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Capital scarcity implies growth and valuation differentials to persist or even expand
Negatives galore, but that’s mostly in the price
Policy logjam, a slow corporate investment cycle, and rising interest rates
and commodity prices are the macro headwinds impacting the
infrastructure sector. Further, many companies have failed to exhibit
strategic prudence. Slippage in execution and aggressive bidding has
dented investor confidence. Accordingly, market is now pricing in
conservative growth and profitability outlook, in our assessment. On an
average, infrastructure (construction, utilities and developers) and capital
goods stocks are down 33% YTD vs a market return of -19%. We find mid
tier construction companies trading below visible net worth, with developer
businesses at or below NAV of existing assets. In terms of P/B, our
universe trades at 2.25x compared to 2.87x in March 2009 at the peak of
the financial crisis. Low expectations imply a good buying opportunity, as
we expect incremental positive moves on policy and interest rates to ease
from here.
Growth and valuation differentials between the best and the rest
could increase
We assume capital will be scarce and selective. We believe companies
with execution track records and strong balance sheets are best placed to
address future growth opportunities. Therefore, we believe the growth and
valuation differentials between “the best” and “the rest” will persist, and
could possibly expand. For the companies under our coverage, we assess
valuations along with balance sheet strength, current profitability, risk to
earnings, risk of value destruction and sector opportunities.
Our picks: L&T, Mundra, Power Grid, IRB, Crompton Greaves and
Ramky
Based on an evaluation on the above factors along with valuations, we
recommend LT, MSEZ, PWGR, IRB, CRG and RMKY as our top picks in
the sector. The key risk to our positive view, in the near term is
deterioration in the global macro environment resulting in higher risk
aversion. We see maximum risk for CRG and LT. However, given
fundamental strengths, we shall be buyers in any such fall.
Fundamentals have worsened...
Policy moves in infrastructure have been slower than expected. A comprehensive
approach that involves all sectors and ministries has failed to take root. Hurdles in
environmental clearances and land acquisitions have slowed investments in
infrastructure, impacting most sectors. For instance, lack of coal availability due to
environmental issues and transportation infrastructure bottlenecks, and state electricity
board (SEB) losses have taken the sheen out of the power generation segment.
Industrial capex has been muted since FY09, and analyst estimates suggest no material
pick up in the near term.
Apart from the policy logjam, the macroeconomic environment hasn't been supportive.
Increased risk aversion, and rising inflation and interest rates aren't positive for the
sector, which is capital intensive. Further, many of the companies in the space have
failed to showcase strategic prudence and execution has left much to be desired.
Bidding aggressively for projects and poor capital management haven't gone down well
with investors. Value destruction due to aggressive bidding and rising working capital are
also key concerns. For instance, in many of the national highway bids the winner's bid
have been significantly higher than NHAI's expectations and NPV loss on account of
higher bids is as much as 50-100% of the project cost. The average working capital days
for construction companies have increased by 22% over FY08-11 and in some cases
(such as for HCC and Simplex) the incremental receivable days in last two years is 50-
75% of company's net worth. For most, the balance sheets are stretched with net debt to
equity rising and RoE falling over FY09-11. On average, net debt/equity ratio has
increased by ~36% (ex capital goods companies), while ROE has come down by 1.7ppt
for the companies. The average cut in FY12 earnings this time around has been ~ 7%
higher than in FY09.
…and this is largely reflected in stock performance
For the stocks, that we have assessed in this report (this include E&C companies,
developers, power companies, capital goods companies) the equity raised in the last
five years account for ~ 10% of the current market cap. The ratio is clearly high for
midcap construction companies (~40%) and developers (~22%). On average stocks are
down 33% YTD compared to Sensex return of -19%. In terms of P/B, the universe trades
at 2.25x compared to 2.87x in Mar 2009 at the peak of the financial crisis. Only Thermax,
Cummins, L&T and IRB among our coverage universe have recorded an increase in P/B
ratio. P/B multiples have fallen from Mar 2009 levels for mid tier construction (ex L&T)
stocks (from 0.97x to 0.69x), utilities (from 2.46x to 1.82x), capital goods (from 5.99x to
3.75x) and developers (from 2.45x to 1.22x). The adverse fundamentals are reflected in
the stock price as mid tier construction companies are trading below visible net worth,
developer stocks are pricing in NAV of only existing assets.
We see value; expect growth differential between best and the rest to increase
Though we don't expect transformational changes, we do expect the policy environment
and interest rate outlook to turn incrementally positive. Given that most of the concerns
discussed above are reflected in the valuations, we assess risk reward as favourable.
We believe execution and balance sheet strength will be the key differentiator. We
assume that capital may remain scarce in the foreseeable future, unless there is
substantial improvement in risk appetite, which is unlikely in our assessment. Capital is
most likely to chase quality names. We note that India will compete with other emerging
markets for capital as EMs increase infrastructure spend to sustain growth (See our note
Takeaways from FICCI Infrastructure Summit, dated 27 Sept 2011).Therefore the growth
differential between the best and the rest would increase and therefore the valuation gap
can sustain or expand further. Our attempt here is to choose quality names at
reasonable valuations.
Our picks: L&T, PWGR, MSEZ, IRB, CRG and RMKY
We assess the companies on four key parameters:
a) Balance sheet strength and profitability of existing operations — We look at
EV/net debt and RoE to assess funding capacity to address growth. Capital
goods companies and select developers and E&C companies including LT,
MSEZ, IRB and RMKY score well.
b) Risk to earnings — Capital goods companies with short cycle projects are at
greater risk compared to construction companies, which have healthy order
books. We believe the risk to earnings from rising interest rate is largely
factored in.
c) Risk of value destruction — Risk primarily emanates from aggressive bidding,
policy changes and high/bad quality receivables.
d) Sector opportunities — We see greater visibility in roads and T&D. We like
companies with a diversified presence.
Based on an evaluation on these factors along with valuations, we recommend L&T,
Mundra, Power Grid, IRB, Crompton Greaves and Ramky and as our picks in the sector.
The key risk to our positive view is deterioration in global macro environment on potential
European Debt crisis, resulting in higher risk aversion. As witnessed during the financial
crisis in FY09, stocks can then potentially fall materially below the fair value levels, at
least in the short term.
We believe in case of global slowdown and high risk aversion, the maximum downside
risk is for CRG and LT in the near term, in our view. CRG has risk to earnings given its
exposure to Europe. For LT, we see risk from multiple contraction in case of order
slowdown and higher risk aversion. For MSEZ, risk to earnings is low in our assessment.
However, given the strong stock performance in the recent past and high valuation,
downside risk is high, in our view.
L&T
In our view, L&T is the standout leader among Indian E&C companies, with strong
technological capabilities and a solid record of execution. It is a market leader in the
Indian E&C industry by virtue of its track record and its ability to offer a wide array of
services. L&T has expertise in design, engineering and construction across various
industries, including oil & gas, petrochemicals, refineries, fertilizer, metals and power. It
is among the largest infrastructure developers in India and has a presence across all
segments —roads, ports, urban infrastructure, airport, water and sanitation and railways.
L&T is also a market leader in electrical and electronics systems in India. Although a
significant portion of the company’s orders are from India, it is also an active player in
overseas markets such as the Middle East and South Asia.
The stock has corrected by 16% over the last 14 trading days, in our view reflecting
concerns over order inflow and profitability. There has been some disappointment in
order inflows for L&T vs our and market expectations in recent weeks, primarily in the
NTPC bulk tender, which has raised concerns. The company recently entered into new
lines of business such as equipment, which is a low-margin business. Owing to a
number of factors (eg, rise in commodities price, new business having low profitability,
etc) its EBITDA margin fell y-y in 1QFY12 for the first time in nine years. This has raised
concerns over a fall in ROE over long term. The stock is currently trading at 14.7x oneyear
forward adjusted P/E (adjusted for subsidiaries), which is lower than 15-20x which
we believe is the fair value range. In our view, moderation in growth and profitability is
priced into the stock. Our 12-month target price is INR1,989, presenting an upside of
38% from current levels. We prefer LT over BHEL (BHEL IN, REDUCE).
IRB
IRB is one of the largest road developers in India, having 18 road BOT projects, of which
11 are operational. IRB was one of the earliest entrants in the BOT segment and owns
some of the very high density stretches in Western India. According to the company, it
owns concessions on ~11% of Golden Quadrilateral, which has among the highest traffic
density in the country. In most instances IRB has been prudent with its bids. The recent
bid for Ahemdabad Vadodara was an exception, where IRB is 62% higher to L2 (ie,
second in bidding list or runner up in bidding). We have factored -INR21/share for the
project into our estimates and this is already factored into the stock price, in our
assessment. We believe IRB has a strong balance sheet that it can use to add US$1bn
in projects annually. We expect ordering activity to remain robust in the road sector, and
expect IRB to capitalise on the opportunity. We believe the current assets and
construction order book is worth INR150/sh. The stock trades at 12% ahead of the NAV
of existing orders, thereby making risk-reward favourable, in our view. Our 12-month
target price is INR212, presenting an upside of 25% from current levels.
Crompton Greaves
Crompton is our top pick in the Capital goods space. Structural drivers in the form of a
huge domestic Transmission & Distribution (T&D) equipment opportunity remain intact
for India. CRG, with its leadership position as indicated by 34% market share in PGCIL’s
transformer orders over FY09-11 and lower costs reflected is double digit margin over
the same period is well placed to capitalize on revival in T&D capex. Following its
1QFY12 results, the expectations for its international business have declined
significantly. Therefore, the risk to earnings from a slowdown in the international market
is limited, in our assessment. The stock is down 51% YTD and is currently trading at 9.6x
FY12F EPS of INR16.06. We reckon these are attractive valuations given our
expectations of an earnings CAGR of ~ 14% and an ROE of 23% over FY11-14F. We
prefer CRG over Thermax and Cummins. As per our estimates, Cummins is trading at
FY12F/FY13F earnings P/E multiples of 17.3x/14.3x; Thermax is at 13.3x/11.1x, while
Crompton Greaves is at 12.7x/9.6x.
Mundra Ports and SEZ
MSEZ is a beneficiary of an increasing demand-supply mismatch in India's port capacity.
Attractive location and connectivity are the key advantages. MSEZ is quite comfortably
placed in terms of cash flows and net leverage. Over FY12-14F, we expect the company
to generate free cash flow of USD1.4bn and be net cash by FY13F. Adani group
ambitious plan across three key business verticals- power, coal and logistics and inter
linkage between the three is expected to drive future investments. The company is well
placed to capitalise on future opportunities. Our SOTP-based 12-month target price is
INR180, which includes INR155/sh for existing port assets. The stock is trading at
INR157, implying little value has been attributed to SEZ and new assets. This makes
risk-reward favorable, in our assessment. We note that 90% of MSEZ's estimated traffic
comprises coal, crude oil and container. We don't expect crude and coal to be impacted
on global slowdown. Container traffic is already down sharply, and we expect Mundra to
be a beneficiary of the limited capacity in India's west coast.
Ramky
Ramky Infra in our top pick midcap construction space. We believe Ramky is one of the
best mid-cap construction players in India, with revenue growth (20-25% vs 5-12%) and
ROE (18-19% vs 4-8%) exceeding our forecasts for peers for FY12-13F. Ramky has an
excellent execution track record, good projects in terms of returns, excellent working
capital management, a robust (4x order backlog ratio), diversified order book and a high
return ratio. This gives us comfort that the company will continue to grow revenue at 20-
25% maintaining its bottom margin even in this tough environment. Our 12-month target
price is INR450, presenting an upside of 112% from current levels.
Power Grid
Power Grid is a relatively hedged play on India’s pipeline for generation capacity addition.
A classic defensive company with high earnings visibility, we expect an FY11-17F EPS
CAGR of 15.5% on the back of ~ INR900bn in capex over FY12-17F and a higher,
sustainable level of capitalization over this period. Further, given the fuel security risk
and regulatory uncertainty for generation companies (including NTPC), PWGR is our top
pick in the power utilities space. The stock is currently trading at one-year forward P/E
and P/B of 12.9x and 1.8x, respectively; 15-20% lower than the last 2-year historical
averages. Our 12-month target price is INR120, represents potential upside of 24% from
current levels.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
Capital scarcity implies growth and valuation differentials to persist or even expand
Negatives galore, but that’s mostly in the price
Policy logjam, a slow corporate investment cycle, and rising interest rates
and commodity prices are the macro headwinds impacting the
infrastructure sector. Further, many companies have failed to exhibit
strategic prudence. Slippage in execution and aggressive bidding has
dented investor confidence. Accordingly, market is now pricing in
conservative growth and profitability outlook, in our assessment. On an
average, infrastructure (construction, utilities and developers) and capital
goods stocks are down 33% YTD vs a market return of -19%. We find mid
tier construction companies trading below visible net worth, with developer
businesses at or below NAV of existing assets. In terms of P/B, our
universe trades at 2.25x compared to 2.87x in March 2009 at the peak of
the financial crisis. Low expectations imply a good buying opportunity, as
we expect incremental positive moves on policy and interest rates to ease
from here.
Growth and valuation differentials between the best and the rest
could increase
We assume capital will be scarce and selective. We believe companies
with execution track records and strong balance sheets are best placed to
address future growth opportunities. Therefore, we believe the growth and
valuation differentials between “the best” and “the rest” will persist, and
could possibly expand. For the companies under our coverage, we assess
valuations along with balance sheet strength, current profitability, risk to
earnings, risk of value destruction and sector opportunities.
Our picks: L&T, Mundra, Power Grid, IRB, Crompton Greaves and
Ramky
Based on an evaluation on the above factors along with valuations, we
recommend LT, MSEZ, PWGR, IRB, CRG and RMKY as our top picks in
the sector. The key risk to our positive view, in the near term is
deterioration in the global macro environment resulting in higher risk
aversion. We see maximum risk for CRG and LT. However, given
fundamental strengths, we shall be buyers in any such fall.
Fundamentals have worsened...
Policy moves in infrastructure have been slower than expected. A comprehensive
approach that involves all sectors and ministries has failed to take root. Hurdles in
environmental clearances and land acquisitions have slowed investments in
infrastructure, impacting most sectors. For instance, lack of coal availability due to
environmental issues and transportation infrastructure bottlenecks, and state electricity
board (SEB) losses have taken the sheen out of the power generation segment.
Industrial capex has been muted since FY09, and analyst estimates suggest no material
pick up in the near term.
Apart from the policy logjam, the macroeconomic environment hasn't been supportive.
Increased risk aversion, and rising inflation and interest rates aren't positive for the
sector, which is capital intensive. Further, many of the companies in the space have
failed to showcase strategic prudence and execution has left much to be desired.
Bidding aggressively for projects and poor capital management haven't gone down well
with investors. Value destruction due to aggressive bidding and rising working capital are
also key concerns. For instance, in many of the national highway bids the winner's bid
have been significantly higher than NHAI's expectations and NPV loss on account of
higher bids is as much as 50-100% of the project cost. The average working capital days
for construction companies have increased by 22% over FY08-11 and in some cases
(such as for HCC and Simplex) the incremental receivable days in last two years is 50-
75% of company's net worth. For most, the balance sheets are stretched with net debt to
equity rising and RoE falling over FY09-11. On average, net debt/equity ratio has
increased by ~36% (ex capital goods companies), while ROE has come down by 1.7ppt
for the companies. The average cut in FY12 earnings this time around has been ~ 7%
higher than in FY09.
…and this is largely reflected in stock performance
For the stocks, that we have assessed in this report (this include E&C companies,
developers, power companies, capital goods companies) the equity raised in the last
five years account for ~ 10% of the current market cap. The ratio is clearly high for
midcap construction companies (~40%) and developers (~22%). On average stocks are
down 33% YTD compared to Sensex return of -19%. In terms of P/B, the universe trades
at 2.25x compared to 2.87x in Mar 2009 at the peak of the financial crisis. Only Thermax,
Cummins, L&T and IRB among our coverage universe have recorded an increase in P/B
ratio. P/B multiples have fallen from Mar 2009 levels for mid tier construction (ex L&T)
stocks (from 0.97x to 0.69x), utilities (from 2.46x to 1.82x), capital goods (from 5.99x to
3.75x) and developers (from 2.45x to 1.22x). The adverse fundamentals are reflected in
the stock price as mid tier construction companies are trading below visible net worth,
developer stocks are pricing in NAV of only existing assets.
We see value; expect growth differential between best and the rest to increase
Though we don't expect transformational changes, we do expect the policy environment
and interest rate outlook to turn incrementally positive. Given that most of the concerns
discussed above are reflected in the valuations, we assess risk reward as favourable.
We believe execution and balance sheet strength will be the key differentiator. We
assume that capital may remain scarce in the foreseeable future, unless there is
substantial improvement in risk appetite, which is unlikely in our assessment. Capital is
most likely to chase quality names. We note that India will compete with other emerging
markets for capital as EMs increase infrastructure spend to sustain growth (See our note
Takeaways from FICCI Infrastructure Summit, dated 27 Sept 2011).Therefore the growth
differential between the best and the rest would increase and therefore the valuation gap
can sustain or expand further. Our attempt here is to choose quality names at
reasonable valuations.
Our picks: L&T, PWGR, MSEZ, IRB, CRG and RMKY
We assess the companies on four key parameters:
a) Balance sheet strength and profitability of existing operations — We look at
EV/net debt and RoE to assess funding capacity to address growth. Capital
goods companies and select developers and E&C companies including LT,
MSEZ, IRB and RMKY score well.
b) Risk to earnings — Capital goods companies with short cycle projects are at
greater risk compared to construction companies, which have healthy order
books. We believe the risk to earnings from rising interest rate is largely
factored in.
c) Risk of value destruction — Risk primarily emanates from aggressive bidding,
policy changes and high/bad quality receivables.
d) Sector opportunities — We see greater visibility in roads and T&D. We like
companies with a diversified presence.
Based on an evaluation on these factors along with valuations, we recommend L&T,
Mundra, Power Grid, IRB, Crompton Greaves and Ramky and as our picks in the sector.
The key risk to our positive view is deterioration in global macro environment on potential
European Debt crisis, resulting in higher risk aversion. As witnessed during the financial
crisis in FY09, stocks can then potentially fall materially below the fair value levels, at
least in the short term.
We believe in case of global slowdown and high risk aversion, the maximum downside
risk is for CRG and LT in the near term, in our view. CRG has risk to earnings given its
exposure to Europe. For LT, we see risk from multiple contraction in case of order
slowdown and higher risk aversion. For MSEZ, risk to earnings is low in our assessment.
However, given the strong stock performance in the recent past and high valuation,
downside risk is high, in our view.
L&T
In our view, L&T is the standout leader among Indian E&C companies, with strong
technological capabilities and a solid record of execution. It is a market leader in the
Indian E&C industry by virtue of its track record and its ability to offer a wide array of
services. L&T has expertise in design, engineering and construction across various
industries, including oil & gas, petrochemicals, refineries, fertilizer, metals and power. It
is among the largest infrastructure developers in India and has a presence across all
segments —roads, ports, urban infrastructure, airport, water and sanitation and railways.
L&T is also a market leader in electrical and electronics systems in India. Although a
significant portion of the company’s orders are from India, it is also an active player in
overseas markets such as the Middle East and South Asia.
The stock has corrected by 16% over the last 14 trading days, in our view reflecting
concerns over order inflow and profitability. There has been some disappointment in
order inflows for L&T vs our and market expectations in recent weeks, primarily in the
NTPC bulk tender, which has raised concerns. The company recently entered into new
lines of business such as equipment, which is a low-margin business. Owing to a
number of factors (eg, rise in commodities price, new business having low profitability,
etc) its EBITDA margin fell y-y in 1QFY12 for the first time in nine years. This has raised
concerns over a fall in ROE over long term. The stock is currently trading at 14.7x oneyear
forward adjusted P/E (adjusted for subsidiaries), which is lower than 15-20x which
we believe is the fair value range. In our view, moderation in growth and profitability is
priced into the stock. Our 12-month target price is INR1,989, presenting an upside of
38% from current levels. We prefer LT over BHEL (BHEL IN, REDUCE).
IRB
IRB is one of the largest road developers in India, having 18 road BOT projects, of which
11 are operational. IRB was one of the earliest entrants in the BOT segment and owns
some of the very high density stretches in Western India. According to the company, it
owns concessions on ~11% of Golden Quadrilateral, which has among the highest traffic
density in the country. In most instances IRB has been prudent with its bids. The recent
bid for Ahemdabad Vadodara was an exception, where IRB is 62% higher to L2 (ie,
second in bidding list or runner up in bidding). We have factored -INR21/share for the
project into our estimates and this is already factored into the stock price, in our
assessment. We believe IRB has a strong balance sheet that it can use to add US$1bn
in projects annually. We expect ordering activity to remain robust in the road sector, and
expect IRB to capitalise on the opportunity. We believe the current assets and
construction order book is worth INR150/sh. The stock trades at 12% ahead of the NAV
of existing orders, thereby making risk-reward favourable, in our view. Our 12-month
target price is INR212, presenting an upside of 25% from current levels.
Crompton Greaves
Crompton is our top pick in the Capital goods space. Structural drivers in the form of a
huge domestic Transmission & Distribution (T&D) equipment opportunity remain intact
for India. CRG, with its leadership position as indicated by 34% market share in PGCIL’s
transformer orders over FY09-11 and lower costs reflected is double digit margin over
the same period is well placed to capitalize on revival in T&D capex. Following its
1QFY12 results, the expectations for its international business have declined
significantly. Therefore, the risk to earnings from a slowdown in the international market
is limited, in our assessment. The stock is down 51% YTD and is currently trading at 9.6x
FY12F EPS of INR16.06. We reckon these are attractive valuations given our
expectations of an earnings CAGR of ~ 14% and an ROE of 23% over FY11-14F. We
prefer CRG over Thermax and Cummins. As per our estimates, Cummins is trading at
FY12F/FY13F earnings P/E multiples of 17.3x/14.3x; Thermax is at 13.3x/11.1x, while
Crompton Greaves is at 12.7x/9.6x.
Mundra Ports and SEZ
MSEZ is a beneficiary of an increasing demand-supply mismatch in India's port capacity.
Attractive location and connectivity are the key advantages. MSEZ is quite comfortably
placed in terms of cash flows and net leverage. Over FY12-14F, we expect the company
to generate free cash flow of USD1.4bn and be net cash by FY13F. Adani group
ambitious plan across three key business verticals- power, coal and logistics and inter
linkage between the three is expected to drive future investments. The company is well
placed to capitalise on future opportunities. Our SOTP-based 12-month target price is
INR180, which includes INR155/sh for existing port assets. The stock is trading at
INR157, implying little value has been attributed to SEZ and new assets. This makes
risk-reward favorable, in our assessment. We note that 90% of MSEZ's estimated traffic
comprises coal, crude oil and container. We don't expect crude and coal to be impacted
on global slowdown. Container traffic is already down sharply, and we expect Mundra to
be a beneficiary of the limited capacity in India's west coast.
Ramky
Ramky Infra in our top pick midcap construction space. We believe Ramky is one of the
best mid-cap construction players in India, with revenue growth (20-25% vs 5-12%) and
ROE (18-19% vs 4-8%) exceeding our forecasts for peers for FY12-13F. Ramky has an
excellent execution track record, good projects in terms of returns, excellent working
capital management, a robust (4x order backlog ratio), diversified order book and a high
return ratio. This gives us comfort that the company will continue to grow revenue at 20-
25% maintaining its bottom margin even in this tough environment. Our 12-month target
price is INR450, presenting an upside of 112% from current levels.
Power Grid
Power Grid is a relatively hedged play on India’s pipeline for generation capacity addition.
A classic defensive company with high earnings visibility, we expect an FY11-17F EPS
CAGR of 15.5% on the back of ~ INR900bn in capex over FY12-17F and a higher,
sustainable level of capitalization over this period. Further, given the fuel security risk
and regulatory uncertainty for generation companies (including NTPC), PWGR is our top
pick in the power utilities space. The stock is currently trading at one-year forward P/E
and P/B of 12.9x and 1.8x, respectively; 15-20% lower than the last 2-year historical
averages. Our 12-month target price is INR120, represents potential upside of 24% from
current levels.
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