Construction stocks on weaker ground

Due to high interest rates and decline in order inflows, shares of majors likely to remain under pressure.

Contrary to expectations for the June quarter, major construction companies — IVRCL, NCC, Hindustan Construction Company, Simplex Infrastructures and Gammon India — have reported only single-digit growth in net sales. While their performance at the operating profit level wasn’t that bad, with three of them witnessing a marginal rise in operating margins (OPMs), higher interest costs saw net profit margins (NPMs) tank for most.

The share prices of these companies have corrected by an average of 60 per cent over the past year, as there has not been any improvement in financial performance, consequent to sluggish order inflows, execution hurdles resulting in a deteriorating working capital cycle and decline in margins on high costs.

Says Ajit Gulabchand, chairman and managing director, HCC, “The industry is confronted with a challenging business environment of hawkish interest rates and a slowing in new infrastructure projects.” Analysts expect the September quarter to show a similar trend, thanks to monsoons, in addition to tough market conditions.

On the flip side, with peaking of the interest rate cycle expected in the second half of 2011-12, sagging order inflows are likely to pick up. Till then, the stocks will remain under pressure or may see range-bound movement. Despite attractive valuations (an average PE of below 10 times the 2011-12 estimated earnings), the risk-to-reward equation still does not look favourable, feel analysts.

SLIPPAGE
While none of the five construction majors managed double-digit growth in top line, there are clear signs of a slowdown. On an aggregate basis, their combined net sales grew at half the rate (5.3 per cent) recorded in 2010-11. The growth in sales was also lower than what analysts had estimated for the June quarter. The worst performer on this front was IVRCL. It reported the lowest growth among peers and despite a lower base (marginal growth of two per cent) in the June 2010 quarter.

Notably, the companies did well in a high-cost scenario, thanks to the price escalation clause in most of the orders — on an average, 75 per cent of their order book has this clause. Three of the five showed a marginal improvement in OPM — again, IVRCL lagged, with its margins down the most.

What, though, surprised negatively was the higher than expected decline in net profits. NPM worsened for all companies due to a jump in interest costs, led by increase in working capital requirements and a high interest rate scenario.

PROFITS UNDER PRESSURE
in Rs crore	IVRCL	HCC	NCC	Simplex	Gammon
Net sales	1124.0	1058.0	1141.5	1261.0	1390.5
% chg y-o-y	1.5	6.3	5.1	7.1	6.2
OPM (%)	7.7	13.0	10.2	9.5	8.8
Chg (bps) y-o-y	-152	38	45	-68	37
Net profit	4.2	2.9	23.3	24.1	29.0
% chg y-o-y	-85.0	-90.0	-44.0	-33.0	-4.0
NPM (%)	0.4	0.3	2.0	1.9	2.1
Chg (bps) y-o-y	-217	-257	-177	-116	-22
Standalone financials for quarter ended June 2011                        Source: Companies

OUTLOOK
The fall in profits apart, future growth visibility of companies is also under the scanner. IVRCL, NCC and HCC have seen a decline in order books (on an aggregate basis, it fell two per cent to Rs 52,689 crore), thanks to new orders drying up. These companies have seen order inflows fall 20-37 per cent year-on-year during the June quarter. The key factor responsible for this is the rising interest rate, which is making projects less viable by the day.

Going ahead, a reversal of interest rate cycle, which many experts believe could happen in the second half of 2011-12, is the only potential silver lining for order inflows. They say the lower rates would boost corporate confidence and investment decisions will be taken at a faster rate, allowing the capex momentum to gather pace.

However, order inflow will depend on the competitive activity levels, currently high in the transport segment. Analysts believe it will take a year for the inflows to show meaningful growth. This, along with a low base of the current year, will enable companies to record robust performance in 2012-13. Till that time, their stocks are unlikely to be re-rated.

Among these, Simplex looks better placed on a fundamental basis, as its order book is more diversified than its peers and the company has least exposure to the most competitive build-operate-transfer road segment. In 2010-11 as well as the June 2011 quarter, sales grew at a moderate but stable rate, and profitability was relatively less impacted. However, most of these positives reflect in the stock, given the high valuation of 13 times.