Investing in India's infrastructure

In this article, we analyse the performance and prospects of various infrastructure related sectors, including petroleum and natural gas. We have left the real estate sector out of the current analysis.

In India, these sectors are characterised by certain common features:

• Large government support for development -- due to high gestation periods, high risk and uncertain revenue stream.
• Government intervention at end consumer level to control delivery and prices, since many of these are perceived to be 'basic' requirements.

Infrastructure sectors in India today

Telecom: The future outlook for telecom continues to be bright, with 6.5 million subscribers being added every month. Indian teledensity (at 18% in January 2007) has still a fair way to go before it catches up with even that of China (27%), and then the developed nations (60%-80%). With a strong telecom regulator in TRAI and several experienced players with financial muscle to scale up, we believe the stage is set for several more years of robust growth in this sector.

With the recent entry of Vodafone through the inorganic route of buying out Hutch, the competition, however, is set to intensify. Falling ARPUs -- average revenue per user -- from reduction in calling rates (and now possible abolition of roaming charges) are likely to be countered by innovative features such as ring tones, caller tunes, GPRS and other value-added features for higher end customers.

Power: Even by India's low infrastructure standards, the power sector has been a shocking underperformer. The power deficit has crossed 20,000 MW or 7% of average demand (13% of peak demand). Load shedding is common in most states, particularly in North India and Maharashtra.

Several factors have contributed to this:

• Bankruptcy of state electricity boards due to rampant theft, cross-subsidies and poor policies. Power producers are thus uncertain of off-take and ability to get customers to pay for the power generated.
• Land acquisition for power plants has been an issue -- with issues of displacement and environmental impact rising time and again.
• Coal linkages have not been provided to thermal power plants, while hydro plants have run into larger political and social opposition.

Going forward, however, we see the situation improving significantly -- not so much due to proactive policy action, but due to sheer desperation and public/industry outcry over power shortage.

This last is likely to force the government to expedite coal linkages, land acquisitions and other procedural issues in setting up power plants. Ultra-mega power plants, five based on imported coal and four at pit head are a good initiative to deliver efficient, low cost power on a large scale.

Thus, electrical equipment companies such as BHEL, Crompton Greaves, L&T (Electrical division), Siemens and ABB are all likely to see their order books full for the next several years.

Power generators like NTPC, Tata Power and Reliance Energy, and distributors like Power Grid Corporation are all likely to see good revenue growth; though occasionally marred by hiccups owing to reasons given above.

Petroleum and Natural Gas: Natural gas is all set to see explosive growth in India with the gas from Reliance's wells in the KG basin expected to start flowing from end 2008.

Reliance itself plans to pump 80 mmscmd of gas from these wells -- compared to the current total gas demand in the country of 120 mmscmd. With Reliance itself having undertaken massive efforts in pipeline infrastructure to bring the gas as far as Mumbai in the West, the industries of power, fertiliser, transportation (CNG), piped natural gas and several small scale industries along the way should get tremendous fillip.

Many of these user segments are likely to switch from more expensive diesel, naphtha or furnace oil to gas. This has tremendous potential to alter the energy landscape in these sectors, making for good returns to gas producers, distributors and consumers alike.

However, on the issue of pricing of gas, regulation of pipeline tariff and the larger issue of the petroleum product prices, we are less optimistic.

Gas pricing, especially to the power sector, has seen several disputes and policy flip-flops. Successive governments have found it politically impossible to have a market pricing regime even for diesel and petrol (besides the long standing kerosene and LPG subsidy).

The losses due to sky-rocketting prices of crude (above $60 per barrel) have been borne alternately or collectively by IOC, BPCL, HPCL, ONGC, GAIL, RIL, etc in terms of under-recoveries or subsidy burden.

The consuming sectors, on the other hand, would see this as an unadulterated blessing. Power (NTPC, Reliance Energy), Fertiliser and City Gas (Indraprastha Gas, Mahanagar Gas) sectors are all likely to enormously benefit from the preponderance of gas in the country.

Civil aviation: The sector is seeing some M&A activity currently -- with Jet Airways completing its takeover of Air Sahara and rumours of large players (such as Reliance and Ryan Air) picking up stake in Jet Airways or Air Deccan. But we remain pessimistic on this industry currently. The problems of the aviation industry are several fold, most of them chronic:

• Lack of adequate infrastructure (particularly parking bays and runways) at major airports has made these routes unviable due to sub-optimal route planning and fuel wastage due to congestion. Neither of these seem to have short-term solutions, given political opposition to privatisation and difficulty in acquiring additional land.
• Passenger trains, which are the competition for low cost airlines, are subsidised. The Railways have undertaken several initiatives to retain their high-end customers -- in contrast to the poor flying experience seen in busier airports of the country.
• High tax on Aviation Turbine Fuel wherein it cross subsidises diesel and kerosene.
• Permission given to several new airlines to operate, thereby removing pricing power from the operators. At present, all airlines are bleeding due to the price war with each hoping for the other to blink first. Given these adverse circumstances, we expect a round of consolidation (and possibly some failures) before the industry stabilises and hence do not advise investment here at this point of time.

Current situation -- In summary

Most of the infrastructure related sectors in India, while offering tremendous scope for growth in the medium to long term, are plagued by several roadblocks including land acquisition, political interference and lack of concerted action backed by a clear vision.

These problems are likely to prevent the sector from reaching its real potential with the next 2-3 years.

Among the sectors, we are most optimistic on telecom and power -- they are seeing huge demand growth, and have strong players who can expand capacity to meet this demand.

Civil aviation and petroleum sectors look less attractive at this point of time. Ports, roads and railways are attractive sectors, but investors lack good avenues for investing in these growth stories today. But in future, we can expect these, as also other sectors like coal, natural gas (especially downstream), parts of railways (like container movement) to open up to private participation in a bigger way.

Mutual funds in infrastructure

There are several mutual funds that have an agenda of investing in the infrastructure space in India. Current investments of these funds include the following major industries and companies therein:

• Electrical equipment: BHEL, Crompton Greaves, Siemens, Thermax.
• Steel and steel products: Tata Steel, Jindal Vijaynagar Steel.
• Telecom: Bharti, Reliance Communication Ventures.
• Banks: ICICI Bank, Andhra Bank.
• Petroleum and Petrochemicals: Reliance Industries.
• Other / Diversified: L&T, Grasim.

Of these, the steel and steel products industry is somewhat less correlated with pace of infrastructure development in the country. Commodity steel in India is traded on import parity pricing, while high end (flat) steels are mostly consumed by the auto sector which we have not included in infrastructure. Yet, in terms of demand growth, commodity steel depends on growth of the real estate and infrastructure sectors.

The table below shows the key funds in infrastructure space, the size of funds managed and their performance over the last one year (relative to the Sensex returning 25.5% over the one-year period).

However, it is important to note that most of these funds do not have a long performance history. None of them have been around for five years; while only Tata and DSPML Funds have been in existence for even two years. Thus, it is all the more important to consider other aspects such as fund manager, portfolio, etc more closely than past performance alone.

While NAVs of all these infrastructure funds have been more volatile than the Sensex in the past, not all these fund portfolios carry similar risk. Reliance Diversified Power, UTI Petro and JM Basic Fund and JM Telecom Fund are all concentrated on a specific infrastructure sector and thus carry higher risk. Among the others, Can Infrastructure, DSPML Tiger and Principal Funds have a larger proportion of large cap stocks in their portfolio, making them less volatile than the others who have a blend with larger mid / small cap exposure.

In light of the discussion on various sectors earlier, we are most bullish on the telecom and power sectors. In this context, among the larger funds, UTI, Birla, Canbank, Tata Infrastructure and DSPML Tiger have greater allocation to these sectors, besides of course Reliance Diversified Power Sector Fund.

Among these four broad infrastructure funds, Mahesh Patil, who manages the Birla Infrastructure Fund, has an excellent track record in the Birla Sunlife Equity Fund as well.

ICICI Prudential Infrastructure Fund has a fund manager with good track record (Sankaran Naren), but its high exposure to banking sector means that the portfolio has to be evaluated in the context of the investor's other holdings in this sector, and not purely infrastructure alone.

Thus, while the Reliance Diversified Power Sector Fund suits a more risk taking investor looking at the power sector alone, the Birla Infrastructure and DSPML Tiger Funds are somewhat more diversified investments covering the entire infrastructure space.

The author is Director, PARK Financial Advisors Pvt. Ltd., Mumbai. He is an IIM-Ahmedabad alumnus. He is an IIM-Ahmedabad alumnus. He can be contacted at iyer.ramganesh@parkfa.com.