HCC: Expensive valuations

Though the outlook is bright, high interest costs may prove to be an overhang on the stock

Hindustan Construction Company’s (HCC’s) revenues (excluding from joint ventures) grew a moderate 13.3 per cent to Rs885 crore in the September quarter due to long-gestation hydro power and transport projects. Good monsoon and higher share of slow-moving government projects (73 per cent of backlog) also hit the performance.

The operating profit margin rose 161 basis points to 12.9 per cent due to cost control and high-margin hydro projects. However, interest costs as a percentage to sales surged 117 basis points to 7.6 per cent – the highest in the construction sector and in the last 10 quarters – due to introduction of base rates, rising interest rates and a Rs3,300 crore increase in the net working capital. Stable depreciation and taxation costs, coupled with doubling of other income to Rs6.1 crore, helped net profit margin rise 67 basis points to 1.4 per cent.

Going ahead, revenue growth is expected to be robust on the back of a pick-up in execution of new large projects, including road build-operate-transfer (BOT) ones. Projects under various subsidiaries, such as HCC Infrastructure and HCC Real Estate (construction work on 247 Park Phase-II to start by March 2011, approvals for slum rehabilitation and Rs2,000-crore primary offering by Lavasa) are also progressing well.

However, the impact of high interest costs on profitability is the biggest risk, given a leveraged balance sheet (net debt-to-equity of 1.9 times), due to its presence in capital-guzzling segments like BOT, real estate and hydro power. The falling share of hydro power and water solutions in the total order book over the past several quarters, compensated partly by the transportation sector, is also a worry. Further, concerns about the company’s exposure to Andhra Pradesh (19 per cent of the total order book) persist, though the share is declining (25 per cent in 2009-10). At Rs66.05, the stock looks expensive at 25 times 2011-12 estimated earnings.
 

Clarification

In response to the Compass item — HCC: Expensive Valuation —  Hindustan Construction Company (HCC) has clarified that its stock gets valued on an SOTP (sum of the parts) basis, which includes its core business of engineering and construction, as well as all other businesses it operates through subsidiaries. However, standalone financial results capture the performance of the engineering and construction business only. In addition, the market uses various parameters to derive the value contribution from all other businesses within the HCC Group, primary amongst which are its portfolio of infrastructure assets (HCC Infrastructure Ltd), the real estate business (HCC Real Estate Ltd) and the urban development & management business (Lavasa Corporation Limited). Therefore, the company says, to conclude that the stock is at 25 times 2011-12 estimated earnings is not correct.