholders’ funds.

Meanwhile, about 60% of its new projects are in the politically troubled states of Jammu & Kashmir and Arunachal Pradesh. China has recently made some noises about Arunachal Pradesh being a ‘disputed’ territory and most rivers that flow through the state originate in Tibet, where our neighbour intends to set up large hydel projects. Why then should I pay two times the book value per share to acquire long-gestation project assets being set up in remote and dangerous locations, and be prepared to earn 6% return on equity for quite some time to come?

Obviously, the government’s hurry to raise funds via divestment has resulted in considerable mis-pricing. This is not visible in the price right now, but markets are known to remain irrational for longer than most people might think. So it’s not correct to consider just the market price as the final indication of over- or under-pricing in an IPO. More importantly, issuers, lead managers and investment bankers are able to rationally and arithmetically justify valuations to level-headed investors and price their issues at or around valuations derived in this manner. I’m afraid this hope is still unrealised for many IPOs in India.

Dipen Sheth is Vice-President, Institutional Equities, BRICS Securities

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