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India E&C: Q1 FY12 preview
Expect weak earnings; focus on order inflow outlook
We forecast weak Q1 earnings outlook (-12% y-o-y) for mid-cap
E&C players but modest growth for L&T (+10% y-o-y)
New order announcements during Q1 have been weak, which
will keep share performance muted. Investors will focus on
management’s guidance for more visibility
Current sector dynamics favour large players with better
balance sheets – L&T (OW, target INR2,187) is our preferred
sector play
Weak Q1 earnings growth outlook. We expect sustained high interest rates and working
capital will impact earnings growth during Q1 FY12. This will be primarily evident in midcap construction companies, where we expect earnings to drop by c12%. However, larger
players should show more resilience; we like L&T due to its better balance sheet and
superior working capital cycle, and expect it to report a modest c10% earnings growth.
Focus will be more on order inflow guidance. Indian E&C companies order inflow
announcements during Q1 FY12 have been substantially weak (-34% y-o-y). While this
has been mostly been in line with expectations, we believe investors will need visibility
on the expected growth revival during H2 FY12. Hence management commentary on
current market dynamics and business outlook will gain focus during the quarter.
Large players better placed; L&T is our preferred pick. The Indian E&C sector’s
changing dynamics towards an asset heavy business model will continue to favour large
companies with better balance sheets. Hence L&T remains our preferred sector play. With
this note we have cut target prices for HCC to INR38 (from INR42, primarily due to cut in
subs value), NCC to INR106 (from INR151, primarily due to cut in EPS and target PEx),
IRB to INR281 (from INR309, primarily due to cut in EPS) and Simplex Infra to INR321
(from INR371, primarily due to cut in EPS) to reflect sustained weakness in the operating
environment, while maintaining our current ratings \
Investment summary
Retain OW rating Larsen & Toubro with target price of INR2,187 (unchanged)
We expect L&T to report a robust 26% consolidated EPS CAGR for FY12-13, driven primarily by
improvement in the business environment and increased contribution from subsidiaries, c22% in FY13
from c16% in FY11. We believe the strategic steps taken by L&T over the past three to five years to
diversify into structural growth segments like power equipment manufacturing, defence, and asset
ownership will start yielding results over the next three to five years. The company has, in our view, put
the building blocks in place in these businesses, and we think the next few years are likely to see L&T
gather critical mass in these segments. This should reduce cyclical business risk and improve the
company’s earnings profile.
L&T shares now trade at 20x March 2013 earnings. Our 12-month target price of INR2,187 (INR1,730
for stand-alone entity and INR457 for subsidiaries) pegs L&T at c20x FY13 earnings suggesting a
marginal multiple expansion over the next 12 month period. In the past five years, the stock has traded at
an average PE of 23.8x its one-year forward earnings. We believe our lower than five-year historical
average target multiple is justified given the company’s lower growth profile of a 26% CAGR over
FY12e-13e, as against c32% over the past 5 years.
Key risks to our rating and estimates include 1) sharp slowdown in economic growth and the resultant
impact on government spending and industrial capex, 2) higher-than-anticipated EBITDA margin erosion
over FY12-13, and 3) a meaningful rise in interest rates, impacting project timelines.
Under our research model, for Indian stocks without a volatility indicator, the Neutral band is five
percentage above and below the hurdle rate of 11%, ie a Neutral band of 6-16% potential return. Our
target price implies a potential return of 19%.
Retain OW(V) rating on IRB with INR281 target price (INR309 earlier)
India’s road sector growth prospects remain very strong. IRB, with segment leadership (5.6% share), is in
the right place at the right time. We expect IRB to win USD1bn worth of new projects per annum during
FY11-13 based on IRB’s current balance sheet strength and existing competitive intensity in the sector.
This should increase its market share to 6.5%, making it our preferred road play.
Toll income growth has picked up momentum, which we believe will complement construction segment
revenue CAGR of 85% (FY11-12). IRB’s fixed price construction contracts have a 10-15% cushion at the
existing bitumen price. Hence, EBITDA margins on its construction business are expected to remain firm.
We expect IRB to report 16% consolidated earnings CAGR during FY11-13 and expect the new BOT
project wins to act as share price catalysts.
Our revised target price of INR281 (INR309 earlier) includes toll assets of INR125 (DCF-based),
construction business of INR102 (INR110, reduced currently primarily due to lower earnings growth),
other businesses of INR10, and future growth of 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 use 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 in our valuation of 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%.
Key risks include 1) Sharp rise in interest rates; 2) weaker-than-estimated traffic growth; 3) lower than
estimated success in future project bids; 4) slower-than-expected execution.
Under our research model, for Indian stocks with a volatility indicator, the Neutral band is 10 percentage
above and below the hurdle rate of 11%, ie a Neutral band of 1-21% potential return. Our target price
implies a potential return of 60%.
Retain OW(V) rating on NCC with target price of INR106 (INR151 earlier)
Healthy revenue visibility – book to bill at 3.2x (4Q FY11) – offers strong revenue visibility. We expect
NCC to report c19% top line CAGR over FY12-13. We expect in-house orders will drive growth in the
near term (Power project order along with road projects worth INR15-25bn). While we expect leverage to
increase due to funding of its portion of power asset equity, net debt to equity should remain under
control (1.03x by FY13).We believe working capital has peaked, but the benefit will start flowing in from
H2FY12 as government spending picks up. We expect NCC to report c23% EPS CAGR over FY12-13.
Our revised target price of INR106 (INR151 earlier) values NCC’s core business at INR77 and assets
held by subsidiaries at INR29. Our target valuation for the company does not include any value for its
new 1,024MW power project asset, as the majority of NCC’s share of equity infusion is likely to be
funded by debt in the near term, and we have little visibility on the project’s timelines. Hence, our current
target valuation factors in only the upside from construction orders to be received from the same power
project, with any additional value from its power asset acting as an upside surprise in the future. NCC
shares now trade at 8x one-year forward core business earnings. In the past 12 months, the stock has
traded in an earnings multiple range of 5.9-14.1x. In line with this we have cut our target PE multiple to
8x (10x earlier) primarily due to lower earnings expectation (FY12-13 earnings CAGR reduced to 23%
from 34% earlier).
Key risks include: 1) Delay in execution of projects; 2) substantial delay in the start of its 1,320 MW power
plant project; 3) the market attributing a lower value to its subsidiaries than INR28 as attributed by us.
Under our research model, for Indian stocks with a volatility indicator, the Neutral band is 10 percentage
above and below the hurdle rate of 11%, ie a Neutral band of 1-21% potential return. Our target price
implies a potential return of 27%.
Retain N(V) rating on Simplex Infra with target price of INR321 (INR372 earlier)
Simplex missed its FY11 guidance of 15% revenue growth which in turn has lowered its revenue
visibility over the next two years primarily owing to slow moving orders. Management is banking on
international projects to increase revenue share and meets its targets. However, this would require
Simplex to ramp up execution drastically during FY12 which in our view is difficult.
Simplex’s working capital requirements have increased by 20-25% during FY11 due to weak execution
and higher resource mobilisation on new locations. With a sharp a sharp order inflow spurt during FY11,
we estimate capital intensity for project execution will remain high during FY12. While we expect
earnings over FY12-13 to remain healthy at 27% CAGR, this is primarily driven by lower depreciation on
slower capex accretion. We expect the top line to increase at 15% CAGR over FY12-13 and 14%
EBITDA CAGR.
Simplex’s share price has corrected c36% y-t-d. We believe the company’s competitive positioning in
the market remains weak due to higher leverage and a weak working capital cycle. Hence, we believe
the stock is unlikely to trade at a premium to its 6-month trading history of 7-10x one year forward.
Consequently, we value the company at 8x FY13 EPS, thereby yielding a target price of INR321
(reduced from INR372 mainly due to earnings changes).We maintain our Neutral (V) rating on the stock.
Under our research model, for Indian stocks with a volatility indicator, the Neutral band is 10 percentage
above and below the hurdle rate of 11%, ie a Neutral band of 1-21% potential return. Our target price
implies a potential return of 12%.
Key risks include: 1) Delay in execution and slower-than-estimated growth in international revenues; 2)
sustained incidence of non-core operating losses; 3) deterioration in working capital cycle leading to a
weaker-than-estimated balance sheet.
Retain N(V) rating on HCC with target price of INR38 (INR42 earlier)
We think HCC has a better business model than its peers, with a high book to bill ratio of 4.4x which
provides revenue visibility over the next 2-3 years. Additionally, complex projects help HCC earn better
operating margins (c12-13% as against peers’ 9-10%). However, HCC has been unable to contain the
rising leverage on its balance sheet owing to weak recoveries on its receivables (disputed receivables are
currently at c80% of the working capital employed). Rising funding cost upon higher leverage along
would impact faster execution leading to weak earnings growth. We estimate low 17% earnings CAGR
over FY12-13. While there has been positive new flow on the Lavasa issue (Environment clearance from
Ministry of Environment Forests) in the past few months, there is still lack of clarity on the time line of a
resolution of the same. Hence in the absence of clarity we expect Lavasa valuations to continue to remain
low. In line we have reduced our value for Lavasa from INR10 per share to INR8 per share (target NAV
discount increased from 50% to 60%). We have also lowered our valuation for real estate projects from
INR9.5 per share earlier to INR 7.5 per share (target NAV discount increased from 20% to 35%). In line,
our target price has reduced from INR42 to INR38. We have maintained our valuation for the
construction business at INR11 per share (7x FY13 EPS).
Key downside risks include: 1) Sustained high receivable days leading to deterioration in the company’s
working capital cycle and in turn a weaker-than expected balance sheet. 2) Delay in resolving the
approvals issue for Lavasa project with the Ministry of Environment and Forest (MoEF). Key upside risks
include: 1) Faster recoveries in response to the improved focus on management to lower balance sheet
leverage. 2) Better-than-estimated valuation for Lavasa project by the market.
Under our research model, for Indian stocks with a volatility indicator, the Neutral band is 10 percentage
above and below the hurdle rate of 11%, ie a Neutral band of 1-21% potential return. Our target price
implies a potential return of 17%.
Retain N(V) rating on IVRCL with target price of INR85 (unchanged)
A sustained slowdown in the Andhra Pradesh order book has put significant pressure on IVRCL’s pace of
execution. While we have seen early signs of execution pick-up for IVRCL, management has consistently
underperformed its guidance and we look for more consistency. If IVRCL Assets (a road subsidiary) is
not able to raise funds in a timely manner, parent IVRCL will not be able to execute the large in-house
road sector orders as scheduled. This remains a key execution risk to our earnings estimates. We expect
IVRCL to report 19% earnings CAGR over FY11-13. Our estimates for IVRCL are c17- 22% lower than
consensus on FY12-13 earnings.
We continue to value IVRCL using sum-of-the parts. We value the construction business at 6x FY13e
earnings, and the company’s investments in both of its majority owned subsidiaries, IVRCL
Infrastructure Holdings (80%share) and Hindustan Dorr-Oliver (55% share), at current market prices less
a 20% holding company discount. Our 12-month target price of INR85 reflects our revised growth
outlook for IVRCL of FY11-13 CAGR of 18%, albeit on a lower FY11 base (weak earnings growth).
IVRCL’s construction business is trading at 6x FY12e earnings, and our target PE multiple of 6x suggests
that the valuation is unlikely to expand in any meaningful manner in a weak earnings outlook scenario.
Key risks: To the upside are the risks of better-than-estimated execution and timely fundraising by
IVRCL Assets. The primary downside risk is a sustained delay in execution.
Under our research model, for Indian stocks with a volatility indicator, the Neutral band is 10 percentage
above and below the hurdle rate of 11%, ie a Neutral band of 1-21% potential return. Our target price
implies a potential return of 16.8%.
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