Back On The Road Again

The government is accelerating road projects when most players have buckled under the pressure of excessive leverage. Should you bet on the last men standing?  

Once bitten, twice shy. That’s the story of most companies in the roads space, which are struggling due to excessive financial leverage and issues such as stalled projects, cost overruns and pending clearances. In fact, many players in the road sector, such as IVRCL, HCC, Gammon, Reliance Infra, GMR Infra and others, have chosen to exit the segment completely or are selling existing road assets. But while the sellers are still lined up, steps to speed up execution and intent of increased spending have reignited investor interest. The government has said that it will spend close to Rs.1.03 lakh crore on roads in FY17, 49% more than last year. It aims to build about 50,000 km of roads over the next five years and has laid down a 10,000-km target for FY17. 

Amit Sinha, analyst, Macquarie Securities, says that the government is on track to achieve its target of 30 km a day thanks to higher project awards. “There has been a significant pick-up in the past 18 months, with NHAI awarding contracts for construction of up to 3,000 km of roads in FY15 compared with 1,400 km in FY14.” He also credits the government for putting in place a funding mechanism and facilitating faster execution of projects. While some might argue that the government is aiming high, it has awarded close to 6,400 km of road projects in the first nine months of FY16, up 40% compared with the corresponding period the year before. 

It is not just new projects that are being awarded. Construction work at existing projects, too, is on in full swing. About 3,900 km has been constructed in the first nine months of FY16, 58% higher compared with last year. “The single biggest issue was land acquisition, which has been addressed through the Land Acquisition Bill. People don’t hesitate to surrender land when compensated handsomely. That is why there is a uptick in execution,” says Virendra Mhaiskar, CMD, IRB Infrastructure Developers. Rohan Suryavanshi, head of strategy and planning, Dilip Buildcon, adds that roadblocks are being removed at the earliest. “You do not have to run after different government departments to get things done.” Dilip Buildcon is an unlisted engineering, procurement and construction (EPC) player, with an order book of about Rs.10,000 crore. 

Reform Highway
Despite this fillip, can companies make money this time around? And which stocks should one bet on? The government has shifted its focus to EPC from PPP and BOT after 2008. Of the 3,000 km sanctioned in FY15, 2,269 km was on EPC basis. In the first half of the current year, too, 66% of orders were EPC. The advantage of EPC-based contracts is that they don’t strain the balance sheet due to low working capital requirement. 

For instance, at KNR Constructions, EPC constitutes the entire Rs.3,500 crore order book, debt-to-equity is less than 1 and fixed asset turnover is almost 4x. In terms of valuation, at its current price of Rs.517, KNR is trading at 12x earnings and 1.9x FY17 estimated book value, which looks stretched but is probably justified because of its high return ratios (operating margin of 14% and RoE of 19%) and strong earnings visibility. If KNR doesn’t slip up on execution, its robust order book-to-sales of almost 4x will ensure a yearly growth of 33% till FY18. 

What also works in EPC’s favour is that bankers are ready to fund these projects, says Satish Parakh, MD, Ashoka Buildcon. The company generates over 70% of its revenue from EPC and has an order book of Rs.4,186 crore (twice FY15 sales). “Our existing projects alone generate close to Rs.200 crore of free cash flow. Based on our present balance sheet, without increasing leverage, we can take orders worth Rs.5,000 crore,” says Parakh. The company had also raised Rs.500 crore via QIB in 2015 and is expected to grow earnings at about 16-18% over the next two years. 

Part of this optimism is also reflected in its valuation, as the stock is currently trading at 31x earnings and 1.7x estimated FY17 book value. “We believe the glut of upcoming awards and banks’ prudence in allocating funds to road players will favour Ashoka Buildcon, as it has steady traffic growth (same-road toll revenue growing at 10-12% on a year-on-year basis), strong balance sheet, low base traffic risk (the bulk of its portfolio is operational) and sufficient order book cover,” Rajarshi Maitra, vice president at Axis Capital writes in a note. However, there seems little upside for Ashoka Buildcon in the near term, as positive news and near-term earnings growth have been factored in. Besides, with a RoE of 6-7%, it may not command the kind of valuation KNR enjoys. Analysts peg its fair value between Rs.200 and Rs.220.

 Ground reality
IRB’s Mhaiskar, too, agrees that people are now going back to EPC. His company was the sole bidder that qualified for the Rs.10,000-crore tunnel project in Jammu & Kashmir, which was later withdrawn after issues were raised about awarding the project to a single party. While it is a major player in the BOT space, which requires constant funding, the company has been able to fund its growth and bid for projects because of its annual operational cash flow of close to Rs.700 crore. “At 2.6:1, our debt-to-equity is quite comfortable compared with the industry. Besides, our cash flows will improve as more projects are coming on stream,” says Mhaiskar. Thanks to its exposure to BOT road projects, IRB is valued at around Rs.300-320 per share as per its discounted cash flows compared with its market price of Rs.232 per share. On other parameters, IRB is trading at 11x its estimated earnings and 1.2x its estimated FY17 book value. This is because the stock has underperformed in the recent past due to worries over its increasing financial leverage and shrinking interest coverage ratio of 2:1 in FY15 compared with 2:3 in FY14. The cancellation of the J&K project has also been a drag on the stock.

Sadbhav Engineering is another key beneficiary because of its relatively clean balance sheet and diversified geographical presence across 12 states. The company continues to operate EPC projects after it divested its BOT road assets by listing its 68% owned subsidiary, Sadbhav Infrastructure Project. On a standalone basis, it has a 0.7x net debt-to-equity and generates close to Rs.220 crore of annual cash flows from operations, making it ideally positioned to grab EPC contracts. With an order book of Rs.8,300 crore — or 2.5x its FY15 revenue — analysts are
expecting the company to clock an earnings growth of 24% over the next two years. But Sadbhav, too, is richly valued, trading at 20x earnings and 2.6x FY17 estimated book value.

The other factor at play within the sector is that competition is easing, while the scope and quantum of work is increasing. “There are only a handful companies to participate in this opportunity because of stressed balance sheets. But if you look at companies such as IRB, Sadbhav Engineering and Ashoka Buildcon, they are relatively better given their execution track record, stronger balance sheet and cash flows from existing projects,” says Vijayaraghvan Swaminathan, analyst, Spark Capital. While most analysts agree that there are opportunities to grab in the segment, valuation has already run up.