India's REC sets floor price for $757 million follow-on

While much of Asia is still seemingly on hold after celebrating Lunar New Year, Rural Electrification Corp will open the books today for a follow-on share sale of at least Rs34.86 billion ($757 million) that will mark the second asset sale by the Indian government in just two weeks.

This time, the shares sold by the government account for just 25% of the total offering, giving REC a chance to raise fresh capital as well. The company, which is currently 81.8% owned by the government, provides financing to various transmission, distribution and generation projects in the power sector and said it will use the proceeds to strengthen its capital base so that it can continue to grow its business. It also hopes that the sale of additional shares will improve the liquidity in the stock for its existing shareholders.

The shares will be offered through a so-called French auction, a system that was pioneered in India earlier this month when the government sold a 5% stake in power producer NTPC. It means that, instead of setting a price range, the issuer will provide only a floor price. Institutional investors then have the opportunity to put in orders at any price at or above the floor price. Orders submitted at the highest price will be filled first, followed by the rest of the orders in descending order -- until all the shares have been distributed.

However, the auction has been modified somewhat in an attempt to avoid a repeat of what happened during NTPC's offering when the market price fell below the top bid (which was large enough to cover the entire tranche set aside for qualified institutional buyers) during the bookbuilding. This meant other investors would have had to pay a premium versus the market price to buy shares in the offering, and as a result, the end demand was very modest.

Under the modified system, institutional investors will be able to lower their bids at no additional cost in response to movements in the underlying share price.

REC yesterday morning set the floor price for the offering at Rs203 per share, which represented a 7.9% discount to Wednesday's closing price of Rs220.30 on the National Stock Exchange. However, the share price fell 2.8% yesterday, immediately reducing that discount to 5.2% -- still slightly wider than the 4.9% discount that NTPC offered at the outset of its share sale though.

The deal will comprise 171.732 million shares, of which 75% are new. The total sale accounts for 17.4% of the enlarged share capital and will see the government's shareholding fall to 66.8%. Excluding the 350,000 shares reserved for company employees, 50% of the issue will be offered to qualified institutional buyers (QIBs), 35% to retail investors and 15% to non-institutional investors, which includes corporates and high-net-worth individuals.

The floor price values REC at about nine times projected earnings for fiscal 2011 (ends in March 2011) and at 1.8 times its book value for the same year, according to a source. This means it is not only coming at a discount to its current market price, but also at a significant discount versus its closest comparable, Power Finance Corp. The latter, which is also controlled by the government, is trading at 11 times its fiscal 2011 earnings and at two times its estimated forward book value, according to the same source.

REC's share price performed strongly until mid-January when it reached an all-time high of Rs271.70 after gaining 249% since the beginning of 2009. The company listed in February 2008 after a $410 million initial public offering that was priced at Rs105 per share. Already then it was clear that investors liked the stock as the deal was priced at the top of the price range and was 27.9 times covered at a time when other companies, including property developer Emaar MGF Land and Wockhardt Hospitals, had to withdraw their IPOs due to a lack of demand.

In the past month, REC's share price has come under some pressure both because of the upcoming share sale and because of the general sell-off in global equity markets. Yesterday it closed at Rs214.10.

Aside from the more attractive valuation, REC is also viewed as a top quality company that is at the centre of the government's efforts to boost the country's power infrastructure. The company was set up in 1969 to develop the power infrastructure in rural India and today its clients are primarily Indian public sector power utilities at the central and state levels, as well as private power utilities. In September last year, REC's mandate was extended to also include financing of other types of projects linked to the power sector, including coal and other mining activities.

Based on the government's Twelfth Plan for the power sector up until 2017, the Central Electricity Authority is estimating that the total investment requirement across generation, transmission and distribution projects will be Rs11 trillion ($239 billion).

Between fiscal 2005 and fiscal 2009, REC's loan sanctions grew at a compound annual growth rate of 25.7% and its loan book increased at a CAGR of 24.1% to Rs513.8 billion, according to its share sale document. As of the end of September 2009, its loan assets had increased further to Rs586.7 billion.

Investors should also like the issue because of the fact that it will result in fresh capital for the company -- as opposed to the NTPC offering where all the funds raised went to the government.

"This is a finance company, which means the minute you put in tier-1 capital it is going to be' EPS accretive. With a bigger tier-1 capital you can borrow more and increase your tier-2 capital, which means you have more resources to lend and if you have more resources to lend you are going to grow your loan book and make more money for investors," noted one banker.

The deal, which will stay open until Tuesday next week, is being arranged by Bank of America Merrill Lynch, ICICI Securities, JM Financial, Kotak Mahindra and RBS.

NTPC, whose transaction totalled $1.8 billion, is expected to start trading next week.