Investors looking for exposure in the infrastructure space can consider the stocks of IVRCL Infrastructures and Projects, and Nagarjuna Construction. The thrust on irrigation and water management in the recent Budget augurs well for the companies, as both are strong in this space.
Buy with a two/three-year perspective. While stocks in the sector have returned manifold gains over the past few years, the re-rating story is unlikely to repeat itself in the near future. Hence, investors need to moderate their returns expectations.
Complementing strategies
Although both the companies operate in similar business segments, we believe they can complement each other well. While IVRCL continues its thrust on water projects and is likely to emerge a key beneficiary, Nagarjuna's relatively more diversified portfolio is likely to offer cushion against slowdown in any one segment.
Further, any risks from IVRCL's more aggressive alliance and acquisition-led strategy is likely to be offset by Nagarjuna's organic growth approach.
At the current market price, IVRCL and Nagarjuna trade at 17 times and 13 times respectively, their expected earnings for FY-08. This is after adjusting for tax implications consequent to the withdrawal of Section 80 IA benefits for infrastructure cash contracts. The premium for IVRCL appears justified, given the possible unlocking of value on the listing of its real-estate subsidiary and the potential in the power transmission segment.
A high growth story
IVRCL's net profits have grown at about 50 per cent over the past five years on an annualised basis. This high growth has been achieved by the company's ability to quickly ramp up its business in roads, power and recently real-estate without losing focus on its core strength — water-based projects. Its controlling stake in Hindustan Dorr Oliver has not only turned around the latter's business, but also strengthened IVRCL's own water and environment solutions division. Further, IVRCL's tie-up with Nefasa of Spain for the Chennai water desalination plant (commencement of which has been delayed) is likely to give it technical qualification, once completed, for industrial and urban waste treatment projects.
The water and irrigation segment generated 52 per cent of IVRCL's total revenues in FY-06. With the added impetus to irrigation projects and the Urban Renewal Mission (86 per cent of the spending related to water infrastructure) in the latest Budget, IVRCL, armed with the requisite technology, is likely to emerge a prime beneficiary.
New businesses hold potential
Spotting opportunity in the power space, IVRCL has forayed into the transmission business. This nascent division has grown six times in the past two years, although from a low base.
A rural electrification project and a sub-station for Alstom Projects are being executed. The company's plans to set up a manufacturing facility in Nagpur to achieve backward integration may improve operating profit margins in the long run.
The listing of the company's real-estate subsidiary, IVR Prime Urban, may see some unlocking of value, given that the company is quickly ramping up activity in the realty space.
With an order-book of Rs 7,800 crore (five times the FY-06 revenue), the earnings visibility remains high for IVRCL, given that it has demonstrated strong execution capabilities in the past.
A well-laid road
Nagarjuna Construction, while diversifying its business segments, has spread its wings to the overseas markets. An office in Dubai and a subsidiary in Muscat have led to the company bagging over Rs 800 crore worth of water and road projects in Oman. Unlike IVRCL, which has used the acquisition strategy, Nagarjuna has so far set up its own subsidiaries to foray into new areas. NCC Infra Holdings and NCC Urban Infrastructure, which undertake public-private partnership projects and real-estate development respectively, have emerged an effective de-risking strategy.
While Nagarjuna's stronghold is water projects, only about 20 per cent of the current order book of Rs 7,000 crore constitutes such schemes with about 40 per cent in transportation. We believe the increased activity in the road segment is a conscious attempt by the company to ramp up volumes. A 50 per cent compounded annual growth in revenue over the last three years appears to have come about through increased proportion of road projects. Given the company's strength in water projects, it can always bid for more such projects in future.
Risks
Both IVRCL and Nagarjuna's management have come out with numbers on the impact of the withdrawal of Section 80 IA tax benefits on their bottomline. The impact appears insignificant given the companies' strong fundamentals and business potential in the infrastructure space.
Further, both the companies are moving away from being cash contractors, toward build-own-operate transfer (BOT and BOOT) players. While this model is successful in the road sector, it is being now taken forward to hydro-related projects and power sector. The SPVs operating such projects will continue to enjoy the tax incentives. However, there are other risks. The increase in the excise duty on cement, will affect construction players. Price escalation clauses wherever available are likely to offer some protection. Given this situation, we do not expect the current OPM (between 9-10 per cent) to improve.
With increasing activity by both the companies in the realty space, the risks related to price fluctuations in land and buildings will have to be factored in. Further, equity expansion, if any, especially for Nagarjuna, can cause earnings dilution in the short term. We, however, maintain that equity expansion is a necessary evil for construction companies to bid for projects and maintain growth.