Build a portfolio of construction stocks:: Business Line,

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Construction stocks have steadfastly held on to their status as underperformers in 2011, with the bigger players losing between 1 per cent and 39 per cent of their share price from the start of the year. Slower execution of projects because of the prolonged monsoons and the resultant drag on net profits, along with the burden of rising interest rates, clouded the sector's prospects over a good part of last year.

Here's the silver lining though. With stock prices declining, valuations of construction companies are now rather attractive. Most of the major players are now available at a PE of less than 11 times trailing twelve month earnings. Low valuations, combined with healthy order-books and steady operating margins, suggest that these may be good additions to your portfolio.

Construction companies primarily undertake contracts to build anything from roads and bridges to industrial complexes and residential buildings. The growth prospects of these companies hinge on the potential in the infrastructure, commercial and residential real-estate space and industrial expansion.

WHY MARKET LAGGARDS

Nineteen of the 25 construction contractors in our coverage have declined between 1 per cent and 69 per cent from the start of 2010 to now. Collectively, the market capitalisation of the entire universe has dropped 24 per cent. In contrast, bellwether indices Sensex and Nifty generated positive returns of about 11 per cent, while the broader index BSE-500 returned about 8 per cent in the same period. Companies such as Man Infraconstruction and ARSS Infra, which posted stellar gains following initial public offers in early 2010, faltered towards the end of the year, while Ramky Infra and Ashoka Buildcon, which debuted in late 2010, plunged on listing, regardless of prospects or valuations.

Ranking among the worst performers are BL Kashyap & Sons, C&C Constructions and Patel Engineering — down 47 to 69 per cent - on concerns over delays in awarding of road projects, slackening residential construction and slowdown in project execution in the politically turbulent Andhra Pradesh . Moreover, the furore over corruption in the Commonwealth Games spilled over to the contractors who executed projects for the Games — particularly Ahluwalia Contracts and MBL Infrastructure.

Delays in key projects and prolonged monsoons in the second half of 2010 resulted in tame revenue growth after a robust June quarter. Interest costs, however, remained high due to working capital requirements and a rising interest rate. The quarters ending September and December 2010 saw collective revenues growing 14 per cent each. A 49 per cent rise in interest costs in the December quarter though, caused net profits to slid 14 per cent. Still, operating profits were fairly healthy, rising 7 and 11 per cent respectively in the September and December quarters.

TIME TO BET

While concerns do cloud prospects, these have been hovering for a couple of quarters. Current valuations seem to have factored in most of the challenges. From a trailing twelve-month valuation of 14.9 times in January 2010, construction stocks now trade at very reasonable 11 times trailing earnings. Here are the key reasons to bet on construction stocks:

Order book: Construction companies, on an average, have order-books executable in two to three years, providing good near-term earnings visibility. Many construction contractors also undertake State and municipal projects, where incidence of repeat orders are high and where contractors have established good relations.

Barring a few, most construction companies have seen healthy growth in order-books so far this fiscal. Companies such as Ramky Infra, Simplex Infrastructure, Supreme Infrastructure, Pratibha Industries, Unity Infraprojects and ARSS Infra score well on the order-book front.

Diversification: Though the shifting fortunes of real estate and roads, where lacklustre prospects execution delays have depressed growth, have impacted investor fancy for construction stocks, most construction players straddle multiple segments, allowing them to shift focus depending on segment prospects. Companies such as JMC Projects, Simplex Infrastructure, Sadbhav Engineering and Unity Infraprojects are diversified across industrial projects, mining, roads, power and realty. On the other hand, companies such as Man Infraconstruction, Simplex Projects and Ahluwalia Contracts have a high real estate presence which may dampen growth prospects for the next few quarters.

Presence in the growth segments of irrigation and waste management, which come under the purview of urban infrastructure development, will help companies build on orders and revenues. Here, Ramky Infra and Pratibha Industries score well.

Geographically, companies with a high exposure to the politically unstable Andhra Pradesh, such as Patel Engineering, have made a concerted effort to reduce exposure which will lessen the drag of stalled projects. Companies such as MBL Infra are also moving into the high-potential, better-margin North-Eastern States.

Backward integration: While raw material costs are a worry across sectors, players such as MBL Infra own stone quarries and manufacture ready mix concrete for own consumption, which reduces input costs. Price escalation clauses built into most contracts help shield companies from rising commodity prices. In fact, collective operating margins for the first nine months of FY-11 held strong at 14 per cent, even as prices of key commodities such as steel were on the rise.

Companies have also made heavy investments in ownership of capital equipment. For instance, ARSS Infra saw an 82 per cent increase in machinery in FY-10. Ownership of key equipment will help reduce hiring charges besides ensuring timely availability of equipment.

Scaling up: Contractors are slowly moving up the value chain to become developers, using consortiums to qualify. Their expertise in construction allows them to execute own projects, resulting in lower dependence on sub-contracting and better margins. Simplex Infrastructure, Sadbhav Engineering, Ashoka Buildcon, KNR Constructions, Ramky Infra and MBL Infra all have completed projects as developers and are in line to secure further orders.

RISKS

A rising interest rate scenario does create challenges for contractors looking to improve their net profit margins. Increase in equipment investments may entail higher depreciation. Net margins, therefore, at about 4-5 per cent now, are unlikely to show significant improvement in the near term, even as growth may be topline-driven. Debt requirement for players transitioning to developers may also shoot up, depending on the projects secured.

Companies with relatively lower debt, such as BL Kashyap, KNR Constructions and JMC Projects, may weather higher interest costs better than peers