Analysing Engineering companies

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One reason why most countries, after the economic downturn last year, announced huge stimulus packages for infrastructure projects was because this would directly increase employment, boost demand and lift the sagging economies. According to data from the World Bank, every 1 per cent increase in infrastructure assets adds another 1 per cent to the gross domestic product (GDP) growth.

OPPORTUNITIES
In India's context, the opportunities are huge. Its poor infrastructure remains a major concern for its required economic growth. However, this is also an investment opportunity, given that if more money is ploughed into this sector, many companies will benefit immensely. This will ultimately translate into more value for shareholders in the long run.

Opportunities
Sectors Xth Plan
($/bn)		 XIth Plan
($/bn)		 Sectoral
Share (%)		 %
Change
Power 75 158 30 110.70
Roads & Bridges 37 80 15 116.20
Telecommunication 32 68 13 112.50
Railways 31 66 13 112.90
Irrigation 29 57 11 96.60
Ports 1 19 4 1800.00
Airports 2 9 2 350.00
Others 20 62 12 210.00
Total 227 520 100 130.10
Source: Planning Commission Consultation Paper Dated Oct 2007

There is a huge demand and supply gap,which cannot be done within a year or two. More investments will be required in infrastructure over several years for meaningful progress.And the economy will grow at the desired growth rate. India invested about 4 per cent of its GDP on infrastructure during the 10th Five-year Plan and now aims to double this proportion. Estimates suggest that not only will this ratio improve, but the growing economy itself would create a huge investment opportunity in the sector.

During the 11th Five-year Plan (2007-12), spending on infrastructure more than doubled to over $500 billion (Rs 23,21,000 crore) against $227 billion (Rs 10,50,000 crore) in the previous plan.

Despite huge opportunities, the profitable ones will be selective. There could be certain periods and certain segments (like roads) within infrastructure, which might grow faster and attract higher investment. The best way is to read through the government's planned expenditure (see table) in different segments.

BUSINESS MODEL
Most companies operate in segments like roads, ports, irrigation, water, airports, urban infrastructure, buildings, bridges, dams and power plants. Projects in these segments are mostly awarded by the state and central government agencies.Companies undertake cash contracts, whose scope of work ranges from pure construction to design, procurement, consultancy and engineering work.

Today, companies not only build these projects but also own and generate revenue from these till (generally after 15-30 years) they are finally transferred to government. Such projects are known as build-operate-transfer (BOT) projects.

KEY STRENGTHS
A good company could have ample experience, a qualified team and a strong balance sheet. Also, management's background and key board members provide an idea about the company's capability to harness the opportunity in the sector. Watch for its success ratio in previous biddings for the projects and the reasons (if any) for which the company could not be qualified.

One also needs to watch out for the company's international or domestic tie-ups for particular technology (like tunnelling technologies, construction of nuclear power project, etc) needed for a particular set of work.

Further, a higher level of integration in terms of the company’s own equipments, ready mix concrete (RMC) plant and other such assets could be rewarding, providing better margins and help against the price war.

DIVERSIFICATION
An infrastructure company can diversify in three ways: geography, segment (road, irrigation, etc) and clients (private or government). Diversification helps in the case of slowdown in a particular region or segment. Political changes and policy initiatives have impact on growth, too. For instance, many South India-based companies took a hit in their share prices when the news of Andhra Pradesh's former chief minister YSR Reddy’s demise came in, as many feared the investments in infrastructure will slip in the state. More recently, share prices of L&T, Punj Lloyd and Simplex Infrastructure, which have overseas presence (in Gulf countries), had corrected due to the Dubai crisis. One also needs to check if diversification is into core fields. For example, during boom time, many companies entered into real estate but later had to suffer due to slow growth.

OTHER FACTORS
Visibility can be assessed from the opportunities within revenue segments. Also, an outstanding order book and flow of new orders gives a good idea. If a company is having Rs 100 crore turnover, it will generally have an order book of Rs 200-400 crore or even more. In other words, the company has the next two to four years' turnover in its hand, which is possible given the long gestation period of the projects. A bigger order book indicates better prospects.

However, investors need to also look at the project profiles in terms of completion dates. Like, Hindustan Construction Company (HCC) had to go through a lot of pain when the Bandra-Worli Sealink was delayed for several years and the overall project cost went through the roof.

Sometimes, companies also bid for projects in a consortium because of lack of expertise and funds. Likewise, expected revenue, revenue sharing arrangements, funding arrangements, internal rate of returns, project margins and client profile are important aspects.

Last year's economic downturn is a classical example. Higher interest rates and lower revenue growth hit the infrastructure companies, given their highly leveraged balance sheet.

During good times, companies take many projects which are financed by banks, as most of these projects have long gestation period and require huge working capital. But in a downturn, it becomes difficult to service debt and the interest cost eats into a large part of the company’s profits.Even banks are more cautious about lending and may withdraw credit facilities. As a result, projects get delayed and revenues suffer.

VALUATIONS
Mostly, the price-to-earnings multiple can give an idea about the valuations of the company, particularly for pure construction business. However, many times, it does not capture the true value, given the long gestation of projects and ownership of certain assets. Meanwhile, sum-of-part valuations (SOTP) method could be applied.

Suppose a company's construction (cash contracts) business is worth Rs 100 per share based on a certain price-to-earnings’ multiple and its BOT road project is worth another Rs 25 per share, based on discounted cash flow method (DCF) or based on the book value per share of such investment, the fair value would be Rs 125 per share.

If the same company has several subsidiaries and JVs, one can add more, based on per share value of such investments in subsidiaries.

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