Investing Idea - Ashiana Housing

Real Estate Business

What is the first thought that comes to your mind when you think about real estate developers in India? Some of the most common words are fraud, corrupt, scam, bubble etc. Every Indian aspires to have a house of his own. If they are fortunate enough to realise their dream, they are hit by all kind of scams by developers such as deliberate delays, false promises, deviation from approved plans etc. This has tarnished the image of all real estate developers in India. 

A simple business

Let us change topic for the time being and look at a very simple business. Lets call this business - “Magic carpet” business and it is run by a chap called Ali. Initially Ali puts in $100 to buy special thread to make magic carpet. Ali has to hire some expert hands to weave this carpet, pay some royalty to Aladdin and so forth, which in total costs him another $250.

With his goodwill and reputation, Ali already has a buyer who always dreamt to fly around the world on a magical carpet. The buyer has agreed to buy the carpet for $500 and agreed to pay advance payment of $250 and remaining payment during handover. Ali uses this advance payment to hire expert hands to weave the carpet, pay the royalty etc.

Ali keeps up his promise to deliver the carpet on time for the buyer to fulfil his life long dream.

Ali can now turn around and once again buy thread worth $100 (keeping balance $50 for himself) to weave another carpet. His reputation and possibly the referral from his previous client helps him to find a buyer who is ready to make advance payment. Once again Ali delivers the carpet on time and the cycle continues. Ali's reputation is having a snowball effect.

Looking at this wonderful but simple business, others jump in and start something similar but with a twist:

1. Buying and stocking the thread in an expectation that thread prices will go up as demand for carpet increases. Why build anything when you can make money trading?
2. Redirecting the advances from customers into buying thread at the cost of delaying or not even delivering the carpet to customers
3. Taking as much debt as possible to buy more and more thread
4. Delivering a carpet that can only crawl rather than fly
5. Trying to make carpets jaded with Swarovski crystals for customers with a rich taste

It is not hard to imagine why many of these businesses would fail.

Meanwhile, Ali has started doing Joint Ventures on revenue/profit sharing model with other people who own the thread but do not have the experience or reputation to build a truly magical carpet. This makes his business even more profitable and asset-light.

Ashiana Housing

Let us replace the magical carpets with simple homes and you will get a wonderful business that started operations in1986 named Ashiana Housing. Ashiana mainly builds houses for middle-income group (Comfort Homes) and senior citizens (Senior Living). You can check the latest presentation of the company to get more insights about the company and its operation.
Ashiana Housing latest presentation

So what makes Ashiana housing business wonderful and different from other run-of-the-mill real estate developers?

Asset Light model – Ashiana enjoys a moat that is float.

Float in its simplest form exist in Insurance industry. In case of the insurance industry, float is the money that an insurance company gets to hold onto between the time customers pay premiums and the time they make claims on their policies.  In fact, this collect-now, pay-later model is central to the way the insurance industry operates.  No matter if a company generates an underwriting profit or loss from its core business, it can still earn investment income from the float.

The source of float in case of Ashiana Housing is the advance from customers. Ashiana Housing does not use these advances to earn income through investments but is able to cover the cost of construction through these advances. This is similar to raising interest-free debt. Naturally if used properly this free leverage can generate superior returns for the company.

Ashiana has generated high gross advances from customers over the years.

Insurance companies run in trouble when they not only underwrite at a loss to generate premiums but also are unable to invest the float wisely to generate enough returns. Real estate companies run into trouble when they divert customer advances in investments unrelated to core business and delaying the delivery of homes to customers.

A low-cost manufacturing company rather than Construction Company

1. Land is considered as a strategic raw material rather than a speculative investment for capital gains. Ashiana Housing keeps a land bank of 6-7 times the annual construction rate and land is acquired keeping in mind the burn rate (% of land consumed from the total land inventory) which is typically 15-20%
2. The business operates more like a manufacturing hub where the objective is to constantly churn out good quality product on a timely manner and keep the operational cost minimal and efficiency high. Ashiana has low construction cost due to simplistic construction such as mid, low-rise development with stilt parking rather than basement etc.
3. The company strives to constantly improve the delivery timelines to improve cash conversion cycle. The company has been able to squeeze delivery time from 30-36 months to 24-30 months by process improvements.

Enjoys brand reputation and goodwill – Ashiana housing, over the years has built a reputation to deliver quality homes on time. Other strategic initiatives to build brand includes:

1. In-house facility management enables the company to keep the facility in good condition and take action based on direct feedback from customers. Ashiana also provides resale and rental services to facilitate easy exits for the customers. This helps build a reputation and brand loyalty among customers.
2. Direct Sales channel – The outcome of perverse incentives in real estate selling is well known and experienced by many homebuyers. In order to avoid customers being misled by intermediaries, Ashiana undertakes all bookings. Varun Gupta, Whole-time director of Ashiana Housing, sums up the key reason for direct sales channel brilliantly. 

All these efforts have led to a high customer satisfaction rate and a high proportion of customer referral sales to overall sales is a testament of its brand value and reputation. Ashiana also enjoys better pricing and better terms from customers.

Debt free – While other real estate companies are burdened with debt, Ashiana has managed to keep itself relatively debt free. Current debt to equity ratio is 0.06

Good accounting practice – Let us first understand why accounting policy reflects the character of the management, which is summed up brilliantly by Charlie Munger is his paper “The Psychology of human misjudgment”

"Where you see in business just perfectly horrible results from psychologically-rooted tendencies is in accounting. If you take Westinghouse, which blew, what, two or three billion dollars pre-tax at least loaning developers to build hotels, and virtually 100% loans? Now you say any idiot knows that if there’s one thing you don’t like it’s a developer, and another you don’t like it’s a hotel. And to make a 100% loan to a developer who’s going to build a hotel... [Laughter] But this guy, he probably was an engineer or something, and he didn’t take psychology any more than I did, and he got out there in the hands of these salesmen operating under their version of incentive-caused bias, where any damned way of getting Westinghouse to do it was considered normal business, and they just blew it.

That would never have been possible if the accounting system hadn’t been such but for the initial phase of every transaction it showed wonderful financial results. So people who have loose accounting standards are just inviting perfectly horrible behavior in other people. And it’s a sin, it’s an absolute sin. If you carry bushel baskets full of money through the ghetto, and made it easy to steal, that would be a considerable human sin, because you’d be causing a lot of bad behavior, and the bad behavior would spread. Similarly an institution that gets sloppy accounting commits a real human sin, and it’s also a dumb way to do business, as Westinghouse has so wonderfully proved.

Oddly enough nobody mentions, at least nobody I’ve seen, what happened with Joe Jett and Kidder Peabody. The truth of the matter is the accounting system was such that by punching a few buttons, the Joe Jetts of the world could show profits, and profits that showed up in things that resulted in rewards and esteem and every other thing... Well the Joe Jetts are always with us, and they’re not really to blame, in my judgment at least. But that bastard who created that foolish accounting system who, so far as I know, has not been flayed alive, ought to be"

In 2012, Ashiana shifted from POC (Percentage of completion) method to contract completion. An extract from Fy2012 annual report explains the merits of contract completion method 

Broadly, real estate companies follow two type of accounting policies—(1) percentage of completion (POC) method, and (2) contract completion method. Within each of these, companies have different thresholds before they start booking revenues.
We shifted from the contract completion to POC method in 2006. Benefits of POC method are that as the construction happens and sales get booked, revenues are recognized and so there is a smoothness in reported revenues over quarters. Under the POC method, revenue gets accounted after a certain minimum cost threshold is reached, which can vary from 5-10% of total budgeted costs to as much as 25%.

However, POC method does not reflect market risks, liabilities and assets accurately. Till the delivery of the unit to the customer, the entire amount received from the customer is a liability for the company and the risk of ownership of the property is only transferred upon delivery of the unit to the customer. For example, the company had recognized revenues from the Utsav, Lavasa project under POC method, and then the project was put on hold by the Ministry of Environment and Forest. Now one must ask what was the liability of the company if that project had not received eventual clearance and had to be discontinued. The liability of the company would have been to refund the entire amount received from the customers of Lavasa and not the amount reflected in the Balance Sheet, which was reduced by the amount of revenues recognized from Lavasa. The POC method understates both the liabilities and assets of the company. It is also our belief that for a real estate company, the balance sheet is the more important indicator of the financial health of the company as compared to the profit and loss statement because our operating cycles tend to be in multiple accounting periods.

Under contract completion, revenues are recognized when the unit is completed and either possession is transferred or deemed to be transferred to the customer. Till that time, whatever cash inflows happen from customers on the projects are recorded in the current liabilities under ‘Advance from Customers’ and direct expenses incurred are accounted in ‘Work in Progress’ under inventories in the Balance Sheet. Revenue recognition gets lumpy as units tend to be delivered in batches and not continuously. It also delays revenue recognition till the completion of units.

The next two years will be a transition phase when the projects nearing delivery have had been accounted under POC method and all the projects under contract completion will be in-construction mode, hence creating volatility in revenues reported. Revenues and profits recognized in the next two years will be significantly lower than that recognized in previous years and will not be comparable to the previous years figures. So for the coming couple of years, it will be difficult to compare the growth of the business through income statement. The best way will be to look at key growth drivers like sales booked, construction done and operating cash flows generated. However, the long-term benefits of contract completion accounting by far outweigh the short-term transition issues involved. As outlined earlier this conservative method of accounting will more accurately reflect the assets and liabilities of the company. This will make it easy to understand the operating cash flows of the company, which is one of the most important parameter to appreciatethefinancialhealthofthecompany. Itwillalso better reflect the margins of the company, as they will be directly linked to the delivered homes and square footage and not subject to future estimations of project cost.

The other benefit of contract completion accounting to the company is that it will help maintain the financial discipline for the business as a whole. The ‘Advance from Customers’ in the liabilities side and ‘Inventories’ in the assets side will let us help in ensuring that the cash inflows from one project are utilized towards the cash outflows of the same project. It will be apparent if advances from a project are utilized to procure land of another project. Lack of discipline around this has been the bane of the industry and has resulted in project delays and mismatched cash flows for many developers. We at Ashiana clearly want to avoid this mistake. Also, contract based method is in compliance with IFRS standards and it will be an important aspect in making our financial statements comparable to those of international players. Whenever it is adopted by the industry at large in India it will help in making the companies comparable on key drivers.

The shift to contract completion method of accounting from POC method will bring with it short-term pain in terms of reported revenues and profits for the next two years. It will make our profit and loss statement more volatile and not comparable on a quarterly basis. But, the contract completion method of accounting better reflects assets and liabilities of the company. It will easily reflect the company’s financial discipline or the lack of it in utilization of advances from customers. It will create incentives to deliver faster to ensure revenues get reported. Cash flows of the company will be easier to comprehend and margins will not be subject to estimations of future cost. Contract completion method of accounting has its shortcomings but overall it will better capture the financial health of the company. 

And here is Varun Gupta’s (whole time director of the company) explanation on the change of account policy

"We have just moved away from the percentage of completion accounting totally to contract completion of possession accounting whichever word you want to use where you would recognise the revenues at the time of delivery of the flat to the customer. So what happens is if you have a two-year cycle of operations instead of revenues getting recognized every quarter over eight quarters, it gets locked into the last quarter. So it delays the revenue. But what it benefits as it gives a better sense of the liabilities of the company that the money has been received from customer against which deliveries have not been made. It also puts incentives to deliver faster to have revenue recognition coming in which is a very important aspect of the business. And third, we are in the business of selling homes and building homes and delivering homes to our customers. A basic situation over there is the customers have a binary situation, a customer thinks either he gets a flat or he doesn't get a flat. My customer is not there to take up half built project and say 50% construction is done, they will take it. The liability only gets set up at the end of delivery, so that is the basic reason for it and the difference is that the revenues get recognized at the end of the year"

Future of Ashiana Housing

1. Joint development model – Ashiana housing is banking on its reputation and execution skills. One of its strategies to scale up is by joining hands with landowners in new markets by way of profit sharing, area sharing or revenue sharing. These partners bring in land, local expertise of the regulatory know-how and Ashiana brings in its execution skills to create value for customers.
2. Entry into new markets – Ashiana is entering new markets such as Chennai, Kolkata, Gurgaon etc. to scale the business to new heights. These new markets present as much risk as opportunity for the company.

Valuation of the company

Ashiana aims to become a “square foot making machine” meaning they target to build a certain square foot every year. So the most logical way to value this company would be to forecast area build every year, estimated growth rate, realization rate, margins and apply a multiple to that value.

Assumptions:

1. Estimated growth in area constructed, area booked, gross margins and PAT margins is 5 year average.
2. Since Ashiana follows contract completion method and takes around 24-30 months for delivery of the homes, revenues are captured after 3 years. So revenues for FY16 will be for area constructed in FY13.
3. Revenues were lumpy from FY12-FY15 because Ashiana changed the accounting method but going forward it should normalize and revenues should grow in line with the area constructed and area booked.
4. Assuming a multiple of 15 gives a market capitalization of INR44.99billion, giving a CAGR return of 14.92%. The current industry multiple is around 15%

However, as mentioned earlier given the change in accounting method there has been some lumpiness in the revenues. So looking at the on-going projects that are scheduled to complete by FY17 gives estimated cumulative revenue of INR11.73billion and PAT of INR2.93billion (compared to cumulative PAT of INR2.08billion under the above method). Here we have assumed economic interest is shared at revenue level which may not be the case.

Most real estate companies are valued on EV/EBITDA as cash flow is like oxygen for these companies, not only to continue construction but also to acquire land and service its highly-levered balance sheet. It is also difficult to track revenues and PAT as almost all firms use POC (Percentage of Completion) method of accounting, so EV/EBITDA becomes a de-facto valuation method. However I'd think that P/E multiple is a better way of valuing Ashiana housing as the balance sheet is not leveraged and accounting is "contract completion" method. Ashiana has negligible debt and interest cost, so EBITDA is also the Pre-tax income for the company.  The issue in applying a multiple to earnings though is that Ashiana may have to dilute the equity again in future if they want to continue to grow at 15-20% for next few years.

Ashiana is currently valued at 6x EV/EBITDA based on expected EBITDA of INR3.2b from on-going projects that are scheduled to finish in next 2 years.

Apart from the on-going projects, Ashiana has projects of 8million square feet saleable area in pipeline and another 4.9million square feet of saleable land bank for future projects translating into 6 years of development activity at the current burn rate. This provides enough visibility and predictability in its earnings for next couple of years.

Importance of Modified pre-tax cash flows

Ashiana publishes pre-tax cash flows of all on-going projects quarterly and annually. This helps the management to understand the cash flows on a short-term basis. For investors these cash flows provide insights on the financial health of the company as well as its ability to generate cash to buy additional land to replace the land consumed in construction.

QIP and use of the cash flows - Ashiana has raised INR2billion through a QIP recently and estimates INR4b of cash flow in next years giving total cash balance of approximately INR6b. Ashiana plans to use the proceed to buy approximately 15-17million square feet of land for replacing the consumed land and estimated growth in area constructed.

Ashiana will not be able to pay any dividends, and in fact may have to dilute equity further to procure land if they want to grow 20% in terms of constructed area which means that have to buy 1.2x of the land consumed annually.

Risk factors to consider

1. Inability to generate cash flows and customer advances - If, for any reason, the booking slows down then Ashiana will have to deploy more capital to undertake construction which will hit the company's operating margins.
2. Increase in taxes – Historically Ashiana Housing was paying taxes under MAT due to tax incentives on certain kind of housing but going forward these incentives will exhaust and will be taxed at full rate from 2015-16. However a lot of income in the books in post-taxed as the income flows from SPV where the tax is already paid.
3. Inability to penetrate successfully in new markets – Ashiana’s goal to grow and build more houses depends on its ability to successfully penetrate into newer markets such as Chennai, Gurgaon, Kolkata etc.
4. Regulatory overhang on the real estate industry in India

Disclosure: The article reflects my personal thoughts on the company and is not a recommendation to buy or sell the security.