– Weak order inflow and slow execution marred Q2 performance
– Companies hope to recoup growth in the second half
– Strong order book provides robust revenue visibility
– Our conviction stocks’s valuations are attractive, they offer highest revenue visibility
For construction companies, the September 2019 quarter was a bummer because of weak order inflows and slower project execution as a result of excessive rains. On an aggregate basis, 23 leading listed construction companies grew sales 9 percent year-on-year (YoY).
Most of these companies highlighted lower execution and delays in approvals and payments, which resulted in higher working capital requirements. Thus, interest costs jumped 17 percent while PBT (profit before tax) grew 13 percent. Nevertheless thanks to new corporate tax rates, aggregate tax outflows grew by merely 2 percent, which helped these companies post a strong 19.3 percent growth in net profit.
The worst is behind
The stocks of construction companies have correctly significantly in recent times and are now trading at attractive levels. Infrastructure stocks as a basket are currently trading at 13 times their trailing earnings and valued at 6 times on a EV (enterprise value) to their trailing EBITDA basis. Interestingly, our focused list of seven high conviction ideas (please see table below) from the sector is trading even cheaper at 11 times their trailing earnings and 5.5 times trailing EV/EBITDA.
Apart from valuations, which are favourable at this time, growth is also expected to bounce back.Company managements believe that what happened in the second quarter was exceptional and they expect execution to pick up post-monsoon and help them report higher growth in the second half of the current financial year.
Moreover, as per media reports, the government is also working towards alternative ways of funding infrastructure projects in the light of the fiscal stress. The pace of road construction, which was around 29.2 km per day in FY19 has fallen to 24.6 km a day in the first half of the current financial year. However, the ministry of road transport and highways is hopeful of achieving 40 km a day by the end of fiscal. In November 2019, minister Nitin Gadkari said that road projects of about 4500 km – worth about Rs 50,000 crore – would be awarded over the next 3-4 months to spur construction activities. Even if the pace of road construction is maintained at about 26-28 km day, activity in the sector will speed up in the rest of the year.Good revenue visibility
The other important point is that today the sector has an order book of about 2.5-3 times its annual revenues. Most companies are sitting on a strong order book which provides good revenue visibility. Even if there is a slide in awarding new projects, these companies can sustain growth. For instance, among our high conviction ideas, J Kumar has orders worth Rs 13200 crore, which is close to 5 times its annual revenue. In the September quarter, J Kumar’s revenues grew 23 percent and net profits 58 percent YoY.
Conviction list: Better placed
Not just J Kumar, companies in our conviction list (7 companies) on an aggregate basis have delivered strong revenue growth of 37 percent, which is much higher than the overall 9 percent growth reported by the sector. For these high-conviction stocks, their profits before tax (PBT) grew by 73 percent YoY. Besides, lower tax helped them post a strong 92 percent growth in net profits.
Companies in our list have demonstrated good execution and had the advantage of better visibility because of the strong order book. These seven companies have an aggregate order book of close to Rs 80,000 crore, which is 4 times their annual revenues. This is much higher than the sector average of about 2.5 to 3 times. Moreover, these companies and their managements have guided to do better in the second half of the current fiscal.
Our conviction stocks have done far better and should continue to deliver good growth because of their superior execution capability, strong balance sheet and highest revenue visibility.
Risks largely comes from a slowdown in domestic capex cycle. Besides, a significant increase in interest rates and government funding constraints could pose project risks and impact execution and the working capital cycle adversely.