This post is not buy/sell/hold advice. Please see the disclaimer at the end before reading further
While the goose of private capex has been cooked, the Government of India is taking every step to boost public spending on infrastructure. The focus is currently on roads. In 2015-16, NHAI awarded about 50 projects to build 2,624 kilometres of roads. A budget of US$22.35 billion has been set out by the Indian Government for infrastructure projects, for which highway construction will play a major part.
As Bala writes in this brilliant piece infrastructure companies have many moving parts that make them unsuitable as buy and hold investments, not least of which are – cyclicity, incalculable extraneous and confounding factors such as commodity prices and the lumpy, often misleading nature of their earnings.
On the other hand Infrastructure is one of the handful of sectors in this market that shows earnings visibility and a clear growth highway ahead.
So how to negotiate this paradox?
Proposed strategy: PROTECT DOWNSIDE RISK (And the upside will take care of itself)
Since the opportunity size is so large, if we can find companies where the downside risk is protected, it should be profitable. Let me lay the downsides for you and the mitigating techniques while researching potential Infrastructure companies to invest in.
Risk 1: Uptick in Commodity Prices leading to Working Capital Problems
Commodity prices are cyclical and have been in their trough for the past two years. It is expected that the uptick in key commodity prices will begin from 2018. Steel, cement are some critical inputs for the construction sector.
Steel – In the recent years India has imposed anti-dumping duty on steel and China has rolled back on capacities. This suggests domestic steel may go up in price.
Cement – Cement is priced by a cartel of producers in India. Further the government has put it in the 28% GST category.
This is sure to increase burden of raw material costs on Infrastructure companies.
Mitigation: Find Companies with Low Leverage and low P/B
Like any sector emerging from a multi-year downturn, most infrastructure companies are currently saddled with debt. Take the following precautions:
- Consolidated earnings – When screening companies, check both the standalone and consolidated balance sheet. Construction/Infrastructure companies in India tend to be conglomerates with diversified interests in power, real-estate and (sometimes) loss making foreign subsidiaries. Always check the consolidated financials to get a real picture of financial health.
- Price to Book value – use this metric for relative valuation as P/E can be misleading, given that earnings are lumpy (more on this later) and P/E does not capture bloat in balance sheet
- Mix of project/order type with the company – While leverage is not a disqualifier in itself, too much debt on the books puts some companies out of the competition for BOT (Build-Operate-Transfer) projects. BOT projects have higher risk of exposure to commodity price related working capital problems. On the other hand BOT projects have higher entry barriers than hybrid and EPC (engineering, procurement and construction) models that require upfront commitment from the government to take on 40% of the burden of costs. It follows logically that EPC models (where the government takes on the full burden of working capital) will face more competitive bidding than BOT projects, which will enjoy higher margins. Companies with low leverage and healthy balance sheets will enjoy a huge advantage to bid and successfully execute BOT projects.
Risk 2: Lumpiness in Earnings
The public infrastructure sector has one key buyer: government. The project lifecycle is long with 100% buyer concentration. This impacts the nature of orders – sometimes you win the bid, sometimes you don’t.
Additionally, infrastructure companies can record “revenues” as time of the order or at time of complete transfer of ownership and risk. Accounting distortion is common in this sector.
Mitigation: Look at Cash EPS and Execution History
While the EPS of the company can be misleading. Cash EPS, which is a measure of Cash Flow from Operations / Dilute Equity outstanding would be a better measure of the health of the company. Again, due to the lumpy nature of infrastructure orders – do not look for consistency in Cash EPS but rather, its relative value compared to EPS.
Execution history is important. Companies that have suffered cost overruns in the past due to poor capital allocation or working capital management can be avoided. A leopard and management, rarely change their spots.
In Sum: The past is not the future
Road Infrastructure itself is a Rs 7-lakh crore opportunity. NHAI has 62000 crores worth of bids up in the next 6 months. Funding for Infrastructure is cheaper than it was in the past – interest rates are lower offering companies with debt significant relief in their existing interest payments while taking on new projects. Further, the Reserve Bank of India (RBI) has allowed companies in the infrastructure sector to raise External Commercial Borrowings (ECB) with a minimum maturity of five years and with an individual limit of US$ 750 million for borrowing under the automatic route.
Further, risk of input costs and overruns have been transferred from the building company, to the government under the Hybrid Annuity Model (HAM) and the EPC (engineering, procurement and construction) model. So the company executes and keeps the money, which is not trapped in working capital. We may be at the cusp of a unique wealth making opportunity in the stock markets. Stay vigilant.
This post is not BUY/SELL/HOLD advice but a statement of my personal analysis and opinion. I hold road infrastructure stocks so my views are biased.
I am not registered with SEBI under SEBI (Research Analysts) Regulations, 2014. As per the clarifications provided by SEBI: “Any person who makes recommendation or offers an opinion concerning securities or public offers only through public media is not required to obtain registration as research analyst under RA Regulations”. No BUY/SELL/HOLD advice is offered on this blog, in any form whatsoever. Views expressed are my own and not of my employer. Stock Markets are very risky and can cause a permanent loss of capital. You should seek professional advice.