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HCC: Riding the infrastructure wave!

May 8, 2006

The future of almost all sectors of the Indian economy hinges on the availability of good infrastructure roads, ports, telecommunication, airports, power, railways and water supply. Currently, on the back of rising demand and consumption, the existing infrastructure setup seems to be crumbling. Lack of decent infrastructure in India is the single largest bottleneck to economic growth. The government has, however, recognised the need for the better infrastructure and has taken positive policy measures in the past few years. More of private investment is being welcomed in the sector, which has attracted many players to be a part of infrastructure creation in the country. Hindustan Construction Company (HCC) is one of the larger players in this business. In this write-up, we shall analyse the past performance of the company, its current status and study where is the company headed into the future.

About HCC
HCC is one of the largest private sector construction companies in India and the foremost in infrastructure building. The company has been involved in the construction of diverse projects ranging from power dams, highways and bridges to marine structures, water supply, factories and waste treatment plant. Apart from the domestic presence, HCC has executed several projects overseas in countries like Iraq, Nepal and Tanzania. Towards this, the company has entered into a number of technical collaborations as well as joint ventures with overseas players, bringing the latest technical know-how into the execution of its projects. Further, the company has created a technical consultancy capability, which will be involved in the design and engineering aspects of construction. During the period between FY02 to FY06, HCC has grown its revenues and net profits at compounded rates of 50% and 31% respectively.

Financial analysis
Increased investment in infrastructure development and higher order inflows for the HCC has helped the company to grow strongly in the past few years. As seen from the table below, the company has been pretty consistent in growing its topline over the past few years. However, in line with the industry performance, operating profitability has taken a severe hit. From earning near 20% operating margins in FY02, HCC's margins declined to around 9% in FY06.

Financial snapshot (Standalone)
(Rs m)FY02FY03FY04FY05FY06
Net Sales 3,948 6,772 10,579 14,873 19,870
% Growth 71.6%56.2%40.6%33.6%
EBITDA7821155143315421829
EBITDA margins (%)19.8%17.1%13.5%10.4%9.2%
Other Income78 59 (15) 56 61
Depreciation222341438453524
EBIT637 873 980 1,145 1,366
EBIT margins (%)16.1%12.9%9.3%7.7%6.9%
Interest257421376395414
PBT380 452 605 750 952
Extraordinary interest201 - - - 431
Tax15416624810135
Net profit427 287 357 740 1,248
% Growth -33.0%24.5%107.4%68.6%
Net profit margin (%)10.8%4.2%3.4%5.0%6.3%
Diluted earnings per share (Rs)1.71.11.42.94.9

The margin depletion should be understood considering the fact that the Indian construction industry has witnessed a tremendous influx of new players in the past few years, each trying to capture a chunk of the growing investment pie. This has led to severe depletion in profitability for existing players like HCC and IVRCL, who have seen sharp contraction in their margins over these years. With rising input costs (mainly cement and steel), the problems have only compounded for construction players. We believe that this situation (of contracting profitability levels) is likely to prevail in the future as well, unless companies develop competencies to execute higher end construction projects (like what L&T is doing).

Depletion in operating margins has taken a toll on HCC's net profits as well, which have seen volatile growth during this period. As a matter of fact, the company's net margins stood at a mere 6.3% during FY06 (10.8% in FY02).

In these times of high competition and reducing profitability, most of the construction companies in India are targeting the build-operate-transfer (BOT) model of infrastructure creation. This models also stands in good stead for the government, as it is an effective way to attract the much required private sector investment into the infrastructure development. HCC is no behind with respect to the BOT model. In fact, to finance its aggressive foray into taking up BOT projects (apart from for other investment purposes), the company, in 4QFY06, has raised US$ 100 m by way of Zero Coupon Convertible Bonds. This is in addition to the US$ 100 m that was raised by way of a GDS issue. While BOT is an effective way to improve profitability (as costs are generally of fixed nature and incremental toll revenues accrue directly to the bottomline), it has its negatives with respect to uncertainty of toll revenues as contracts are of very long nature (generally 20 to 30 years).

What to expect?
At the current price of Rs 168, the stock is trading at a price to earnings multiple of 34.5 times its standalone FY06 earnings. In being a participant to infrastructure creation in the country in the past, we believe that HCC has attained a critical mass in terms of resources, technology and manpower skill sets with excellent technical tie-ups and partnership with leaders in different infrastructure segments. The company is also eyeing other emerging markets and efforts made towards technology absorption, adaptation and innovation. While growth in order book and topline terms shall not pose any major problem, investors need to look out for quality of such growth (profitability). In the medium term, valuations are also an issue. We shall soon be initiating our coverage on HCC.

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