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Construction: The infrastructure push!

Sep 14, 2006

The Indian economy, with an expected growth rate of around 7.5% to 8% in FY07, is amongst the fastest growing in the world. In order to sustain this kind of growth rate, the country needs, among other things, robust and world-class infrastructure. It needs no repeating that the infrastructure in the country can, at best, be described as sub-standard, and at worst, pathetic. The country's financial capital, Mumbai, has, in some places, the kind of roads that you would not even find in a third-class village!Thus, it goes without saying that if the country is to consistently grow at a good pace and attract investments, both domestic as well as foreign, then it will have to get its act together and consciously strive to improve its infrastructure - be it roads, power, ports, airports, irrigation, sanitation or telecommunications. In this regard, we briefly examine here, the kind of growth potential and investments that are there in the infrastructure segment of the construction sector.

Roads - Laying the route to prosperity!
The roads sector is one that is expected to see the maximum action in the infrastructure segment. Overall, infrastructure investments are expected to rise from Rs 1,700 bn in FY05 to Rs 2,200 bn by FY08. Of this, the roads sector is expected to contribute as much as 34%, or Rs 757 bn. A major part of this activity will be centred on the National Highway Development Programme (NHDP). This is the government's flagship project in its grand plan to give a facelift to the entire country's road network over the next decade. The project entails the building, upgrade and maintenance of 51,411 kms of roads at a cost of nearly Rs 1,900 bn.

Public-Private partnerships - Partnering for growth
With the pressing need to develop the country's infrastructure, the government has clearly realised that it cannot do it all on its own. It will have to involve the private sector, and the fact that a significant number of projects are being planned predominantly on a build-operate-transfer (BOT)^ basis is a strong indication of the government's intention to invite greater private sector participation in infrastructure creation.

Irrigation and water supply and sanitation (WSS)
Irrigation projects and urban infrastructure are expected to be other major areas contributing to the growth of the infrastructure segment. These 2 segments comprise 39% of the total outlay expected till FY08 at Rs 869 bn. Dam projects, water reservoirs, water treatment plants, desalination plants and sewage treatment plants are some of the project types that are expected to be awarded by state governments over the next few years. The state of Andhra Pradesh alone has envisaged investments of Rs 400 bn in irrigation projects over the next 5 years.

Power - Empowering India!
In India, the power infrastructure is in fairly poor shape. Power theft is rampant, and the quality of power supplied often leaves a lot to be desired. Thus, the need to accelerate power reforms cannot be understated. The government's capacity addition plans in the Tenth Five-Year Plan (2002-07) amount to 41,110 MW, while for the Eleventh Five-Year Plan (2007-12), the addition envisaged is to the tune of 60,896 MW. However, it should be noted that, given the past track record, it is unlikely that a great percentage of this addition will actually come on-stream during the plan periods. Nonetheless, construction investments are expected to amount to Rs 450 bn by FY10, giving significant scope for players operating in this sector.

Players in the sector
We give here, a brief fundamental check on the major players in the Indian construction sector.

The ones who matter!
 SalesEBITDA marginsNet profitRoEMarket price*P/E ratio**
(FY06)(Rs m)(%)(Rs m)(%)(Rs)(x)
Gammon#14,851 13.0% 1,043 20.6%374 34.9
Hindustan Construction19,870 9.2% 1,248 20.1%109 21.9
IVRCL14,957 9.0% 930 24.8%253 27.8
L&T 147,631 7.2% 9,424 23.7% 2,522 35.3
Nagarjuna Construction18,404 8.9% 1,039 16.4%312 26.7
* Closing market price on the BSE as on September 13, 2006.
** On a trailing 12-month basis.
# Gammon's fiscal was changed from December to March from FY06, thus making FY06 a 15-month period (starting from January 1, 2005 and ending on March 31, 2006). For comparison purposes, we have taken FY06 as the 12-month period ended March 31, 2006.
@ Net profit for L&T calculated excluding extraordinary items.

As can be seen, all these players trade at reasonably high P/E multiples on a trailing 12-month basis, reflecting the high expectations that the market has from them. To their credit, so far, they have performed admirably, justifying the premium valuations that they enjoy on the bourses. However, we would say that while studying a construction stock as an investment, do not go by the order book size alone.

Factors like the duration of the order book, raw material costs, escalation clauses and the ability to protect margins are factors that, in our view, are more important than simply the order book-to-sales. Execution risks and, of course, finding adequate and qualified people to execute the projects, in our opinion, are the biggest risk factors.

^ In the BOT model, the vendor builds a highway or bridge, operates it for a period of time and later hands it over to the government. Here, it is important to note that this model rests on specialists who bring in the best knowledge and skill-sets for setting up such projects. The model works on outsourcing the early stages of project execution to specialist private players and once the project starts running smoothly, it is taken over and run by someone else like the government in this case.

Note: The source of all the figures in this write-up is CRIS INFAC.

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