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Indian construction sector: A perspective - Views on News from Equitymaster
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  • Sep 7, 2006

    Indian construction sector: A perspective

    India is amongst the fastest growing economies in the world, with the GDP growth for FY07 expected at around 7.5% to 8%. At this rate of growth, India's GDP, currently at around US$ 750 bn, will double to US$ 1.5 trillion in 9 years, and will quadruple to US$ 3 trillion in 18 years. Nonetheless, we believe that the long-term average growth rate of around 6% is sustainable in future, and even at that rate, the country's GDP will double and quadruple in 12 and 24 years respectively.

    Now, while the opportunities are undoubtedly significant (strong demographic profile, domestic demand, the offshoring story, etc.), we believe that there are big challenges ahead for the country to maintain this kind of growth. Chief among them is, of course, the country's dismal state of infrastructure. This is one of the biggest stumbling blocks that is preventing India from achieving a 10%-plus economic growth rate. To give an example, in Mumbai, India's financial capital, there are literally hundreds of potholes, and even the more affluent areas, such as Malabar Hill and Pedder Road, are not spared the blushes! In contrast, the infrastructure in China, considered as a major competitor to India in the global economy, is recognised as world-class by global investors.

    In this regard, we give here, a perspective on the Indian infrastructure/construction sector, opportunities and challenges faced by the companies in this sector.

    Opportunities galore!
    One of the major focus areas in the 'Common Minimum Programme' of the UPA government is infrastructure development. Undoubtedly, with the economy on a fast growth path, getting investments from domestic and foreign investors is imperative, and a major factor that attracts investments is world-class infrastructure - better roads, ports, airports, railways, power and telecommunications. These factors are very important to enable higher economic growth and to sustain it in future.

    There are significant opportunities for companies in the Indian construction sector. Construction is the second largest economic activity after agriculture, and accounts for 11% of India's GDP. The investments made in this sector amounted to Rs 6.6 trillion in FY05, and are expected to grow to over Rs 8 trillion by FY08, thus reflecting the significant opportunity ahead for such companies. The construction sector can be broadly classified into 3 sub-segments:

    • Real estate construction (Residential and commercial),
    • Infrastructure (roads, power) and
    • Industrial construction (Steel, textiles, fertilisers, oil and gas refineries and pipelines).

    Real estate
    There is significant demand for quality housing in India. With trends such as younger people wanting to own a house earlier in life, plus greater affordability due to reasonable interest rates on home loans and favourable tax treatment, the demand for residential housing is expected to continue to grow in the near future. On the other hand, as regards commercial property, major drivers for this segment are expected to be the IT-ITES, retail, FMCG, telecom, media (multiplexes) and banking and financial services (BFSI) sectors. The SEZ Act passed recently is also expected to lead to greater demand for commercial real estate.

    In fact, Pantaloon Retail, one of the top retail companies in India, is alone expected to add over 25 m sq. feet over the next few years! Software companies like Infosys, on the other hand, add several million sq. feet of space each year to add to their already-massive employee bases, in order to cater to the burgeoning demand for offshore IT services. Total investments in this space (real estate) are expected to increase from Rs 4.5 trillion in FY05 to Rs 5.1 trillion by FY08.

    With the government's focus on infrastructure development, a lot of promise is in store for the infrastructure segment. Road construction projects, railways, urban infrastructure, power and irrigation projects, which are the major focus areas, are expected to witness investments of Rs 2.2 trillion by FY08, as compared to Rs 1.7 trillion in FY05. Around 50% of the cost of infrastructure projects are accounted for by construction activity, thus reflecting the potential that is there in this segment.

    Industrial construction
    After a slowdown in industrial investments between FY99 and FY03, these have started picking up. With higher demand and capacity utilisation, the need for incremental capex investments is quite strong. With higher imports of capital goods, a strong indicator of increased capital spending by corporates, significant investments are expected over the next few years. The total investment in this segment is expected to hit Rs 973 bn by FY08, up from Rs 414 bn in FY05. This is expected to be led by the oil and gas, steel, auto, petrochemicals, cement, paper and fertiliser sectors. Thus, clearly, this is the fastest growing segment, and companies operating here are expected to see stronger traction in terms of order book accretion and sales growth going forward.

    The challenges...
    Undoubtedly, in our view, the biggest challenge facing this sector is the lack of skilled and quality human resources. This sector is not too different from the software sector, where skilled employees come at a premium. This is a major 'raw material' for construction companies as well, as the timely and 'within-budget' execution of projects requires experienced personnel, which are scarce in this industry. As a matter of fact, in many ways, the construction sector is actually worse-off than the software sector, since engineers perceive software as a 'glamorous' career, and therefore, the sector is losing out to its more glamorous software cousin.

    Another risk that this sector is facing is the risk of execution, which is correlated to the above risk. Most of the companies in this sector have order books ranging from 2x to 5x their annual sales, and if they are unable to get quality personnel to staff their projects, executing them on time and within the stipulated budget will prove to be a challenge. The time taken by the government to award contracts could also be a hindrance to the order book accretion, apart from escalating raw material costs.

    Having given a brief understanding of the Indian construction sector, it is obvious that there are a myriad of options to choose from. Investing in companies from this sector is a subject that will take up another few pages, so we would refrain as of now from making any comments about how to choose an infrastructure/construction stock, and discuss it in another forthcoming write-up. What we would say now is that do not go by the order book size alone, which is what many people do without understanding the intricacies. We need to understand the execution period of the order book, and the kind of margins that the company would make, given the kind of raw material prices at which it has booked these orders.

    Therefore, the need to do all your homework before investing in such stocks cannot be understated, given the complexity of the sector. Of course, this applies to stocks from all sectors. Only if you yourself are convinced about the story, should you take the plunge.



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