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Sunday, May 20, 2007

Hindustan Construction: Sell


Hindustan Construction's revenue and profit numbers continued to disappoint on the back of start-up and execution delays and mounting losses from the Bandra-Worli project.

The company's balance-sheet also faces the pressure of fresh capital for the various projects in its core business and real-estate ventures. HCC's strong order backlog therefore does not provide much visibility in the near term.

Investors can consider switching to other infrastructure stocks to prevent any opportunity loss given the bright prospects for the sector. Hindustan Construction's performance over the next couple of years may provide direction for fresh investments

At the current market price, the stock trades at about 32 times its expected earnings for FY-08 on a diluted basis. This valuation is at a premium to a number of peers and also appears to have captured earnings the potential of its real-estate ventures. But we believe this to be a bit premature, given the long-term nature of real-estate projects, and HCC's ventures being at a preliminary stage. We would be comfortable valuing the real-estate projects once the realisations trickle in.

Huge orders, less comfort

While Hindustan Construction's order backlog of Rs 9,300 crore provides optimism, the execution has not been smooth to provide the much-needed visibility to earnings growth. Apart from natural hazards, such as heavy rain and snowfall that have delayed projects, the company has been facing delays due to non-completion of land acquisition by clients.

This apart, the above order backlog includes Rs 1940-crore worth of HCC's share of the Sawalkote hydel project, which is subject to the decision of High Court. The company has also decided to remove Rs 151 crore of the Icha Dam project, as there is no development on that front though the order award stands. Our concern on the delays stems from the fact that apart from delaying revenue flows, such projects may become unviable or less profitable by the time the execution begins.

Power projects account for 48 per cent of the current order backlog. While this is a positive (as the segment provides relatively lucrative margins), hydel power projects typically have a long gestation period and require fresh capital investments.

Profitability

The company continued to book losses from the Bandra-Worli Sea Link project and expects to book another Rs 110 crore of losses. The losses arose, as the Maharashtra State Road Development Corporation did not accept some price variations apart from new additions to the project work not bargained for initially.

While there is some optimism in receiving claim for the latter issue, the rest is subject to arbitration. Any positive ruling in HCC's favour may well see improvement in margins. For now, the losses are expected to be booked up to 2008 and would continue to drag the margins over the next few quarters.

There was a steep rise in HCC's staff and interest costs. The interest coverage ratio for FY-07, though comfortable at 2.9 times the profits, has nevertheless declined from over four in FY-06. We do not expect the interest cost to ease as the debt component can only go up, with the company tying up with banks for partly funding the real-estate projects.

A positive feature is that the company has managed to maintain its OPM in the 9 per cent range as raw material and construction costs remained under control. As power projects now form a larger chunk of the order book, the OPM may improve once these projects start yielding returns.

On the removal of Section 80 IA benefits, the company had to effect only accounting treatment and did not have any cash outflows as it had either paid taxes and made claims or created provisions for the same. Hence, the net profits have not been affected as much as other peers on account of this issue.

Real-estate Investments

The company has so far invested Rs 550 crore in the Lavasa Project and would require additional investments of Rs 300 crore over the next couple of years. While the company plans to launch the first phase in the market in October 2007, the 12,500-acre project is a long-drawn one and may see revenue flows in a phased manner.

Investors need to watch the development in this project before factoring any income from the company's real-estate venture. Further, that the company has shelved plans for a township in Navi Mumbai and decided to convert its Vikhroli (a Mumbai suburb) project into a corporate park instead of an IT Park planned earlier appears to reflect lack of clear strategy and foresight for these projects.

While real-estate is a natural extension for an infrastructure player and a number of companies have ventured into this space, our caution stems from the following: HCC's project portfolio have traditionally been long-term in nature. Its foray into real-estate has been made with the over 10-year-old Lavasa project. A long-term pay-back period, possible dilution in earnings as a result of huge capital necessitated by the nature of projects and execution risks do not augur well for this otherwise established company's earnings visibility in the medium term.

If the pace of execution of the company's core and real-estate business improves and arbitration issues get sorted quickly, the medium-term picture may turn positive. This possibility remains the principal risk to our recommendation.