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  • Stock Recommendation | Adani Ports and SEZ - BUY - Target price : 390

    Publish date: OCTOBER 24, 2018

    Outperformance continues.ADSEZ’s good operational results despite evacuation constraints at Dhamra and impending start of Kattupalli’s port operations beyond container boost the case for it to outperform the market. Increase in debt levels, partly driven by forex, is worrying. While we broadly retain our operational estimates (ex-forex), we still lower SoTP to ₹390 (from ₹460) primarily on higher cost of capital to factor in (2) higher G-Sec yields and (2) volatility in port-level financials. We expect modest impact of forex movement on our SoTP.

    ADSEZ reported a strong 21% yoy growth in volumes on (1) rebound in crude (Mundra) and coal (across portfolio) and (2) sustained growth momentum in container (across portfolio). INR depreciation benefits further boosted port revenue/EBITDA that grew 26/30% yoy. Given the static market share for ADSEZ in FY2018, 2QFY19 reaffirmed the scope of share gains. More outperformance would be a function of (1) start of Ennore operations, (2) evacuation concerns at Dhamra getting relieved and (3) start of operations beyond containers at Kattupalli.
    While a 2.75X net debt to annualized 1HFY19 EBITDA is comforting (happens on a base with limited SEZ income), we had anticipated a decline in absolute levels. Despite the ₹30 bn 1HFY19 port EBITDA being >2X capex spent and some part of container JV receivables getting paid back, gross debt levels increased by ₹13 bn. Key drivers for this were (1) forex MTM impact, (2) large increase in other financial assets (have largely related to SEZ income in the past) and (3) investments in gas assets (would get transferred to Adani-Total JV in 3QFY19).
    We increase our cost of capital/equity estimate by 130/100 bps to 12.0%/13.5%. Stiffer cost of equity bakes in (1) increase in 10-year G-Sec yields and (2) uncertainty in forecasting ADSEZ’s port-based income and EBITDA. On the latter, we note recent instances of restatement of such metrics, possibly reflecting the complexities associated with a large consolidated portfolio. We also note the scope of certain non-recurring items such as SEIS income in such metrics.
    In our analysis, we assess stiff requirement on retaining forex-related benefits on top-line to obviate the impact of repayment and servicing of forex debt over all periods of time. Improving but still low capacity utilization comes in way and may lead to a cash-flow impact when the US$650 mn bullet repayment happens in CY2020. The impact is disproportionate on near-term earnings estimates and modest on SoTP—3% cut required at 10% higher ~₹80/US$ rate.
    Notes: Exhibit 1– reported financials, Exhibit 2 – adjusted financials
    Revenue growth led by all-round cargo growth. Adani Ports reported 2QFY19 revenues of ₹26 bn, up 18% when yoy financials are adjusted for port development income of ₹5 bn, which was absent in this quarter. Port volumes grew 21% to 52 mn tons and on half yearly basis, the company crossed the milestone of 100 mn tons for the first time. Coal volumes grew 35% in the quarter led by resumption of coal imports by Mundra power plant of Adani Power; crude volumes grew 42% due to higher offtake by HMEL (unlike maintenance shutdown in 1QFY18) and IOCL. Container volumes continued their strong double-digit growth at 16% in the quarter.
    Another quarter of market share gains. The flagship Mundra port volumes grew 20% in 2QFY19 while other ports registered even faster growth except Dhamra that continues to suffer from shortage of rakes for evacuation. Total volume growth of 21% across ADSEZ portfolio was much higher than 6% growth registered by major ports. Similarly, container volume growth of 16% across ADSEZ portfolio was higher than 9% container growth reported by major ports in the quarter. The company has thus continued to gain market share.
    Port EBITDA margin up 100 bps yoy. ADSEZ has once again met its target of achieving 100 bps improvement in 2QFY19 and 1HFY19. Port EBITDA margin thus stood at 70% led by automation, better cargo mix and sweating of existing capacity.
    Comfortable position on forex borrowings. Management maintains that as long as the company has natural hedge on account of USD-denominated container pricing, it will continue to prefer forex debt over domestic debt in order to save on interest costs. Notwithstanding the MTM loss on forex debt, the company’s cumulative forex earnings are expected to be more than cumulative forex payments (forex debt service + repayments) in each period of the next 12/24/36/48/60 months. The management considers net debt to EBITDA level of 3X as the threshold for comfort. Current net debt to EBITDA of 2.75X continues to be in the comfort zone. The company has also made progress on recovery of related party receivables such as that from CT3/CT4 JVs for port development/asset transfer (down to ₹4.5 bn from ₹15 bn as of end-FY2018) and that from Adani Power for coal imports. The management expects to fully receive outstanding balance from CT3/CT4 JVs by end-FY2019.
    Strategy and outlook. The management mentioned that ADSEZ will continue to pursue strategy of cargo diversification and will try to get greater share of long-term contracts. The company has guided for SEZ income of ₹8-10 bn, capex of ₹23-25 bn and FCF of ₹17-20 bn in FY2019. Port EBITDA margin is expected to improve further to 71% by yearend. Most of the capex will be consumed by expansion of Dhamra, Kattupalli and construction of Vizhinjam port. The company also mentioned progress on establishment of new ICDs in the logistics business as well as procurement of 11 rakes to mitigate shortage for cargo evacuation at Dhamra. The sale and transfer of Dhamra LNG assets to the new JV with Total SA will be completed by Dec-2018/Jan-2019 and these assets will be removed out of the ADSEZ portfolio. On the international front, the strategy remains to pursue greenfield developments in partnership with local players but the management clarified that there are no concrete proposals under consideration at the moment.

    Natural hedge against INR depreciation may not be enough; impact more on estimates than on SoTP
    Our analysis of the forex depreciation impact on Adani Ports throws some interesting considerations. There are primarily three ways in which recent INR depreciation affects the company:
    Benefit on dollar-denominated container pricing. Globally, ports price their container offerings in USD terms. Recent sharp depreciation of INR vs USD thus provides a benefit to Adani Ports on topline. Adani Ports will have ~US$400 mn of dollar-denominated revenues in FY2019E.
    Impact on forex debt due to MTM losses as well as interest cost. Adani Ports has a forex debt to the tune of US$2 bn on its balance sheet. INR depreciation thus affects financials through (1) one-time exceptional marked-to-market loss on this forex debt and (2) natural hedge available to interest payments will dampen the topline benefit on container pricing to that extent.
    Competitive pressure. A secondary impact could occur from lower pricing that can be offered by competition; e.g. Gujarat Pipavav is a debt-free asset and thus does not suffer from INR depreciation the way Adani Ports does due to its forex debt. Such a port can potentially exert pricing pressure by lowering its USD pricing thereby passing on some of the INR depreciation benefit to shipping lines.
    Stiff requirement for Adani Ports to maintain US$ pricing over time
    In the exhibit below, we bring out the quantum of the benefits of depreciation on revenues that ADSEZ would need to retain in order to obviate the impact of such currency movement on servicing and repayment of debt. While it may be reasonable to assume that 100% depreciation benefits can be retained in the near term (US$-denominated rate contracts fixed for a year), shipping lines may end up negotiating hard whenever the rates are due for revision. Capacity utilization for west coast container terminals is likely to improve in FY2019 though it would still be at weak sub-60% until FY2020E and will thus lower the bargaining power of port operators.
    Our analysis suggests that, depending on the period of cash flow hedge, ADSEZ would need to retain up to 9% quantum of the recent 14% yoy INR depreciation in its US$- denominated port handling charges. The analysis takes into account the timing of forex debt repayments and interest payments. It does not assume any further depreciation in currency beyond current USD-INR rate of ~₹74.

    Based on the repayment schedule of the company’s forex debt, FY2023, i.e. 5 years from now will see a significant cash requirement. In order to meet that cash requirement in FY2023, assuming INR does not depreciate further, Adani Ports will have to retain 9% equivalent quantum out of the 14% yoy depreciation of INR vs USD seen in YTD FY2019.
    While such benefits can be retained in the short term due to the fixed term of an ongoing rate contract, shipping lines may drive a hard bargain when the contracts come up for renewal. In such a scenario, weak capacity utilization of container ports on western coast will reduce bargaining power of port operators including that of Adani Ports.

    The evidence so far suggests that there has already been a modest pass-through of INR depreciation benefits by port operators to shipping lines. While INR has depreciated ~14% yoy, the INR-denominated tariffs for a large shipping line have gone up by only 4-7% indicating that port operators have likely reduced the dollar pricing.

    Cash-flow mismatch unlikely to impact SoTP
    Below we put a sensitivity of SoTP and FY2020E EPS to the end-FY2019 US$/INR rate and to the extent of related INR depreciation benefits that ADSEZ would be able to retain. Our analysis suggests a limited 3% impact on SoTP for a 10% further depreciation in currency. The impact is much more for near-term EPS estimates given the Ind-AS requirement to book MTM impact on all forex debt issued after April 1, 2016. Out of ~US$2 bn of forex debt of ADSEZ, 50% was borrowed after April 1, 2016.

    ADSEZ likely to gain share beyond west coast from FY2020 onwards
    Specific factors at play in FY2018 and FY2019 have deferred the benefits of market share gains that would have come ADSEZ’s way in a good growth environment. These factors have largely impacted growth in liquid cargo (HMEL shutdown issue in FY2018) and coal cargo (Mundra plant shutdown, limited rake availability for Dhamra). Modest outperformance in container and impact of select new bulk cargo contracts with key customers have helped ADSEZ grow market share by 50 bps/150 bps over the past 2/4 years. Beyond an in-line growth for ADSEZ on the west coast in FY2019, Dhamra and Katupalli port should drive overall market share gains. We anticipate a 400 bps improvement in market share to 19% over FY2019E-24E.
    Broadly retain operational estimates; higher interest cost and MTM forex losses lead to an optically large cut
    We broadly retain our volume and EBITDA estimates for ADSEZ. Higher interest outgo reflects the impact of a higher forex rate of ₹72/US$ (KIE estimate FY2019E) versus ₹65 in FY2018. The Ind-AS treatment of INR depreciation on forex debt leads to a higher cut in reported PAT. Excluding such impact, we bring down our EPS estimates by 1-2%.

    Revision in SoTP largely on account of a higher cost of capital
    We increase our cost of capital/equity estimate by 130/100 bps to 12.0%/13.5%. Stiffer cost of equity bakes in (1) increase in ten year G-Sec yields and (2) uncertainty in forecasting ADSEZ’s port-based income and EBITDA. On the latter, we note recent instances of restatement of such metrics, possibly reflecting the complexities associated with consolidating a large portfolio of assets having business dependencies.
    We also note the scope of certain non-recurring items within port income/EBITDA. For instance, there is ₹4 bn asset related to export incentives and other receivables, a part of which may be SEIS income included in the ₹73 bn port revenues and 70% port EBITDA margin reported in FY2018. Another source of uncertainty in estimating port financials relates to the income/PAT from container JVs that would not reflect in reported financials due to Ind AS-related restrictions.

    Definitions of ratings

    BUY - We expect this stock to deliver more than 15% returns over the next 12 months.
    ADD - We expect this stock to deliver 5-15% returns over the next 12 months.
    REDUCE - We expect this stock to deliver -5-+5% returns over the next 12 months.
    SELL - We expect this stock to deliver

    Our target prices are also on a 12-month horizon basis.

    Other definitions

    Coverage view. The coverage view represents each analyst's overall fundamental outlook on the Sector. The coverage view will consist of one of the following designations: Attractive, Neutral, Cautious.

    Other ratings/identifiers

    NR = Not Rated. The investment rating and target price, if any, have been suspended temporarily. Such suspension is in compliance with applicable regulation(s) and/or Kotak Securities policies in circumstances when Kotak Securities or its affiliates is acting in an advisory capacity in a merger or strategic transaction involving this company and in certain other circumstances.
    CS = Coverage Suspended. Kotak Securities has suspended coverage of this company.
    NC = Not Covered. Kotak Securities does not cover this company.
    RS = Rating Suspended. Kotak Securities Research has suspended the investment rating and price target, if any, for this stock, because there is not a sufficient fundamental basis for determining an investment rating or target. The previous investment rating and price target, if any, are no longer in effect for this stock and should not be relied upon.
    NA = Not Available or Not Applicable. The information is not available for display or is not applicable.
    NM = Not Meaningful. The information is not meaningful and is therefore excluded.

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