The Secrets of Outperformers - Revealed

Is the slowdown over? While financial figures reveal signs of revival, Charu Bahri speaks to CFOs to gauge the bigger picture. It was the best of times. In the years running up to 2008, the Indian economy registered a GDP growth rate of over 7 per cent, led by the boom in the construction and infrastructure sector. Then came the worst of times: the global financial meltdown and the ensuing slowdown in the Indian economy. Almost every sector of the economy was hit, including the construction industry. And now, like a dependable Ferris wheel, powered by a series of timely stimulus measures by the Indian Government, things seem to be looking up again. Factors such as better cost management, lower commodity prices compared to the prior peaks and relief provided to the corporates for adjusting the forex losses by amending accounting standard 11 has helped India Inc post better bottomline numbers. The numbers bear this out. While on a cursory glance corporate India seems to have notched up good gains by tightening its belt, the real picture throw up scars of recovery: a fall in the topline of 7 per cent but an impressive 41.75 per cent rise in bottomline is illusory as after adjusting for refinery numbers and extraordinary items, India Inc.’s topline grew by a mere 0.79 per cent while its bottomline is up by 13 per cent only. Meanwhile, the infrastructure sector posted a healthy 20.9 per cent and 19.9 per cent revenue and net profit growth rates respectively for Q2FY10 on a year-over-year basis. Infrastructure sector is a clear outperformer. In view of the important position of the infrastructure sector within the Indian economy, we present an analysis of the salient aspects of the recent financial performance of the top 15 publicly traded players within the construction sector, with due reference to their performance in the critical months of 2008. The 15 companies comprising our universe are Larsen & Toubro (L&T) Engineering and Construction Division, Punj Lloyd, IVRCL Infrastructure & Projects, Simplex Infrastructure, Nagarjuna Construction, Lanco Infratech, Gammon India, Hindustan Construction, Jaiprakash Associates, Ircon International, Era Infrastructure Engineering, Consolidated Construction Consortium Ltd (CCCL), Engineers India, Patel Engineering and BL Kashyap. From top-line to bottom-lineFirst things first - the growth across the top-line, like the increase in the bottom-line, reflects the benefits realised from the government’s stimulus package. Comparing figures of two key six-month periods, we find that the infrastructure industry reported a revenue growth of 24.6 per cent in H1FY10 over H2FY09. This reflects an uptick in the trend. At the same time, on a year-over-year basis, the coverage universe recorded 34.1 per cent top-line growth. A similar trend is observed in the bottom-line. The sequential growth in net income across the universe was 45.4 per cent in H1FY10 vis-à-vis 13 per cent sequential growth recorded in H2FY09. The universe also witnessed a 64.3 per cent increase in net income on a year-over-year basis in H1FY10.  From the looks of it, the recovery has aided bottom-lines more than the top-line, as apart from a few mid-sized players, we haven’t seen any significant revenue increases across the universe. In this context, we perceive the lack of liquidity to fund projects as the key reason for the comparatively lacklustre sequential growth in the top-line, and not so much the drying up of the projects in the past two quarters. To add to that, slower order execution and delays in the clearance of infrastructure projects appear to have further slowed down expansion in the top-line across the universe. Now that tight liquidity seems to be rapidly becoming a thing of the past, the majority are able to execute their projects comfortably. Only five companies within our universe reported a sequential decline in revenue for Q2FY10. Interestingly, the overall uninspiring growth in revenues within the universe on a year-over-year basis overshadows the strong growth registered by Lanco Infratech (130.9 per cent), Era Engineering (99.4 per cent) and Gammon India (84 per cent). These companies have largely fared well because of their engagement with power and transmission-related infrastructure projects. In comparison, IVRCL reported a mere 7.1 per cent revenue growth in Q2FY10 over Q1FY09  owing to slower order executions resulting from the recent assembly elections in Maharashtra and floods in Andhra Pradesh and Karnataka. (Put together, the three states account for ~50 per cent of the order backlog.) Gammon India was benefited by irrigation and water-based infrastructure projects while the year-over-year revenue growth in companies such as Patel Engineering (20.2 per cent) and Jaiprakash Associates (24.1 per cent) was driven by their higher exposure to road and transport industry-related projects. On the other hand, BL Kashyap reported a 40 per cent decline in year-over-year Q2FY10 revenues possibly owing to project slowdowns as well as its management’s conscious decision to reduce its debt. BL Kashyap seems to have been the most affected in the recent economic slowdown as it reports an over 37 per cent average year-over-year decline in revenues over the past three quarters. Beyond doubt, its management would be concerned by the serious situation it finds itself in, as it has also recorded four quarters of year-over-year negative growth in revenues. Revenue visibilityOn account of slower accretion of orders in the past two to three quarters, the Order Book/Trailing Twelve Months (TTM) revenue ratio, a key indicator of revenue visibility, is at the bottom of its current trough. During peak seasons, the Order Book/TTM revenue ratios for most companies in our universe have stood between 4.0x and 5.5x. In contrast, the current Order Book/TTM revenue ratio for the entire universe stands at 3.0x, apparently as a result of fewer new projects awarded. Within the universe, companies relying more on the private sector have been affected in a greater manner than those depending on the public sector. For instance, companies like Nagarjuna Construction and Simplex Infrastructure, known to be exposed to the private sector, were most affected by the economic slowdown as private industries awarded few projects. In fact, only the hydropower sector has awarded significant new projects during this period of time. What’s more, the growth in order inflows is likely to remain moderate in the near term as most industrial companies continue to hold on to their capex plans. In all likelihood, the award of industrial projects will commence after another two to three quarters, by which time liquidity in the system is expected to ease further, thus encouraging these companies to roll out their capex plans.  Turning the focus to the public sector, the Central Government was fairly inactive until it recently changed stance, aggressively awarding projects in the road sector. Significant projects have been awarded in Q1FY10, particularly building projects (primarily social infrastructure like government buildings) and projects related to power generation and transmission. A few state governments - Karnataka, Rajasthan, Andhra Pradesh, Tamil Nadu and Maharashtra - have caught up with the pace of reforms and development and gone on to award projects in the road, irrigation and water sectors. Fortunately, even the recent floods did not dampen the mood of the governments of Andhra Pradesh, Karnataka and Bihar to award new projects. We are currently experiencing an uptick in new projects being awarded by both state and central governments. We firmly believe this trend is likely to be driven by enhanced government spending and, as a result, we are likely to see moderate revenue growth over the next three to four quarters across our universe. “The pace of the kind of orders booked in the past two quarters suggests that orders for the construction of factory buildings and structures to build industrial capacities are still not forthcoming, which in turn indicates that capacities built up in the past are enough to take care of current demand,” says TR Seetharaman, CFO, CCCL. “However, in the infrastructure sector, especially in the power, roads and urban infrastructure segments, the appetite for construction is high. There is also considerable activity in the low-cost housing segment where does not have much of a presence.” Trends in cost componentsEmployee and raw material costs are two key components of the recurring expenses of construction companies. Therefore, our analysis would be incomplete without mention of the trend in these expense headings. Employee costs: Companies in the universe reported an average 2.6 per cent and 0.30 per cent decline in their year-over-year raw material and employee costs as a percentage of revenues respectively in Q2FY10. However, the companies reported an average 2 per cent and 0.7 per cent increase in their sequential raw material and employee costs as a percentage of revenues respectively in Q2FY10. Engineers India reported a 2.4 per cent sequential increase in its employee costs as a percentage of revenues in Q2FY10 compared to a 13 per cent sequential increase in Q1FY10. On the other hand, BL Kashyap reported a 2.1 per cent decrease in its Q1FY10 sequential employee costs compared to a 7 per cent decrease in its Q1FY10 sequential revenues. These variations in employee costs may not necessarily be attributed to similar reasons in companies across the universe. For instance, Shyam Mohan Gupta, CFO, Era Infrastructure Engineering Ltd, explains the 1.3 per cent decrease in its employee cost as a percentage of revenue costs on a yearly basis as being on account of the increase in average ticket size of its projects. “In the past two to three years, the number of projects we have on hand has remained almost the same whereas the average ticket size has increased,” he says. “Our making do with the same [numbers of] manpower to implement larger projects translates into greater efficiency in using manpower.” According to Dipak Ashar, CFO, Gammon India, “Our 1.5 per cent increase in sequential quarterly employee costs is partly because of the annual salary increase given to employees during the second quarter. It is also attributed to a greater number of new recruits hired to work on projects. We expect good growth in coming months.” In the case of CCCL, Seetharaman reveals, “The employee cost rose mainly on account of a recruitment drive undertaken in 2008 for new projects. However, many of these projects were cancelled owing to the downturn in the economy leading to a 0.7 per cent increase in employee cost as a percentage of revenues. Subsequently, we implemented a process to identify and weed out non-performers, which has helped us rein in employee costs at the current level. We are simultaneously trying to improve productivity levels to maintain our employee cost by introducing a productivity-linked incentive programme.” Meanwhile, J Suresh Kumar, CFO, Lanco Infratech, says that on a stand-alone basis, its employee cost as a percentage of revenue stands at the same level in spite of the absolute employee cost registering an increase of 161 per cent in FY09 over FY08. From Rs 61.4 crore in FY08 to Rs 160.2 crore in FY09 to approximately Rs 119.9 crore in H1FY10, the employee cost reflects the increase in employee base. “The rise in input costs in this quarter is largely because of the inflow of large orders,” notes YM Deosthalee, CFO & Whole-Time Director, L&T. “Even so, L&T conti-nues to keep costs under control.” And NK Kakani, Executive Director, Simplex Infrastructure Ltd, explains that its rising quarterly and yearly employee costs as a percentage of revenues is indicative of its new projects as well as the fact that employee costs include payments to subcontractors. The latter reason also accounts for the differences in revenue booked for each quarter, because of the diverse construction verticals the company caters to. The order book increased by Rs 505 crore in Q2FY10. Raw material costs: Coming to the raw material component, HCC reported a 12.9 per cent decline in its Q2FY10 year-over-year raw material costs as a percentage of revenues. The company also registered a 5. 20 per cent decline in its raw material costs in Q2FY10 vis-à-vis Q1FY10. Punj Lloyd however reported a 9.6 per cent sequential  increase in its raw material costs in Q2FY10, a 3.50 per cent increase over its Q1FY10 sequential increase in raw material costs as a percentage of revenues. Again, the trend differs from company to company. Kakani points out that it is not prudent to compare Simplex Infrastructure’s 6.1 per cent year-over-year increase in raw material as a percentage of revenues (not its QoQ for that matter) as most of its contracts have escalation-enabled clauses in different forms, that is, with respect to fix price of material, free supply by client, WPI linked. As a result, he says “The revenue derived from the contracts in a quarter will differ from the other one because of the modes of escalation availed in each quarter and the order mix. Some orders with free issue of material when taken up in higher proportion in any quarter will reduce the percentage of material cost.” Narrowing marginsThe coverage universe reported 13.5 per cent EBITDA margins in Q2FY10 compared to 14 per cent in Q1FY10 and 12.4 per cent in Q2FY09. This shows that EBITDA margins have been unsteady for these companies over the past few quarters owing to company-specific reasons and the emerging market scenario. However, it is noteworthy that the universe also registered a marginal year-over-year improvement in margins. Most companies in the universe were severely impacted by the fact that fewer projects were awarded in FY09. In fact, most projects awarded last year were from the public sector. As these projects typically offer lower margins vis-à-vis private sector projects, it made for a tightened market that saw players aggressively bid for smaller pies of the available orders at the cost of compromising margins. Companies were also unable to benefit from lower input costs as the impact of rising costs was majorly negated by price variation clauses (PVC). Further, given the liquidity squeeze faced in FY09, most companies maintained lower capex requirements. In order to keep up the execution of orders, companies such as HCC began awarding more subcontracts, which again had a drag on EBITDA margins. Overall, as most players aggressively bid for irrigation and other government projects in FY09, we are likely to see a near margin decline in coming quarters and no improvement in margins over the next five to seven quarters. Interest burdens The cost of debt has come down in recent months and is likely to reduce further in the near term. Even so, we are not witnessing a situation where interest burdens reduce in absolute terms, possibly because funding requirements continue to remain high. In Q2FY10, the coverage universe notched up a 56.5 per cent year-over-year increase in interest costs with companies maintaining an average 3.9x trailing EBITDA to interest coverage ratio. This useful ratio, indicating a company’s ability to meet its interest expenses from its earnings from core business operations, was 3.3x in Q1FY10 and 5.9x in Q2FY09. It would appear that in light of tighter and longer working capital cycles, companies have been hard-pressed to provide for interest in the past two to three quarters. L&T-ECC division, Simplex Infrastructure, Lanco Infratech and CCCL’s registering a most recent interest coverage ratio of over 5x indicates their financial soundness to cover up interest-related expenses from core business operations. In contrast, the lower coverage ratios of ~2x reported by companies like BL Kashyap, Hindustan Construction, Jaiprakash Associates and Punj Lloyd seem to reflect the tougher working capital cycle they are facing. A medley of reasons came up in a conversation with a few CFOs to unearth the reasons for the increase in interest burdens. Gupta opines that Era Infrastructure Engineering Ltd’s 48.2 per cent increase in interest expenses on a yearly basis reflects its increase in debt, which was raised to meet its capital expenditure and greater working capital requirements for its big ticket projects. Apparently, in just the past two sequential quarters, the company has bagged projects worth Rs 1,100 crore. Ashar shares that Gammon India’s interest expense has gone up owing to higher borrowing and marginally higher interest rates. Higher borrowing is attributable to higher requirement of funds for working capital for growth in business as well as investments. The figures for this year are higher than last year as this year’s numbers indicate merged figures after amalgamation with Associated Transrail Structures Ltd, an electric power transmission services provider. As for managing liquidity in challenging times, he says, “The strength of our balance sheet allows us to raise debt to meet our working capital needs as required.” Kumar points out that on a consolidatedbasis, Lanco’s interest and finance charges more than doubled in FY09 over FY08 (Rs 92.1 crore to Rs 218.5 crore) primarily on account of an increase in total debt (from Rs 3,164.9 crore to Rs 5,596.9 crore) to meet its enhanced need for working and long-term capital to execute the larger number of projects in its kitty and because of the increase in interest rates during FY09. “Since March 2009 we have reduced working capital limits at our EPC and construction arm from Rs 530.6 crore as on March 31, 2009, to Rs 94.4 crore on September 30, 2009,” he says. “Currently, we are sitting on enough liquidity and not facing any pressure on working capital.” Deosthalee attributes the rise in interest costs to the company raising more than $ 500 million in debt during this period. “At a gross level, the company’s interest costs remain competitive,” he adds. CCCL had almost Rs 60 to 70 crore of unutilised IPO monies parked in an overdraft account during H1FY09 which helped it to reduce its interest costs last year. But this year, as that money was not available, the company required to revert to borrowing from this overdraft account. This partially explains its staggering 160 per cent rise in year-over-year interest expenses. In addition to that, Seetharaman notes, “In the aftermath of the sub-prime crisis, banks and FIs have become very cautious in lending and credit appraisals have become stricter as creditors who used to be liberal in their credit policy have adopted strategies to minimise credit risks. Consequently, payments to creditors happen much faster while debtor payment cycles are longer. This has also contributed to the increase in interest expenses. So certainly, part of the rise may directly be attributed to the tighter operational environment.” According to Kakani, “Simplex Infrastructure’s total borrowing as on September 2009 stands at Rs 1,285 crore and its average cost of funds is below 8 per cent. The fact that there is ample liquidity in the market and banks are ready to lend for a shorter period of time at a rate well below its PLR, at least to reputed clients like us, works in our favour. It will continue as long as liquidity overhang continues.” In the near term, we expect companies within our coverage universe to find some comfort in raising money from various markets, especially diluting their equity stakes, and subsequently deploy this money to fund their projects. Over the medium term, we expect more and more projects to be put up for bids, especially from the government and public sectors. Hence, we claim with a fair measure of confidence that the Indian construction industry is poised to establish new benchmarks in the long run. (With research inputs from first)