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Earnings disappoint once again: Earnings for 2QFY2011 were disappointing,
mainly from mid-size contractors. The slippage in the profits of the universe was
visible due to lower-than-expected EBITDA margins and higher interest costs, with
aggregate top-line growth coming in line.
Balance sheets throw a worrying picture: Analysis of the balance sheets indicates
that the sector is experiencing a sharp rise in working capital and pick-up in
capex, leading to pressure on the cash flow. We compared the working capital
ratios (in terms of day’s sales excluding cash) at the end of 1HFY2011 with that at
the end of FY2010 as well as 1HFY2010. It is evident from the comparison that
WC requirements have increased for the sector, mainly on account of increased
loans and advances as well as debtors. We believe the key reasons for the same
are 1) stocking up in anticipation of pick-up in 2HFY2011; and 2) lending to
subsidiaries to ensure flow of in-house C&EPC revenue. For the 12 months ended
September 2010, fixed asset investment has grown ~20% yoy, with most
companies seeing at least 20% yoy growth in capex. This is despite subdued
growth on the top-line front during the quarter. This also corroborates
management’s commentary of better times ahead. The resultant squeeze in free
cash flow has led to accretion to cash, significantly lagging overall balance sheet
growth. Further, there is strong evidence of re-leveraging.
Order inflow and order backlog – The silver lining: One of the most positive, if
not the only, outcomes from the quarter and 1HFY2011 has been traction on the
order inflow side, leading to soaring order backlog levels – despite unexciting
activity from the NHAI front particularly during the 2QFY2011. Most of the
contractors have seen good order inflow (we have not considered players solely
dependent on in-house projects for order inflow). Further, with positive
commentary from the management of various companies with regard to times
ahead and strong bidding pipeline, we expect the momentum to continue.
Favourable risk-reward ratio: The sector, after outperforming in the initial run-up
from abysmal levels, has underperformed over the last one year. Against a 16.7%
return generated by the Sensex over the last one year, most construction stocks
have generated negative returns (excluding L&T), leading to average
underperformance of ~25–30%. However, going ahead, with earnings
momentum expected to pick up in 2HFY2011 on the back of strong order book,
in the midst of the recent meltdown in the stocks post the quarterly numbers, the
sector is trading at attractive valuations (available at 6–8x our FY2012E earnings,
excluding L&T). We prefer IVRCL Infra, NCC, Patel and ITNL; our preference
indicates our relative comfort on execution, state of order book position, funding
and valuations within the sector. We have valued construction companies on an
SOTP basis. For the core construction business, we have assigned earnings
multiple in the range of 10–14x (excluding L&T), based on certain quantitative
and qualitative factors. The listed (unlisted) subsidiaries of construction companies
are valued at 30% discount to their CMP (1–1.5x book value).
Balance sheets throw a worrying picture
Analysis of the balance sheets indicates that the sector is experiencing a sharp rise
in working capital and pick-up in capex, leading to pressure on the cash flow.
Working capital ratios on the rise: We compared the working capital ratios (in
terms of day’s sales excluding cash) at the end of 1HFY2011 with that at the
end of FY2010 as well as 1HFY2010. It is evident from the comparison that
WC requirements have increased for the sector mainly on account of
increased loans and advances as well as debtors. We believe the key reasons
for the same are 1) stocking up in anticipation of pick-up in 2HFY2011; and
2) lending to subsidiaries to ensure flow of in-house C&EPC revenue.
However, it should be noted that the data of last year, i.e. 1HFY2010 and
FY2010, also indicates the same trend, which might point to the inherent
nature of the business; however, the same cannot be confirmed with the
historical trend due to lack of data from earlier years.
Investment picking up: Data also shows a distinct pick-up in fixed asset
investment. For the universe as a whole, fixed assets increased by
~7–8% during 1HFY2011 from FY2010. For the 12 months ended September
2010, fixed asset investment grew by ~20% yoy, with most companies
witnessing at least 20% yoy growth in capex. This is despite subdued growth
on the top-line front during the quarter. This also corroborates management’s
commentary of better times ahead.
Companies are starting to leverage their balance sheet: The squeeze in free
cash flow (on account of reasons mentioned above) has resulted in accretion
to cash, significantly lagging overall balance sheet growth. Further, there is
strong evidence of re-leveraging, which corroborates the above-mentioned
analysis. Contractors such as IVRCL Infra and NCC have seen a staggering
increase in debt levels – thereby interest cost – which we believe is one of the
major reasons for disappointing earnings during the quarter.
Order inflow and order backlog – The silver lining
One of the most positive, if not the only, outcomes from the quarter and
1HFY2011 has been traction on the order inflow side, leading to soaring order
backlog levels – despite unexciting activity from the NHAI front particularly during
the 2QFY2011. Most contractors have seen good order inflow; we have not
considered players solely dependent on in-house projects for order inflow. Further,
with positive commentary from the management of various companies with regard
to times ahead and strong bidding pipeline, we expect the momentum to continue.
Outlook
Robust medium and long-term sector growth outlook
Infrastructure investment is projected to touch US $135bn p.a. during FY2011 and
FY2012, which represents 145% growth over the last three year’s annual spend of
US $55bn. The XIth Five-Year Plan has missed the projections by ~20% during the
initial three years of its duration, and we believe even if this performance is
maintained, it would lead to huge opportunities for infrastructure players.
We believe the power, road and water segments will witness maximum traction.
Favourable risk-reward ratio
The sector, after outperforming in the initial run-up from abysmal levels, has
underperformed over the last one year. Against a 16.7% return generated by the
Sensex over the last one year, most construction stocks have generated negative
returns (excluding L&T), leading to average underperformance of ~25–30%.
However, going ahead, with earnings momentum expected to pick up in
2HFY2011 on the back of strong order book, in the midst of the recent meltdown
in stocks post the quarterly numbers, the sector is trading at attractive valuations
(available at 6–8x our FY2012E earnings, excluding L&T). We prefer IVRCL Infra,
NCC, Patel and ITNL; our preference indicates our relative comfort on execution,
state of order book position, funding and valuations within the sector. We have
valued construction companies on an SOTP basis. For the core construction
business, we have assigned earnings multiple in the range of 10–14x (excluding
L&T), based on certain quantitative and qualitative factors. The listed (unlisted)
subsidiaries of construction companies are valued at 30% discount to their CMP
(1–1.5x book value).
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