Description

India Globalization Capital (IGC)

India Globalization Capital (IGC) is a SPAC targeting infrastructure companies in India.  The company is led by a very strong CEO who has negotiated two simultaneous majority control stakes in Indian E&C companies for 22.1x TTM earnings.  While this multiple seems high both targets are positioned for outstanding growth with fully contracted revenue that will surge 8-fold from historical FY March 2007 to FY March 2009.  As explained below, IGC believes it can use its cash to dramatically improve the profitability of these companies.  These efforts allow us to purchase IGC for 7.1x FY March 2009 earnings which is a substantial discount to the 21.0x multiple of the public Indian comps.  A 17.5x forward multiple implies that IGC has 100% upside on a fully diluted basis (where we punitively assume the company raises cash through warrants at $5.00 then instead of deploying that cash productively it immediately buys back the stock at a higher price).  Given the growth opportunity here I believe this investment could provide much greater returns over time as the company is also planning a foray into owning infrastructure assets such as toll-roads as well as alternative energy power generators like wind-farms.  This equity will also have scarcity value since there are few options for American investors who want to play the Indian infrastructure theme.  From a timing perspective, these deals took a long time to get through the SEC and IGC’s liquidation deadline is March 8^th so the vote will take place on February 20th. 

Industry Overview

It is an understatement to say that rapid economic growth in India is predicated on improved infrastructure. India’s GDP is growing 8-9% per annum and the country expects to spend $475 billion on infrastructure in the next 5 years.  This figure includes $40 billion for highways and $160 billion for power generation.  IGC’s initial platform companies will focus on both roads and power generation.  This infrastructure boom could last up to a decade. 

The road network in India is clearly inadequate and cannot handle the traffic demands of its rapidly growing economy.  Though India has approximately 2 million miles of roads, most of its highways are subpar.  They are narrow and congested with poor surface quality.  According to the World Bank, approximately 40% of India’s villages do not have access to all-weather roads and are cut off during the monsoon season.  Remarkably, in the last 50 years, the government has built only 334 miles of 4–lane roads.  All these facts suggest an outstanding tailwind for the companies IGC plans to back. 

There are three types of road building contracts:  maintenance, third-party road building and Build Operate and Transfer (BOT).  BOT is a government mechanism common in infrastructure initiatives that can attract private investment as well as rapidly build out world-class roads.  A participant will fund the construction of the project, such as a toll road, operate it for a specified period such as 20 years and then transfer the asset back to the government.  As I will detail below, IGC will focus its early efforts on executing simple road building contracts but will also endeavor to build out a portfolio of BOT projects. Maintenance will also provide an ongoing revenue stream to the company.    

Business Description

India Globalization Capital is a SPAC that raised $62.8m in March 2006 to acquire an operating business in India.  The driving force behind the company is Ram Makunda, a very smart former telecom entrepreneur who has ties to India.  In speaking with Ram I get the sense that he is on “our team” and that he will make good decisions.  This is a far better quality manager than you might expect in an emerging market micro-cap company.  Both the final merger proxy dated 2/8/08 and the investor presentation filed on 2/1/08 can provide additional information beyond what I supply here.  The proxy is very helpful.  

IGC is buying 63% of Sricon and 77% of TBL for $40m.  Sricon and TBL are infrastructure companies that specialize in road maintenance and road building, in India.  Buying majority stakes in Indian companies is no easy task and it is important to note that the current management teams of the target companies are still sufficiently aligned to grow their businesses.  IGC actually announced a previous LOI with another roadbuilder called MBL but it was too difficult to get US GAAP audited financials completed so IGC moved on to Sricon and TBL.  Prior to termination of that deal, IGC did a bridge financing for MBL which it now carries as an asset on its balance sheet.  Similarly, IGC has already done a $7.2m bridge financing for Sricon and TBL to build momentum for their pipelines.  After completing the deals, IGC will still have $19m on its balance sheet for further acquisitions or incremental investment into its initial targets.  In pursuing these deals, IGC noted that most of its competitors were focused on offering $5-$10m for smaller ownership stakes in Sricon and TBL while IGC’s willingness to step up with significant capital was a key differentiator.  The most interesting aspect of the deals is the exceptional backlog that provides top-line visibility into FY10.  The proxy breaks out the backlog by project.    

Sricon is an engineering and construction company that is engaged in the execution of civil construction and structural engineering projects. It has $195m of project backlog.  It is involved in the design, building and maintenance of roads, highways, toll booths, overpasses, as well as industrial infrastructure development such as power plants, water supply systems and mining.  Sricon also has a BOT contract for one of the highways in India. This is important because it shows that the company has the skills to execute on a BOT.  A significant portion of the business is categorized as “industrial logistics” which entails contract mining for excess rock as well as transportation of coal and ore.  This segment is a 25% margin business.  The industrial infrastructure segment offers a 15-17% margin while the road building business is more of a 5-6% margin (with opportunities to earn a higher margin by vertically integrating back into a quarry to reduce aggregate costs).  Sricon’s CEO had 30 years of experience for Larsen & Toubro before founding the company in 1997.  In addition there are 300 skilled employees and 800 unskilled labor contractors. 

TBL (Techni Bharathi Limited) is also an engineering and construction company that is engaged in the execution of civil construction and structural engineering projects, such as the design and building of roads, highways, bridges, tunnels, airport runways, railroads and dams.  Its project backlog is $47m.  TBL has a regional focus in the states of Andhra Pradesh, Karnataka and Tamil Nadu.  It is also experienced in Assam which is a mountainous Northern region where the difficult terrain and occasional political instability mean contracts are extremely profitable.  TBL is run by a father-son team who previously founded Bhagheeratha  Engineering and took it public as one of the 10 largest construction companies in India. TBL was founded by the chairman's son.  The chairman retired from Bhagheeratha engineering several years ago, before the boom.  However, after he left it was taken over by another family.  The company still exists but is not one of the larger companies. TBL has 57 skilled employees and 70 unskilled labor contractors. 

The key insight that IGC brings to these transactions revolves around the immediate increase in net profitability by injecting capital into these two businesses.  IGC believes several straightforward changes can improve net margins from 3-5% to 14-18%.   As can be observed in the financials in the next section, neither of these companies have grown in the last few years and they have both been marginally profitable or loss-making.  IGC cites numerous benefits from shoring up the company’s balance sheet and providing it with an American sponsor.  These improvements fall into three categories:

• First, the companies can save 500bps by improving their payment terms.  In the past, the companies did not have the cash to pre-pay or even pay on time for raw materials.  Adequate capital provides leverage with vendors that increases purchasing power.   IGC has had detailed discussions with vendors and other construction companies and is confident that obtaining these terms would not be a stretch. 
• Second, the companies can improve margins by 300bps by investing in PP&E and improving productivity.  Specifically Sricon could invest in a crusher that would allow it to make its own aggregate.  Leasing rates can be 18% in India so it makes sense to borrow at a lower rate and purchase equipment.
• Finally, the companies expect to improve margins on the order of 500-700bps through a reduction of the cost of capital.  They expect to reduce their interest rate from 13.5% to 9% by improving their balance sheet and Ram also believes he can access less expensive lending sources in the United States and Europe.  He has had discussions with RaboBank, Citi, JP Morgan and HSBC for example.  In addition, he has hired a consultant to help raise the debt.

Due to the holding company structure, IGC believes its two infrastructure companies will be perceived as local, but it will also benefit from being an American company.  This will give it the local advantage to partner with governments on projects that may not be as easily available to the Bechtels of the world.  Yet the company will also bask in the prestige of an American listing and will obtain an American cost of capital. 

For the medium term these companies will be run separately. However, IGC will be able to exploit certain synergies: (1) IGC will organize a joint-risk management committee and the companies will share equipment where geographically appropriate; (2) there will also be scale in project bidding as IGC estimates a 1 in 7 win rate on projects and plans on bidding 2/3 a month; and (3) longer term IGC may combine Sricon and TBL then take that entity public in India. 

Also in the long term, IGC would like to build a portfolio of 100% owned assets such as BOT projects.  It is also moving into the power generation business.  As part of this transaction, IGC will purchase a 24-megawatt wind energy farm to be built by an engineering firm called CWEL. According to Ernst and Young, 60% of India’s population has no electricity and even major cities face power cuts.   It is expected that CWEL will take between 9 and 12 months to build out the wind energy farm.  Due to the timing of the initial contract to build it, the construction cost is 25% less than it would cost to replicate it now.  The wind energy farm will serve as a platform for future growth and acquisitions in the alternative energy sector in India.  Ram also believes he will be able to run the business tax-free for 10 years and potentially sell carbon credits to further improve the economics. He has initially budgeted a 30% ROE.  I have marked the wind business at the book value of the cash invested as it will not be up and running for a year. 

Financial Summary and Valuation:

The following chart lays out the fully diluted capitalization of IGC.  In addition to the typical SPAC common shares and warrants, there are additional shares and warrants associated with two bridge financings.  IGC has a 7% stake in MBL, another roadbuilder not involved in this transaction, through a convertible bridge financing that it did back when it thought it was going to invest in MBL.  This is held on the balance sheet at $3m. While this is not in the proxy, Ram states that MBL will do $80m of revenues this year and its net income will be $5m.  Capitalizing this investment at 20x implies a $7m value which I have backed out of the valuation.  I have also backed out the book value of the wind business, although it is arguably worth more.  Though it is conservative, I have assumed that the $19m of excess cash on the balance sheet does not get deployed.  There is a substantial warrant overhang which I have addressed by quoting all valuations as fully diluted treasury method. 

Capitalization Summary:

The following chart lays out the historical and projected financials of the target companies.  All financials are US GAAP.  Sricon’s projections through FY 2010 are based on the lower of proxy or earnout targets through 2010 while 2011 and 2012 represent simple 15% growth which I feel is reasonable.  TBL’s historical financials exclude a one-time gain while 2008-2009 projections are based on the presentation which has lower numbers than the earnout targets in the proxy.  Years 2010 through 2012 are based on earnout targets.  I have included all earnout shares as if they are earned to calculate IGC’s share of net income.  Note that the earnout shares are not in IGC stock but rather in the stock of the individual companies. There is further detail in the proxy that I have chosen not to delve into here.   I would also add that the company has hired a consulting firm of ex-PWC accountants to supplement the existing internal finance team make sure controls are adequate and there is never an issue with the numbers. 

The most recent six month period show a significant uptick in the business level that is in part due to a bridge loan from IGC, but also reflects the fact that IGC’s commitment to invest once the deal closes allowed the companies to receive soft loans to push execution up.  Together, this is early evidence that IGC’s investment will drive much stronger performance going forward.  There are also no BOTs in the projections though these projects can offer 25-30% IRRs.  It is possible that the company could benefit from BOTs in FY 3/10.

Finally, these projections do not include any benefit from either the $19m of cash on IGC’s balance sheet or from warrant proceeds which are incorporated via the treasury method.  In reality, investing this cash in the business should be extremely accretive. 

The following chart shows IGC’s dramatic undervaluation relative to its construction peers.  It is also worth noting that Noida Toll Bridge, a company not in the comp list,  is a $250m market cap pure BOT company that trades at 36x 08 EPS and 29x 09 EPS which a premium to the other comps.  Should IGC be successful in building-out a BOT portfolio then it would raise its valuation.   

The following tables show the potential value of IGC at more reasonable multiples as well as if it was market to the average comp valuation.  As 3/08E is essentially trailing and does reflect the large ramp in revenues and improved profitability, 3/09E is a better period to reflect this investment’s potential.   I feel some discount is warranted as it is a holding company and has yet to fully execute on its projections.

From a downside perspective, IGC’s revenue is locked-in for FY 3/09 but if it is unable to achieve its margin improvement goals to the tune of a 700bps difference from its projections then their EPS would be $0.34 in FY 3/09.  At a depressed 7.5x multiple after taking into account the $1.90 of cash and other assets, the stock would trade to $4.40 implying 25% downside. 

Investment Concerns

Trust Buyers Could Hold Up the Deal: As in some other SPACs, there is a large trust buyer presence in the shareholder base.  These funds arb the spread between their purchase price and the cash in the trust of $5.89.  Looking at what happened with the MQC deal (which I previously wrote up), there is a chance that management might have to cut a deal at the last minute and offer some of its shares to investors who step  up and bring the deal across the finish line.  I will keep the VIC community abreast of that situation in the event it is necessary and takes place.  The deadline is March 8^th so all of this might happen in short order.   

SPAC CEO’s prior experience includes a bankruptcy:  Ram founded one of the first ethnically-focused international long distance telecom carriers back in the 1990s called Startec Global Communications.  The company IPO’ed on the NASDAQ in 1997, generated $300m in revenue and turned a profit.  At its peak, its market cap exceed $1 billion.  Ram was approached to do a convert which ensnared the company in a liquidity crisis as the tech boom imploded.  Ram led the company through a long restructuring which ultimately returned all the senior debt’s capital.  Interestingly of the 25 public companies with similar business models, only 3 survived including Ram’s company.  His model worked but he got in trouble on the capital structure.   The two main items I take from this is that 1) Ram is an honorable individual who committed himself to a multi-year painful restructuring to get his lenders their money back and 2) I think it is unlikely that Ram will allow any venture he leads to find itself in a liquidity crisis again. 

CEO is New to Industry: Ram has excellent business judgment but he is new to the industry.  He has spent a year digging into MBL before passing on that opportunity and he also passed on two other similar companies. I have not met other management at the target companies.  They have strong backgrounds, however, and I suspect they will remain the key operators post-deal. 

Lots to Execute: Taking a step back, it looks like hyper-growth is a lot to ask of two tiny companies, particularly as it relates to bid activity for new projects.  In reality, its quite doable.  It takes 4 people to create one bid team.  One team can bid on two contracts per month.  Collectively, IGC’s targets have three teams in place now (two in Sricon and one at TBL).  IGC expects to put together one more team.  Ram believes that getting more contracts is the smallest risk, because of the number of contracts available and the inroads that these companies already have.  Rather, the keys are a strong balance sheet, technical qualifications which the companies have (they are pre-approved to bid on contracts up to $116m), and adequate contacts/influence.

Margin Improvement on the Come: As simple as the margin expansion sounds here, it still needs to happen.  The market might not be willing to reward the company with a full multiple until it posts a few quarters of solid financial performance. 

Indian Economic Risk:  Future growth is dependent on the Indian government following through on its spending programs.  I think India will continue to spend and IGC investors are well protected by its backlog and its valuation. 

Holding Company Structure: Given that IGC is a holding company, it may trade at a discount.  On the plus side, it is a majority shareholder in Sricon and TBL so their financials will flow through the IGC P&L. 

DISCLOSURE:  We and our affiliates are long India Globalization Capital and may buy additional shares or sell some or all of our shares, at any time.  We have no obligation to inform anybody of any changes in our views of IGC.  This is not a recommendation to buy or sell shares.

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