In the last two years, the infrastructure sector has witnessed many pitfalls, which have hurt investor sentiment. We believe the valuation of the sector is close to the bottom as the stocks of infrastructure companies have corrected 60-75% in the period between July 2010 and August 2011.
We believe slower order inflow, rising interest rates, regulatory issues and earnings downgrade have been largely discounted by the market. Although we believe the earnings will not improve significantly, concerns over rising interest rates, regulatory issues and execution risks are likely to subside in the short term, thereby leading to outperformance by infrastructure stocks.
Fundamentals versus valuation: We believe the infrastructure sector is currently moving from a moderation phase to a slowdown phase and the slowdown has started hurting profitability (as seen from a sharp decline in earnings in the first quarter of FY12 by 97% year-on-year, or y-o-y) which will continue in the short term. However, as the slowdown has already been factored in (stock prices declined by around 60-75% between July 2010 and August 2011), we believe the sector is set for a rerating as FY13 net profit for our universe of companies is set to grow by 44%.
Also See | Positive Outlook (PDF)
Stability in interest rate cycle to aid performance: To curb rising inflation, the Reserve Bank of India (RBI) raised its repo rate by 25 basis points in September, the 12th hike in the past two years. As per estimates, the repo rate may be hiked further and it may stabilise at that level (not correct sharply as in the previous FY09 cycle). Historically, whenever interest rates peak, infrastructure stocks outperform.
Earnings downgrade due to rising rates unlikely: Between January 2010 and September 2011, revenue estimates of our universe of companies (Bloomberg consensus) have been downgraded by 11% for FY12 and 5% for FY13 and profit after tax estimates cut by 33% and 31% for FY12 and FY13, respectively. As per our analysis, we believe the market has already discounted higher interest rates and further earnings downgrade is unlikely.
There would be uncertainty in order execution in the near term, but FY13 is likely to witness strong growth. Despite a strong order book, revenue growth was muted during the past one year due to order execution-related issues. The market believes these issues will continue to affect the growth of the sector. However, we believe the order execution will improve because these issues are more technical (short term in nature) rather than structural.
We initiate coverage on five companies with a “buy” rating on IRB Infrastructure, Reliance Infrastructure Ltd, GMR Infrastructure Ltd and IVRCL Infrastructures and Projects Ltd, as we believe they are best placed in terms of execution track record, balance sheet strength and valuation parameters. Despite attractive valuation, we assign a “hold” rating to Hindustan Construction Co. LTd as we believe that higher leverage and the Lavasa issue will cap any upside.
Graphic by Ahmed Raza Khan/Mint
Edited excerpts from a report by Nirmal Bang. Send in your comments at firstname.lastname@example.org