Upside in India's Monopolistic Railway Stocks 

After months of euphoria around railway stocks, investors seem to be pulling away from the sector.

Does that make you wonder if the railway stocks could nosedive hereon?

Well, such euphoric market conditions typically end up in a bubble.

Question is - when could the bubble pop?

More importantly, not every bubble is clearly visible.

The economy of Iceland, for instance, was not the most obvious bubble in 2008.

During the mid-2000s, it went from being an Arctic backwater that specialized in fishing and aluminium smelting to a global financial hub. But the transformation went largely unnoticed.

Iceland's three biggest banks grew to 10 times the size of the economy by offering overseas investors higher interest rates than they could get at home.

Then, armed with this cash, Iceland's bankers went on an asset buying spree. They bought foreign companies, real estate and even foreign soccer teams.

Iceland's banks were not only paying high prices for questionable assets. They were also promising to pay their depositors high interest rates. This was about as unsustainable as business models get. It wasn't that hard to tell. But no one raised an eyebrow until the global financial crisis of 2008 unfolded in the US.

All three of the Iceland's major privately owned commercial banks defaulted in late 2008. This, relative to the size of Iceland economy, was the largest systemic banking collapse in economic history.

So, while the world stayed focussed on the collapse of Bear Stearns, Lehman Brothers and US market crash, Icelandic financial crisis was no less.

But it was quickly forgotten, thanks to its relatively small size.

Similarly, there are sectors and companies today which are brewing excesses that could eventually lead to a crash. Both in the business and stock price performance.

Could railway stocks be amongst them?

The railway stocks euphoria is largely backed by the Rs 2.4 trillion capex outlay by 2030.

There are several parts to this mega capex trend.

The Railway Ministry has finalised the largest acquisition of 75,000 wagons over the next three years. In addition, the government is considering introducing nearly new Vande Bharat trains.

To add to that there is a plan to revamp almost 200 major stations around the country.

So, needless to say that a bunch of railway companies, most of which are now listed, are winning orders at a pace never seen before.

The news headlines on the railway capex plans have kept investors hooked to the railway stocks for months.

But most of the railway stocks are very different from each other. What is common amongst them is the certainty of growth in order book and certainty of revenue from their single customer, the government.

This has allowed several railway PSUs to have business models that are both lean and profitable.

Let's consider three of the most sound railway stocks.

Take the case of RITES.

RITES is primarily a consultancy company which gets guaranteed consulting assignment business from dozens of customers in India.

Thanks to its affiliation with the government, selling its services is not a problem. Indeed, in many projects of a strategic nature, the government does not want to trust a non-government entity.

For example, when integrated checkposts are required to be built on borders with neighbouring countries like Pakistan, Nepal, Bangladesh, and Myanmar, the government prefers to only deal with entities controlled by it.

RITES does not have to undertake risks relating to land acquisition, funding, getting paid by toll bridges and road customers, power plants, etc. For turnkey projects of Indian Railways, it gets paid in advance.

Similarly, IRFC is a 'systemically important' NBFC, which ironically, has neither funding risk nor credit risk.

It is the dedicated market borrowing arm for the Indian Railways.

So, the primary business of IRFC is the financing of the acquisition of rolling stock (locomotives, carriages, or wagons etc.) for Indian Railways as well as providing funding for its other infrastructure assets.

IRFC does this by borrowing money from debt markets for investing in rolling stocks and infrastructure projects sanctioned by the Indian Railways. It then leases these assets to the Railways at an effective yield at just a little above its cost of borrowing.

In effect, IRFC is like bank having just one customer, who is supposed to guarantee IRFC's profitability.

Most importantly, since the quality of assets on IRFC's books are guaranteed by the government the company must neither make provisions for bad loans (NPAs) not worry about credit or funding risks.

IRCTC is the only entity authorised by Indian Railways to offer online railway tickets. The company charges convenience fees in the range of Rs 15-30 per ticket.

It's also the only entity authorised to manage catering services on trains and major static units at railway stations.

The company also enjoys a monopoly in packaged drinking water. It's the only entity authorised by the Ministry of Railways to manufacture and distribute packaged drinking water at all railway stations and trains under the 'Rail Neer' brand.

IRCTC has seen a sharp jump in online ticketing volumes over the past decade. Having a monopoly in railway ticketing, it fetches operating margins as high as 80% compared to barely 10% and 20% margins in the catering and packaged water businesses.

Thus, these are few railway stocks that sport excellent fundamentals thanks to their unique positioning and strong government back. Above all, it is the lack of competition from the private sector that has kept their financials impressive.

Therefore, any signs of competition could become a big valuation risk.

Compared to other railway stocks, these three are certainly less vulnerable to destruction of shareholder wealth, especially when held for long.

However, just like the Icelandic bubble, there could several pockets of bubbles in the Indian stock markets waiting to burst.

Do check out the comparative financials of best railway stocks on Equitymaster Screener.

Hope you like this video. Thanks for watching