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Are you buying an infrastructure story? - Views on News from Equitymaster
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  • Aug 16, 2006

    Are you buying an infrastructure story?

    The last three months have been an acid test for all sets of investors. The 'so-called' intelligent foreign institutional investor is no exception to this fact. Perhaps, one of the major sectors that have suffered the most during the stock market 'sell-off' in terms of the absolute decline in market capitalization are the construction and engineering stocks.

    The construction lotů
    (Rs) 52-week high 52-week low Current price % change* % change**
    Simplex 2,725 876 1,375 -49.6% 211.1%
    Era Constructions 542 99 283 -47.8% 447.5%
    Madhucon Projects 437 136 230 -47.4% 221.3%
    Patel Engineering 635 170 339 -46.7% 273.5%
    HCC 196 71 105 -46.4% 176.1%
    MSK Projects 138 50 74 -46.4% 176.0%
    Mahindra Gesco 1,300 190 742 -42.9% 584.2%
    Gammon India 589 276 373 -36.7% 113.4%
    IVRCL Infrastructure 326 123 234 -28.4% 165.0%
    Nagarjuna Constructions 404 188 291 -28.0% 114.9%
    Unitech 303 8 226 -25.3% 3608.7%
    *from 52-week high, **52-week high upon 52-week low, sorted by the decline from 52-week high

    At its peak, even a real estate company was also an 'infrastructure story' for all its worth. Any company that was/is remotely associated with construction (never mind that it was just supplying pipe for building construction) was termed as an 'engineering company'. At its peak, when we met a fund manager of a foreign mutual fund in India, he duly made a case for such astounding valuations by comparing them with software stocks. To this date, we are trying to figure out his rationale! This mutual fund's tax savings scheme is still down almost 22% in the last three months, even after the recent rally. It is not that we do not subscribe to the positive side of the broader infrastructure story. But we really do not subscribe to the astronomical valuations, no matter what the growth rate is!

    The engineering lotů
    (Rs) 52-week high 52-week low Current price % change* % change**
    Engineers India 1,020 392 505 -50.5% 160.2%
    Bharat Earth Movers 1,785 723 948 -46.9% 146.9%
    Voltas 1,110 290 810 -27.0% 282.8%
    Thermax 410 135 309 -24.6% 203.7%
    Cummins 269 123 208 -22.7% 118.7%
    L&T 2,915 1,272 2,307 -20.9% 129.2%
    Siemens 1,262 438 1,007 -20.2% 188.1%
    ABB 3,350 1,465 2,759 -17.6% 128.7%
    Suzlon 1,400 650 1,228 -12.3% 115.4%
    BHEL 2,465 1,020 2,180 -11.6% 141.7%
    *from 52-week high, **52-week high upon 52-week low, sorted by the decline from 52-week high

    And post the decline in the recent past, the media and some set of investors are again latching on to these stocks just because they are trading at much lower price as compared to May 2006. Just because 'Simplex Construction' has fallen by almost 50% (yes, it is correct) from its 52-week high, it does not mean it is attractive. We question the 211% rise in the stock from its 52-week low levels itself! Here is a fundamental view.

    Price to earnings multiple of key construction stocks
    (FY06 - times) On 52-week high price On 52-week low price on current price
    ERA Construction 24.2 4.4 12.6
    MSK Projects 23.6 8.5 12.6
    Hindustan Construction 36.0 13.1 19.3
    Madhucon Projects 41.8 13.0 22.0
    Patel Engineering 44.3 11.9 23.6
    Nagarjuna Construction 33.4 15.6 24.1
    Simplex Construction 51.8 16.6 26.1
    IVRCL Infrastructure 36.9 13.9 26.4
    Gammon India 43.9 20.6 27.8
    Mahindra Gesco Corp 366.2 53.5 209.0
    Unitech Limited 543.3 14.6 406.0

    The tables above reflect the price to earnings of select construction and engineering stocks. During peak prices in April-May 2006, the average price to earnings multiple was as high as 45 times! One could argue that P/E may not be the right way to decide the attractiveness of a stock. We agree. But we do not agree to the fact that one should value these companies based on an order book multiple either! Take the case of software stocks in the late 1990s. When earnings were growing at more than 100%, P/E multiple were more than 100 in the case of certain stocks. But a company/sector is unlikely to grow at 100% to perpetuity no matter how big the story is. Infosys, for instance, is close to reaching its peak prices in 2000 after six long years. Then, the justification for software valuations was the PEG ratio (price to growth). PEG has come and gone in the case of software stocks but is now finding relevance in the case of infrastructure-related companies for all the wrong reasons!

    Here are some takeaways for investors.

    1.   The order book of a company can be very misleading. Factors to be considered include the duration of the order book (the period over which the orders will be completed), cost escalation clauses (ability of the company to pass on any change in input costs to consumers), nature of work (is it a largely sub-contracting work portfolio) and more important, whether the company understands the execution risks clearly.

    Take the escalation clause for instance. Most of the contracts have an escalation clause, which is linked to the wholesale price index (in the case of road projects) or a basket of raw materials (say steel and cement). When cement prices go up, the company can also increase prices and vice versa. At times (like in 2000), a major engineering company that was executing a road project connecting two major cities faced issues with sub-contractors. Those sub-contractors undertook a portion of the road project at a pre-determined steel price clause. But when steel prices increased sharply, the sub-contractors literally stopped construction and the onus of finishing the project shifted to the engineering major (including the cost of time overruns). This construction company stopped focusing on road projects after this incident! Road construction projects, in which operating margins are just about 8% if executed on time, can be financially dangerous for contractors at times. So, the next time an engineering/construction company announces that it has won a contract, do not buy its shares blindly. We definitely do not subscribe to the idea of paying 30 times price to earnings multiple for an engineering stock just because it is expected to grow its earnings by 30% in the next one or two years.

    2.  As far as valuations of construction/real estate companies are concerned, one has to practice caution. When valuing a real estate company, taking the best price per square foot (as it is now) skews the investment decision in favor of risks. It is therefore, pertinent to value real estate companies based on a 'normalized' square foot price. What is also important to focus is not just on price per square foot but also the profit per square foot. This is because real estate developers increase prices also because of higher input costs (including legislative policy changes).

    In our view, earnings growth and corporate performance are cyclical in nature but not valuations. Yes, one may upgrade/downgrade a company's valuation multiple to reflect the changes in broader fundamentals or the company performance. History can teach valuable lessons while taking investment decisions. So, the next time someone tells you that 'this time its different', you know what to do!



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