'Power On, India On' – there is no doubt about that. But, Reliance Power will take a long time to turn on its generators and the valuation is a bit too exuberant. By Vivek Sharma

The power is finally ''turning on'' today, as the Reliance Power IPO opens to unprecedented frenzy among investors. Stories about the IPO are prime time news on most television channels, not just business channels. There has been a surge in demat account openings, brokers are said to be taking demat accounts on rent to apply for the IPO and the Reliance Power stock is rumoured to have already doubled in the grey market.  

There is no doubt that this IPO will become a case study in many business schools across the world. This is simply the best marketed IPO the country has ever seen and 'Power On, India On' is probably the best catch phrase invented to sell an IPO. Even the controversies surrounding it, with allegations and counter-allegations flying between the two Ambani brothers, seem to have only added to the allure of the IPO.  

But, will Reliance Power become a case study for future investment professionals on how a start-up company with unlimited ambitions became one of the best investments? Will it become a case study on how one company re-wrote the rules of a staid industry, reinvigorated it and cleared the path for incredible growth?  

Why Reliance Power was made separate?
Reliance Power took over most, not all, of the power generation projects that were awarded to or were in active consideration by the Anil Ambani group. The group's established power utility, Reliance Energy, should have executed these projects in the normal course. But, Reliance Energy will own only around 45 per cent of Reliance Power's post-IPO capital.  

Anil Ambani, through his privately held investment company, will own another 45 per cent and the rest will be with the public. In effect, Anil Ambani, who is also the largest shareholder of Reliance Energy, has a majority stake in Reliance Power. Is this shareholding structure unfair to minority shareholders of Reliance Energy, who should also have been extended the full economic benefits of the power generation ventures?  

While Reliance Energy is an established power utility, the promoter does not have any background competency or expertise in the power sector. So, what did the promoter bring in to take an equal equity stake in the generation projects? 

This is the biggest controversy surrounding Reliance Power and has raised concerns about corporate governance, especially so since Anil Ambani had positioned himself as the champion of corporate governance, transparency and minority shareholder rights – during his fight with elder brother Mukesh prior to the demerger settlement between the two after the death of their legendary father, Dhirubhai Ambani.  

The group's justification is that the projects being considered by Reliance Power need significant financial resources and would have stretched Reliance Energy. A separate company would naturally reduce the exposure and risks of Reliance Energy, especially when substantial debt is involved.  

Besides, Reliance Energy is repositioning itself as more of an integrated infrastructure developer – rather than a pure play power utility. These diverse projects – from metro rail in Mumbai to integrated township development in Hyderabad – will need additional capital. So, it makes sense to hive off the power generation ventures to another company, rather than keep everything in one basket. But that still doesn't answer why the promoter should be allowed to take an equal stake.  

Execution risks
The scale of the projects under consideration by Reliance Power is unprecedented in this country, a fact acknowledged by the company in its prospectus. In this age when the entire execution of a project – right from design to trial runs – can be outsourced to large multinational engineering companies, actual execution experience is not much of a concern. Anyone with a vision and enough money can build large projects.  

But the risks most projects face even before they reach the design stage can be quite intimidating, especially in the case of large infrastructure projects. Apart from a plethora of permits from multiple agencies, land acquisition will be a major challenge for the promoters. These roadblocks are multiplied for a power company executing multiple projects in different locations.  

Reliance Power has completed land acquisition only for some of its smaller projects. After the Nandigram, Singur and Goa SEZ episodes, land acquisitions will be even more difficult, particularly the forthcoming general elections. One added risk for Reliance Power's proposed projects in Uttar Pradesh is the close identification of the promoter with Amar Singh of the Smajwadi Party, which is now out of power in the state. 

If industrial commodity prices, especially cement and steel, rise further, then project costs will have to be revised upwards. This would lower the projected returns and extend the time required for the projects to break even.  

As the capacity addition in the power generation sector increases rapidly, there are concerns that equipment manufacturers may not be able to cope with the demand. To overcome this hurdle, the company may venture into equipment manufacture on its own. But the technology required for large generators is difficult – with public sector giant BHEL having acquired it only recently.  

Fuel linkages
Once a power plant is set up, its profitability is directly related to the availability and price of fuel, unless the plant has its own captive fuel sources. In the case of Reliance Power, only one large project has a captive fuel source – the ultra-mega power project (UMPP) at Sasan in Madhya Pradesh.  

All the other projects depend on external sources – either coal or natural gas. Coal and gas prices have gone up substantially, in line with crude oil prices. As long as global energy demand continues to rise, prices of coal and gas can rise further.  

Reliance Power has an agreement with group company RNRL to source natural gas. RNRL in turn has an agreement with Reliance Industries (RIL) to buy gas from the latter's KG basin fields, which was part of the settlement between the Ambani brothers. While it is reasonably certain that RNRL, and in turn Reliance Power, will get gas from RIL, its price will depend on the outcome of the ongoing legal dispute between RIL and RNRL. 

For coal, especially for the second UMPP in Andhra Pradesh, the company will have to depend on foreign sources. Though Reliance Power is said to be actively scouting for coal assets abroad, nothing has been finalised so far. As the number of potential targets are limited and hence very attractive because of high coal prices, acquisitions will not be cheap. 

Competition
There is no doubt that the domestic power generation sector holds immense potential for growth. As the potential is pretty evident, it is attracting many large players.  

In recent months, established business houses like JSW Steel, Videocon, Sterlite, and Adani have announced plans to set up large power plants. Established players like NTPC and Tata Power also have large expansion plans.  

Though there will be no fears of overcapacity in power generation, as long as the economy chugs along nicely, the potential for superior returns will diminish as supply improves.  

Many of these new players in the sector are banking on free pricing, at least to large direct customers like big industrial units. As the number of suppliers increase, large buyers will have better bargaining power and hence price upsides will be limited. 

Good potential, but exuberant pricing
Reliance Power is undoubtedly in a unique position to exploit the immense potential in the power sector. As the company has rightly pointed out, it has one of the largest bouquets of power projects in the country.  

It has already landed two UMPPs, for which all the permits and licences are in place.  

The risks listed above are significant, but not insurmountable. The group has the ability to raise sufficient money to fund all these projects. The IPO offers another opportunity to large investors to buy into the India infrastructure story, an international best seller now. 

But the fact remains that it will be quite a while before the projects go on stream and start generating cash flows. It will be another two years before the company's first project, a relatively small 600 MW project in Uttar Pradesh, which is already behind schedule, is commissioned.  

In another three years, the company will have an aggregate capacity of over 7,000 MW – if the Sasan UMPP can be executed as scheduled. It will take another four years, or by 2017, for the company to reach its full projected capacity of over 28,000 MW.  

By then, Tata Power will be at least as big and NTPC could be three times bigger in aggregate capacity. Some analysts contend that Reliance will be more aggressive and will land more large projects than its competitors. But, what will prevent others – especially the newcomers – from turning equally aggressive?  

Why then should Reliance Power be valued at over seven times its book value – when established players like NTPC and Tata Power are quoting at less than five price-to-book multiples? It should also be kept in mind that the price-to-book multiples of power utilities have surged way above their historic levels, on expectations of aggressive pricing for the Reliance Power IPO. If the valuations correct and revert to the historic average, the excessive pricing of Reliance Power will be even more glaring. 

The Reliance Power IPO is yet another case of investors getting all too excited about future prospects, however long it takes to execute the projects, build the business and realise the potential.  

While the potential is for real, business valuations run way ahead of time. They may even appear acceptable when markets are on a high, but markets can go through many cycles before these businesses mature. The high pricing make them inappropriate even for very long term investors, who can afford short to medium term market swings.  

Given the huge demand for the IPO, it is quite possible that Reliance Power will offer good gains on listing – if investors can get some allotment. But long term investors will be better off avoiding the IPO. They can consider the established power utilities, but only after the euphoria has died down and valuations are more attractive – whenever that is.