What is the reason behind the recent collapse of infrastructure stocks?
One is the sharp rise in metal prices. This would seriously affect the margins of companies, specially those in the capital goods space. These companies have price escalation clauses for around 70 per cent of their contracts. The balance 30 per cent will result in the companies taking some hit on the price rise.
So in the next 12-18 months, there will be some amount of stress on the margins. We expected margins to expand because of growth in volume which will result in fixed overheads being lower as a percentage of sales. Now that will get negated due to rising steel prices. And those with a bulk of fixed price contracts will see their margins dip by 30-50 basis points.
Also lot of projects have seen a delay in implementation, specially in the power space. So a number of capital goods companies have shown lower-than-expected sales growth. Not because they do not have an order book or due to internal issues, but due to external issues like delay in projects affecting the turnover. As a result, the top-line was lower than what the market expected.
Delays in project implementation and the steep rise in metal prices is what is worrying investors at large as far as the capital goods space is concerned.
When you speak of metal prices, which ones are you referring to? Do you see any change?
Initially it used to also be copper where transformer companies would have got hit. Recently it is mainly ferrous metals.
Given the demand and supply dynamics, they do have that pricing power. In the immediate quarters I do not see a change. But on a longer term trend it is not much of a worry.
Going by the earlier valuations, do you think such PE re-rating will ever take place? Will we ever see the past returns repeat themselves?
Yes. PEs were very high because these companies have the highest visibility in terms of revenue and profitability. They have order books ranging from 18 months to 4 years of their annual sales. And this demand will carry on for many years to come. That is why investors were willing for pay for growth three years down the line. They paid a lot of premium for visibility of earnings.
Now the froth in valuations is out but the fundamentals remain intact. We are far behind many developing nations in terms of infrastructure, let alone developed. What is projected to be spent in the 11th 5-year Plan on telecom and energy is cumulatively more that what has been spent in the earlier ten 5-year plans. And we will still have a deficit in power at the end of this 11th 5-year plan.
As far as returns in infrastructure funds are concerned, if it is not capital goods this year, it will be something else. Take a look at the material space (metals). It is a bane for capital goods but is a positive for metal companies.
Today the large metal companies have backwardly integrated into raw materials. In iron ore there is full backward integration and partly in coking coal. These will make money in a scenario of high metal prices as and when the government permits it. Small companies which do not have raw material backward integration today will do so in the next 18 months. They will also be beneficiaries of high metal prices and low material costs. So if it is negative for some companies, it is a plus for others.
So we can play metals, cement and look for other opportunities. Investors can expect 15-20 per cent returns from now on. Valuations are attractive and growth is intact.
Price is a function of earnings and the price-earnings ratio. Earnings can be predicted. But PE is pure sentiment. So if oil corrects and global liquidity is back to normal and the focus is back on the infrastructure story in India and China, you might see those PEs coming back.
Do you think this government has failed on the infrastructure front?
The previous government built up a huge momentum in terms of road construction and power reforms. The privatisation of the power sector led by trifurcation of the SEBs — separation of generation, transmission and distribution was a big move. Initially it was NHAI that was largely taking responsibility of building the roads along Golden quadrilateral.
The current government changed direction and began looking at PPP - public-private partnerships. However, before the PPP model took off, the government lost two years in the bargain. Privatisation in the telecom sector succeeded and so the government tried to replicate that model in roads but lost crucial time.
Now oil prices and inflation are other issues that are hindering the government. The RBI tried to tame inflation rates by hiking interest rates and squeezing liquidity in the system. Last year, money was easily available in equity and debt. Now equity money is not easily available and interest rates have gone up. Consequently, infrastructure projects cost much more today.
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