Neither the rise in share prices over the last three months nor high valuations have dented investor interest in the construction sector. This fiscal has seen shares of Larsen and Toubro Ltd (L&T), IVRCL Infrastructure and Projects Ltd and Nagarjuna Construction Co. Ltd rise 100%-plus. Is the rally on strong ground?
An analysis of 43 companies in the civil construction space shows that from FY07 to FY09, the net revenue and net profits grew at a compounded annual growth rate of around 39% and 25%, respectively. The operating profit margin (OPM) average was around 16% for the three years, though it dipped in FY09 due to the meltdown during the second half of the year. Similar was the case with net profit margin (NPM), whose average was around 6% for the three years.
However, in April-September, OPM of these firms bounced back to around 19%, with NPM also better at around 8%. The question is if the growth rates and margins can be sustained.
The answer lies in two parts. One is in the order book, which will determine the growth rate in revenues. Another is the ability of firms to execute projects in time which, in turn, determines the cost viability and profit margins in the long term.
There is little concern given that leading firms such as L&T, IVRCL, Nagarjuna and Gammon India Ltd have an order book of nearly three times their FY09 revenues. The government’s commitment to infrastructure, mainly roads and power, is also a given.
According to a report by broking firm Anand Rathi Securities Ltd, “India’s infra spend will rise from 6.5% of GDP (gross domestic product) in FY09 to 9.3% by FY12.” This would mean a high order inflow for contracting firms, given that an estimated 36,000km of roadworks worth Rs1.6 trillion is on the anvil.
Besides, analysts estimate that with a greater role in road construction, operation and maintenance works worth $5 billion every year could be the additional opportunity for private firms.
However, from a shareholder viewpoint, the moot question is whether the order build-up will generate returns via higher profits. For now, there is concern on the execution front on account of land acquisition delays or the inability of contractors to raise resources on time.
A report by a foreign broking and research house, Nomura Equity Research, states that 18 companies in road construction have had projects delayed by an average of six months. Most are in the cash contracts segment rather than in the build-operate-transfer category. A few, such as L&T and GMR Infrastructure Ltd, are among those with no delays indicated. A World Bank study done in 2008 of 48 national highways and 35 state highways also indicated similar delays in execution.
Another aspect crucial to sustained growth in the sector is the funding. The National Highways Authority of India estimates that the private sector will have to cough up more than half the funds required over the next six years. This could mean increase in borrowings by firms, which would mean either a dilution in equity or higher interest costs, given that a higher interest rate scenario is envisaged.
These factors could affect profit margins both at the operating and net levels in the next 24 months, despite an expansion in revenue for firms.
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