Construction firms’ growth hinges on execution

While order inflows have doubled in FY17 versus FY15, pace of implementation and lower finance costs expected to boost profits

Construction sector companies have continued to see strong traction in their order inflow.

Recently, a HCC–URC construction joint venture was awarded a ~798 crore Bangalore Metro Rail contract. The strong order flow from metro rail projects is improving the outlook for companies such as Larsen & Toubro, J Kumar Infra (JKIL), Simplex Infrastructure and HCC.

Also, the government’s focus in recent years has translated to more orders in roads and urban infrastructure for most companies in the engineering and construction space. Dilip Buildcon, IRB Infra, PNC Infratech, KNR Infra and many others are well placed in terms of order book.

Analysts at Credit Suisse say order inflow continues to rise and are now twice that of the FY13-15 average. It was ~29,400 crore in FY15 and was ~60,000 crore in FY17. Investment in infrastructure is expected to grow 10 per cent annually in FY15-18, after stagnating during FY12-15.

This momentum has led to a higher book-to-bill but not revenue growth, which comes with a lag, due to government being the customer, say analysts. Coupled with a pick-up in revenue growth and continued benefits of financial leverage, the industry expects companies in the space to post double-digit annual earnings growth, say analysts at Ambit.

With strong order books helping, the focus and trigger for these companies’ shares will be execution. Divyata Dalal at Systematix Shares says while FY17 ended on a flat note in this regard, FY18 should see a pick-up. Credit Suisse says while orders are up two-fold, revenues are up only 25 per cent (versus FY13-15). Thus, a lot of catching up in execution is ahead, driving earnings from operating leverage. A fall in interest costs (as a proportion) would buoy earnings further.

Hence, most companies in the space offer opportunities for investors. However, given the run-up in the stock prices with the increase in order flows, the valuations also need to be looked at. Further, investors will need to pick companies with a healthy balance sheet or those expected to see the most improvement in financial health.

Among companies in the road segment, PNC Infratech and KNR Construction are better placed, with asset-light models, says Yellapu Santosh at India Nivesh Securities. Dalal prefers KNR Construction, saying it has started seeing execution in most of its projects, while PNC’s in some are yet to start. PNC, though, will see better execution in the financial year's second half, she adds. However KNR is also currently trading near its 52 week high and at 17-18 times its FY18 earnings estimate, looks fairly valued.

Among other road players in the build-operate-transfer space, IRB Infrastructure has seen significant improvement in the balance sheet and in order flow. While analysts are positive, they see it as a long-term investment option. The toll growth numbers remain good, they say, but are slightly below Street expectations. And, the benefits of under-implementation projects will start driving earnings growth only from FY19. Thus investors with a longer-term horizon could invest in it.

Dilip Buildcon remains among the top picks of most analysts, with its execution, consistent performance and earnings visibility. While Santosh feels the stock is reasonably priced, Credit Suisse has an ‘outperform rating’ with a target price of ~650, on the back of strong revenue visibility, robust net profit growth, focused execution and differentiated positioning.

In the metro rail segment, while order inflow benefits will flow to JKIL, HCC and Simplex Infra, among others, JKIL remains largely focused on only this segment; the others have a more diversified portfolio. However, Simplex has stress in the balance sheet due to a high working capital requirement which needs to be addressed. For HCC, gradual reduction in debt will drive operational performance. Credit Suisse has an ‘outperform’ rating on JKIL, with a price target of ~375, given the strong growth visibility, 20 per cent estimated annual earnings growth in FY17-20, and emergence as a contractor for metro rails.