The Hindu Business Line : Construction is a Cinderella story

CONSTRUCTION companies have never before enjoyed such strong investor fancy. Lifted suddenly out of years of low single-digit price earnings multiples (what the market is willing to pay for every rupee of earnings), stocks from the sector now figure prominently in the portfolios of domestic mutual funds and foreign institutional investors, and appear to hold promise from a two-to-three year perspective.

For instance, Hindustan Construction, Nagarjuna Construction, Madhucon Projects, Gammon India and IVRCL Infrastructure. A portfolio of one share in each of these of companies would have cost you Rs 196 in January 2003. This collection will now fetch you Rs 3,620. Even in the protracted bull market of the last two-and-half years, few sectors have offered such eye-popping returns.

The stock price of Larsen & Toubro — the big daddy in the industry — has increased four-fold since the cement business was sold to Grasim Industries. In itself, this is not unique, as sugar, fertiliser and chemicals stocks too recorded manifold gains in this period. But the difference is that these sectors enjoyed good times even in the past. In contrast, for construction, the bullish trend over the past two-and-half years is a watershed, as this is the first time the sector has enjoyed such sustained investor fancy.

What the re-rating means

The grant of industry status and expression of interest by foreign investors a couple of years ago seem to have triggered the re-rating of construction stocks. The entry of private equity investors such as ChrysCapital and Citicorp — when they bought into IVRCL Infrastructures — meant the sector had become an attractive investment destination.

Construction had traditionally been looked upon as a cash business marked by lack of transparency and small-time brick-and-mortar contractors. Industry players faced problems of sizeable doubtful debts, reluctance of banks to provide funds and non-fund based support such as guarantees, and other political links leading to lack of confidence among investors in the sector. Larsen & Toubro had for long remained the only prominent player that rose above these problems and enjoyed the goodwill of lenders and investors.

Now, companies such as Hindustan Construction, Gammon India, and Nagarjuna Construction have emerged as fit competitors in segments such as roads, irrigation and urban infrastructure. Investor acceptance has also begun to have a favourable impact on operations.

Companies in the sector have for long been hamstrung by low shareholder fund base; an expanded equity base is critical to bid for public projects. The past 18 months have seen most construction companies raise capital through various modes.

The expansion of the equity base has not only given these companies the financial strength to own construction equipment and provide a range of services; it has also, more importantly, encouraged banks and financial institutions to fund the sector.

It has also enabled companies to bid for large orders such as build-operate-transfer projects.

Higher earnings visibility

Does the expanded equity base create an equity lag in terms of reduced per share earnings and does it appear worthwhile to wait for earnings to catch up? It appears that it is worth the wait in the case of companies with a sound track record, such as Hindustan Construction and Larsen & Toubro. The comfortable order-book coupled with the imminent flow of orders from the government in the next two to three years appear to suggest that the sector has enough space for growth.

Most of the prominent players in the field have order-books to support robust revenue growth for the next three years.

With fiscal incentives for infrastructure projects cleared in 2005, profit margins will receive a further boost.

Are valuations sustainable?

Based on the current orders and order accretion expected in the next two years, an expected PEM of 9-14 in FY07 does not appear expensive for players with a track record.

Dramatic improvements in operating profit margins are unlikely despite the huge order-book positions. But the order-books and cost escalation clauses now built into most contracts may ensure that the margins improve gradually over time.

There is also a strong support cast. The current order backlogs and imminent order flows are likely to lead to a revenue growth of 20 per cent per annum over the next couple of years for such companies as Larsen & Toubro, Gammon India and Hindustan Construction. The following factors could keep the orders flowing:

Revenues and earnings from the ongoing highway projects do not come to a standstill with the completion of construction work. Once the infrastructure is in place the focus is likely to shift from construction to "corridor management", meaning managing the highways built. This further throws up ample opportunities in the form of improvement and road maintenance contracts.

Mounting infrastructure bottlenecks in roads, water supply, transport and sewerage in major cities has prompted the government to give a facelift to urban infrastructure projects through the "National Urban Renewal Mission" (see accompanying story).

The Bandra-Worli sea link project by Hindustan Construction and the Chennai seawater desalination project bagged by IVRCL Infrastructures on BOT basis prove that public-private partnerships are no longer considered unattractive.

Water and irrigation projects have become the key drivers for incremental order booking in the current year. Apart from a two-fold increase in the outlay for irrigation under the Accelerated Irrigation Benefit Programme, several States have been vying with the Centre in allocating funds for irrigation development.

These orders are reflected in the order-books of companies such as Nagarjuna Construction and IVRCL Infrastructures. For example water-related projects accounted for 69 per cent of the order books of IVRCL in terms of value.

Apart from funding through budget allocation and special purpose vehicles (likely to take off soon), several of the State-level projects are now being funded by multilateral agencies such as the Word Bank and the Asian Development Bank. Realisation of dues by contractors is no longer an area of concern in such projects.

The pre-Budget announcement of 100 per cent foreign direct investment in construction and realty is likely to facilitate increased investment flows. In the current situation it appears that the foreign players are experimenting the Indian market through joint ventures.

The local players benefit from the technical knowledge through such joint ventures and get a foothold to qualify independently for successive projects. If the order sizes increase from the current average of about Rs 200-400 crore to the Rs 800-1,000 crore range, foreign players may well turn out to be competitors to domestic companies over the longer term.

Sustaining profitability

With improvement in working capital situation, several mid-cap players have done well to utilise the funds to enhance their technical capability and carve for themselves a status as Engineering, Procurement and Construction (EPC) contractors. EPC status gives an edge over other players in securing bulk orders.

The same cannot be said of all the players in the industry. While the liquidity position has improved, the small players may still be hard pressed for funds to scale themselves to being integrated solution providers unless they find a way to expand their equity base.

Another notable factor is the diversification of order books in terms of geography and segment. IVRCL Infrastructures, which has been a dominant water solutions player, has made an aggressive expansion in the road sector. Nagarjuna Construction, a south-based company has spread its roots to northern and westerns regions of the country. In the overseas market industry major Larsen & Toubro has entered into several joint ventures to expand globally. Larsen & Toubro expects 30 per cent of its FY06 revenues from overseas market especially the Persian Gulf and oil rich nations.

The positive image acquired while executing projects in new regions and segments gives scope for more orders. Such diversification of revenue sources leads to mitigation of risks and provides a cushion to the earnings margin.

Risks and outlook

WHILE the huge order-books of most companies offer comfort, there is the risk that these orders may not translate into revenues. There have been instances of delays or cancellations of projects that led to a dent in margins.

Any glitches in execution may also reflect badly on a company, especially in public-private partnerships; this could have a negative bearing while bidding for future projects.

The risk is, however, less for companies with good track record and strong execution capabilities.

At present, a major chunk of orders for most companies are from the Central or State governments. Any change in the government's focus or deterioration in a State's financial position may affect investment flows.

Going forward, high technical and managerial capabilities, sound execution capabilities, diversification across segments to mitigate risk and forays into overseas markets in West Asia, Africa and parts of Asia may be the key drivers of growth, as funding has ceased to be a deterrent.

Companies such as Larsen & Toubro and Hindustan Construction have proved this. Gammon India, Madhucon Projects and Nagarjuna Construction are likely to benefit from the domestic market boom.

Investors can consider holding these stocks despite the sharp run-up in prices over the last six months.

The ability of other smaller players to thrive will depend on their capability to enter into joint ventures and acquire independent qualification. Diversification and de-risking shall become imperative for these companies to protect their margins.

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page