Infra, realty companies stand to gain from rate cut

Larger gains will accrue after interest rates are lowered further and the business cycle picks up

The Reserve Bank of India’s (RBI’s)  surprise 25-basis point cut in the repo rate, much before its next month’s meeting, is good news for infra and realty companies, which have been reeling under pressure for long. Most banks had not cut their base rates after the RBI cut repo rate by 25 basis points last month, which signalled the start of the rate-cut cycle. But now, experts believe it is only a matter of time before lending rates inch lower.

Infrastructure companies such as L&T, NCC, HCC, GMR, GVK, Sadbhav Engineering, Ashoka Buildcon, and many more are expected to gain from the rate cuts. While the gains should translate into lower interest costs, bigger gains will accrue when the business cycle picks up (estimated from around the second half of FY16).

Given the government’s focus on adding new infrastructure and clearing bottlenecks, companies, especially from the construction and engineering space, should benefit. In fact, road construction players are already seeing higher orders as compared to 2013-14.

In the Budget, the government has raised the infrastructure allocation by Rs 75,000 crore for 2015-16. It is also infusing Rs 20,000 crore as seed capital into National Infrastructure Fund (NIF) and working on a hybrid system whereby it will provide 40 per cent of the equity for select infrastructure projects.

Says Ajay Bodke, Head (investment strategy & advisory), Prabhudas Lilladher, “The rate cuts are important, but these should be seen in conjunction with the government’s attempt to revive the investment cycle, which is equally crucial. The railway minister is also in talks with LIC for Rs 100,000 crore of projects for long-term innovative funding methods. The ‘plug and play’ route for projects across infra segments is another positive. Projects have been stuck due to a lack of clearances. A government that is making ministries sit together and solve problems in itself is money saved. These measures are helping avoid time and cost overruns, which is half the battle won.”

  He adds that if the top line growth improves, operating leverage comes into play, which along with savings in interest costs will boost return on equity (RoE) of companies, leading to a sharp increase in their market value.

For instance, theoretically, GVK Power’s equity can be bought for only Rs 1,526 crore, which is equal to just a tower in South Mumbai, for a company that has significant assets. Although there is debt of over Rs 22,000 crore taking the enterprise value (EV) to Rs 23,500 crore, if over two-three years the top line inches up gradually and interest rates come down, there can be a change in the mix of equity value and debt. Even if the ratio changes by 20-30 per cent, then there will be a significant impact on market value. The case is the same for GMR and many other companies.

On the other hand, real estate companies, especially those reeling under debt, will also gain. But, don’t expect any significant gains in the short term.

Experts say once RBI cuts the rate further, companies could see visible reduction in interest costs. Expectations are that the central bank will cut rates by at least 75 basis points more this year. So, there is hope for at least another 50 basis points of a rate cut in the coming months.

“In our view, the framework for a monetary policy response remains unchanged, with RBI likely to target real rates of around 175 basis points. We believe that inflation will decelerate to 4.75 per cent by end-2015 in our base case and 4 per cent in our bull case scenario. This inflation outlook and the real rate policy framework followed by RBI therefore means that the central bank will cut the rate by a further 100 basis points through CY2015, with the next move happening during the April 7 meeting,” wrote Chetan Ahya and Upasana Chachra of Morgan Stanley in a note on Wednesday.

IIFL Research shares a similar view. “In our view, further rate cuts to the tune of 75-100 basis points are possible in the current calendar year.”

Like infra plays, realty companies would also stand to gain more from an increase in business (higher demand for houses). However, the affordability factor (cost of owning a house) is still pretty low and will keep demand in check in the medium term.

Bodke says, “In the first phase, infra (construction) companies will benefit; then cement, steel, capital goods and banking companies will gain; then wages will rise and only then when gains from a pick-up in investment cycle reflect on consumption will realty companies gain.”

The share price of many infra and realty companies, which gained in the first half of trading on Wednesday, declined on profit-booking and a weak sentiment globally. Given the positive longer-term implications, the stocks should also rise but not in a hurry. So, use corrections for selective buying, say experts. Companies such as DLF, Prestige, Oberoi and Sobha stand to gain. Overall, experts suggest that only those companies that are better placed in terms of execution (in their business) and have sufficient operating profits currently to service their debt should be considered.