Improving order flows and higher infra investments will drive earnings growth of companies over the next two years.
Construction companies, which had seen their growth rates take a hit in the last two years consequent to the economic slowdown and liquidity crunch, are once again ready to bounce back. Their new order inflows have seen a visible pick up in the recent past, especially the March quarter. However, analysts believe that this is just the beginning and there’s lot more to come. Notably, the government is also taking some right steps that should improve order flows and activity levels. On the other hand, a benign input costs scenario along with mildly firm interest rates suggests that the business environment will remain conducive for growth. A majority of companies have managed to keep their debt levels under check, which should help them fund future growth. Analysts expect earnings of most companies to grow by 20-30 per cent annually over two years, as compared to sub-10 per cent in the past few quarters. If the momentum in infrastructure investment is sustained, expect earnings growth to remain strong even beyond 2011-12.
Companies under HSBC Securities’ coverage have seen their order inflow rise almost 50 per cent year-on-year to over Rs 13,000 crore in the March 2010 quarter, the absolute order inflow crossed its all-time highs seen 16 quarters ago. This has led to their order book to sales ratio rise to 3.56 times (indicates high revenue visibility), which is marginally below the four-year peak of 3.68 times seen in June 2006 quarter. There is little difference in the trend as captured by other research houses like IDFC Securities or Prabhudas Lilladher. Notably, smaller companies have also seen a rise in new orders, suggesting that the trend is turning secular. “We believe we are at the early stage of a cyclical upturn,” wrote HSBC’s analysts.
On a broader level, too, even as the government is running behind its infrastructure investment target at $437 billion for the eleventh five-year plan, things are changing for the better. Experts say that implementation of the B K Chaturvedi report is helping eliminate delays in awarding road projects as well as improving access to capital—a trigger for increasing private sector participation. The introduction of model concession agreement would facilitate investments in India’s ports sector, say IDFC Securities' analysts. HSBC's analysts add that the government is making some right moves by assigning quarterly performance targets to task. All these should help improve order flow (by 20-25 per cent annually) and execution.
The confidence over robust order flows also stems from the government’s move of setting an ambitious infrastructure investment target of $872 billion for the 12th five-year plan. Very recently, the Planning commission has also begun work towards approaching the 12th plan, which should help lower hurdles and achieve growth targets.
Profitability to remain healthy
While improving business is positive, construction companies should also benefit from a benign medium-term outlook for input prices. For instance, steel and crude-based input prices are likely to remain soft consequent to concerns over weak global demand. Likewise, the commissioning of large capacities in India should keep cement prices under check. Nevertheless, most companies have over 75 per cent of their orders covered by price-variation clause, which should protect them if input prices rise. However, a benign price environment helps enhance project viability (due to lower costs) while easing working capital pressure for companies. On the interest rate front though, the concerns over inflation are likely to see some increase in rates. Hence, the impact, if any, is unlikely to be significant. Companies, too, have reduced their leverage levels resulting in strong balance-sheets.
All these developments have led analysts to upgrade their earnings growth estimate for construction companies, which they estimate will range 17-26 per cent over the next two years. The markets have already sniffed the change environment, which is why stocks of construction companies have outperformed the broader markets in recent past. Nevertheless, stock valuations are still attractive. Given that the longer-term outlook is expected to only improve, investors could buy into stocks with a one-three year perspective.
Among individual companies, IVRCL Infrastructures and HCC have successfully diversified their business and geographical portfolio in the past with current presence spanning water, irrigation and roads among others. Interestingly, their earnings are expected to grow at the fastest pace as compared to others and hence are good bets. In case of HCC, there’s potential for value unlocking too, which should happen when it goes for a separate listing of its real-estate subsidiary, Lavasa Corporation. Similarly, while Nagarjuna Construction’s outlook is good led by robust order inflows, progress over its 1,320 Mw power plant should provide further trigger to the stock. In L&T’s case too, there is scope for value unlocking through listing of different subsidiaries. However, the near-term returns from the stock look limited and hence, investors could buy it on dips.
Patel Engineering, a big player in the hydro-power space wherein investment opportunities of over Rs 50,000 crore exists, has been gradually enhancing presence in the roads segment, while its real estate business is also gaining ground. While its long-term prospects look good, Prabhudas Lilladher’s analysts cite lower order flows (due to focus on niche segments) and high equity requirements (over Rs 2,000 crore in three-four years) in projects as some concerns.
India’s largest road sector company, IRB Infrastructure, should gain from the pickup in road infrastructure investments. It recently tied-up (equal venture) with Reliance Infrastructure to bid for an over Rs 5,000 crore national highway project, which if successful will boost its portfolio.
Overall, barring a sharp cut down in government spending or jump in interest rates (both very unlikely), the prospects of the sector look good. Continuing robust infrastructure investments should improve growth visibility for companies going forward, which should provide trigger for some re-rating too.