25 April, 2024


Pulling forward profits

Mark Webb

Indian toll road operator, IRB Infrastructure Developers (IRB), appears to be pulling forward earnings through aggressive accounting. The company recognises unusually high construction margins from intragroup revenues and inflated sales to related parties. Additionally, IRB amortises its roads at rates well below those implied by the life of its concessions. It has suffered large operating and free cash outflows; meanwhile, its 5% return on capital is only half its cost of capital. If the accounting is brought in line with best practice and peers, we estimate IRB would have reported losses in FY23. Despite a mediocre underlying performance, IRB’s shares have outperformed. They now trade at double its historical rating and well above sector averages. Our target of INR31 implies 17x FY25e PER and 1.3x P/BV and, with 54% downside, we rate IRB as SELL/SHORT.

Toll road operator

IRB’s construction and toll revenues are largely generated from build-operate-transfer (BOT) service concessions. The accounting follows the controversial IFRIC 12 interpretation which allows a company to recognise a non-cash intragroup construction profit when it builds roads that it intends to operate. Unfortunately, IRB has considerable discretion in determining the construction margin which has enabled it to frontload earnings. IRB also uses infrastructure investment trusts to move assets off balance sheet; we believe the company still controls one of these, the Private Trust.

Margins probably supported by aggressive accounting

IRB’s 32% construction margin in FY23 was more than double its closest peers. However, IRB is simply selling from one part of the group to another. Such a high margin is unlikely to have been concluded on commercial terms, is inflated and largely non-cash in nature. Furthermore, toll road earnings appear to be embellished. Best practice would entail amortising toll roads on a straight-line basis over the life of the concession. Instead, IRB amortises its roads using traffic revenues relative to total projected revenues over the concession. This is notoriously subjective and causes amortisation charges to be materially lower during the early years of each concession than if recognised on a straight-line basis.

Poor cash flow and weak return on capital

Operating cash flow has been dreadful with outflows of INR9bn over the last 3 years, INR43bn lower than cash profits of INR34bn over this period. IRB has also suffered substantial free cash outflows on a headline basis and after adjusting for its restructured group. This poor performance supports our concerns about the use of aggressive accounting to generate non-cash earnings. IRB’s FY23 ROIC of 5% is about half its cost of capital, even though we suspect performance has been embellished.

Significantly overvalued

IRB’s share price has more than doubled over the last year and now trades at 37x FY25e PER, well above its historical range and sector peers. Furthermore, the use of aggressive accounting suggests earnings and book value per share are overstated. IRB’s underlying performance suggests a mediocre business. We set our target at INR31/share, or approximately 17x FY25e PER and 1.3x P/BV, implying 54% downside. We rate IRB as SELL/SHORT.