Earnings, not order book, to drive construction companies’ valuations

Earnings, and not order book positions, will drive the valuations of Indian construction companies, since most construction firms have a healthy order books but their valuations have taken a beating.
  
Moreover, at current valuations, which are at historical lows, the risk-reward ratio appears favourable given the growth potential of the sector, according to a study by Crisil Research.
  
The muted earnings growth was mainly due to execution hurdles, hardening interest rates and stretched working capital cycle, it said.
  
In the past one year, construction stocks have significantly underperformed - negative 55 per cent return compared to S&P CNX NIFTY's negative 8 per cent.  Even though some of these concerns may continue to plague the industry in the near term, the risk-reward ratio appears favourable.
  
After registering strong earnings growth of about 60 per cent during FY05-08, construction companies reported just 2 per cent growth during FY08-11 due to weak margins and high interest costs.
  
While Crisil Research expects earnings pressure to continue to cloud FY12 due to execution hurdles and high interest, it believes all is not lost.
  
The silver lining is that order awards and execution issues have started showing signs of easing up in the second quarter of this financial year and companies have a healthy order book of 2.5 times FY11 revenues.  The order book position provides good revenue visibility, it said.
   
Additionally, one cannot ignore the long-term growth potential for companies in this sector given the large-scale infrastructure spending expected over the next 5 years.
  
''The current state of infrastructure is increasingly becoming a bottleneck to the ambitious 9 percent plus GDP growth target. Hence, spending on infrastructure is imminent. We expect construction investments to grow at a CAGR of 13 per cent to Rs14.8 trillion over FY12-16,'' said Prasad Koparkar, head, industry and customised research, CRISIL Research.
  
During the strong growth years of 2005 to 2008, construction companies were valued on their order book position. Coupled with robust economy growth and high infrastructure spending, most construction companies traded at their all-time high.
  
However, over the past two years, the order book has witnessed muted growth and profitability has weakened, resulting in re-pricing of construction companies.
  
The construction companies' valuations are currently at a historical low with median one-year forward price-to-earnings ratio (PER) of 6.5 times and one-year forward price / book ratio of 0.5 times.
  
''We believe that valuations will improve over the next 12 months as some of the concerns such as execution hurdles and interest rate are expected to fade out by the year-end, resulting in moderate earnings growth,'' said Tarun Bhatia, director, capital markets, Crisil Research.
  
Companies under Crisil's equity research coverage are trading at PERs of 4.2-13.8 times FY12 estimated EPS. The P/BV ratio of some of these companies is below one, which given the expected healthy RoE offers a favourable risk-reward ratio.
  
Crisil Research has coverage on ARSS Infrastructure Projects, C&C Construction Ltd, Era Infra Engineering Ltd, Marg Ltd and MBL Infrastructure Ltd.
  
Of these, ARSS, Marg and MBL have a valuation grade of 5/5, indicating a strong upside (more than 25 per cent from current market price); C&C and Era have a valuation grade of 4/5, indicating an upside (10-25 per cent upside from current market price).