Building momentum

SECTOR UPDATE - Construction

Construction component

(Rs cr)(%) Urban Infrastructure184,900

1,10,900

60 Roads85,90085,900100 Railways60,60025,40042 Hydel Power27,80019,40070 Ports16,9008,40050 Airports12,9005,40042 Tourism2,9001,50055 Total3,91,9002,58,65466 * During the Tenth Plan period (2003-07)  Urban infrastructure, which involves major construction work, will alone spend Rs 1,10,940 crore on construction activities (60 per cent of sectoral investment). With roughly 30 per cent of India's population living in cities, urban infrastructure - which is already over-burdened - is slated to get the highest component.  Next in line are roads where the construction component will be close to Rs 85,900 crore. According to analysts, order inflows are expected to accelerate in the coming quarters.  So, who will gain? The construction sector is highly fragmented as low capital intensity and fewer entry barriers attract a lot of small and non-serious players - so much so that even L&T has a market-share of less than 2 per cent.  Obviously, the presence of too many players has resulted in low margins for most construction companies. But this could be changing. Analysts are confident that private organised players will emerge winners in the long haul. Increasingly, the company's experience and size are becoming important in bagging large contracts.  Meanwhile, the government is encouraging private participation in big projects on a build own and operate (BOT) basis which smaller companies may not be capable of.  A lot of private companies like Gammon, L&T, Jaiprakash Associates and Nagarjuna have entered into BOT projects (as the term suggests, under BOT projects the private player agrees to raise funds, build and operate infrastructure for an agreed time-period and then transfer the property to the government).  Clearly, this will weed out unorganised players who do not have the financial muscle to undertake large projects.  Most construction companies score low on profit margins (barring Hindustan Construction as it undertakes high-margin, capital intensive projects). However, as the construction business has a high capital-output ratio, return on capital is usually satisfactory.  A majority of the players have capital output ratios of nearly 2x which makes up for lower operating and net profit margins. For FY04, all the listed players delivered net profit growth of over 20 per cent and they are expected to keep up this pace.  Given the kind of growth expected in the sector, there is significant upside to be seen. Not all these gains seem to be reflected in the stock prices yet.  Of the lot, L&T, being the leading player, commands the highest valuation of 12.8 times its FY05 earnings estimate at a price of Rs 858. The cheapest is Nagarjuna which trades at a P/E of 3.5 times its FY05 estimate at a price of Rs 339.4. 
 

Construction companies have decent return ratios, despite low margins
Companies	Sales (Rs cr)	Operating margins (%)	Net profit (Rs cr)	Growth y-o-y (%)	Capital output ratio	ROCE (%)	FY05 P/E
L&T	962.32	8	532.75	23	2.33	21.7	12.8
HCC	73	14	35.65	24.3	1.25	18.7	4.3
IVRCL	77	9	39.18	152.61	1.89	10	4.6
NCC	76	8	31.57	71.6	3.62	16.5	3.5
Gammon	106	11	34.09	62.87	2.74	16.3	12.7

 Analysts say the gains are yet to fully accrue given the robust order-book size, earnings growth and cheap valuations which make them attractive at current price levels. So go on, build your positions.