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Infrastructure (Robust order book, execution is missing)
Neutral
The construction sector underperformed the broader markets in CY10
despite a bulging order book (adjusted order book to bill ratio of 2.3-3x
providing revenues visibility over a couple of years). This was led by factors
such as execution delays due to political uncertainty at the major region of
AP (exposure of 0-20% in current order book), delay in financial closure at
client specific and captive BOT orders, prolonged monsoons etc. Going
ahead, while we expect the execution rate to pick up, tightening liquidity
leading to rising interest rates could restrict earnings growth in H1CY11.
Significant earning growth can only be seen in H2CY11 with a benign
interest rate scenario. Hence, we remain selectively positive on the sector.
We believe players with a diversified order book, comfortable liquidity
position and low exposure to slow moving AP orders and less equity
commitment towards subsidiaries will emerge as preferred bets in CY11.
Theme/key monitorable for CY11
⇒ Execution rate
Given the slower than expected revenue growth despite bulging order
book, the execution rate is a focal point in CY11 compared to the
momentum of order inflow. Players with better execution capabilities
would command better multiples than others. To monitor this, we
prefer players with shorter duration of orders, lesser exposure to the
slow moving AP region and geographical diversity in the order book.
We prefer NCC (Nagarjuna construction) and SIL (Simplex infra) on this
parameter. In the infrastructure space, execution delay is due to
regulatory hurdles and a delay in monetization of assets. However,
with the fund raising activity through private equity and WIP, we
believe infrastructure players will be better funded and, hence,
execution should pick up in H2CY11.
⇒ Working capital management
Given the fact that WC accounts for 30-50% of the topline for leading
construction companies, players with efficient working capital
management would command a premium in their valuation compared
to other players. To gauge this, we prefer players who have a shorter
duration of the order book, higher exposure to private players in the
order book and lesser exposure to the slow moving AP region and
captive orders. We again prefer NCC and SIL on these parameters.
⇒ Funding requirement at subsidiary level
We prefer players whose subsidiaries in different business verticals
have lower funding requirement. To fund their requirement, the parent
company may have to stretch its balance sheet. Among all, SIL is
particularly differentiated on this parameter. We also like NCC on this
parameter. However, any revival plan on the Sompeta power plant
could put pressure on the balance sheet over the next one or two
years
⇒ Liquidity & interest rate movement
With the anticipated tightening liquidity condition, interest rates are
expected to remain firm in the first half of CY11. The rising interest rate
coupled with tight liquidity condition could provide a negative surprise
in the first half of CY11. Nonetheless, the liquidity condition and
interest rate is expected to remain benign in H2CY11 and would
provide respite to construction companies. To tackle this situation, we
believe players with lower debt to equity position will be best placed in
H1CY11. NCC and IVRCL have lower net debt to equity level vis-à-vis
their peers.
Given the multiple headwinds in CY10, the valuation of construction
companies has become compelling (adjusted P/E of 7-11x for leading midcap
construction companies). Though the valuation has been compelling,
we remain selectively positive on the sector. In our view, players with short
duration and diversified order book, comfortable liquidity position, lesser
exposure to the slow moving AP region and captive BOT projects and
lesser equity requirement at the subsidiary level putting lesser funding
pressure on the balance sheet of the parent would see better earning
growth and command better valuation than its peers. We like SIL and NCC
on these parameters.
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