Institutional Equities This page has been intentionally left blank IV Institutional Equities Infrastructure Sector 26 September 2011 Light At The End Of The Tunnel View: Positive The infrastructure sector has witnessed many pitfalls in the last two years which have hurt investor sentiment. We believe the valuation of the sector is Amit Srivastava close to the bottom as the stocks of infrastructure companies have corrected [email protected] between 60%-75% in the period July 2010 to August 2011. Post correction, they +91-22-3926 8116 are trading 33%-47% below their five-year historical average price-to-earnings of 20x-44x. We believe slower order inflow, rising interest rates, regulatory issues Nitin Arora and earnings downgrade have been largely discounted by the market. Although [email protected] we believe the earnings will not improve significantly, concerns over rising +91-22-3926 8169 interest rates, regulatory issues and execution risks are likely to subside in the short term, thereby leading to outperformance by infrastructure stocks. Sector Sector Fundamentals versus valuation: We believe the infrastructure sector is currently moving from a moderation phase to a slowdown phase, and the slowdown has started One Year Indexed Performance hurting profitability (as seen from a sharp decline in earnings in 1QFY12 by 97% YoY) 230 which will continue in the short term. However, as the slowdown has already been 210 190 factored in (stock prices have declined by around 60%- 75% between July 2010 170 150 & August 2011), we believe the sector is set for a re-rating as FY13 net profit for 130 our universe of companies is set to grow by 44%. 110 90 Stability in interest rate cycle to aid performance: To curb rising inflation, the 70 50 09 09 10 11 10 09 10 11 09 11 10 09 10 11 10 11 Reserve Bank of India (RBI) raised its repo rate by 25bps in September 2011 (175 09 - - - - - - - - - - - - - - - - - Jul Jul Jul Jan Jan Jan Sep Sep Sep Nov Nov Mar Mar Mar May May bps since January 2011), the 12th hike in the past two years, to 8.25%, which is May 75bps below the peak witnessed in October 2008. As per consensus estimate, the Nifty Infra index repo rate may be hiked further by 25bps and then it may stabilise at that level (not Source: Bloomberg correct sharply as in the previous FY09 cycle). Historically, whenever interest rates peak, the infrastructure stocks outperform. Further earnings downgrade due to rising interest rates unlikely: Between January 2010-September 2011, revenue estimates of our universe of companies (Bloomberg consensus) have been downgraded by 11% for FY12 and 5% for FY13 and PAT estimates cut by 33% and 31% for FY12 and FY13, respectively. As per our analysis, we believe the market has already discounted higher interest rates and further earnings downgrade is unlikely. Uncertainty in order execution in near term, but FY13 to witness strong growth: Despite a strong order book, revenue growth was muted during the past one year due to order execution-related issues. The market believes these issues will continue to impact the growth of the sector. However, we believe the order execution will improve because these issues are more technical (short-term in nature) rather than structural. Coverage universe: We initiate coverage on five companies with a Buy rating on IRB Infrastructure, Reliance Infrastructure, GMR Infrastructure and IVRCL, as we believe they are best placed in terms of execution track record, Balance Sheet strength and valuation parameters. Despite attractive valuation, we assign a Hold rating to HCC as we believe that higher leverage and the Lavasa issue will cap any upside. Market cap EPS (Rs) P/E (x) RoE (%) CMP Target Up/ Company Rating Rsbn US$ bn (Rs) price Down (%) FY11 FY12E FY13E FY11 FY12E FY13E FY11 FY12E FY13E IRB Infra Buy 54.1 1.1 163 235 44 13.6 14.0 18.0 12.0 11.7 9.1 18.6 16 17.1 Reliance Infra Buy 116 2.3 434 724 67 58.0 60.6 72.6 7.4 7.1 5.9 6.6 6.5 7.3 GMR Infra Buy 110.4 2.2 28 39 39 (0.3) 0.2 1.2 NA 134.4 22.8 NA 1.0 5.8 HCC Hold 17.4 0.38 29 33 14 1.2 0.8 1.5 23.9 33.1 18.7 4.7 3.3 5.7 IVRCL Buy 10 0.20 38 59 55 5.9 5.1 6.7 6.3 7.3 5.6 8.2 6.6 8.1 Source: Company, Nirmal Bang Institutional Equities Research Institutional Equities Table of Contents Cyclical nature of infrastructure sector………………………………………………………………...….03 Stress case valuation level indicating downturn is already priced in.........…………………….……..04 Our mode of valuation………………………………………………………………………….……….….07 RoE trend of BOT projects…………………………………………………………………………………09 Further earnings downgrade due to rising interest rates to be limited………………………..………11 Our estimates versus consensus: Improvement expected in FY13…………………………..………12 Short-term hiccups in order inflow, but long-term growth intact…………………………………….…13 Road segment: Improvement in order inflow, but at a cost………………………………………….…15 Power segment: Capacity up, but operational issues hurt future valuation …………………………19 Key operational issues in power sector and our view ………………………………………….………20 Funding problems for big scale 12th Plan infrastructure spending ………………………….….……22 Project execution uncertainty in near term, but FY13 to witness strong growth…………….………23 Initiating coverage on five infrastructure companies………………………………….……….……….25 Companies IRB Infra……………………………………………………………………………….…………..….……27 Reliance Infra………………………………………………………………………………...…….….…..41 GMR Infra……………………………………………………………………………………………..……55 HCC. ………………………………………………………………………………...………….……….…67 IVRCL ………………………………………………………………………………...………….……..….79 2 Infrastructure Sector IV Institutional Equities Cyclical nature of infrastructure sector The infrastructure industry tracks the cyclical nature of the economy, which we have described in phases in Exhibit No. 1, and accordingly the valuation parameters change. During FY10-11, the industry shifted from the growth phase to the moderation phase because of macro factors like monetary tightening, rising interest rates, trimmed gross domestic product (GDP) estimate and slack demand tracking the global slowdown. Lower GDP growth, cancellation of orders, subdued Index of Industrial Production (IIP) growth and declining profitability of companies are indicating that sector fundamentals are moving from the moderation phase to the slowdown phase. We believe it would remain under the slowdown phase in the short term. However, the sector’s valuation has already factored in the slowdown phase, as the stocks of infrastructure companies have corrected between 60%-75% in the past one year (July 2010-August 2011) & trading at 33% to 47% below their five-year historical average PE of 20x-44x and at 0.6x-1.2x their book value of our universe of stocks. Going ahead, even if the companies’ earnings are subdued in the short term, their stock prices will start factoring in the recovery phase expected in FY13. Hence, we believe the stocks are trading at below stress case level valuation and provide a good investment opportunity for investors. Exhibit 1: Fundamentals versus valuation Fundamentals moving from moderation to slowdown Current valuation Source: Nirmal Bang Institutional Equities Research 3 Infrastructure Sector IV Institutional Equities Stress case valuation level indicating downturn is already priced in During the past one year, the infrastructure sector’s revenues (infrastructure developers and construction companies) have gone up by 17% and earnings by 6.3%. However, given the multiple issues such as slower order inflow, rising interest rates, regulatory issues, delay in project execution and depressed return ratios, the stock prices of infrastructure companies have corrected by around 60% to 75% between July2010-August 2011. Post correction, the stocks are trading at 33% to 47% discount to their five-year historical average PE of 20x-44x and at 0.6-1.2x book value, thereby appearing attractive for investment. The stocks are trading below their historical trough valuation, close to the levels witnessed after the Lehman collapse, which we believe is unjustified (as the companies are better placed in terms of order book-to-bill ratio, leverage and return ratios). If we adjust the embedded value of investments in stock prices of construction companies, they are trading at a PE multiple of 4x-6x on FY13. Hence, we believe the infrastructure stocks are trading below stress case valuation level and have factored in the worst case scenario. Exhibit 2: Stock price returns Stock returns (%) Companies Revenue (YoY %) PAT (YoY %) 1 month 3 months 6 months 1 year IRB Infrastructure 43.0 17.0 3.8 4.0 (12.8) (42.7) IVRCL 2.6 (25.0) 1.6 (40) (49) (77.8) GMR Infrastructure 26.0 N/A 0.5 (8.2) (11.2) (51.7) HCC 12.3 37.0 2.9 (1.6) (20.6) (51.9) Reliance Infrastructure 2.7 2.1 (3.7) (20.0) (31.9) (59.2) Source: Bloomberg, Nirmal Bang Institutional Equities Research Exhibit 3: Infrastructure stocks versus Nifty performance 330 Over-expectation post Congress- led government in majority 280 Dubai ,Telangana issues Scams Rising interest 230 rates & earnings cut 180 130 80 30 11 10 11 10 09 09 10 10 11 09 10 11 10 09 09 09 - - - - - - - - - - - - - - - - Jul Apr Apr Oct Jan Jan Jun Jun Feb Mar Nov Dec Sep Aug Sep May GMR Infra R-Infra IVRCL IRB Infra HCC Nifty Source: Bloomberg, Nirmal Bang Institutional Equities Research Investment comfort based on valuation parameters In FY12, we expect the construction companies to report a decline in return ratios following moderate growth in earnings. However, during FY13, these companies would report robust growth driven by ongoing concerns waning and the low base of FY12, thereby improving the return ratios. We believe the current valuation indicates the risks and concerns have been factored in and investor sentiment towards the sector is at its lowest level.