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India: Construction: Infrastructure
Equity Research
Moving focus to execution and balance sheet from order flows
Weak order inflows in E&C likely to continue for another quarter
Cumulative order inflows for construction companies we cover (bar JPA)
are down 7% YoY over Q3FY11, due to delays in project awards. We think
this trend of declining order inflows is unlikely to have changed in Q4FY11,
as there was only Rs95bn of order inflows for the top 10 construction
companies over Jan-Feb 2011. Moreover, because of land acquisition
issues, uncertainty over regulation and clearances, we think this trend of
weak order inflows is likely to continue for at least the next three months.
Looking beyond near term order inflow pressures...
Our analysis of L&T before and after it achieved sizeable order backlog
(>2X sales) indicates its valuation has shown strong correlation with order
inflows when its order backlog was <2X sales. After the backlog surpassed
2X sales, however, its valuation has shown stronger correlation with sales
growth and execution, and the correlation with order flows has declined.
...to focus on execution track record and balance sheet strength
As mid-cap construction companies have strong order backlogs of 2X-5X,
we believe metrics such as balance sheet strength and timely execution
will be key differentiators for these stocks this year. Our benchmarking
analysis of construction companies vs. the BSE-500 (excluding-financials)
indicates that high working capital requirements and poor cash flow
generation will remain salient features of the construction space. Our top
picks are L&T and NCC (both Buy) as we believe they are best placed in
terms of execution track record and balance sheet strength. Although JPA
ranks low in our analysis of 20 construction companies across balance
sheet and cash flow metrics, we retain our Buy on the stock, based on our
expectations of improvement in its margins and hence cash generation and
returns over FY10-12E, driven by the commissioning of its new projects.
Although we expect an improvement in billings for Punj Lloyd, we retain
our Sell, on near-term execution concerns.
Volatility in input prices (cement, energy) – key near term risk
We believe that apart from slow order inflows, the bigger risks to earnings
over next six months is from sharp fluctuations in key raw material prices
such cement, steel, coal and oil. Given current normal inventory levels of
key raw materials (1-3 months), we expect an impact from recent price
rises to show on companies’ results with a one quarter lag
Pressure on order inflows likely to continue in the near term
Cumulative order inflows for the six construction companies we cover are down 7% YoY in
Q3FY11 (except JPA), mainly driven by the 25% YoY decline in order inflows that L&T
experienced in Q3FY11. The top 10 Indian construction companies have recorded order
inflows of only Rs95bn in January and February according to CMIE, implying there is likely
to be a YoY decline in the cumulative order inflow for the top 10 construction companies in
Q4FY11E. CMIE’s capex investment data also indicate a poor order inflow trend for Q4FY11.
Time to look beyond short term variations in order inflows
We tracked the correlation between L&T’s valuation and its order inflow and execution
strength (measured by sales growth) over FY2004-07 (when its order book coverage was
still <2X) and also over FY2008-FY2011E (after its order backlog had stabilized at >2X sales).
As shown in Exhibits 4-7, our analysis indicates that:
At lower coverage ratios, valuations for L&T show a closer correlation with order
inflows than with sales growth.
However, once the order backlog achieved a comfortable size (>2X, in this case),
L&T’s valuations show closer correlation with sales growth than order inflows.
With most of the mid-cap construction companies having succeeded in building up strong
order backlogs (2X-5X for construction companies in our coverage universe), we believe
metrics such as balance sheet strength and execution track record are the most important
factors in identifying the firms that are relatively better positioned to deal with the ongoing
slowdown in order inflows across the various infrastructure segments. In our view, this is
because such companies are better positioned to:
Win any bigger and relatively more attractive contracts that do get awarded over
this period of order inflow weakness (over the next 3 months at least, in our view).
Not resort to price competition to win projects at a low IRR that would impact their
long-term profitability.
Deal with rising interest rates, given their strong balance sheets.
In our view, L&T and NCC are best positioned to benefit based on these parameters.
High working capital and poor cash generation inherent challenges
Average EBITDA levels are about 9% (over the past five years) for Indian construction
companies, and with about 35% of sales tied up in working capital, this has meant that free
cash flow generation is low. In addition, most of these construction firms have adopted asset
ownership models targeting to benefit from a steady stream of toll/annuity revenues and also
from captive construction possibilities. Without surplus cash flows, however, Indian
construction firms have become prone to further equity dilution to fund growth.
Execution record, balance sheet strength are key to performance
We analyze Indian construction companies — both companies within our coverage
universe and fourteen that we do not currently cover — on various key parameters:
Margins (EBITDA margin)
Cash generation ability (CFO/Sales)
Balance sheet strength (Debt-equity ratio)
Working Capital efficiency (Working Capital to Sales ratio)
Returns (ROCE)
Asset utilization (Sales/ Gross Fixed Assets)
For each of these parameters, we assign a score of 20 to the company that ranks
highest and a score of 1 to the company that ranks lowest. We sum the scores across
the six parameters to arrive at our overall score for each company.
Although a few smaller construction companies ranked well on these metrics in FY10,
most have seen deterioration in their earnings performance in 9MFY11 compared with
L&T and NCC. In our view, this highlights importance of a strong order backlog and
execution track record along with strong balance sheet and cash flow metrics to tide
them over during the current period of uncertainty in order inflows.
In-line with this, the median stock price decline for this set of construction companies
(excluding L&T which is the industry leader) is 39% over the last 12 months, whereas
L&T’s stock price has remained flat over the same period. Given our view that order
inflows are likely to remain under pressure for the next three months at least, we
expect L&T and NCC – as better positioned in our view — to outperform their Indian
construction peers.
NCC & L&T: Significant improvement in performance in FY08-FY10
Our analysis of the change in rankings/scores of companies over FY08-FY10 indicates that
both L&T and NCC’s rankings have improved significantly over FY08-10. While L&T’s
ranking has improved from seventh to third, NCC’s rankings has improved from 14th to
eighth over this period.
The key driver of this improvement has been the improvement in margins for both
companies — about 400 bps for L&T and 600 bps for NCC. In addition, NCC has also seen
an improvement in cash flow and ROCE over this period. In the case of L&T, although cash
generation and ROCE have trended lower (on account of the changing mix of its order book
and revenues, with is share of the power segment increasing), both cash flow generation
and ROCE remain well above industry median, leading to an improvement in rankings. We
believe this improvement is sustainable and gives L&T and NCC an advantage over
covered peers.
Cash generation, working capital cycles to improve over FY10-12E
We expect better execution and an improvement in billing cycles to lead to an
improvement in margins, and hence return, for both Punj Lloyd and Jaiprakash Associates.
However, we estimate that despite the improvement, both JPA and Punj’s ROCE will
remain only around 6% vs the 11% ROCE that we expect for L&T in FY12E and 9% ROCE for
IVRC and NCC. Therefore, L&T and NCC (both Buy) remain our top construction picks
based on the six balance sheet and cash flow metrics in our score card.
However, for any sustainable improvement in cash generation and working capital, we
believe it is essential for there to be a pick up in order inflow, a moderation in interest rates
and stable commodity prices.
Valuations
Stock prices for the six companies we cover have moved up on an average by about 10%
over the last month. And although the 12-month forward P/Es for these six companies have
increased by 4-22% over the last month, all stocks continue to trade below their five-year
historical median valuations — in our view providing attractive entry levels for L&T and
NCC, which have good execution track records and strong balance sheet and cash flow
generation ability.
Rising crude prices – risks to both order inflows and margins
We believe that apart from slow order inflows, the greatest risks to earnings over the next
six months is from sharp fluctuations in key raw material prices such cement, steel, coal
and oil. Given current normal inventory levels of 1-3 months, we expect the higher
commodity prices to impact margins with a 1-2 quarter lag.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
India: Construction: Infrastructure
Equity Research
Moving focus to execution and balance sheet from order flows
Weak order inflows in E&C likely to continue for another quarter
Cumulative order inflows for construction companies we cover (bar JPA)
are down 7% YoY over Q3FY11, due to delays in project awards. We think
this trend of declining order inflows is unlikely to have changed in Q4FY11,
as there was only Rs95bn of order inflows for the top 10 construction
companies over Jan-Feb 2011. Moreover, because of land acquisition
issues, uncertainty over regulation and clearances, we think this trend of
weak order inflows is likely to continue for at least the next three months.
Looking beyond near term order inflow pressures...
Our analysis of L&T before and after it achieved sizeable order backlog
(>2X sales) indicates its valuation has shown strong correlation with order
inflows when its order backlog was <2X sales. After the backlog surpassed
2X sales, however, its valuation has shown stronger correlation with sales
growth and execution, and the correlation with order flows has declined.
...to focus on execution track record and balance sheet strength
As mid-cap construction companies have strong order backlogs of 2X-5X,
we believe metrics such as balance sheet strength and timely execution
will be key differentiators for these stocks this year. Our benchmarking
analysis of construction companies vs. the BSE-500 (excluding-financials)
indicates that high working capital requirements and poor cash flow
generation will remain salient features of the construction space. Our top
picks are L&T and NCC (both Buy) as we believe they are best placed in
terms of execution track record and balance sheet strength. Although JPA
ranks low in our analysis of 20 construction companies across balance
sheet and cash flow metrics, we retain our Buy on the stock, based on our
expectations of improvement in its margins and hence cash generation and
returns over FY10-12E, driven by the commissioning of its new projects.
Although we expect an improvement in billings for Punj Lloyd, we retain
our Sell, on near-term execution concerns.
Volatility in input prices (cement, energy) – key near term risk
We believe that apart from slow order inflows, the bigger risks to earnings
over next six months is from sharp fluctuations in key raw material prices
such cement, steel, coal and oil. Given current normal inventory levels of
key raw materials (1-3 months), we expect an impact from recent price
rises to show on companies’ results with a one quarter lag
Pressure on order inflows likely to continue in the near term
Cumulative order inflows for the six construction companies we cover are down 7% YoY in
Q3FY11 (except JPA), mainly driven by the 25% YoY decline in order inflows that L&T
experienced in Q3FY11. The top 10 Indian construction companies have recorded order
inflows of only Rs95bn in January and February according to CMIE, implying there is likely
to be a YoY decline in the cumulative order inflow for the top 10 construction companies in
Q4FY11E. CMIE’s capex investment data also indicate a poor order inflow trend for Q4FY11.
Time to look beyond short term variations in order inflows
We tracked the correlation between L&T’s valuation and its order inflow and execution
strength (measured by sales growth) over FY2004-07 (when its order book coverage was
still <2X) and also over FY2008-FY2011E (after its order backlog had stabilized at >2X sales).
As shown in Exhibits 4-7, our analysis indicates that:
At lower coverage ratios, valuations for L&T show a closer correlation with order
inflows than with sales growth.
However, once the order backlog achieved a comfortable size (>2X, in this case),
L&T’s valuations show closer correlation with sales growth than order inflows.
With most of the mid-cap construction companies having succeeded in building up strong
order backlogs (2X-5X for construction companies in our coverage universe), we believe
metrics such as balance sheet strength and execution track record are the most important
factors in identifying the firms that are relatively better positioned to deal with the ongoing
slowdown in order inflows across the various infrastructure segments. In our view, this is
because such companies are better positioned to:
Win any bigger and relatively more attractive contracts that do get awarded over
this period of order inflow weakness (over the next 3 months at least, in our view).
Not resort to price competition to win projects at a low IRR that would impact their
long-term profitability.
Deal with rising interest rates, given their strong balance sheets.
In our view, L&T and NCC are best positioned to benefit based on these parameters.
High working capital and poor cash generation inherent challenges
Average EBITDA levels are about 9% (over the past five years) for Indian construction
companies, and with about 35% of sales tied up in working capital, this has meant that free
cash flow generation is low. In addition, most of these construction firms have adopted asset
ownership models targeting to benefit from a steady stream of toll/annuity revenues and also
from captive construction possibilities. Without surplus cash flows, however, Indian
construction firms have become prone to further equity dilution to fund growth.
Execution record, balance sheet strength are key to performance
We analyze Indian construction companies — both companies within our coverage
universe and fourteen that we do not currently cover — on various key parameters:
Margins (EBITDA margin)
Cash generation ability (CFO/Sales)
Balance sheet strength (Debt-equity ratio)
Working Capital efficiency (Working Capital to Sales ratio)
Returns (ROCE)
Asset utilization (Sales/ Gross Fixed Assets)
For each of these parameters, we assign a score of 20 to the company that ranks
highest and a score of 1 to the company that ranks lowest. We sum the scores across
the six parameters to arrive at our overall score for each company.
Although a few smaller construction companies ranked well on these metrics in FY10,
most have seen deterioration in their earnings performance in 9MFY11 compared with
L&T and NCC. In our view, this highlights importance of a strong order backlog and
execution track record along with strong balance sheet and cash flow metrics to tide
them over during the current period of uncertainty in order inflows.
In-line with this, the median stock price decline for this set of construction companies
(excluding L&T which is the industry leader) is 39% over the last 12 months, whereas
L&T’s stock price has remained flat over the same period. Given our view that order
inflows are likely to remain under pressure for the next three months at least, we
expect L&T and NCC – as better positioned in our view — to outperform their Indian
construction peers.
NCC & L&T: Significant improvement in performance in FY08-FY10
Our analysis of the change in rankings/scores of companies over FY08-FY10 indicates that
both L&T and NCC’s rankings have improved significantly over FY08-10. While L&T’s
ranking has improved from seventh to third, NCC’s rankings has improved from 14th to
eighth over this period.
The key driver of this improvement has been the improvement in margins for both
companies — about 400 bps for L&T and 600 bps for NCC. In addition, NCC has also seen
an improvement in cash flow and ROCE over this period. In the case of L&T, although cash
generation and ROCE have trended lower (on account of the changing mix of its order book
and revenues, with is share of the power segment increasing), both cash flow generation
and ROCE remain well above industry median, leading to an improvement in rankings. We
believe this improvement is sustainable and gives L&T and NCC an advantage over
covered peers.
Cash generation, working capital cycles to improve over FY10-12E
We expect better execution and an improvement in billing cycles to lead to an
improvement in margins, and hence return, for both Punj Lloyd and Jaiprakash Associates.
However, we estimate that despite the improvement, both JPA and Punj’s ROCE will
remain only around 6% vs the 11% ROCE that we expect for L&T in FY12E and 9% ROCE for
IVRC and NCC. Therefore, L&T and NCC (both Buy) remain our top construction picks
based on the six balance sheet and cash flow metrics in our score card.
However, for any sustainable improvement in cash generation and working capital, we
believe it is essential for there to be a pick up in order inflow, a moderation in interest rates
and stable commodity prices.
Valuations
Stock prices for the six companies we cover have moved up on an average by about 10%
over the last month. And although the 12-month forward P/Es for these six companies have
increased by 4-22% over the last month, all stocks continue to trade below their five-year
historical median valuations — in our view providing attractive entry levels for L&T and
NCC, which have good execution track records and strong balance sheet and cash flow
generation ability.
Rising crude prices – risks to both order inflows and margins
We believe that apart from slow order inflows, the greatest risks to earnings over the next
six months is from sharp fluctuations in key raw material prices such cement, steel, coal
and oil. Given current normal inventory levels of 1-3 months, we expect the higher
commodity prices to impact margins with a 1-2 quarter lag.
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