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India Construction — Roads
Proposed new toll rate pyramid is a near-term negative
To avoid a transport operators strike, the Govt has proposed
adding a new toll rate slab at 30% lower price for new projects
We anticipate this move will impact project awards through
increased demand for viability gap funds (VGF) from 1QFY12
Sector’s valuation expansion in the near term could be capped
until visible progress on project awards. However, we remain
positive on long-term prospects with IRB as our top pick
Government has proposed adding a new toll rate slab at 30% lower price for new
projects. The Transport Ministry has proposed (subject to approvals) adding a new toll rate
slab for three-axle commercial vehicles at c30% lower pricing in a bid to avoid transport
operators from going on strike. Additionally, it has proposed reducing the toll rate for local
commuters in new projects by 50% (refer page 2 for details of proposed changes).
We anticipate this move will delay project awards through increased demand for VGF.
The three-axle segment is the biggest contributor to toll revenues (c30%) and a 30% reduction
in toll rates for this segment would reduce cash flows for a project by c10%. We anticipate this
will increase demand for VGF while bidding for a project by a similar proportion. Demand for
VGF above the upper limit (20%/40% as per type of project) would make such projects
unviable under toll concession rules and would be converted into annuity projects, thereby
delaying the awards process. Additionally, charging 50% lower toll rates to local commuters
could encourage toll collection employees to manipulate collections by charging lower fees to
inter state vehicles, thereby reducing project cash flows.
Reduced visibility on new project awards will restrict valuation expansion near term.
The proposed changes exclude existing projects in the Request for Proposal (RFP) and Letter
of Award (LOA) stage, most of which are likely to be awarded during 4QFY11. Hence the
visible impact of proposed changes will be seen from 1QFY12, in our view. Lack of visibility
on the impact of new rules will increase uncertainty on the quality of new projects being
awarded, thereby restricting valuation expansion in the near term.
However, we remain positive on long-term sector prospects. IRB is our top pick.
Despite the near-term growth pangs, we believe long-term potential of the Indian road
development sector remains strong (cINR3trn worth projects to be awarded over next 7-10
years). IRB (IRB IN, OW(V), TP INR355) with its market leadership position and healthy
balance sheet remains our top pick. We also like L&T (LT IN, OW, TP INR2,341) for its
strong balance sheet and ability to finance potential new projects.
Proposed changes in the toll rate pyramid
The Government has proposed a separate category, namely three-axle commercial vehicles, to be
incorporated in National Highways Fee (Determination of Rates and Collection) Rules, 2008. It has also
been proposed that the base toll rate for the three-axle commercial vehicle category will be pegged at
INR2.4 per km as against the current INR3.45 per km. Additionally, the difference between the toll rate
for two-axle bus/trucks and three-axle commercial vehicles will be maintained at a minimum of 10%.
50% lower toll rate fee for local commuters
The Government has agreed to form a separate class of commuters, which will be added in the concession
category in the National Highways Fee (Determination of Rates and Collection) Rules, 2008 to provide
50% concession on toll rate charged to local commercial vehicles registered within the district (excluding
vehicles plying under National Permit) of the respective toll booth. Local vehicles are expected to be
defined as those carrying the address of the owner of the vehicle (are from the same district as the
concerned toll booth) as mentioned in the vehicle registration certificate.
Lower toll rate fee after concession period is complete
The Government has also proposed that after the concession period is over, toll rate fee for maintenance
and development would be charged at 40% of the rate applicable at the time of completion of concession
period and would be adjusted annually for inflation. However, in case of further development of the same
road stretch, full user fee would be collected as per the rules.
Key sector picks
IRB Infrastructure (IRB IN, OW(V), INR227, TP INR355)
Valuation argument
Our target price of INR355 is derived by a sum-of-the-parts approach, with the major components being
existing toll assets, valued at INR143 per share (DCF basis), the construction business at INR157 (18x
FY12e earnings), EPC business at INR11 and future business potential and terminal value at INR44. We
prefer a DCF-based valuation of IRB’s toll assets to capture the benefit of a defined concession period
(typically 10-25 years). We have used the free cash flow-to-equity method of DCF to account for the
varying degree of gearing for project assets across the asset life. Key parameters used in our valuation for
BOT assets are a cost of equity of 13%, a risk-free rate of 7.5%, an equity risk premium of 5.5%, and
interest cost of 11%. We value IRB’s construction business at 18x FY12e construction segment earnings.
Our target price implies an exit multiple of 4.1x FY12e PB (pre-dilution) and 21.1x FY12e earnings.
Ratings rationale
For Indian stocks, HSBC considers the average cost of equity to be 10.5%. A volatile Indian stock with a
potential total one-year return of 10ppt on either side of 10.5%, i.e., within a band of -0.5 to 20.5%,
merits a Neutral (V) rating. As the total potential return on IRB shares is above this band, we retain our
Overweight (V) rating.
Risks
1) Sharp rise in interest rates, 2) weaker-than-estimated traffic growth, 3) lower-than-estimated success in
future project bids, and 4) slower-than-expected project execution on existing under-construction
projects.
Larsen & Toubro (LT IN, OW, INR2,021, TP INR2,341)
Valuation argument
Our 12-month target price of INR2,341 includes INR1,855 for the standalone entity (22x Sep 2012e EPS)
and subsidiaries at INR486. At our target price, L&T would trade at 22.6x Sep 2012e earnings. L&T in
the past five years has traded in a range of 11-47x, and at an average of 23.8x its one-year forward
earnings. While the stock is up 19% ytd, our target PE is still 10% lower than its five-year average.
Higher earnings visibility (E&C book-to-bill at 2.9x) makes up for the 16% lower growth profile (27%
two-year forward EPS CAGR against last the five-year average of 32%). On an EV/order backlog
(adjusted for subsidiary value), L&T is still trading at 0.94x, or 18% lower than its five-year average.
Ratings rationale
For Indian stocks, HSBC considers the average cost of equity to be 10.5%. A volatile Indian stock with a
potential total one-year return of 10ppt on either side of 10.5%, i.e., within a band of -0.5 to 20.5%,
merits a Neutral (V) rating. As the total potential return on Larsen and Toubro shares is above this band,
we retain our Overweight rating.
Risks
1) A sharp slowdown in economic growth and the resultant impact on government spending and
industrial capex, 2) higher-than-anticipated EBITDA margin erosion over FY11-13, and 3) a meaningful
rise in interest rates, impacting project timelines.
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