Institutional Equities Sector Report Potential 5-baggers in 5 years Analyst October 2006 Amar Ambani [email protected] 91-22-6749 1739 Institutional Sales Sandeepa Arora [email protected] 91-22-6749 1776 India Under ‘Construction’ Index Particulars Page no. Investment summary 3 Our top picks 6 Need for investments in infrastructure development 8 Factors favoring India’s infrastructure boom 10 Industry classification 17 Investments in ‘infrastructure development’ to remain robust 18 Performance of construction stocks 19 Will this rise be sustainable? 20 Hefty order flows expected for construction majors 21 Funding issues reasonably under control 22 Overseas opportunity 25 Key success factors 26 Valuations in the sector 29 Concerns 32 Company section 35 - Gammon India Ltd 36 - Hindustan Construction Company Ltd 49 - Nagarjuna Construction Company Ltd 67 - IVRCL Infrastructures & Projects Ltd 78 - Patel Engineering Ltd 91 - Simplex Infrastructures Ltd 105 - Era Constructions (India) Ltd 115 - Valecha Engineering Ltd 126 Annexures Industry overview 137 Segmental overview 140 Infrastructure investments - Roads 141 - Power 145 - Water and irrigation 149 - Railways 153 - Airports 157 - Ports 161 Industrial investments - Oil and gas 164 - Pipelines 170 - Metals 172 Real estate investments 176 Notes 185 October 18, 2006 Construction Sector 2 India Under ‘Construction’ India is under construction and it is visible all over - houses, roads, ports, power plants et al. Favorable policy environment and easy flow of capital is helping India to build and improve its woefully poor and inadequate infrastructure. Order books of all construction companies are overflowing and we see a sustained revenues growth of 40-50% pa for at least next 5 years. Investors can have a double windfall, as rising EPS quarter after quarter invariably leads to P/E re-rating (see Case Study on Software Services IT sector on Page 4). We do not want to build- in euphoric re-rating of IT sector the way it happened in the late 90s, but even with a reasonable PEG of 0.8x, we have 8 companies that can potentially be 5- baggers over the next 5 years. We met several companies and government officials and have attempted to present data and analysis as concisely as possible in this report. The buoyant mood prevalent was put in words quite well by a director of a large construction company ‘Just the requirements of DLF, already planned can keep Gammon, HCC, NCC and IVRCL fully booked for 2 years.’ Investment Summary Woefully inadequate infrastructure requires investments We expect US$180bn of Infrastructure in India is woefully inadequate and manifests itself in myriad ways investments in infrastructure in our daily lives – be it traffic jams or jam-packed trains or delayed flights or load over next 3 years shedding or goods stuck in ports or roads with pot holes. Even Urban infrastructure is crumbling and needs rejuvenation. These calls for immediate investments, that too over the next 10 years if India has to realize its dreams of being an economic The construction sector is the power house. We expect US$180bn of investments in infrastructure over the biggest beneficiary of the next three years. The construction sector, accounting for 65% of the total capex spend investment on infrastructure development, has been the biggest beneficiary of the capex spend. Conducive policy environment to boost infrastructure investments The political will and improved situation of central and state government finances have contributed to the rise in spend on infrastructure development. Political differences with reforms across political parties are reducing. The common man holds the local government answerable for fulfilling his needs for Bijli, Sadak, Pani (Power, Roads and Water). Media coverage and recent RTI Act has further empowered the common man. The Left bastion in West Bengal is also talking of infrastructure and economic development. Airport privatization in Mumbai and Delhi was pushed through in spite of opposition. We believe that current policy environment is conducive to infrastructure development and even if the political power equations change, investments will continue. Overflowing order book position Construction companies have Most Indian construction companies have built engineering and project order books in the region of management skills to garner the lion’s share of this spend. The construction sector 3.5-6.5x turnover is expected to witness 10-12% growth in the coming years on the back of high investments on infrastructure development. We believe that India has barely A lot still needs to be done: scratched the surface. China has been spending over 6.5% of its GDP on China spends nearly 4x construction, for the last 10 years. In India’s case, construction spend stood at 4.5-5.8% of GDP prior to 1999-00 and reached 6% only in the last few years. India’s spend on construction China’s spend on construction is nearly 4x of India’s spend. The amount of development planned by real estate companies itself will entail extensive construction work, let aside government orders. Funding – not a constraint Funding sources identified for With the rising share of construction in total bank credit and greater clarity having a major portion of emerged with sources identified for a major portion of investments, funding issues investments in most sectors are reasonably under control. Innovative measures like cess on petroleum products, privatization through BOT, budgetary support, borrowings from multilateral agencies and a buoyant capital market have helped. We do not envisage any funding bottlenecks to derail investments in infrastructure. October 18, 2006 Construction Sector 3 India Under ‘Construction’ Valuations attractive – earnings visibility over a long period We are overweight on the construction sector and believe valuations to be attractive. The sector offers high visibility with huge investments in the pipeline and order book of companies at 3.5-6.5x current turnover. Construction companies in India are scaling up fast and are expected to attain considerable size going forward. We believe that the sector is placed to exploit the infrastructure spend, just like software services in mid 90s exploited the Y2K bug. There is considerable scope for a second round of re-rating, just like what happened to software services in the last decade. In the beginning, software services was compared to low value, manpower contracting. Strong revenue growth not only led to EPS growth on a quarter on quarter basis, but also drove multiple expansion. We expect the same story to repeat in the construction sector also. We recommend investors to overweigh this sector and build a portfolio of stocks in construction universe. Our top picks are Simplex Infrastructures (CMP Rs333), Hindustan Construction (CMP Rs128), Nagarjuna Construction (CMP Rs175), Gammon India (CMP Rs385), Patel Engineering (CMP Rs361) and IVRCL Infrastructures (CMP Rs287) among large caps and Valecha Engineering (CMP Rs208) and Era Constructions (CMP Rs358) in mid caps, in that order. Case Study – Will IT repeat in construction? Scope for continuous re-rating The comparison with software services is compelling. 15 years ago, the software services industry in India comprised small sized companies doing low value added “body shopping” - manpower contracting, with strong investor concerns on quality of management. When India Infoline Ltd (then Probity Research and Services Pvt Ltd) came out with our seminal report on Indian Software Services Industry in 1998, it was met with huge skepticism. Investors and analysts used to ask questions like: Ö How will Infosys manage 10,000 employees? Ö Is software services not a manpower multiplication game? Ö ICDs of Company X have bounced. Ö Shady management - This in fact was the most common refrain from investors not willing to buy the huge growth story. Y2K changed the landscape Strong qoq performance led Thanks to the Y2K boom, IT companies scaled up aggressively. They not only to EPS and P/E expansion became “professional”, but also set standards for corporate governance and transparency. Strong quarter-on-quarter performance for years, not only led to an expansion in EPS, but also in P/E. From times, when the sector traded at a discount to the market index, it started trading at a premium. A similar trend and sequence of events can be observed, taking place with the construction sector. A few years back, construction companies were trading at low multiples with reservations on management quality. Today, the opportunity at hand has worked in favor of these companies. They have geared up and possess the competitive ability and people to undertake complex jobs. Earnings performance has already resulted in a re-rating in the sector over the last 2-3 years. Revenue visibility still continues to be high and we project EPS growth to drive a second round of P/E expansion. No doubt, these companies will raise capital, still they will be EPS accretive. October 18, 2006 Construction Sector 4 India Under ‘Construction’ Sensex and Infosys P/E compared P/E over 200x - Massive Out-performance 70.0 The meltdown Earlier days Infosys stock 60.0 Discount to Discovered fell sharply in Sensex Y2K 50.0 one day (x) 40.0 30.0 20.0 10.0 - Jun-93 Jun-95 Jun-97 Jun-99 Jun-01 Jun-03 Jun-05 Sensex Infosys Sensex and HCC P/E compared 50.0 40.0 30.0 We believe (x) construction 20.0 sector poised for a re-rating 10.0 - Mar-98 Mar-00 Mar-02 Mar-04 Mar-06 Sensex HCC Source: Bloomberg, India Infoline Research October 18, 2006 Construction Sector 5 India Under ‘Construction’ Our Top Picks We have covered eight companies that are poised for growth and are trading at attractive valuations. To factor in BOT ventures, land bank value and investment in subsidiaries along with the core construction business, a sum of parts valuation approach is used.