Simplex Infrastructures

We reiterate a buy on the stock of Simplex Infrastructures (Simplex) for investors with a two-three year perspective. The company’s strong business and financial fundamentals — arising from its diversified business, presence in the relatively low risk business of contracting and superior return on equity — support its prospects in the construction space.

Simplex is unlikely to grow at the scorching pace (62 per cent compounded annual growth in earnings over the last five years) seen in the past; in other words, it may no longer witness the ‘mid-cap rate of growth’ witnessed from early 2000.

However, the company’s order-book and strong execution skills are likely to offer a more sustainable earnings model. Further, there remains substantial potential for higher spending in infrastructure and housing in the Indian context.

Contractors such as Simplex, with superior execution skills are likely to benefit from the long-term spending in these sectors.
Why the correction?

At the current market price of Rs 137, the stock trades at six times its trailing 12-month earnings. For the half year ended September alone, the company’s adjusted net profit grew by 82 per cent.

We believe that the steep correction witnessed by the stock over the past few months, is the result of an en masse de-rating of the infrastructure space.

While some among the infrastructure-developer players do face concerns in terms of slower order flows and shrinking IRRs, a steep hike in raw material costs and stretched working capital were the predominant risks seen in the contracting space.

However, with the liquidity situation easing, fears on the second score may be overdone.

Further, while September numbers did show some contracting companies give in to cost pressures, Simplex’s financials suggest that it handled these pressures better than the rest.

With the recent trend of declining cost of borrowing, improving liquidity and sharp reversal in commodity prices, the risks to earnings faced by the contracting companies may also partially abate.
Diversification helps

Simplex’s order-book, at Rs 10,700 crore, witnessed a growth of 50 per cent in the first half of FY09; impressive, at a time when orders especially from the private sector have been on the decline. Interestingly, building and housing accounts for as much as 28 per cent of the order book.

However, a good part of this comes from overseas projects, especially in West Asia, where the building activity was hectic until recently.

With the global economic recession beginning to be felt in West Asia as well, a slowdown in the construction activity in this region appears imminent.

The company appears to have anticipated this as it has diversified its presence into other segments as well. Urban infrastructure, power and other transport projects together account for a chunk of the order book.

The company has also shifted focus back to its core business in these tough times. Piling and ground engineering works, the key strength for Simplex, has once again gained ground, with the segment contributing 16 per cent to H1FY09 sales as against 10 per cent in FY08.

Overall, infrastructure projects would be the biggest revenue driver followed by industrial and building segments.

To this extent, the company’s exposure to sectors that have slowed down appears limited. In the long-term however, we expect Simplex to benefit from a gradual revival in the domestic housing construction.

Simplex has protected close to 90 per cent of its future revenues through price escalation clauses.

Nevertheless, the steep commodity price hikes, together with booking of mobilisation expenses for projects for which revenues are yet to be booked, led to about 120 basis points dip in operating profit margins to 8.7 per cent in the September quarter.

We expect OPMs to improve over the next few quarters for the following reasons: One, the benefit of a decline in commodity prices may be reflected in the financials with a lag of a quarter or two.

Two, the effect of a higher share of overseas orders (26 per cent of total order book) is likely to provide superior margins, once these translate into revenues.

On the bottomline, however, net profit margin may remain muted for sometime as higher depreciation (as a result of new assets) and interest costs may act as a drag.

On the latter, while the cost of borrowing could well decline, the quantum of borrowing, especially for working capital purposes, may remain high for sometime.

This premise is based on the likelihood of private sector clients (who account for about 60 per cent of expected revenues) needing longer periods to pay their dues or, in other words, higher debtor days as a result of the less robust industrial growth.