[T.S.R:16701] Goldman Sachs goes Negative On Construction-Cites Eq Dilution, Expensive Debt, Negative Cash Flows, Poor Returns on Capital

Goldman Sachs

India Construction

Weak cash flows – an inherent feature of India's construction space 

The four mid-cap construction names under coverage — NCC, Punj Lloyd, HCC, IVRC — are down 15%-32% over the past 3 months vs. BSE Sensex down 5%, underperforming in our view due to concerns about increasing costs (debt and commodities) and still-weak order flows.  

1) EBITDA margins and cash flow generation trend remain weak

-Average EBITDA levels of about 9% (last 5 years), with c. 35% of sales tied up in working capital has meant that free cash flow generation is low. Although these four had average sales CAGR of >40% over FY05-FY10, cash flow from operations (CFO) was weak at only 5% of sales, well below L&T's 12% (which had better margins and working capital efficiency). 

2) Equity requirements in next 12 months likely

- With weak orders over the past 18-24 months, these construction firms have adopted asset ownership models providing captive construction possibilities. Without excess cash flows, however, they have become prone to further equity dilution to fund growth. We estimate NCC and IVRC would need to invest Rs 2.75bn and Rs16.2bn respectively towards the equity component on their BOT projects over FY11E-13E — implying no funding gap for NCC and of Rs11.2 bn for IVRC — likely requiring some form of equity issuance or asset stake sale. 

3) Leverage and Interest rate sensitivity remains high

– with leverage ratios averaging 1.24X, and most debt being of short term duration (used for working capital), sensitivity of earnings to interest rate changes is high — with EPS moving 5% for every 50bps hike. Based on our expectation of 100bps hike in financing costs over next 12 months (in line with our economists), we lower our numbers on all five construction companies under coverage: our FY11E-13E EPS down 2-18% and our 12-month target prices 2-14% down (all based on SOTP, bar PUNJ.BO on P/E).  

Maintain Buy on NCC on stronger balance sheet, better visibility 

We prefer Nagarjuna (NCC; Buy) for its: (1) better ROE (10% vs. average 8% for peers for FY12E); (2) good visibility on growth; and (3) relatively strong balance sheet, with a lower equity requirement relative to IVRC (for its BOT projects). We believe NCC is on track to achieve Rs57 bn revenue in FY11E (company guidance Rs58 bn). We rate the other firms Neutral. 

Risks:

Up: Stronger execution recovery and order inflows; Down: Higher interest and commodity costs, slower order inflows.
 

Safe Harbor Statement:

Some forward looking statements on projections, estimates, expectations & outlook are included to enable a better comprehension of the Company prospects. Actual results may, however, differ materially from those stated on account of factors such as changes in government regulations, tax regimes, economic developments within India and the countries within which the Company conducts its business, exchange rate and interest rate movements, impact of competing products and their pricing, product demand and supply constraints.

 

Nothing in this article is, or should be construed as, investment advice.

 

 

 

 

 

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