Infrastructure companies — Stack up with discretion

October 14, 2006

Driven by infrastructure spending, the demand side for construction companies remains robust. The key to success will lie in their ability to ramp up resources and capitalise on order flow.

Compound Annual Growth over 3 Years (%)
Indicative OPM across segments (%)

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Infrastructure has been the new market mantra the past two years. While private equity investors showed keen interest in infrastructure/construction companies, a number of mutual funds also jumped on to this booming bandwagon, investing a chunk of their assets in the sector. An annualised revenue growth of 30-40 per cent over the past three years and an average order size of three-four times the revenues also seem to justify this newfound enthusiasm.

Do these factors indicate that this is a sector to be bought outright? A Business Line study suggests that while the sector will, no doubt, receive continued fillip from infrastructure spending in the country, a stock-specific rather than a sector approach is the right route to superior returns over the long term. We take a look at factors that not only distinguish some companies from the rest, but may also act as pointers to identify the better ones in the basket.

Such issues as the business mix, equipment strategy and asset maintenance/ownership (build-own-operate-transfer) strategy of various companies are studied for the pointers they might offer for investment decisions. The study was of a sample of 25 companies which are turnkey players and those that are into the core contracting business.

Order-book composition

The announcement that a new order has been bagged by an infrastructure firm often sends such positive signals that the market welcomes it with a 2-4 per cent increase in the company’s stock price. The order composition, the gestation period and the terms of the project are some aspects that need to be factored in before drawing an immediate conclusion on the earnings expectation from the new order.

Most orders in the road, irrigation and power segments are typically executed over 18 to 36 months, provided regulatory and financial issues are sorted out. Projects in the hydropower space may have even longer gestation periods. Valuations need to be tempered for such long-gestation projects, as the risk of uncertainty is high. Similarly, a BOT (build-operate-transfer) toll-road project may need to be discounted as it is a high-risk, high-return proposition compared to an annuity-based contract, where revenue flow is assured.

The operating and net margins are different across various business segments as a result of the complexities and competition in various verticals. At present oil and gas pipelines, hydropower and nuclear power projects enjoy relatively high operating profit margins (OPM), in the 10-24 per cent range, with few players. Patel Engineering, Larsen & Toubro and Gammon India are, for instance, the only majors in nuclear power projects, while Larsen & Toubro and Punj Lloyd are the established players in the oil and gas pipeline segment.

In contrast, road projects (other than BOT), at 6-8 per cent OPM, yield the lowest. Hence, volumes are the key to driving earnings for companies that predominantly operate in the road business.

A broad-based portfolio, such as roads, irrigation and power, appears to support faster growth. Companies such as IVRCL Infrastructures and Nagarjuna Construction rapidly diversified from their stronghold in water projects to roads, power transmission and distribution (IVRCL), hydropower (Nagarjuna) and, recently, real-estate. The Table on revenue and profit growth shows that these companies have grown at a scorching pace compared to those with less diversified businesses such as Jaiprakash Associates and Patel Engineering.

Execution capabilities

Companies with fewer orders but of a larger size may face less execution risks. Hindustan Construction, for example, has only about 30 orders on hand with the average size at Rs 300 crore. This indicates that the company’s resources are dedicated to fewer projects at a time, thus reducing the probability of errors and time over-runs.

Smaller players, such as Valecha Engineering or Era Constructions, are, however, likely to bid for a good number of small-size projects to drive up volumes. This can lead to higher execution risks than bigger players with better resources, such as L&T are prone to.

External factors can, however, cause execution delays even in bigger companies. Hindustan Construction’s Bandra-Worli Sea Link project was dogged by delays and consequent cost overruns due to changes in project specifications.

Equipment strategy

With increasing order-book, leasing of equipment often cuts into the margins of companies. Nagarjuna Construction’s OPM was as low as 5 per cent in 2004. Since then, with a ramp-up in asset base by over 80 per cent and an ability to undertake more projects, the company’s OPM is close to 9 per cent. The ability of companies that take up an increasing number of projects to go for own equipment would depend on their financial sourcing. This is also likely to reflect in superior return on equity (RoE) over a period. Companies such as Larsen & Toubro have consistently exhibited superior RoE, despite relatively lower margins, through optimum utilisation of resources.

Asset ownership

The build-operate-transfer strategy appears to be the way forward, especially for the transportation sector. This has led to a number of players moving from core contracting business to developers who build, maintain and also own the roads, in some cases, and bear revenue risk. BOT projects require skill-sets such as assessing traffic risk (for toll-based projects) and committing capital, as opposed to just construction skills in a pure contracting business.

Companies such as Hindustan Construction have been wary of fresh projects in this space, while Gammon and IVRCL have made aggressive strides in this vertical. These projects, no doubt, offer higher returns than regular road contracts but the question is whether the company can handle the risks involved. While the highly-leveraged Rajamundhry Expressway project, for instance, was an instant success for Gammon, the Noida Toll Bridge project languished for long before turning around slowly now.

The answer seems to lie in the de-risking strategy adopted by players such as Gammon. The company has formed a separate subsidiary, Gammon Infrastructure Projects (GIP), which is likely to go public soon. This will not only unlock the value of the assets, but also prevent locking of funds for the core contracting business. But can smaller players, such as Sadbhav Engineering and Unity Infraprojects, possess the resources or use the holding company strategy? This could mean constantly raising capital and bearing interest rate risk. Spinning off a separate company for a BOT project also requires accumulation of sizeable projects before attempting it. While annuity-based projects are less risky, the cost involved is again high.

Bigger the better

In all the above issues, the bigger players clearly have an edge over the smaller ones. They have an advantage in terms of equity expansion without earnings dilution, technical capability, capturing new markets or raising debt. Hindustan Construction, Gammon India and Larsen & Toubro are stocks to be held over the long term. Nagarjuna Construction and IVRCL Infrastructures are the stocks to choose to ride the infrastructure boom.

Since 2002, when the initial flow of road projects started, the National Highways Authority of India (NHAI) has banned 17 companies from bidding. Small companies that bid low later found the project financially unviable. This is not to say that the smaller players will not survive. Small companies such as Tantia Construction or Pratibha Industries have a niche business that distinguishes them from the rest. Companies such as GMR Infrastructure, although in new territory (airports) and clouded with uncertainties, may nevertheless get a head-start in the nascent airport privatisation operation sector.

Fuelled by infrastructure spending, the demand side remains robust, providing business to players of various sizes. The key to success will lie in companies’ ability to ramp up resources and capitalise on order flow, while being more selective.