IPO Analysis- DLF

DLF IPO

Should you invest?

Sandeep Singh
Posted online: Monday , June 04, 2007 at 1708 IST
Updated: Wednesday, June 29, 2005 at 1257 hours IST

Back in the early-eighties, the DLF Group started buying chunks of land in Gurgaon, adjoining Delhi, with the objective of developing a township. Two decades on, it’s still reaping the benefits — and will continue to do so for some years to come — of that foresight. It still has land reserves acquired at decade-old low rates, but on which it is able to charge current high prices. In 1994, DLF sold houses in DLF City for Rs 650 per sq ft; in 2004, the average sale value ranged around Rs 3,500 per sq ft; today, it ranges from Rs 4,500-7,000 per sq ft. Can DLF build on that and build more such success stories? It sure has the foundation, ambition and vision to do so, which makes its IPO a ‘buy’.

The planDLF is looking to raise Rs 8,750-9,625 crore from its IPO. Of this, it has earmarked Rs 6,993 crore for buying land and developing it. The balance, minus issue expenses, will go into repaying some of its Rs 9,933 crore of debt. DLF, like most developers, believes the real estate sector in India is primed to take off, and it wants a big piece of that action. The scale and sweep of that development is ambitious, suggesting big payoffs, as well as big risks.
First, the scale. So far, over six decades, DLF has completed projects worth 224 million sq ft, of which, 25 million sq ft was in 2006-07. At present, it is working on 44 million sq ft, which will come to the market over the next three years. In addition, it has a land bank of 10,255 acres in 31 cities, with an estimated saleable area of 574 million sq ft. Three-fourths of this is in the National Capital Region (NCR) and in Kolkata, that too in urban areas, and the lion’s share of this is earmarked for residential projects (See graphic: The big build-up).
Next, the sweep. DLF is into residential, commercial and malls. Even as it builds more in these three segments, it is pursuing new opportunities in special economic zones (SEZs), hotels (in a JV with the Hilton group) and infrastructure projects (a JV with Laing O’ Rourke).
It already has approvals for five SEZs and several more are in the pipeline. Land acquisition is a continuous process. As and when the SEZs take off, DLF’s land bank should treble or quadruple.
The businessDLF buys land and constructs on it. Houses are sold, while commercial and retail projects are sold or leased out. Obviously, the big money is in outright sales. In order to generate more money for new constructions, DLF has started selling the commercial buildings owned by it. In 2006-07, DLF sold 3.3 million sq ft of commercial assets to DLF Assets, a group company, for Rs 1,324.7 crore.
This was the main reason for the 10-fold rise in its net profit. However, company officials insist this is not a one-off value unlocking exercise and that they will persist with this strategy. DLF has 3.7 million sq ft of commercial space constructed and another 27 million sq ft is being built. By that estimate, at the same rate, it can make such sales for 10 years. When it sells a commercial building, it loses a steady stream of rental income, but gains cash — at least 10 times more — to be used in new constructions. With India and Indians moving up the progress curve, construction demand is on the upswing, and DLF needs all the funds it can get to make the most of this purple patch.
In the last three years, the four big listed real estate companies have seen their revenues grow at a compounded annual rate of 79-97 per cent and net profit at 145-311 per cent. Such growth won’t continue forever. A FMCG company like Hindustan Unilever is assured of recurring sales because people use Surf every day. Similarly, people replace cars every six to 10 years, which lends some stability to sales of a car company like Maruti. The real estate business, though, is different, as people stay in a house for decades. Once a builder sells a building, that story is over for it and it has to start from scratch. At present, demand is good, as individuals are buying houses with their rising incomes and companies are expanding.
The risksWhile the numbers capture this unprecedented period of growth, they also hold out red flags for investors in estimating the potential of the real estate business. Because of cheap land and rising property prices, DLF’s operating margin (sales minus building costs) have shot up from 27.2 per cent in 2003-04 to 60.8 per cent in 2006-07; net margin has increased from 9.7 per cent to 23.6 per cent.
DLF’s profitability will fall as it uses up its old land reserves in Gurgaon. Increasingly, in its new projects, land will be priced closer to current market rates, which will reduce its margins. However, chances are, it will make up by building more.
Rising interest rates and falling property prices also pose a risk. Like DLF, other builders are also pitching for a manifold increase in business, which could lead to an oversupply situation in some pockets. As it is, the rise in interest rates has reduced the affordability quotient for homebuyers and speculators. If homebuyers stay away, and speculators get edgy and start unwinding positions, property prices might drop, eating into margins. And even as demand slumps, it will still have to keep servicing the mountain of debt it needs to fund its massive land reserves and construction activity.
The recommendationOn balance, the outlook for DLF looks good for the next three to five years at least. Four residential projects and 10 million sq ft of commercial projects with a total revenue potential of at least about Rs 8,000 crore — on a conservative basis — are heading for completion and sale in the next three years. Then, there are more projects and DLF’s value unlocking strategy.
Valuing a real estate company is tricky. One handle is earnings. At its price band of Rs 500-550, the PE on the consolidated earnings — including sale of building to DLF Assets, which is expected to continue — works out to 43.5-48.3. That’s not cheap, but considering the growth plotted out, it is worth it for the long run.
A more accepted benchmark is the value of land banks and its immediate realisible potential, but the scattered nature of the holdings make it difficult to value. DLF’s land bank is being valued at about Rs 80,000-90,000 crore, or an average land cost of about Rs 2,000 per sq ft. If you stay invested and wait for this land to get converted into buildings, your investment should do well.
‘15 years of land’On DLF’s prospectsOur current land reserves can sustain us for 15 years. We are also continuously buying land in areas primed for growth.On selling buildings to DLF AssetsWe will sell only those assets we find suitable. We will follow an open bidding route, as we did for the last sale. That said, we have set a minimum sale price of 10 times the annual rental value. Another qualification criteria for bidders is maintenance of the asset in a way that it doesn’t change anything for the asset and its tenants. DLF Assets won because it fulfilled both conditions.On real estate demandOur GDP growth is 8-9 per cent, which will have a multiplier effect on the real estate sector. Demand is high. Also, our ratio of mortgage loans to GDP is just 6 per cent, compared with 40 per cent in developed nations.On rising interest ratesHigher rates increase our costs. They also reduce affordability levels for the middle-income group, which brings down demand. But I don’t think the RBI will persist with a high interest rate regime.

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