The Hindu Business Line : ‘Power, railway expansion, airports to drive capex spending’

We have hardly scratched the surface in terms of railway capex or even the port capex. —SRIVIDHYA RAJESH, FUND MANAGER-EQUITY, SUNDARAM BNP PARIBAS MUTUAL FUND

SRIVIDHYA RAJESH, FUND MANAGER-EQUITY, SUNDARAM BNP PARIBAS MUTUAL FUND

Vidya Bala
Aarati Krishnan

Infrastructure stocks have seen a focused re-rating over the past couple of years, leading the stock market rally from the front. These are also the top sector exposures for many equity funds. Should investors now be wary of this sector after the dream run? Not really, feels Srividhya Rajesh, who manages Sundaram Capex Opportunities Fund — a top performer that is keenly focused on companies benefiting from the rising capex spends. She, in fact, makes a strong case for why investors should remain bullish on this theme despite concerns about a slowdown and rising interest rates.

Excerpts from the interview:

There are some concerns on the capex (capital expansion) cycle. Is it slowing down?

We don’t see the capex cycle swinging down at this point in time. It is not as if we have reached the peak of the cycle or are even half way through the cycle. Look at any industry where the capex is happening — steel capex has hardly started. Many of the greenfield projects have just been lined up and none of them are able to proceed further because of land acquisition problems.

It has become a necessity to find oil and because the exploration costs are so low when compared to current oil prices that it makes sense to continue to invest (in capex). Even the petrochemical cycle has got elongated, and there are no refineries coming up except for Reliance’s petroleum refinery.

Even infrastructure capex has hardly kick-started. Expansion in roads has happened to some extent. Capex in power is happening in terms of adding capacities. We have this 1,00,000 MW to be added out of which hardly 30-35 per cent has been added. We have hardly scratched the surface in terms of railway capex or even the port capex. Port privatisation has started. But the capacity we need is much more than what is available, as can be seen from all of them operating at more than 100 per cent capacity utilisation. SEZ is another segment which is waiting to see capex investments.

It is only the macro concerns such as the interest rates and subprime market-related concerns that are causing a temporary slowdown. Of course, land related issues have to be sorted out.

Are infrastructure and capital goods stocks too expensive? These stocks have seen a focused re-rating over the past two years?

Yes… They have become more expensive relative to the market. If you look at an ABB or a Larsen & Toubro, they are trading at about 20 times forward (FY 09) earnings, on a consolidated basis. Whereas, on forward numbers, the market is probably trading at about 14-15 times (Rs 1,000 being the earnings consensus for Sensex) FY 09 numbers. To that extent, the premium still remains.

But clearly the growth visibility is much higher for these infrastructure companies. The important thing in these companies is that there have been continuous earnings revisions in the last three years. These earnings upgrades will continue to happen as long as the macro picture remains intact. In that sense, the valuations may not seem as expensive a few quarters down the line as there are now. The cycle is in their favour and the valuations appear justified. Any corrections will provide attractive entry points.

A good proportion of the investments in capex are happening in the commodity sector. What will be the picture if the commodity cycle reverses?

If you look at India’s capacity, say in steel, it is about 40 million tonnes (mt). Globally, the capacity is over 1,000 mt, with China having some 450 mt. So, we have one-tenth of China’s production.

India’s per capita consumption is low and our steel demand is growing at 9-10 per cent. So, if we do not invest now, there may be a shortage of steel two-three years down the line. The steel intensity of the economy has also been low in the past. Even the construction sector is more cement-intensive than steel intensive.

As there is a crunch in terms of time needed to complete construction, the way ahead may be to go for more steel-related structures because prefab can be done much faster. That is how global constructions cycles have come down. So steel demand will continue to grow and we are under-invested. We have iron ore, but we have really not explored the possibility of expanding our steel capacity.

Globally, we expect the commodity cycle to lengthen going forward. We have West Asia, which is a strong driver of growth that arises from their oil surpluses. Russia has not invested for many decades either in pipeline-related network or even overall infrastructure. They have also benefited from the oil and gas prices moving up. China is anyway consuming for their hinterland development. We also see replacement capex coming up in the US as it has not invested for many decades.

I think the strength in natural resources will continue and the cycle itself will get extended. And we are not over invested and are not carrying inventories. In fact, many of the brokerages have upgraded their commodity price forecasts by 7-8 per cent. It is not a big delta change, but in metals every one per cent increase, translates in a much bigger impact on the bottom line.

What are the domestic segments that are likely to benefit from capex spending?

Roads and power are the segments, which kick-started the growth. But there has been a slow down in roads, as stretches of roads that were being allocated were increased and initially some of the rules of bidding changed. Then there was some slowdown due to interest rates moving up.

But clearly this time around it is going to be power, which will be a big growth driver. Of course, the Ultra Mega Power Plants (UMPPs) have land acquisition problems as a result of which only four of the eight projects will take off immediately.

Second, will be railway capex as railways have been generating surplus. The dedicated freight corridor is expected to be ready by 2012. On the metro side also there will be many cities planning for the metro rail. So, power and railways will be the big drivers.

Similarly, more airport privatisations are expected (currently, greater Noida and Navi Mumbai), as the tendering for a few will start in a couple of months.

There will also be specific segments such as cold chain infrastructure that will benefit once retailing kicks off. Reliance has already spent Rs 600 crore in retailing with more to come. They have to set up cold chain infrastructure.

Similarly, container movement and other logistics businesses will benefit. Although there is not much news on ports, there will be some modernisation and privatisation. In the west coast, privatisation is more or less happening. East coast will also see some privatisation. Dredging is another activity that will continuously happen in all ports.

On the corporate capex side, there are greenfield projects in sectors such as cement, metals and petrochemicals. In the oil and gas space, ONGC has a big capex plan. Once the gas finds come up a lot of sub sectors such as pipeline, terminals, regasification, pumping stations and compressors will gain traction. Gas-related distribution capex such as the domestic network — city gas (by GAIL and Reliance) will accelerate growth of ancillary businesses.

In real estate, the top 20 companies are talking about developing 2,000 million sq ft in the next 10 years. So, construction is another area that will do well, provided one does not take the risk of development. That is a different business altogether.

There is more assured business in construction. Given the number of projects, there is a dearth of construction companies. Purely, construction-oriented companies will do well. Meanwhile, road construction is well on its way. Irrigation is another area, which will do well as we near assembly and general elections, Governments have to show some progress.

How do you view the outsourcing opportunities (in the engineering space) for companies in India?

There are only a few large-cap companies in this space. Companies such as L&T, Punj Lloyd or Voltas have the experience of working outside India and derive revenue from exports. Although they talk about taking their exports to 20 per cent of their total revenues, they are still mostly focused in India.

India, being under invested will be a much longer-term infrastructure story than other countries globally.

While, it gives them a good diversification and also helps gain pre-qualification, we are not banking too much on that although it provides some cushion in terms of any slow down or in terms of better margins.

Having talked about this, defence offset policy related business may be a good outsourcing opportunity. India is probably one of the biggest buyers of commercial airplanes and one of the biggest defence spenders. Because of the 30 per cent offset clause foreign defence suppliers will be forced to outsource from India.

Getting approvals and qualification in this business is difficult. So vendors who are already certified and work with foreign companies stand to gain. Both defence and aerospace related companies such as L&T and other smaller companies will benefit.

Do you see a widening gap between mid-sized and larger companies within this sector because of execution capabilities?

There is no such thing as capacity additions here except for fabrication capacity, which too can be in-house only to a certain extent. So, there is a lot of subcontracting for which one needs to have a good vendor base. Of course, to improve margins and mix, and to be able to do bigger projects independently, companies may have to scale up.

Only some companies would make that transition. For such companies, the bargaining power improves as they execute a wider range of projects. To that extent there will be a case of widening gap. Earlier there were not so many projects thus forcing companies to compete with each other. Now with so many projects across the globe, there is not much competitive pressure.

Given the size of opportunity, the number of players are limited. Take power equipment manufacturing, there is only a BHEL or a smaller-sized Thermax and a few unlisted companies. In rigs for instance, Aban is the only player with a sizeable scale. In every space, there is a clear leader who is well entrenched.

Are high relative valuations for Indian markets a concern?

Yes, but India has always had higher return on equities and higher growth rates. Further, the basket of companies available here gives diversification that is not there elsewhere. Most of them are say commodity or real estate focused.

India is now at 14 times (valuation) FY2009. We will clearly grow above 15-20 per cent. Most of the growth has been back ended and is being upgraded. And then there are these embedded values. For instance, Reliance has its retail business and E&P, which is not captured.

You have a large number of stocks in your fund’s portfolio. Do you think a concentrated approach would have helped your fund outperform the BSE Capital Goods index?

We are not defined as a sector fund. Further, in BSE Capital goods five stocks account for 80 per cent of the index. We thought it would not be prudent to replicate that kind of index although it is our benchmark. Only L&T and BHEL have given most of the returns. The re-rating that has happened in L&T has been a surprise to us. Being the largest beneficiary of any capex spending in India and being a highly-liquid stock, it has benefited the most.

We have gone up to the limit of 10 per cent and to some extent not trimmed any appreciation. But we did not find it appropriate to hold 35 per cent in L&T. We have also kept the option of going up to 30 per cent in non-capex stories if the situation warrants or maybe few years down the line if the theme itself becomes less compelling.

You seem to have a couple of telecom stocks in the portfolio. How do they fit into the theme?

Yes, we have Bharti Airtel, Reliance Communications and Reliance Industries. But again Reliance is a large stock, which we are positive on and also have across-the-board exposure. We are finding that other infrastructure funds were also more diversified with huge exposure to Reliance. So if we are to be compared to them, to some extent we have to own Reliance. But we have stayed from other large caps such as ONGC; we have never owned banks, expect IDFC for brief periods. We have not bought into any of the other diversified stories until now. To that extent it is a more focused fund.

Other infrastructure funds also have probably 35-40 per cent towards capex benefiting stocks and rest in normal diversified stocks. This is what differentiates us from them. Also when we launched the fund, we planned to target the beneficiaries of the capex cycle rather than companies actually doing the capex. Because the former stand to gain more and faster without having to spend so much thereby diluting the return ratios. That is the key idea behind the fund.

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