Sunday, December 27, 2009

>Indian mid-cap construction (MACQUARIE RESEARCH)

We spoke to managements of various mid-cap construction companies to discuss key issues. We are very positive on the space and believe the recent underperformance is an excellent accumulation opportunity. We think valuations are at very attractive levels of 10–11x FY11E earnings with a very strong order inflow cycle about to begin. The stocks have come under pressure due to shortterm issues like the Dubai credit crisis and statehood demand for Telangana.

Valuations extremely attractive with substantial growth: The mid-cap construction space has underperformed the broader indices recently and trading around 10x FY11E (adjusted for subs valuations) due to short-term irritants, despite we believe substantial growth opportunities beginning in FY11. Interestingly, most of these companies have recently raised equity financing, so the risk of dilution is also substantially reduced in the near term.

Near-term sentiment spoilers are temporary in nature: The issues like the Dubai credit crisis and a separate statehood issue in Telangana have created a dampener on stock prices. We strongly believe that these issues are temporary with no material impact and create an opportunity to accumulate these stocks.

Substantial structural opportunity to support long-term earnings growth: We expect order inflow in the infra space to strongly rebound in FY11 as governments get their acts together on sectors like roads, ports and continued push in power. In the near term, top-line growth will likely rebound in FY11. Roads, which were around 30% of order backlog, have reduced to close to 10–15%. Roads itself are likely to witness order inflow of US$10bn in FY11. Even without roads, the order backlog for the space remains healthy at 3x last year’s revenues.

Lower interest costs can provide upside to earnings estimates: Interest costs have reduced by 150–200bps for construction companies in 2H FY10, which have yet to be reflected in earnings. Recent fundraising will further help in lowering interest costs, which are not built into consensus estimates.

Subsidiary valuations are becoming material: For all the three companies, BOT (Build-Operate-Transfer) assets are getting commissioned gradually, which will start contributing to earnings while new BOT assets are being added to the portfolio, hence enhancing the size and valuations. Also, we believe valuations for all these companies’ real estate portfolios have
bottomed out and present upside to the valuations.

All three stocks seem attractively placed for the short and medium term: We like all the three companies at current valuations with near-term triggers in place. NJCC and PEC have near-term triggers in the form of Q3 FY10 earnings, while in the case of IVRCL, visibility on BOT revenues and the settling down of the Telangana issue will likely be the triggers.

To read the full report: INDIAN MID-CAP CONSTRUCTION