Brickbats

Construction stocks have not recovered much even as the Sensex has run-up close to peak levels. Have the markets over-reacted?

The meltdown in May pulled down valuations of most stocks. Particularly, shares of infrastructure and construction companies, which had seen a dream run ever since the rally began, came under heavy selling pressure as these were already quoting at very high valuations.

Though most front-line stocks have recovered from their lows in the recent run-up to 12K, construction stocks are still lying low. 
 

RETURNS DIP
RONW (%)	FY 06	FY 05	FY 04
Larsen & Toubro	21.74	22.70	16.99
Hindustan Constructions	13.40	28.64	23.52
Nagarjuna Constructions	16.41	23.53	23.31
Gammon India	23.97	24.48	17.62
Patel Egineering	44.73	34.59	26.64
Simplex Infrastructures	24.53	26.32	12.00
IVRCL Infraprojects	29.28	33.84	16.65
Madhucon Projects	12.98	18.55	30.73

Consider this. The market barometer Sensex is trading at 3.4 per cent lower than its peak in May. But baring bellwether L&T that is around five per cent lower than its mid May levels, most core construction companies are trading at substantially lower than their peak levels -- Patel Engineering (down 44 per cent), Hindustan Construction Company (HCC) (37.5 per cent), Gammon India (32 per cent), Punj Lloyd (29.5 per cent), Nagarjuna Constructions (down 15 per cent) and Jaiprakash Associates (16 per cent). Is the fall just a response to high valuations or is there something more fundamental?

Notably, FII holdings in key stocks like Nagarjuna Constructions, Madhucon Projects and HCC saw a drastic fall during the June quarter. FIIs also reduced stake in L&T and IVRCL Infraprojects. 
 

FII HOLDINGS
(%)	March 2006	June 2006
Larsen & Toubro	19.13	18.05
Hindustan Constructions	12.67	10.71
Nagarjuna Constructions	27.83	21.39
Gammon India	17.90	24.93
Patel Egineering	5.26	9.24
Simplex Infrastructures	15.41	16.03
IVRCL Infraprojects	37.90	36.51
Punj Lloyd	18.74	17.04
Jaiprakash Associates	19.53	19.44
Madhucon Projects	33.63	21.54

"Construction stocks have seen sharper moves in both directions. The stocks spiralled down much faster than the market average, but they have seen a smart recovery of over 25 per cent since their lows. Since the fall was drastic, they have not recovered fully despite the comeback. But we don't buy the argument that something seems to have gone wrong," says Deepak Jasani, head-retail research HDFC Securities.

He believes that the fall has more to do with market sentiments and risk appetite than fundamentals.

Point taken. But the fact is that some broking houses have downgraded these stocks in the past month and that has meant that institutional buyers are not rushing to buy these stocks in a hurry.

In a recent report, downgrading construction stocks, leading broking firm First Global said, "While there is no doubt that the demand driver for the industry will remain intact, it is the supply side that will create pressure on margins. The Ebitda margins are already thin and we believe that fast rising fuel and interest costs will bring margins under pressure. This will lead to a fall in the return on assets."

While it is clear that the sell-off has not been without genuine concerns on the fundamentals, are these concerns exaggerated?

What went wrong?

June numbers disappoint. The business outlook, the order books and earnings visibility may indicate otherwise, but glancing through the June quarter results it seems like some construction players are not performing up to the mark.

While revenue growth seemed to be intact, several companies experienced severe margin pressures due to rising input costs, project delays and interest rate concerns.

HCC's revenues increased by 24.4 per cent to Rs 573 crore, but operating margin declined by 100 bps to 7.9 per cent due to 54 per cent increase in the construction expenses, thanks to spurt in the cement prices.

Gammon India saw its revenues growing at 44 per cent y-o-y to Rs 410 crore, but net profits increased by mere 3 per cent to Rs 15.9 crore. Strong revenue growth failed to translate into operating margin, which declined by 6.2 percent as against 11.9 per cent in June FY06 quarter, due to higher cost allocation in the initial phase of projects and the company's inability to pass through escalation in cement prices.

Return on investments decline. Over the past four years, infrastructure companies have been growing at a scorching pace, riding on the boom in infrastructure activity. Thus, to bid for major projects and also meet their working capital needs, construction companies have been on a capital-raising spree.

In FY06 alone, the aggregate net worth across the industry increased a stunning 141 per cent as major constructors raised money to fund their mega growth plans.

While some companies such as Patel Engineering raised funds through a domestic issue, others took the FCCB or GDR route. Patel raised Rs 400 crore. HCC raised Rs 890 crore through GDR and FCCB issues in March 06, which led to a 16 per cent equity dilution. Madhucon Projects too raised Rs 300 crore through a GDR issue causing 26 per cent equity dilution.

The aggressive capital raising seems to have only damaged the return on investment ratios for most infrastructure builders. "To grow, infrastructure companies need to raise funds almost on a continual basis. For most of them, cash earned from operations is reinvested to run newer projects, leaving almost no free cash," says Prateek Agrawal, head-equities, ABN Amro Mutual Fund.

While constant equity raising tends to suppress earnings, increased debt burden builds margin pressure.

"The toplines and bottomlines are no doubt growing at an excellent pace, but EPS growth doesn't seem to be keeping pace. The stock prices plummeted because the euphoria came to a temporary halt, as market men noticed that robust orders and earnings need not always translate into proportional EPS numbers," says an analyst.

In fiscal FY06, barring a few, most players have seen their return on networth decline. While L&T, IVRCL Infraprojects and Patel Engineering have managed to increase return on networth, other players like HCC, Gammon India and Madhucon Projects have seen drastic a fall in return ratio. 
 

STOCK RETURNS
	Peak levels	CMP	Fall (%)
Sensex	12435.41	12009.59	3.42
Larsen & Toubro	2776.55	2639.95	4.92
Hindustan Constructions	170.70	106.55	37.58
Nagarjuna Constructions	365.45	315.45	13.68
Gammon India	542.00	369.65	31.80
Patel Egineering	605.50	338.65	44.07
IVRCL Infraprojects	314.50	254.50	19.08
Punj Lloyd	1177.25	830.75	29.43
Jaiprakash Associates	540.10	472.55	12.51
Madhucon Projects	356.75	252.05	29.35

Is the year an exception or indication of a new trend?

Analysts are not jumping to conclusions, but want to give these companies some more time to generate substantial incremental returns when most projects actually start rolling.

BOOT projects add to risk. Another concern relates to companies that are pitching for BOOT (build-own-operate-transfer) projects. With the asset ownership model catching the fancy of most players, they are taking up high-risk BOOT projects, which promise much better returns.

The initial years are bound to be testing times for BOOT projects. Since execution delays could lead to heavy cost over-runs, companies need to manage risk carefully. Punj Lloyd's road projects in Assam and Rajasthan worth Rs 1200 crore ran into delays and this dragged down FY06 revenues to Rs 1,368 as against FY05 revenues of Rs 1429 crore. Besides, these projects are hit by rising interest rates.

"The large sizes and long gestation periods of mostly debt funded BOOT projects make them sensitive to interest rate moves. Rising rates adversely impact the net present value (NPV) of these projects," says Agrawal.

How serious are the concerns?

Some short-term cues may be painting a negative picture but most analysts are quite confident about the business outlook for next few years.

They say the June quarter could have been an aberration too. Due to the nature of the industry, earnings tend to be lumpy and considering the scorching pace at which the construction players are racing, there are bound to be some intermediate hiccups.

"Judging the performance of construction companies on the basis of June quarter results is not fair and it is a fallacy to assume that growth is slowing down. In coming quarters when projects reach revenue recognition stage the numbers will improve, " says Jabal Patel, Sushil Stock Brokers.

As far as margins go, prices of raw materials are expected to stabilise and analysts feel price-escalation clauses, committed raw material supply agreements with customers and better operations will keep operating margins firm across the industry for the rest of FY07. Rising interest costs and capex ramp-up are likely to keep net margins under pressure though.

If BOOT projects add to risks, companies are also trying to look elsewhere for better returns. They are bidding for more complex projects and branching into newer avenues to improve profitability and reduce risk of overexposure to a certain segment.

For instance, players are moving towards real estate business that offers much higher returns of around 15 to 20 per cent. IVRCL has three land projects worth Rs 900 crore in its kitty, which are likely to generate revenues in FY09.

There are talks that the company is planning to list its real estate subsidiary IVR-Prime Urban Developer soon. Nagarjuna Constructions has land projects is Ranchi, Bangalore and Vizag. HCC and Madhucon Projects are also increasing exposure to real estate business to accelarate their earnings.

The long-term growth story in infrastructure still stands steady. "The Rs 75,000 crore construction industry is poised to grow at 15 per cent CAGR over the next six years. The industry order book is likely to grow by more than 20 per cent to Rs 50,000 crore in FY07. Industry revenues and profits are likely to grow at 48 per cent and 62 per cent in FY07," says a report by Edelweiss Securities.

SSKI estimates a CAGR growth of 25 per cent in revenues and 34 per cent in profits through FY06-08.

"Construction being a domestic sector, is not vulnerable to global slowdown. Outlook on construction stocks is positive, but a lot depends on whether future quarter results match with the expectations. In early May, the valuations seemed high and stocks were also over-owned. After the fall, valuations looked reasonable and funds have started logging on to construction stocks once again," says S Naren, co-head equities, Prudential ICICI AMC.

"These stocks surged much beyond fundamentals and they also fell much beyond justification. Over the next six to twelve months, we expect a strong rally in the construction scrips. But pure project players will have sure shot edge over asset owners," says Tarun Sisodia, director, Anand Rathi Securities.

Construction companies stock prices have enjoyed a strong run on the bourses in the past week. While the Sensex gained 3.97 per cent, construction players clocked excellent returns: L&T (7 per cent), Punj Lloyd (10.7 per cent), IVRCL Infraprojects (5.2 per cent) and Nagarjuna Constructions (3.3 per cent).

Though these stocks may not be able to replicate their outstanding performance in the past three years, they may not lag behind the markets either. 
 

We reported the standalone financials of Indiabulls instead of the consolidated financials in our cover story last issue. We regret the error. The following are the consolidated numbers:
Q-o-Q growth(%)	Jun-06	Mar-06	5-Dec	5-Sep
Sales	13.34	24.73	2.64	55.24
Profit	-4.68	12.12	19.62	46.42