At the current early stage of the business upcycle in the infrastructure segment, there are several key positives to look forward to over the next two to three years. Below are the potential catalysts which will drive execution and earnings growth.
Order inflow growth visibility is improving: The government expects infrastructure investment totalling $135 billion per annum during FY11 and FY12, which is a 145% growth over what was spent during the last three years. Even with an 80% success ratio (as during the last three years), annual infrastructure spending could stand at $108 billion per annum, a still substantial figure. The government wants to accelerate infrastructure investment further during the 12th Five-Year Plan (FY13-17) with a target of $837 billion. Hence, order inflows are likely to remain healthy.
Order inflows over the past three-four quarters have poured in with absolute orders overtaking the highs witnessed during the past 16 quarters. The book-to-bill ratio is currently at 3.56x, which is marginally below the four-year peak of 3.68x in Q1FY07 and sharply up from the cycle bottom at 2.86x observed during Q3FY09.
Working capital cycle is expected to get shorter: Average working capital days expanded by 25 days, 15% growth during FY10. However, we believe the working capital cycle is likely to get shorter from FY11 as the share of orders from PPP (public-private partnerships) and owned assets increases. This will be further helped by a revival of private capex, since working capital requirements on these projects are 15-20% lower than government orders (80-90% share currently).
Potential to enhance leverage to fund assets and execution: Our sector coverage universe (excluding IRB) has a net debt/equity ratio of 0.9x, with IVRCL and NCC lower at 0.6-0.7x. While Simplex?s net debt/equity is 1.1x, it has a lower growth trajectory and does not have an asset ownership plan. HCC is the only stock under some pressure, with its higher leverage of 1.6x. While we expect leverage to increase by 30-50% over the next three years to fund assets and execution, sector leverage are likely to remain within our comfort range of 0.9-1.1x.
Earnings growth will accelerate: Factoring in the effects of a business upcycle on order inflows, working capital and leverage, we expect earnings growth to accelerate to 30-32% during FY11-12 against 5-10% during the past two years. We expect core ROEs (returns on equity) to either meet or beat their last upcycle peak.
We observe that during business upcycles, the PE (price-to-earnings) multiples tend to expand for construction companies. However, the multiple expansion theme has already played out over the past 12 months. Looking forward, earnings growth will be driven primarily by earnings growth and with a modest multiple expansion of 8-10%.
We have factored this into our 12-month target prices and arrive at overweight ratings for all but one (HCC) of our five-stock construction universe. Our target prices are arrived at through a sum-of-the-parts method where the core construction business is valued using an earnings multiple, while other assets are valued using price/book, traded value or discounted cash flow. We see 12-month potential returns of 22-42% for our OW(V) stocks and 14% for HCC. Accordingly, we retain our Overweight (V) ratings on IRB, NCC and Simplex. We upgrade IVRCL to Overweight (V) and maintain our Neutral (V) rating on HCC.
Any major cutback in spending by the government due to a rapid increase in fiscal deficit or any policy-led delays could hurt business prospects for the construction sector.
Any sharp increase in interest rates can impact our earnings and valuation. Execution delays owing to a slow ramp-up in manpower and capital goods or short- to medium-term liquidity tightening on the back of any global financial turmoil could turn into an earnings risk.
Historical experience suggests that a sharp increase in commodity costs and a subsequent increase in project costs lead to delays on advance payments by the originator and hence, a slowdown in execution.