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According to the ratings agency, valuations of construction companies will improve over the next 12 months as some of the concerns, such as execution hurdles and high interest rates, are expected to fade out by the year-end, resulting in moderate earnings growth
Though most construction companies have a healthy order book, valuations have taken a beating due to muted earnings growth that is attributed mainly to execution hurdles, hardening interest rates and stretched working capital cycle, according to Crisil.
"The current state of infrastructure is increasingly becoming a bottleneck to the ambitious 9% plus GDP growth target. Hence, spending on infrastructure is imminent. We expect construction investments to grow at a compound annual growth rate (CAGR) of 13% to Rs14.8 trillion over financial years 2012-16," said Prasad Koparkar, head of Industry and Customised Research at Crisil Research.
In the past one year, construction stocks have significantly underperformed-registering a negative 55% return compared to a negative 8% by the S&P CNX NIFTY.
But Crisil believes that at current valuations, which are at historical lows, the risk-reward ratio appears favourable, given the growth potential of the sector. Crisil is a unit of international ratings agency Standard & Poor's.
After registering strong earnings growth of around 60% during the period 2005-2008, construction companies reported a mere 2% growth in the subsequent three years (2008-2011) due to weak margins and high interest costs.
Crisil expects pressure on earnings to continue to cloud 2011-12 due to execution hurdles and high interest rates. However, one cannot ignore the long-term growth potential for companies in this sector, given the large-scale infrastructure spending expected over the next five years. In addition, construction companies have a healthy order book, which provides good revenue visibility, Crisil said.
During 2005 to 2008, construction companies were valued on their order book position. Coupled with robust economic growth and high infrastructure spending, most construction companies traded at their all-time highs. However, over the past two years, the order book has witnessed muted growth and profitability has weakened, resulting in re-pricing of construction companies. Construction companies' valuations are currently at historical lows with median one-year forward price-to-earnings ratio (PER) of 6.5 times.
Tarun Bhatia, director-capital markets, Crisil Research, said, "We believe that valuations will improve over the next 12 months as some of the concerns such as execution hurdles and interest rates are expected to fade out by the year-end, resulting in moderate earnings growth."
Companies under Crisil's equity research coverage are trading at PERs of 4.2 times to 13.8 times the 2011-12 estimated EPS (earnings per share). The P/BV (price-to-book value ratio) of some of these companies is below one, which, given the expected healthy RoE (return on equity) offers a favourable risk-reward ratio. Crisil has coverage on ARSS Infrastructure Projects (ARSS), C&C Construction Ltd (C&C), Era Infra Engineering Ltd (Era), Marg Ltd (Marg) and MBL Infrastructure Ltd (MBL). Of these, ARSS, Marg and MBL have a valuation grade of 5/5, indicating a strong upside (more than 25% from current market price); C&C and Era have a valuation grade of 4/5, indicating a 10%-25% upside from the current market price.
In terms of performance, ARSS Infrastructure's June quarter sales totalled Rs 438.41 crore (a 23% growth over the corresponding quarter in the previous year). Quarterly profit was Rs38.65 crore (14% growth) and price to earnings ratio of 2.86 (September 2011). Similarly, MBL Infrastructure had quarterly sales of Rs309.70 crore (39% growth) in the June 2011 quarter, quarterly profit was Rs20.03 crore (36% growth), and the price-to-earnings ratio at 2.71 (September 2011).