The recent decline in interest rates and commodity prices coupled with the huge investments planned over the next 10 years are conducive for infrastructure construction companies.
Construction companies, which have been reeling under severe pressure of rising commodity prices and interest rates, could see better days ahead. While commodity prices have substantially corrected, the measures taken towards improving liquidity in the domestic financial system, should benefit these companies. Also, since interest rates are expected to come down, a part of the worries with regards to rising interest costs and project viability (unattractive in a high interest scenario) would partly be eased.
In light of the changing scenario, The Smart Investor looked at some of these developments and their impact on the sector and the key companies, which will benefit.
Easing cost pressure
The increase in prices of steel and cement, which together account for 30-50 per cent of total project cost, had put severe pressure on construction companies. While a part of the increase in prices was passed on to customers, thanks to the cost escalation clause in the project contracts, prices of these two commodities grew by a higher margin (more than the increase in the Wholesale Price Index; the benchmark to ascertain the quantum of cost escalation) resulting into lower margins. The industry’s operating profit margins, which were high at 12 per cent till FY08, came down to 8.5 per cent in Q1 FY09 and further to 8 per cent in Q2 FY09.
However, with domestic steel prices down by 30-40 per cent, companies should see better days ahead. “It will help the industry in two ways. One, by way of generating additional demand, and two, by providing higher margins. The impact will differ from company to company and the mix of the projects.
Companies that are having projects with escalation clause might benefit by 30-40 basis points, but for those that are not having much of pass-through in contracts might see a saving to the extent of even 30-40 per cent,” says N K Kakani, executive director, Simplex Infrastructure.
More From This Section
Experts suggest that falling crude oil prices would be also positive. As about 7-8 per cent of the project cost is accounted by fuels like diesel (used in equipments), the industry should gain if their prices are reduced, going forward.
Falling interest rates
The bigger problem for this working capital intensive industry however, is interest cost. Companies, which borrowed at 6-8 per cent during 2007, have seen their average interest rates rise to 10-14 per cent. “If we do not lower interest rates, the internal rate of return required in order to deliver a good project of PPP (public private partnership) would be very high,” says Ajit Gulabchand, chairman and managing director, Hindustan Construction Company (HCC).
The good news is that things are seen stabilising if not improving. “Two months back, the funds were available at interest rates of about 13-14 per cent. Today, it has come down to about 12 per cent,” says N K Kakani.
| HOW THEY STACK UP | ||||||||||
| Rs crore | FY08 | PE (x) | Debt-Equity Ratio (FY08) | Order book | Order bk to FY08 sales (x) | Interest cost as # | Price (Rs) | |||
| Sales | Net profit | FY08 | FY09E | % of sales | % of PAT | |||||
| L&T * | 29,199 | 2,118 | 21.7 | 15.2 | 1.1 | 63,000 | 2.16 | 0.74 | 11.14 | 791.5 |
| IVRCL Infrastructure * | 4,209 | 332 | 8.3 | 6.8 | 0.7 | 15,000 | 3.56 | 2.39 | 49.52 | 115.1 |
| Simplex Infrastructure | 2,812 | 90 | 10.9 | 7.2 | 1.0 | 10,600 | 3.80 | 2.96 | 90.17 | 226.5 |
| HCC * | 2,995 | 87 | 16.3 | 11.6 | 1.6 | 12,000 | 3.89 | 5.83 | 173.8 | 49.9 |
| # Interest as a per cent of sales/PAT is for the six months ended September 2008 and, as per standalone numbers Order book as on September 30, 2008 * Consolidated, except for Simplex Infrastructure E: On estimated FY09 EPS | ||||||||||
“I think interest rates should remain stable in the near-term and fall in the long-term as inflation is coming down. Lower rates are good for construction companies, as they require large funding for projects and working capital. Some of the projects, which were put on hold due to viability issues, will be revived again,” says Ravathi Kasture, head – research, CARE.
The RBI’s moves to ease liquidity (including relaxation of ECB norms for infrastructure companies) are also positive. “These measures are definitely positive. However, it might take four-six months before the real impact is seen by the industry,” says Suren Jain, managing director, Jaiprakash Power Ventures, a subsidiary of Jaiprakash Associates.
The time-lag to gain from such moves apart, there could be some slowdown in construction activity during the election period. However, these near-term concerns are mitigated by the huge orders the companies are sitting on.
Overall, the macro environment is turning favourable and most concerns are discounted in stock valuations (PE), which have declined from 25-30 times one-year forward earnings to 10-12 times FY08 earnings, currently. Interestingly, many companies can sustain growth through their strong internal accruals and by choosing right mix of projects.
Experts say that companies with good execution capabilities, manageable debt levels and strong order books, should benefit in the long run. That infrastructure spending in the Twelfth Five Year Plan is estimated at $989 billion ($492 billion in the current plan) indicates robust long-term prospects for the sector. To know more on individual companies, read on.
HCC
No doubt, HCC has a high debt-equity ratio of 1.6 times, which is also the reason why its interest cost went up by 44 per cent in Q2 FY09 (up 33 per cent in first half) against sales growth of 18-19 per cent. Notably, the interest cost was almost 7.6 per cent of the company’s net sales during Q2. However, if interest rates come down, as they have started to, the company should emerge as a beneficiary.
In terms of business, the company generates about 80 per cent of its revenue from projects sponsored by government-owned entities. This is seen in positive light, as it is expected that the flow of orders from the government should start improving, while existing projects could be put on a fast track for completion.
Nonetheless, HCC’s order book continues to be strong. In fact, its order book which had ranged Rs 9,000-10,000 crore for the past few quarters has currently crossed Rs 12,000 crore and is expected to rise further to Rs 15,000 crore by March 2009. The current order book thus, provides good revenue visibility.
In the real estate business, the company has put in place most of the funding needs for its ongoing projects. As per the company, the first phase of its Lawasa township project is already sold and there is still two to three years to go before raising funds for the second phase of work.
While the company is expected to start booking revenues from the Lawasa project in FY09, this project has not been factored in by most analysts in their earnings projections indicating their wait-and-watch approach till the project revenues start reflecting in the numbers.
The stock is currently trading at 10.4 times its FY09 estimated earnings. Investors with some appetite for risk (in light of its real estate exposure) can invest with a long-term perspective.
IVRCL
IVRCL Infrastructures & Projects (IVRCL) is relatively insulated from the rising commodity prices and high interest cost. During FY08, the cumulative rise in commodity prices of steel and cement was about 28-30 per cent. However, the impact on IVRCL’s margins was about 40 basis points; about 90 per cent of its projects have escalation clause allowing it to pass on cost increase to customers.
With respect to leverage, even after its debt nearly doubled to Rs 1,068 crore, the company is relatively better placed given its low debt-equity of 0.69 as on March 2008. However, the increase in debt has started to reflect in financials.
During H1 FY09, the company’s interest cost went up by 432 per cent to Rs 49.8 crore or a little less than a third of profit before tax of Rs 165 crore. Thus, with a decline in interest rates and easing of ECB regulations, the benefits on this count should start reflecting in the ensuing quarters.
The company is a major player in the water and irrigation (about 69 per cent) segments and most of its projects come from the government sector (over 70 per cent in FY08). The company currently has an order book of Rs 15,000 crore, which is four times its FY08 revenue.
While this provides visibility, it also indicates strong revenue growth in future. Estimates suggest that the company’s revenue should grow at about 33-35 per cent, while earnings should increase by about 25-27 per cent over the next three years.
While the concerns regarding the rising interest cost and funding of new projects are already discounted into the share price and should hopefully recede in the coming quarters, IVRCL’s strong order book, better execution capability and the growing government spending on water and irrigation related projects make it a less risky investment.
At Rs 115, the stock is trading at 6 times its estimated FY09 earnings. Analysts also value its share, on the basis of the sum-of-part valuations assigning different values in its subsidiaries in real estate, BOT projects and its stake in Hindustan Dorr Oliver at Rs 200-250 per share.
L&T
Unlike any other company in the sector, analysts prefer Larsen & Toubro (L&T), which has a strong balance sheet that can be leveraged in case of shortage of funds or funding of projects in the future. Besides, the company’s standalone debt-equity is quite low at 0.38 times. However, on a consolidated basis (including infrastructure development subsidiaries), the debt-equity of 1.1 times is still at comfortable levels.
On a standalone basis, the company has seen its interest costs go up 270 per cent to Rs 107 crore during H1 FY09, which is about 7.4 per cent of its profit before tax (or just 0.74 per cent of sales of Rs 14,588 crore).
Since it is the largest engineering and construction player in the country, it could be the best play on India’s growing investments in infrastructure and industrial capital expenditure (capex). Its well diversified revenue stream allows the company to leverage its resources and also helps it remain largely insulated from any slowdown in a particular segment.
This is also a reason that the company continues to bag contracts. Very recently, in a consortium, the company won a contract worth Rs 2,460 crore from the Mumbai Metropolitan Region Development Authority to implement the first Monorail System in Mumbai, which is to be completed within 30 months.
And this is not included in the company’s order book of Rs 63,000 crore as on September 2008 (up 46 per cent compared to September 2007), which is over two times its FY08 revenues and provides good revenue visibility. Of the order book as well as order inflows (in the first half of FY09), about 55 per cent is accounted by infrastructure and power sectors, two segments where investment are unlikely to see any significant slowdown.
However and even as no signs are visible yet, the decline in crude oil prices could lead to some slowdown in orders from the oil & gas sector, which accounted for 13 per cent of order flows in H1 FY09 and 20 per cent of order book as on September 2008.
Analysts expect L&T’s revenues to grow at 32-35 per cent, while earnings will rise by 25-28 per cent over the next two years. Overall, the falling commodity prices and lower interest rates will prove beneficial for the company. The valuations, too, are now at reasonable levels and factor in most of the concerns with regards to the macro environment and the company. At Rs 791.50, the stock is trading at 14.4 times its FY09 estimated consolidated earnings.
Simplex Infrastructure
Simplex Infrastructure, which has strong execution capabilities, is relatively less leveraged. The company’s debt-equity stood at about one as on FY08, thanks to about Rs 400 crore of funds raised through an equity issue to institutions in December 2007.
This has helped in keeping interest costs as a percentage of sales under check, which stood at about 3.21 per cent for Q2 FY09. The company reported a rise in interest cost of 29.4 per cent, whereas the turnover growth was higher at 76.5 per cent on y-o-y basis for Q2.
In terms of raw material costs, the company is well placed as 80 per cent of its contracts (in value terms) have an escalation clause. Of this, 20 per cent of the contracts are linked to the WPI index. The balance 20 per cent contracts are on fixed-price terms. The falling commodities prices are thus good for the company.
| SMALL IS BEAUTIFULL? | |||||||||||
| Rs crore | FY08 | Six mths ended Sep’08 | Interest cost as # | Price (Rs) | |||||||
Capitalisation
P/E (x)
# Interest cost as a per cent of sales/PAT is for six months ended September 2008
Notably, the company has presence in different verticals of infrastructure segments such as power, marine, industrial, roads, railways, bridges, urban infrastructure and housing. Also, its recent foray into the mining, onshore drilling and power T&D segments, will prove to be the future growth drivers. This diverse portfolio provides comfort as it will also provide stability in the event of any slowdown in a particular segment or geography.
Again, the company’s order book of Rs 10,600 crore or 3.8 times its FY08 revenues provide strong revenue visibility. As per estimates, the company’s revenue should grow at 55 per cent in FY09 and 35 per cent in FY10. The stock is currently trading at 7.2 times the estimated FY09 earnings, which is also reasonable considering its historical (2004 to 2008) PE band of 5-25 times.
SMALL WONDERS?
Many small and mid cap construction companies, too, have fallen in the current market correction. The announcements of repeat orders have not helped much in shoring up their share prices. However, the interesting thing is that most of these companies are now trading at a PE multiple of about 2-4 times their trailing 12 months earnings. As far as the growth prospects are concerned, many of them are sitting with order books, which are much higher than their bigger counterparts, ranging about 3-5 times FY08 revenue.
Analysts however, caution while investing in these companies. “I don’t think investors should look at the mid and small cap companies at this juncture as the bigger companies, which have execution capability and can manage the funding efficiently, are more comfortable investments,” says Shailesh Kanani, analyst, Angel Broking.
“Also, with respect to small cap companies, there is very high risk that the order might get delayed or cancelled considering that companies might go slow on their capex,” says Ajay Parmar, head - research, Emkay Global Financial Services.
Though not all of them could be an investment choice, for those who have higher appetite for the risk, a few companies which are well diversified, less leveraged, strong order book and proven execution capability, and available at reasonable valuations may be considered.
Among smaller companies, analysts like J Kumar Infrastructure, which is engaged in construction of roads, irrigation projects, flyover & bridges, airport sub-contracts, civil work and piling. Since the company generates about 79 per cent of its revenue from government-sponsored projects, it is likely to be less affected in the event of a slowdown in the private sector spending.
The company came out with an IPO in January 2008 at a price band of Rs 110-120 per share. The stock made a high of Rs 469 and currently trades at Rs 74, or at a PE of 4.2 times its FY09 estimated earnings and 3.2 times FY10 earnings. Also, the company is relatively less leveraged having a debt-equity of 0.32 times.
The company earns relatively high operating margins of 18.2 per cent. This can be attributed to its presence in the pilling business, which enjoys 35-40 per cent margins helped by the advantage of having its own equipments (over 90 per cent of its requirement). The company’s current order book of Rs 750 crore is almost 3.5 times its FY08 revenue.
Among other stocks, analysts prefer Pratibha Industries, which is mainly into water and urban infrastructure development. The falling steel prices will be a great advantage for the company as it will not only help in infrastructure business but also provide relief to its recently ventured business for manufacturing steel pipes.
The company’s debt-equity of 0.71 times is also comfortable and its order book stands at Rs 2,050 crore or 3.6 time its FY08 revenue. And, valuations are also reasonable, wherein the PE works out to 2.8 based on estimated FY09 earnings.