The construction sector has embarked on a secular growth path led by the boom in infrastructure activity across sub-segments (roads, ports, power, airports, railways, urban planning, etc). We estimate investments of Rs 12,66,000 crore to flow into the Indian infrastructure sector over 2008-12, which would translate into construction orders worth Rs 7,08,600 crore. Also, we believe operating margins would remain robust in the wake of escalation clauses and higher margins inherent in fixed price contracts.
Consequently, we expect robust earnings CAGR of 25% over 2006-9. However, there are concerns relating to margin pressure led by rising prices of raw material such as cement, steel, etc, working capital intensive nature of the business and higher interest rates on the value of BOT (build-operate-transfer) assets. But, we see these concerns unwarranted and overplayed as we delve deeper into the business dynamics.
After the recent correction in stock prices, construction stocks are trading at attractive valuations (adjusted for BOT values). The stocks currently trade at an average discount of 10-15% to market multiples, which we believe is not justified in view of their superior earnings growth, high revenue, earnings visibility and superior return ratios.
We maintain our overweight stance on the sector with Jaiprakash Associates, Hindustan Construction and Madhucon Projects as our top picks.
Jaiprakash Associates (JAL): With proven capabilities in hydel power, construction and an order backlog of Rs 6,700 crore, the company is well positioned to capitalise on the rich pipeline of hydel power projects. The strong performance in cement business, Vishnu Prayag Hydel Power Plant and Jaypee Green would likely drive a consolidated earnings CAGR of 26.4% over 2006-9. The stock trades at 10.6 times 2008-9 standalone earnings, and 8.5 times consolidated earnings. We estimate JAL’s fair value at Rs 836 a share on a sum-of-parts basis. Reiterate outperformer.
Hindustan Construction Company (HCC): With its proven capabilities across a wide spectrum, the company has a diversified order backlog of Rs 7,370 crore (3.1 times 2006-7 revenues). We expect HCC’s strong order book to drive an 18% CAGR in its earnings over 2006-9. At seven times 2008-9 earnings (net of real estate valuations), valuations are at a discount to peers and are quite attractive. Given its huge order backlog, improving return ratios and value in real estate ventures, we reiterate outperformer with a price target of Rs 150 per share.
Madhucon Projects (MPL): With its focus on road, irrigation and real estate sectors, the company earns superior margins vis-a-vis peers owing to its prudent policy of using own equipment and limited subcontracting. A strong order backlog of Rs 4,380 crore, along with stable margins, would likely drive a 39% CAGR in MPL’s earnings over 2006-9. At six times 2008-9 earnings, MPL trades at a steep 25-30% discount to peers despite the sharp earnings growth and value-accretive ongoing BOT projects. Reiterate outperformer.
