Construction & Engineering - Tight funding scenario hurts

The June 2008 quarter results highlight the pressure on profitability from increased input costs and interest expenses. We trim FY09-10F EPS by 12-38% for our coverage universe. IVRCL remains the best performer in the sector, in our view. We reiterate our Buy calls in the following order: IVRCL, Nagarjuna and Gammon India.

June 2008 quarter results highlight profit pressure
The sales momentum was impressive across our sector universe, but we highlight that EBITDA margins declined (by 30-230bp) for all companies, barring IVRCL. However, the steep jump in interest expenses even for well funded companies like IVRCL and Nagarjuna Construction surprised us, leading to weaker-than-expected yoy PAT growth (in the range of +15% to -54%). Order inflow in the quarter mainly came from water irrigation and industrial projects.

Guidance reduced sharply
Construction companies have reduced guidance significantly within just two months of having announced it. In particular, they have lowered EBITDA margin guidance by 50-100bp (due to higher input costs) and increased interest expenses as a percentage of net sales by 70-100bp (due to higher interest rates). As a result, we trim our EPS numbers by 12-30% for FY09F and 12-38% for FY10F. Gammon India and HCC have seen the highest cuts

Twin concerns: working capital expansion and tight funding situation
We expect the working-capital cycle for companies to expand in a toughening operating environment. Combined with the funding requirements of BOT subsidiaries and high growth in construction, we foresee pressure on interest costs, especially as rates are rising. Another concern is the difficulty in raising equity funds at attractive prices (around US$1bn, or 26% of market cap, raised from December 2005 to date), though net-debt-to-equity ratios are reasonable.

Macro opportunities large enough to help absorb intermittent weakness
We are concerned rising input costs may affect the sector's short-term profitability, but we believe the large order book (nearly 3x FY08 sales) provides room to absorb shocks and to show a 20% sales CAGR for FY08-11F. We believe macro opportunties in the infrastructure construction space are quite large and new verticals like urban infrastructure, railways (dedicated freight corridor), nuclear power plants, smaller airports and ports should help create scale. Hence, we remain positive on companies with a wide portfolio of operations like IVRCL, Nagarjuna Construction and Gammon, as we believe these can benefit from the new growth areas. But we remain cautious about their large real-estate portfolio exposure.