Nomura: 2011 Update: Infrastructure and construction

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Infrastructure and construction
 Action
We believe the Indian construction companies have underperformed the broader
market YTD CY10 on concerns over low execution rates, increase in working
capital, rising interest rates and company-specific issues regarding investments
and receivables. However, we remain positive on execution and improvement in
working capital in CY11F. We believe valuations are attractive and maintain our
Bullish stance on the sector.
 Catalysts
A pick-up in execution and an improvement in working capital are potential
catalysts in the near term.
Anchor themes
The Indian construction sector is a play on improvement in corporate capex and
investment in infrastructure. We expect order-booking momentum and
revenue/earnings growth to accelerate in 2H FY11.

At the cusp of a turnaround?
 Execution to pick up by CY11F
We expect execution to pick up in 2H FY11F (3Q CY10F) on the back of a strong
order backlog and start of execution of BOT projects won in 2H FY10. In our view,
construction companies could report 20-30% growth in revenue in 2H FY11F and
FY12F. A pick-up in execution would impact margins positively as operating
leverage comes into play, we believe.
 Working capital likely to improve
Working capital for most companies has gone up in FY10 and 1H FY11. We
expect working capital to come down in the next few quarters as projects in the
mobilisation stage move into a stable execution phase. An increasing proportion
of private projects (including captive BOT projects) should also help improve
working capital, in our view.
 Risks: interest rates and lower-than-expected order inflows
We expect interest rates to remain high, but we don’t expect any disruptive
increase in interest rates. A 150bp increase in interest levels could negatively
impact construction companies’ FY12F EPS by 2-18%, on our estimates. The
order booking rate in 1H FY11 has been largely below full-year company
guidance. Although there could be some slippage in the near term, we do not see
this as an immediate concern as the current order backlog ratio is high, at 3-5x
trailing 12-month sales, presenting near-term growth visibility.
 We prefer pure-play contractors to developers
We see contractors as being best placed to benefit from the secular growth
opportunity in infrastructure due to their ability to diversify across sectors. Lower
risk of foreign competition and lower requirement of capital vs developers are
other positives, in our view.
 Valuations attractive; we reaffirm Bullish stance
Adjusted for subsidiary valuations, the mid-tier BUY-rated stocks under our
coverage are trading at 6.6-7.2x FY12F adjusted earnings while L&T is at 19.8x.
The risk/reward looks favourable and we reaffirm our Bullish stance. Our top pick
is IVRCL.