>INDIA CONSTRUCTION (RELIANCE EQUITIES)

Slow earnings recovery

■ Order inflows likely to revive, but not rapidly
On average, companies in our coverage universe saw a 22% decline in order booking in 4Q FY09 and grew just 8% in entire FY09 (pulled up mainly by strong order inflow for HCC, which grew 143% YoY). We expect an improvement in FY10, but the pick-up in order flow will likely remain moderate owing to high fiscal deficit restraining government spending and a slowdown in private-sector capex. We estimate order inflow growth of 15–20% in FY10 (-50% for HCC, due to the high base in FY09) and 20–25% in FY11.

■ Earnings growth to be much lower than pre-FY09 levels, in the near term
After a rather forgettable FY09, earnings are likely to pick up from the current fiscal onwards. However, earnings growth is unlikely to reach pre-FY09 levels in a hurry. For companies in our coverage, we expect earnings CAGR of 17% over FY09–11E compared to 52% in FY03–08. We expect slow recovery on account of: (1) low revenue visibility (owing to low order inflows in FY09); (2) depressed EBITDA margins; and (3) high interest costs (despite a significantly lower cost of debt).

■ Quality of earnings remains weak, equity dilution risk lingers
Our biggest concern about the sector has been negative cash flows generated primarily due to an elongating working capital cycle. We expect the cycle to remain stretched, resulting in: (1) low or negative cash flows; (2) rising debt and low interest coverage; and (3) low return ratios (with ROIC below 12%). This will eventually lead to a series of equity dilutions, as was seen in the past.

■ Optimism is overdone, we are cautious on the sector
Post elect ion results, all construction stocks have run up significantly on the back of optimism that the new government will push infrastructure spending aggressively. We believe an improvement in earnings is likely to be gradual rather than dramatic, thus leaving room for disappointment. Thus, we believe that construction stocks are not likely to trade at the high multiples they commanded in 2007-08. We are upgrading Simplex to Buy based on our revised valuation and maintain our Sell rating on HCC, IVRCL and NCC.

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