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Battling Headwinds

The construction sector is beset with a number of problems & investors should exercise caution…

On an average, construction sector stocks have declined 30 per cent over the last one year whereas the Sensex has risen 11.5 per cent over the same period. The sector has faced rough weather with inflow of orders falling to a trickle. Key client industries like real estate, cement, steel and oil and gas face difficulties and are not expected to tender significant orders anytime soon. Valuations have cooled down, but that is of scant comfort to investors given the sector’s poor outlook.

Opportunities
Opportunity for construction companies arises from the government’s huge planned investments: up from $0.5 trillion in the 11th five-year plan to $1 trillion in 12th five-year plan. According to Nitin Bhasin of Ambit Capital, this would translate into an opportunity of $0.36 trillion (Rs16,50,000 crore) for the private sector (assuming that the latter maintains its share of total investments at 36 per cent, as in the 11th plan).

Headwinds
The sector is going through a rough patch due to a number of reasons:
Weak order inflows: Construction companies have seen weak order inflows in the nine months ended December 2010. That situation is not expected to change anytime soon. According to a recent report by Nomura, actual orders for a number of key players will be lower than the guidance provided by them for FY11. For instance, Hindustan Construction is expected to see slippage in order inflows to the tune of 38.9 per cent compared to its initial guidance; IVRCL, 20 per cent; and L&T, around 5 per cent.
What has added to investors’ pessimism is that there are no signs that FY12 will be any better than FY11. For quite some time, the government has been bogged down by multiple scams and disruption of the Parliament, and has been unable to get down to serious business.
Investments from the private sector too are not expected to shore up the sector’s dampened fortunes. The real-estate sector is grappling with subdued demand and tighter credit. Cement is reeling under the burden of overcapacity. No major investments are lined up within the oil and gas sector, while the metals sector is struggling with issues such as land acquisition, the Naxal problem, and environmental clearance.
Rising raw material prices: Earlier, escalation clauses present in contracts allowed construction companies to pass on the increased costs of raw materials to clients. That trend is changing. With companies now working on more fixed-price contracts, they are forced to absorb such escalations. From 10 per cent in FY09, the proportion of fixed-price contracts within the industry has risen to 30-35 per cent in the current year. About 35 per cent of L&T’s order book comprises fixed-price contracts (as on December 2010). Consequently the sector’s margins have taken a beating.
Impact of high interest rates: With interest rates rising, companies’ interest expenditure has gone up. HCC, for instance, saw 85 per cent of its Q3FY11 Ebit go towards interest payment, up from 67.4 per cent in Q3FY10. With the execution of projects slowing down, working capital requirements of construction companies have risen, and with it, debt levels. Today the average interest coverage ratio of construction companies is only five times. If their earnings take a hit, many of them will struggle to service their debts.

Valuations
Despite the average 30 per cent decline in prices over the last one year, construction companies are still trading at an average P/E of 18. The PEG ratio (calculated using three-year EPS growth rate) of these stocks is at around one. If earnings to not pick up — and there are no definite signs of that happening yet — valuations could decline more. Do not invest till the sector’s prospects improve.