Mid-cap construction space has underperformed due to execution issues in FY10. We believe these issues are behind us as the low base created in FY10 an opportunity for top-line growth to bounce back strongly. We recommend significant overweight position in mid-caps with NJCC and IVRC as our top picks.

Mid-cap stocks have traditionally traded at 35-40% discount to the large-cap stocks. However, the valuation discount has widened to 50%, providing excellent opportunity to accumulate these names. Mid-cap construction companies had a muted revenue growth of 10.4% in 9mFY10 on back of execution issues. Order backlog coverage stands at 3.7x (considering set of seven mid-cap names), close to all-time highs and setting stage for strong top-line growth rebound. This is also boosted by low-base in FY10.

The fourth quarter of FY10 would mark sharp turnaround in order inflows, especially from roads. National highways itself plans to give out projects worth US $26 billion in FY11 while order backlog for the entire mid-cap space (top 10 mid-cap names) is at about US $18.5 billion. Even with 40% achievement and 30% market share of mid-cap space, order book growth from one sector alone would be 18%, while other sectors still remain strong.

Investments in subsidiaries have increased considerably for the mid cap companies (NJCC, PEC and IVRC) and have become too big to be ignored. In case of NJCC, book value of subsidiary investment stands at 40% of the total book value which is current being valued only at 1x P/B. Any fund raising in these subsidiaries could materially impact the valuations of the respective parent companies.

Outlook

We prefer mid-caps to large-caps, given the valuation discount and stronger earnings growth rebound. IVRC and NJCC are our top mid-cap construction picks, while we still like L&T (LT IN, Rs 1,659, Outperform, Target Price: Rs 1,841) among large-caps.

NJCC earnings to surprise with 70% order inflow growth in FY10: NJCC with an order inflow of Rs 87 billion in FY10YTD has beaten its initial guidance of Rs 62 billion. We expect revenue and earnings growth to be 29% and 35% respectively in FY11, as against consensus forecast of 20% and 25%.

IVRC to gain from value unlocking in subsidiary: IVRCL had transferred the BOT assets to its subsidiary IVR Prime for a consideration of 17.9% additional stake in the company. We believe there is scope for significant value discovery as IVR Prime with its 10 BOT assets gets valued like an infra stock rather than real estate company. Moreover, concerns on Andhra irrigation order book would subside as company can deliver revenue growth despite assuming no progress in those projects.

Valuation gap between large-cap and mid-cap construction companies should narrow: Large-cap construction companies like L&T are trading at ~25x FY11E EPS whereas mid-cap companies like NJCC and IVRC are trading at ~13x FY11E EPS. Adjusted for subsidiaries valuations, the same would be 20x and 10x respectively. We understand that there exists a discount between large-cap and mid-cap companies, however, we believe that there is a case for the mid-cap companies to trade at 15x multiples on their core business against the backdrop of strong order inflows and stable margin outlook.

FY10 was a washout year (revenue growth of just 10%) for mid-cap construction companies marred by slow order inflow in FY09 and execution-related challenges in FY10. However, FY11 should witness the return of growth trajectory for these companies against the backdrop of low revenue base and strong order inflow in FY10.

Given the lull in project awards in FY09, NHAI has recently said that about 11,800 km of highways would be awarded in FY11 under work plan 2. Even if 4,800 km roads are awarded, it would translate into Rs 480 billion of total awards. If 30% order is awarded to mid-cap companies, it would mean an order inflow of Rs 144 billion or 18% of current outstanding order book of top 10 companies.

Investments in subsidiaries are becoming material: Recent success of IPOs like ITNL suggests that the appetite for BOT projects in investors is increasing. Over the last few years, investment in subsidiaries by PEC, NJCC and IVRC has become significantly big in the overall scheme of things. Any fund raising activity in listed or unlisted subsidiaries could boost the valuations of these companies significantly.