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Gravy Train Approaching?
Expectations of declining interest rates and receding Governmental
policy paralysis are raising hopes of an improved operating
environment for the Engineering & Construction (E&C) and
Infrastructure companies. Whilst we do expect a pick-up in GFCF
growth and a decline in repo rates in FY13, (which can lead to better
execution and higher profitability for companies in these sectors), we
believe that only a small subset of companies will be able to capitalize
this recovery. We highlight L&T, Voltas, Simplex and EIL as the key
filter-based ideas in the E&C sector. In the Infra sector, our filter-based
ideas are Adani Ports, IRB, ITNL and Sadbhav.
Recommendations E&C sector - L&T, Voltas, Simplex and EIL: In our
screens for the sector, these companies have always appeared as the ones
with not only better managed balance sheets and management quality but
also the ones with strong competitive advantages in their businesses. We
presently have BUY recommendations on EIL and Voltas.
Infrastructure developers – Adani Ports, IRB, ITNL and Sadbhav: IRB,
ITNL and Sadbhav are the leading players with strong competitive advantages
facing ample growth opportunities with limited equity needs. However, Adani
Ports is a developer with a unique asset with strong competitive advantages
and steady cash flows for funding future asset developments.
Conviction shorts/SELL: NCC, HCC, GVK and Gammon Infra.
Over the last 12-15 months, stock prices of most of the E&C and infrastructure
companies have sharply declined and their stocks are trading at significantly low
valuations. Whilst the stock prices of most of the E&C and Infra companies have
rallied in the last two months (more than 100% stock price movement for
companies like IVRCL, GVK etc. from their lowest levels in December 2011), these
stocks are still trading significantly below their 5-year historical average valuations.
We have compared the FY13 valuation multiples of the E&C companies and the
infrastructure companies with their respective 5-year historical average multiples
and ranked the companies with a higher deviation from the average as the more
attractive v/s those with a lower deviation.
For E&C companies, we compare FY13 P/E and P/B multiples with their 5-year
historical averages; for infrastructure companies we compare FY13 EV/EBITDA and
PB multiples with their 5-year historical averages.
In the E&C space, companies like Simplex, Gammon and IVRCL are trading
at a significant discount to their historical averages, hence, they appear
attractive compared to others like Era Infra and EIL. Amongst the Infrastructure
companies, GVK and GMR are trading at a significant discount to their
historical averages, hence, seem to be more attractive compared to peers.
The imminent “interest rate”
catalyst: Is it meaningful?
Our Economist, Ritika Mankar, believes that interest rates in India are set
to decline in the near term unless global external shocks such as rising
crude prices drive up inflation. Already, expectations of interest rate
declines have driven the stock prices of E&C firms and Infrastructure
developers, with the stock prices of the most leveraged companies rising
the most. However, a sustained rally in the stock prices of these companies
needs more than a small drop in interest rates.
Decline in interest rates can drive stock prices …
As highlighted in the chart below, stock price returns for E&C firms and
Infrastructure developers are inversely related to interest rates. Given that interest
rates have risen by ~350bps in the last 15-18 months, E&C firms and
Infrastructure developers are facing the heat of the rising cost of borrowing, which
is not only eating into present profits but also eroding project/equity IR`. Against
that background, and given the signals that the RBI has given regarding imminent
repo rate cuts, the rally in these companies’ share prices is understandable.
… but high leverage will inhibit this rally
However, we believe that a valuation uptick on account of a decline in interest
rates will face resistance as E&C companies find themselves capital starved and
have low PBT margins (kept low by high interest expenses). The positive impact of
declining interest rates on the long-term PBT margins for construction companies is
more a factor of debt:equity and absolute debt rather than interest rates. Exhibit
40 shows that despite declining interest rates in FY2010 (relative to FY2009), PBT
margins barely inched up, as debt:equity was high at end-FY2009. The present
high debt and high debt:equity for most of the companies will restrict their longterm
growth and hence multiples (as most companies find themselves short of cash
to infuse either in their core construction business or their BOT assets).
Infra developers need more structural changes/improvements
Procedural/policy improvement: Resource (coal/fuel/land) availability
delays/problems, environmental clearance problems and lengthy approval
procedures have resulted in long execution cycles for infrastructure projects,
especially in the power and the roads sectors. Over 65% of the NHAI’s projects
have been impacted by time and cost overruns. Nearly, 20gW (40% of underconstruction)
of the present power projects under development are facing issues
regarding resource (fuel linkages), clearances and offtake risks by near-bankrupt
State Electricity Boards.
Development of a long-term bond market for reducing dependence on
banks: Creation of a long-term bond market can increase the availability of funds
for the sector and reduce the dependence on banks. Given that infrastructure
projects have long gestation periods of 25-30 years, the average debt tenure for
the infrastructure sector should be ~15-20 years. However, Indian banks are
reluctant to lend for such a long duration, thereby reducing the average loan
tenure to 10-12 years. This then leads to the developers having to make
aggressive repayment assumptions. Moreover, the recent heightened risk
perception regarding Infrastructure projects could lead to structurally higher
lending rates for the Infra and E&C companies, thus impacting the return potential
of most of the infra assets.
Availability of equity capital: Our primary data checks have highlighted that
more than the rising interest rates, the lack of availability of equity capital has
resulted in execution slippages for infrastructure assets. Given the lack of sufficient
cash flows from operations, asset developers have continued to depend on equity
markets for funds. Indian Infra developers have been finding it difficult to get
capital for their projects. Any improvement in the Government’s policies related to
infrastructure can positively impact the availability of equity capital for
Infrastructure developers.
Weeding for
accounting and management quality
We check our top six investment ideas in each sector (based on the earlier
discussed primary filters) on our accounting and management quality screens,
which we believe are the utmost importance parameters. We exclude the
companies such as GMR and Punj from our list of top investment ideas, as they
appear poor on our accounting and management quality screens.
In the E&C sector, we find EIL, Voltas, L&T and Simplex to be the strongest
companies and in the infrastructure sector, we find Adani Ports, IRB, ITNL
and Sadbhav to be the strongest players.
Filter I: Accounting quality
Indian E&C and infrastructure companies are blamed for using contentious
accounting policies which raise questions about the extent to which the reported
financials of these companies are a reflection of the companies’ actual operating
performance. In our January 20, 2012 Forensic Accounting Thematic, Bhargav
Buddhadev had highlighted that whilst the infrastructure sector has average
accounting quality, the construction sector ranks as one of the worst.
Given the above background, we performed accounting quality checks for both the
E&C companies and the Infrastructure developers. We use various accounting
ratios to evaluate these companies’ revenue recognition and cash/expense
mismanagement practices. We have analyzed the consolidated data for these
companies for the last four years (FY08-FY11) as the consolidated financial
analysis provides a true picture of the overall accounting quality including
performance of the BOT and real estate subsidiaries for most of the companies
Based on our analysis we find that in the E&C space, whilst EIL and Blue Star
are the best companies when it comes to overall accounting policies, Ramky
and HCC appear to be the worst placed companies. Whilst EIL and Voltas
stand out on revenue recognition checks, Blue Star and NCC stand out on expense
manipulation and cash pilferage checks.
Exhibit 22: Ranking of E&C companies on our accounting metrics
Company/Metric Ranking on revenue
recognition checks
Ranking on expense manipulation
and cash pilferage checks Final ranking
EIL 1 3 1
Blue Star 4 1 2
NCC 5 1 3
Voltas 2 5 4
L&T 3 7 5
IVRCL 6 4 5
Simplex 9 5 7
Era Infra 8 8 8
Gammon 6 12 9
Punj Lloyd 10 8 9
Ramky 10 10 11
HCC 12 11 12
Source: Ambit Capital research, Company, Notes: (a) We have taken consolidated data for our analysis (b) Growth in audit fees to growth in revenues
is on standalone basis (c) Rank 1 being the best and Rank 12 being the worst. Data is sorted on final ranking.
Filter-based recommendations
Exhibit 30: The four best placed E&C companies based on the above filters
E&C companies Mcap
(US$ mn)
Rev. FY11
(US$ mn)
FY13 P/B
(x)
FY13P/E
(x) Comments
L&T 16,235 10,468 1.9 11.6
L&T is the market leader in the Indian construction
industry having excellent execution capabilities, strong
operational performance and strong balance sheet. In the
current uncertain macro environment, any improvements
in order flow growth can be a near-term catalyst to drive
stock price. In the long term the key drivers for growth
are strong execution momentum and impact on the cash
generation and balance sheet from new investments (in
BOT assets and new businesses).
EIL 1,850 578 4.0 12.3
EIL, with its strong balance sheet (no leverage), cash flow
generation profile, large talent pool and Government
relationships is strongly placed to bid competitively for
contracts awarded on lowest-cost basis in the
hydrocarbon sector. Whilst the near-term order inflow
concerns and the expected low growth will weigh upon
any material rerating in the near term, 5 to 10 year
opportunity will be driven by the 5%-7% CAGR in
petroleum products demand and 10%-11% CAGR in
petchem demand.
Voltas 785 1,051 2.1 12.6
Voltas is an excellent project management company in
the E&C space, which has a history of high RoCEs and
superior cash generation profile. Despite expected nearterm
weakness in the operational performance, rerating
in the stock is highly likely given pick-up in the EMP
segment order flow, stable-to-strong UCP segment
operating performance and stabilization in working
capital/capital employed invested after witnessing 3-4
quarters of deterioration
Simplex 231 990 0.9 8.4
We highlight Simplex as one of the strong mid-sized
construction companies with focus on fast moving
industrial/building contracts, strong cost structure v/s
peers and limited equity needs for BOT projects. Whilst
high debt:equity (1.6x at end of Dec-11) and exposure to
the MENA region raises concern in the near term, strong
pick-up in the order flow momentum in the buildings and
factories segment can drive the stock price.
Source: Ambit Capital research, Company, Bloomberg, Note (a) Mcap, P/E and P/E data is as on March 2, 2012, data is sorted by mcap (b)P/E and
P/E is excluding the embedded values.
The four best placed Infrastructure developers based on the above filters
Infrastructure
developers
Mcap
(US$ mn)
Revenues
FY11
(US$ mn)
FY13
P/B (x)
EV/EBITDA
FY13(x) Comments
Adani Ports 5,963 406 4.6 11.2
Primarily, a single port asset developer, Adani Ports over the last
3-4 years has emerged as the largest Indian port developer with
focus on primarily bulk cargo and asset dominance in the
Western coastline, which is witnessing continues growth. Unlike
other developers which are continuously short of equity because
of large number of smaller assets under development, Adani
Ports primary asset (Mundra Ports and SEZ) is a growing cash
generating asset, which will not only provide cash for reinvestment
in Mundra but also for equity investments in new
assets. The near-term growth may be a concern given the global
trade conditions, but the competitive advantages of its primary
asset will make it one of the key beneficiaries of India’s rising
share in the global trade.
IRB 1,265 492 1.8 6.5
IRB is one of the largest road developers in India with 16 road
projects of which 10 projects are operational. All the operational
projects are on the attractive routes which are witnessing high
traffic growth. Strong revenues and margin growth in the EPC
business (from own BOT road projects) and increasing traffic
volumes on the current operational projects are the key growth
drivers. However, there are concerns regarding the aggressive
bidding for the recently won Ahmedabad-Vadodara road
project.
ITNL 746 789 1.2 6.3
ITNL is the only management-driven company in the road BOT
space, has diversified geographical presence and balanced
revenue mix with about 48% of revenue contribution of about
`6.7bn from annuity projects, offering high visibility and stability
to earnings. Strong in-house project management team,
financial support from parent for funding BOT projects and
strong cost structure place ITNL ahead of the other road
developers.
Sadbhav 409 474 1.6 7.0
Sadbhav is a strong and sensible developer company with
superior cash flow generation profile, no immediate equity
dilution risks and a strong balance sheet for capturing growth
when the Indian infrastructure and construction sector recovers.
Consolidated returns (RoEs) are expected to improve with the
rising cash flow generation and profitability of the BOT assets,
which commenced operations over the last 12-18 months.
Source: Ambit Capital research, Company, Bloomberg, Note:) Mcap, EV/EBITDA and P/B data is as on March 2, 2012, data is sorted by mcap
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
Gravy Train Approaching?
Expectations of declining interest rates and receding Governmental
policy paralysis are raising hopes of an improved operating
environment for the Engineering & Construction (E&C) and
Infrastructure companies. Whilst we do expect a pick-up in GFCF
growth and a decline in repo rates in FY13, (which can lead to better
execution and higher profitability for companies in these sectors), we
believe that only a small subset of companies will be able to capitalize
this recovery. We highlight L&T, Voltas, Simplex and EIL as the key
filter-based ideas in the E&C sector. In the Infra sector, our filter-based
ideas are Adani Ports, IRB, ITNL and Sadbhav.
Recommendations E&C sector - L&T, Voltas, Simplex and EIL: In our
screens for the sector, these companies have always appeared as the ones
with not only better managed balance sheets and management quality but
also the ones with strong competitive advantages in their businesses. We
presently have BUY recommendations on EIL and Voltas.
Infrastructure developers – Adani Ports, IRB, ITNL and Sadbhav: IRB,
ITNL and Sadbhav are the leading players with strong competitive advantages
facing ample growth opportunities with limited equity needs. However, Adani
Ports is a developer with a unique asset with strong competitive advantages
and steady cash flows for funding future asset developments.
Conviction shorts/SELL: NCC, HCC, GVK and Gammon Infra.
Over the last 12-15 months, stock prices of most of the E&C and infrastructure
companies have sharply declined and their stocks are trading at significantly low
valuations. Whilst the stock prices of most of the E&C and Infra companies have
rallied in the last two months (more than 100% stock price movement for
companies like IVRCL, GVK etc. from their lowest levels in December 2011), these
stocks are still trading significantly below their 5-year historical average valuations.
We have compared the FY13 valuation multiples of the E&C companies and the
infrastructure companies with their respective 5-year historical average multiples
and ranked the companies with a higher deviation from the average as the more
attractive v/s those with a lower deviation.
For E&C companies, we compare FY13 P/E and P/B multiples with their 5-year
historical averages; for infrastructure companies we compare FY13 EV/EBITDA and
PB multiples with their 5-year historical averages.
In the E&C space, companies like Simplex, Gammon and IVRCL are trading
at a significant discount to their historical averages, hence, they appear
attractive compared to others like Era Infra and EIL. Amongst the Infrastructure
companies, GVK and GMR are trading at a significant discount to their
historical averages, hence, seem to be more attractive compared to peers.
The imminent “interest rate”
catalyst: Is it meaningful?
Our Economist, Ritika Mankar, believes that interest rates in India are set
to decline in the near term unless global external shocks such as rising
crude prices drive up inflation. Already, expectations of interest rate
declines have driven the stock prices of E&C firms and Infrastructure
developers, with the stock prices of the most leveraged companies rising
the most. However, a sustained rally in the stock prices of these companies
needs more than a small drop in interest rates.
Decline in interest rates can drive stock prices …
As highlighted in the chart below, stock price returns for E&C firms and
Infrastructure developers are inversely related to interest rates. Given that interest
rates have risen by ~350bps in the last 15-18 months, E&C firms and
Infrastructure developers are facing the heat of the rising cost of borrowing, which
is not only eating into present profits but also eroding project/equity IR`. Against
that background, and given the signals that the RBI has given regarding imminent
repo rate cuts, the rally in these companies’ share prices is understandable.
… but high leverage will inhibit this rally
However, we believe that a valuation uptick on account of a decline in interest
rates will face resistance as E&C companies find themselves capital starved and
have low PBT margins (kept low by high interest expenses). The positive impact of
declining interest rates on the long-term PBT margins for construction companies is
more a factor of debt:equity and absolute debt rather than interest rates. Exhibit
40 shows that despite declining interest rates in FY2010 (relative to FY2009), PBT
margins barely inched up, as debt:equity was high at end-FY2009. The present
high debt and high debt:equity for most of the companies will restrict their longterm
growth and hence multiples (as most companies find themselves short of cash
to infuse either in their core construction business or their BOT assets).
Infra developers need more structural changes/improvements
Procedural/policy improvement: Resource (coal/fuel/land) availability
delays/problems, environmental clearance problems and lengthy approval
procedures have resulted in long execution cycles for infrastructure projects,
especially in the power and the roads sectors. Over 65% of the NHAI’s projects
have been impacted by time and cost overruns. Nearly, 20gW (40% of underconstruction)
of the present power projects under development are facing issues
regarding resource (fuel linkages), clearances and offtake risks by near-bankrupt
State Electricity Boards.
Development of a long-term bond market for reducing dependence on
banks: Creation of a long-term bond market can increase the availability of funds
for the sector and reduce the dependence on banks. Given that infrastructure
projects have long gestation periods of 25-30 years, the average debt tenure for
the infrastructure sector should be ~15-20 years. However, Indian banks are
reluctant to lend for such a long duration, thereby reducing the average loan
tenure to 10-12 years. This then leads to the developers having to make
aggressive repayment assumptions. Moreover, the recent heightened risk
perception regarding Infrastructure projects could lead to structurally higher
lending rates for the Infra and E&C companies, thus impacting the return potential
of most of the infra assets.
Availability of equity capital: Our primary data checks have highlighted that
more than the rising interest rates, the lack of availability of equity capital has
resulted in execution slippages for infrastructure assets. Given the lack of sufficient
cash flows from operations, asset developers have continued to depend on equity
markets for funds. Indian Infra developers have been finding it difficult to get
capital for their projects. Any improvement in the Government’s policies related to
infrastructure can positively impact the availability of equity capital for
Infrastructure developers.
Weeding for
accounting and management quality
We check our top six investment ideas in each sector (based on the earlier
discussed primary filters) on our accounting and management quality screens,
which we believe are the utmost importance parameters. We exclude the
companies such as GMR and Punj from our list of top investment ideas, as they
appear poor on our accounting and management quality screens.
In the E&C sector, we find EIL, Voltas, L&T and Simplex to be the strongest
companies and in the infrastructure sector, we find Adani Ports, IRB, ITNL
and Sadbhav to be the strongest players.
Filter I: Accounting quality
Indian E&C and infrastructure companies are blamed for using contentious
accounting policies which raise questions about the extent to which the reported
financials of these companies are a reflection of the companies’ actual operating
performance. In our January 20, 2012 Forensic Accounting Thematic, Bhargav
Buddhadev had highlighted that whilst the infrastructure sector has average
accounting quality, the construction sector ranks as one of the worst.
Given the above background, we performed accounting quality checks for both the
E&C companies and the Infrastructure developers. We use various accounting
ratios to evaluate these companies’ revenue recognition and cash/expense
mismanagement practices. We have analyzed the consolidated data for these
companies for the last four years (FY08-FY11) as the consolidated financial
analysis provides a true picture of the overall accounting quality including
performance of the BOT and real estate subsidiaries for most of the companies
Based on our analysis we find that in the E&C space, whilst EIL and Blue Star
are the best companies when it comes to overall accounting policies, Ramky
and HCC appear to be the worst placed companies. Whilst EIL and Voltas
stand out on revenue recognition checks, Blue Star and NCC stand out on expense
manipulation and cash pilferage checks.
Exhibit 22: Ranking of E&C companies on our accounting metrics
Company/Metric Ranking on revenue
recognition checks
Ranking on expense manipulation
and cash pilferage checks Final ranking
EIL 1 3 1
Blue Star 4 1 2
NCC 5 1 3
Voltas 2 5 4
L&T 3 7 5
IVRCL 6 4 5
Simplex 9 5 7
Era Infra 8 8 8
Gammon 6 12 9
Punj Lloyd 10 8 9
Ramky 10 10 11
HCC 12 11 12
Source: Ambit Capital research, Company, Notes: (a) We have taken consolidated data for our analysis (b) Growth in audit fees to growth in revenues
is on standalone basis (c) Rank 1 being the best and Rank 12 being the worst. Data is sorted on final ranking.
Filter-based recommendations
Exhibit 30: The four best placed E&C companies based on the above filters
E&C companies Mcap
(US$ mn)
Rev. FY11
(US$ mn)
FY13 P/B
(x)
FY13P/E
(x) Comments
L&T 16,235 10,468 1.9 11.6
L&T is the market leader in the Indian construction
industry having excellent execution capabilities, strong
operational performance and strong balance sheet. In the
current uncertain macro environment, any improvements
in order flow growth can be a near-term catalyst to drive
stock price. In the long term the key drivers for growth
are strong execution momentum and impact on the cash
generation and balance sheet from new investments (in
BOT assets and new businesses).
EIL 1,850 578 4.0 12.3
EIL, with its strong balance sheet (no leverage), cash flow
generation profile, large talent pool and Government
relationships is strongly placed to bid competitively for
contracts awarded on lowest-cost basis in the
hydrocarbon sector. Whilst the near-term order inflow
concerns and the expected low growth will weigh upon
any material rerating in the near term, 5 to 10 year
opportunity will be driven by the 5%-7% CAGR in
petroleum products demand and 10%-11% CAGR in
petchem demand.
Voltas 785 1,051 2.1 12.6
Voltas is an excellent project management company in
the E&C space, which has a history of high RoCEs and
superior cash generation profile. Despite expected nearterm
weakness in the operational performance, rerating
in the stock is highly likely given pick-up in the EMP
segment order flow, stable-to-strong UCP segment
operating performance and stabilization in working
capital/capital employed invested after witnessing 3-4
quarters of deterioration
Simplex 231 990 0.9 8.4
We highlight Simplex as one of the strong mid-sized
construction companies with focus on fast moving
industrial/building contracts, strong cost structure v/s
peers and limited equity needs for BOT projects. Whilst
high debt:equity (1.6x at end of Dec-11) and exposure to
the MENA region raises concern in the near term, strong
pick-up in the order flow momentum in the buildings and
factories segment can drive the stock price.
Source: Ambit Capital research, Company, Bloomberg, Note (a) Mcap, P/E and P/E data is as on March 2, 2012, data is sorted by mcap (b)P/E and
P/E is excluding the embedded values.
The four best placed Infrastructure developers based on the above filters
Infrastructure
developers
Mcap
(US$ mn)
Revenues
FY11
(US$ mn)
FY13
P/B (x)
EV/EBITDA
FY13(x) Comments
Adani Ports 5,963 406 4.6 11.2
Primarily, a single port asset developer, Adani Ports over the last
3-4 years has emerged as the largest Indian port developer with
focus on primarily bulk cargo and asset dominance in the
Western coastline, which is witnessing continues growth. Unlike
other developers which are continuously short of equity because
of large number of smaller assets under development, Adani
Ports primary asset (Mundra Ports and SEZ) is a growing cash
generating asset, which will not only provide cash for reinvestment
in Mundra but also for equity investments in new
assets. The near-term growth may be a concern given the global
trade conditions, but the competitive advantages of its primary
asset will make it one of the key beneficiaries of India’s rising
share in the global trade.
IRB 1,265 492 1.8 6.5
IRB is one of the largest road developers in India with 16 road
projects of which 10 projects are operational. All the operational
projects are on the attractive routes which are witnessing high
traffic growth. Strong revenues and margin growth in the EPC
business (from own BOT road projects) and increasing traffic
volumes on the current operational projects are the key growth
drivers. However, there are concerns regarding the aggressive
bidding for the recently won Ahmedabad-Vadodara road
project.
ITNL 746 789 1.2 6.3
ITNL is the only management-driven company in the road BOT
space, has diversified geographical presence and balanced
revenue mix with about 48% of revenue contribution of about
`6.7bn from annuity projects, offering high visibility and stability
to earnings. Strong in-house project management team,
financial support from parent for funding BOT projects and
strong cost structure place ITNL ahead of the other road
developers.
Sadbhav 409 474 1.6 7.0
Sadbhav is a strong and sensible developer company with
superior cash flow generation profile, no immediate equity
dilution risks and a strong balance sheet for capturing growth
when the Indian infrastructure and construction sector recovers.
Consolidated returns (RoEs) are expected to improve with the
rising cash flow generation and profitability of the BOT assets,
which commenced operations over the last 12-18 months.
Source: Ambit Capital research, Company, Bloomberg, Note:) Mcap, EV/EBITDA and P/B data is as on March 2, 2012, data is sorted by mcap
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