In 1943, Austrian economist Paul Narcyz Rosenstein-Rodan made a strong case for ‘social overhead capital’, which, simply put, underscored the need to create infrastructure to spur economic development. His argument was that to achieve balanced growth a large volume of investment in a variety of fields was needed over a shorter period of time.

Back home, the realisation dawned about 60 years late. The policy makers and the government may be keen to take credit for the belated delivery, but really, no thanks. The industry received an aggregate of $6.6 billion in infrastructure investments over the past six years largely because of the favourable external situation and private sector investments.

Five years of dream growth and a year of nightmare, and the administration is waking up to smell the coffee. So here we are finally sensing that the sector has the potential to absorb $150 billion in foreign direct investment over the next five years. And if the outside world remains good and we do not fall asleep at the policy wheel, we will see the sun shining brightly for many years to come.

But stock markets are in the habit of counting the chickens before they hatch. That infrastructure will be critical to India’s growth story also saw the stock markets take a fancy for any stock remotely associated with the sector. In fact, the appetite (read frenzy) for infrastructure stocks was at its peak during the boom period up to FY08, when there was growth largely driven by a dramatic surge in private investments.

So much so that, as of today, of the over 100 infrastructure companies listed on the bourses, almost 50 per cent went public in just the last six years. To be precise, 49 companies raised over Rs 48,000 crore between 2004 and 2009. According to Shashank Khade, vice-president, portfolio management services, Kotak Securities, the paucity of infrastructure stocks soon translated into a large basket of companies across the segment. The euphoria and risk appetite among the investing community was so high that companies raised funds at crazy valuations. For example, GMR Infrastructure, which has a presence in roads, airports and power, raised Rs 800 crore in 2006 at multiples of 78-93 times FY06 earnings. Similarly, Lanco, which is into construction, power, EPC, infrastructure, property development, and renewables, went public at 63-76 times FY06 earnings in the same year.

Thanks to the US subprime crisis, and evidence of a slowdown underway, the bubble burst in January 2008 and by the year-end the markets had tumbled to new lows. During the ensuing period, domestic liquidity got squeezed, as banks turned wary of lending. Since the infrastructure sector is a guzzler of capital, there were delays/cancellations or postponement of projects, especially by the private sector, due to domestic liquidity crunch. Consequently, confidence levels of infrastructure companies hit a low as financial closures of projects got delayed. Reflecting the turn of events, the average valuations of the 49 stocks fell to 16 times in 2008 from more than 30 times pre-crash.

Going forward, retail demand for IPOs should pick up as recent issues have listed at a premiumAnil Ladha, Senior VP and head - capital markets, ICICI Securities

Though the situation did improve post-elections in May 2009, coupled with the Reserve Bank of India’s efforts to infuse liquidity, the stimulus packages and improving global economic scenario, the stock prices have not yet overcome their blues. Nearly half of the 49 infrastructure companies, which raised money from the primary market between 2004 and 2009, recorded disappointing returns. Around 19 companies are still trading below their adjusted issue prices, in simple words, are still in negative terrain. Four companies have clocked marginal returns of less than or equal to just 10 per cent. Some high profile names such as Reliance Power, Indiabulls Power and Suzlon Energy feature in the list of 19 companies yielding negative returns since their big-bang debut on the bourses.

The biggest reason for the disappointing returns of infrastructure stocks is the hype built around the sector’s prospects and timing of the initial public offers (IPOs). A majority of the IPOs came at the fag end of the rally — 12 in 2006 and 15 in 2007 — more than half of total 49 companies. Anand Shah, head-equities, Canara Robeco Mutual Fund, says, “Normally, valuations are higher at the fag end of the rally. Besides, growth expectations from the sector were too high without realising that they involve long gestation periods. The best example is power companies.” According to Rajnish Rangari, head-investment banking, Karvy, the fundamental reason for aggressive pricing of infrastructure IPOs was the assumption that GDP will continue to grow at 8.5-9 per cent. But that didn’t happen as the economy bore the brunt of the global financial meltdown. Given that infrastructure is a dormant sector in the GDP growth rate, both of them got affected.

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Powerful theme

Most gainers are large players from the power sector

Source: BSE; *Change over the adjusted issue price

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Also, the IPO list was dotted by small-sized companies, which had raised less than Rs 250 crore from the public markets. There were 27 such companies – more than 50 per cent of the list of the 49 companies – and half of these companies match with the overall trend of declining to marginal returns. On the other hand, only seven of the 20 large companies fell into the category of negative to marginal returns. According to Anil Ladha, senior vice-president and head - capital markets, ICICI Securities, IPO pricing gets primarily derived from institutional demand. In a downturn, smaller companies are affected more due to lower bargaining power and lesser capacity to absorb shocks.

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Pricey but profitable

Though most of the companies look expensive, holding them for the long term will pay off significantly

	Price*	P/E (x)				P/BV (x)
	(Rs)	FY09	FY10E	FY11E	FY12E	FY09	FY10E	FY11E	FY12E
BGR Energy	556	34.7	22.2	16.3	13.6	7	5.7	4.4	3.6
JPVL	80	26.5	66.2	72.2	17.3	3.6	3.8	3.5	2.8
PTC India	122	31	34.2	28.2	19.1	1.8	1.7	1.6	1.5
KSK Energy	199	78.1	62.4	15.9	12.7	3.4	3.2	2.7	2.2
IRB Infra	263	49.7	24.8	18.3	15.6	5.1	4.3	3.6	3

Source: Analyst reports; * As on January 13, 2010

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Further, of the 49 companies, a majority (26 companies) were construction and infrastructure companies and 21 were power companies. Half of the construction and infrastructure companies fall into the category of negative to marginal returns, while it is just seven companies in the case of power sector.

Construction companies get orders based on awarding of projects by clients from the steel, oil & gas and power sectors. Since companies from these sectors reined in their budgets during the slowdown, construction firms were affected the most. Also, construction players constantly need working capital for executing projects, which was impacted by the liquidity crunch. Adds Shashank of Kotak Securities, “Most of the funds raised in 2007 and early 2008 are already in place and incrementally investors are not investing money in infrastructure stocks.

Will the trend change?

In the case of the construction sector, experts see only a remote possibility of a revival in stock prices, given that a majority of these companies are small in size. Abhinav Bhandari, analyst, Elara Capital, says, “Liquidity notwithstanding, the operating environment is still not conducive, given that interest rates are likely to rise by 100 basis points over the next six to eight months and crude prices are expected to inch closer to $100 levels again.” However, Rangari expects these companies to bounce back given that their businesses come into play at the starting point of a project value chain. “Also, their projects have a smaller gestation period and, hence, higher visibility,” he adds.

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High five

The top infra picks are likely to register good growth on all parameters

	Revenues			CAGR	Operating profit			CAGR	Net profit			CAGR
in Rs cr	FY10E	FY11E	FY12E	(%)	FY10E	FY11E	FY12E	(%)	FY10E	FY11E	FY12E	(%)
BGR Energy	2,881	4,107	5,086	38.1	344	485	584	40.8	180	244	293	36.3
Jaiprakash Power	666	678	2,970	115	600	609	2,671	114	242	236	1,349	109.4
PTC India	7,333	9,126	13,113	27.3	43	60	119	93.3	106	127	188	31
KSK Energy	422	1,895	2,587	95	193	1,037	1,420	96	111	434	542	59
IRB Infra	1,811	3,318	4,394	64.2	829	1,203	1,534	52	352	476	558	47

Source: Analyst reports

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In the case of power companies, market experts do not expect any positive trend, either till the time projects get commissioned, and better visibility is in store for earnings and cash flows. Most projects are likely to be commissioned FY12 onwards, which Rupesh Sankhe, analyst from Angel Broking, believes are already factored in power stocks. Thus, as of now, chances of a revival in prices of 23 stocks trading below their issue prices or with marginal returns look bleak. More importantly, in the days to come, the focus will shift to the deluge of paper major public sector companies are likely to come up with.

Will history repeat itself?

The new year has brought good tidings for the new issue market with four companies, JSW Energy, Godrej Properties, DB Corporation and MBL Infrastructure, trading well above their issue price, post listing, primarily on account of their sound operational background and better sentiment in the stock market. For example, despite stiff valuations of about three times for FY11 price-to-book value, JSW Energy got a good response on listing and is 17 per cent above its issue price of Rs 100 mainly due to the reason that it already has an operational capacity of 995 mw. This has brought some confidence especially among retail investors, say investment bankers. “Going forward, retail demand for IPOs should pick up as recent issues have listed at premium and institutional demand continues to be robust,” points out Ladha of ICICI Securities.

Infra- structure IPOs were aggre- ssively priced due to the assumption that GDP will continue to grow at 8.5-9 per centRajnish Rangari, Head-investment banking, Karvy

However, investment bankers believe that given the huge PSU paper in the pipeline, retail demand will hinge on how PSU listing pans out. However, Rangari of Karvy is optimistic that investment sentiment will be revived as PSUs have always given better returns owing to good and reliable track record.

For example, NTPC has delivered a return of about 270 per cent since its listing in 2004. The fact, however, remains that although there is no denying that NTPC has measured up in terms of financial performance, its debut on the bourses when the overall markets were still lying low has contributed to its superior returns over time.

Investment bankers feel infrastructure stocks too will get a good response depending on the pricing. As Shah of Canara Robeco puts it: “The key success factor will be valuation, valuation and valuation! Most of the problem with the IPOs has been valuations even though fundamentals are strong.”

Concurs Khade of Kotak Securities, who feels that “the scarcity premium for infrastructure companies has come down.”

Recalls Sankhe of Angel Broking, “After Reliance Power’s disappointment, people have realised that there has to be some fundamentals and operational history. Thus, Adani, NHPC and Indiabulls Power issues have not done well.”

Future strategy

While retail investors are still wary, market experts believe the sector still has potential. They feel execution capability and time frame for commencement of operations of projects are the common parameters to watch out for.

The scarcity premium for infrastructure companies has come down and incrementally investors are not investing moneyShashank Khade, Vice-president - PMS, Kotak Securities

In the case of infrastructure and construction companies, visibility on order inflows and order book is no more a concern with a revival in the economy. Says Bhandari of Elara Capital, “Impact of interest rates and companies’ ability to fund future projects, especially in a build-operate-transfer model, will be the key things to look at. In the case of power companies, risks such as availability and arrangement of fuel, offtake agreements and possibility of declining tariff rates due to competition should be considered.

Also the experience of the current private players who have used Chinese equipment would be critical for private companies in the years ahead. Says Sankhe of Angel, “Going ahead, the focus will be on earnings and asset returns, because there will be a lot of competition once the planned projects are commissioned.”

For the universe of 49 companies, the average price-to-earnings multiple based on annualised half-yearly earnings for FY10 comes to 32 times, which has doubled in the last one year. Thus, by any means, the pack does not look cheap. However, there are still some bets, which are lesser known (except IRB Infrastructure) that are good long-term bets. We reason out some of them.

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Jaiprakash Power Ventures (JPVL)

In order to bring all power projects under one fold, Jaiprakash Hydropower was merged with Jaiprakash Power Ventures (JPVL) in a ratio of 3:1. The merger created the country’s largest private hydroelectric power producer with an operational portfolio of 700 mw – 300 mw at Baspa and 400 mw at Vishnuprayag.

The combined entity is undertaking massive expansion and developing projects of 12,770 mw involving a capex of around Rs 72,000 crore, which is expected to start contributing from FY12 onwards. Execution of projects will not be much of a concern as its parent, Jaiprakash Associates, is a leader in hydro EPC works and has been involved in building third-party hydro projects of 9000 mw – one-fourth of the total hydro capacity – in the past seven years. Moreover, things like financial closure, land, water, fuel (captive mines in case of thermal generation), environmental clearances and national grid connectivity, are in place for most of the upcoming projects. On completion of projects by 2018, the mix is likely to shift to thermal power, which will be 58.3 per cent of the total capacity of 13,470 mw.

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Growing big

JPVL has massive expansion plans through its subsidiaries

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Though the company will continue to sell more power through power purchase agreements (PPAs) in the ratio of 70 (PPAs): 30 (merchant power), say by FY15, as against 100 per cent currently, it has provision to pass on the fuel cost hike. Moreover the company has sourced BTG (boiler-turbine-generator) from leading suppliers such as Siemens, Alstom, BHEL and L&T-MHI, which means higher efficiencies and, thus, less consumption of fuel. Consequently, the company will earn higher return on equity with a combination of factors such as a higher ROE of up to 20-25 per cent even for regulated assets for hydel-based power, coupled with higher rates for merchant power.

Q3FY10 was the first quarter post-merger and, hence, figures are not comparable. Net sales jumped to Rs 114 crore (which includes Vishnuprayag’s 400 mw) against Rs 55 crore (from 300 mw at Baspa) in the same period last year. Consequently, operating profit also zoomed to Rs 96.8 crore vis-à-vis Rs 49.5 crore. However, net profit was flat at about Rs 24 crore, owing to higher debt on account of securitisation of operational project’s cash flows, a forex loss of Rs 7 crore and interest refund of Rs 20 crore.

The company is planning to raise about Rs 1,500 crore either through follow-on public offer or qualified institutional placement. The stock offers reasonable margin of safety at the current price of Rs 80. As of now, analysts peg the fair value of the stock at Rs 100.

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BGR Energy

The engineering equipment supplier has gained only 16 per cent since its listing in January 2008. However, the good news for new investors is that the company is well positioned to cash in on multiple growth opportunities. The Chennai-based company has turned itself from a leading balance of plant (BoP) services provider into a full-service EPC (engineering, procurement and construction) company. This is mainly due to the rising participation of private players in power generation. Plus, increasingly power generation companies are bundling BoP and EPC work contracts to avoid delays and the hassles of multiple vendor management.

The total market size of BoP, which contributes about 35-40 per cent of the cost of constructing a power plant, is Rs 1,320-1,509 billion in the 11th Plan and Rs 1750 billion during the 12th Plan. BGR has an edge over its peers as it manufactures 40-50 per cent of a typical BoP contract in-house.

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End to end

BGR Energy is among the top fi ve power equipment players with a BoP and EPC presence

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The company opened huge gateways for itself in the EPC business when it secured two large orders worth Rs 8,000 crore in FY09. This catapulted its order book to Rs 12,200 crore, 6.3 times its FY09 revenues. Power projects division accounts for 95 per cent of the orders and high-margin EPC contributes more than 60 per cent of power projects. To complete the whole value chain in executing EPC contracts, BGR intends to manufacture BTG (boiler, turbine, generator) by establishing a 4,000–5,000 mw facility in southern India on an equity capex of Rs 600–700 crore over the next 18 to 24 months. It has also signed an exclusive 20-year licence agreement with US-based Foster Wheeler for the transfer of technology for the manufacture of sub-critical and super-critical boilers ranging from 100 mw to 1,000 mw. It is also looking for a partner for turbine and generators. This will help garner some contracts in the bulk tendering by NTPC for 7,260 mw worth Rs 21,000-25,000 crore, in the first round. NTPC is expected to float another lot of bulk tenders for 4000 mw by March 2010.

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Backward integration

The company is entering the BTG space which has few players today

Source: Religare

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There are some concerns though. Its order-book is highly concentrated with the top three clients – mainly state electricity boards – accounting for 81 per cent. About 70 per cent of the contracts are fixed-price contracts, thus, any adverse rise in raw material or power equipment prices could impact margins. Besides, tightening of credit and consequent rise in interest rates will hit the company’s profitability. Though the stock is fairly valued at current levels of Rs 530, the company’s robust growth will soon make it look cheaper.

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PTC India

The Central Electricity Regulatory Commission issued new guidelines by increasing the trading margin to 7 paise per unit for inter-state short-term trading in electricity, in case the selling price exceeds Rs 3 per unit. This will benefi t PTC India as short-term trading constitutes 47 per cent of total power traded and sells at around Rs 4-4.5 per unit.

However, over the longer term this benefit will erode as the company is shifting its focus to long-term power purchase agreements (PPAs), which is not covered under the new guidelines. Incrementally, it has signed for PPAs of 5,087 mw over FY09 – a jump of 45 per cent. Further, the memorandum of understanding of 18,290 mw as on Q2FY10 is also convertible into PPAs over the next 2-3 years. The company’s trading volumes are likely to register 46 per cent CAGR between FY09 and FY15 driven by long-term trading pacts of more than 6,000 mw translating to roughly over 30 billion units (BU), about 10 BU from cross-border trading and only 9 BU from short-term trading. However, this would be contingent on timely execution of projects in the pipeline. Analysts have incorporated at least a one-year delay in their valuation estimates. Also, there is increasing competitive pressure from new power trading companies and power exchanges. Moreover, there are low entry barriers for applying for trading licenses due to low net worth requirement of Rs 5 crore according to CERC guidelines. Thus its core trading business is likely to come under pressure. Thus, the stock looks expensive at the current market price of Rs 122 considering the near term growth. But there are several triggers for the stock, which has been the biggest gainer among the infrastructure players post listing.

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The company has investment commitments close to Rs 1,000 crore in various subsidiaries out of which 680 crore has been invested. Its biggest subsidiary by value, PTC Financial Services (PFS), which provides equity and debt funding for power projects, is likely to be listed in FY11. Its 100 per cent subsidiary, PTC Energy (PEL) is involved in power project development and power tolling. PTC holds 20 per cent each in two coal-based projects of about 2,520 mw through Athena Energy Ventures, a joint venture with IDFC, which is progressing well. Since these subsidiaries will need capital in future, there is a possibility of PTC going in for listing of these companies, which will result in unlocking of value. Its foray into coal trading augurs well as India’s coal imports are going to rise rapidly over the next few years, thanks to massive power expansions. The stock is currently quoting at Rs 119.

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KSK Energy

KSK Energy is a pioneer in setting up power plants for exclusive supply to a single user or a group of users – termed as ‘outsourced captive power’ or ‘group captive power’. This helps industrial users eliminate risk of irregular supply and the task of investing and maintaining a captive power plant.

The company operates under two unique models for small and large projects. In the first one, KSK develops captive projects for a group of industrial users, wherein it retains almost 100 per cent of the economic interest in the projects, though the users partly contribute towards the project’s equity requirements through low-yielding preference shares. Besides, the tariffs are higher than those determined under the regulated norms although lower than that of the grid. Under the second business model, KSK enters into unique long-term fuel supply pacts with state mineral corporations, wherein it will mine for companies that have been allotted blocks by the government and, in turn, utilise part of the fuel (by paying a royalty, or facilitation fee) for operating thermal power plants. Such agreements give KSK access to a total 32 million tonne of coal per annum, which will support about 7,200 mw of power capacity, and fuel cost at 30-35 per cent lower than market rates.

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Aiming high

Starting from a small base, KSK has massive expansion plans over the next few years

Source: Company, Credit Suisse

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Moreover, PPAs for most of these capacities are back-ended, which means the projects will allocate a higher proportion of capacities towards merchant sales in initial years of the project life. KSK plans to retain 51 per cent of the planned generation from its projects for sale in the open market on industrial captive/ merchant basis.

From its current capacity of 144 mw with just three small group captive power projects, the company is eyeing 10,900 mw in the next few years. About 718 mw is at advanced stages of construction and will be commissioned in phases over the next two years. KSK’s power assets portfolio, with a diversified mix of fuel types (coal, gas, lignite and hydel) and offtake arrangements (mix of captive, PPA and merchant) will mitigate the risk of fuel availability and its price on the one hand and hedge its revenue mix and project operations on the other, thus, yielding superior returns on equity. However, there is a huge execution risk and possibility of delays, since the company’s plans are large compared to its current size. Analysts have assigned it a target of Rs 270, which implies an over 30 per cent upside.

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IRB Infrastructure

Investments close to Rs 3 lakh crore are expected in the roads sector during the 11th Plan. Of the total NHDP (National Highways Development Programme) of 54,500 km to be completed by FY16, only 11,746 km is completed, 5,782 km is under construction, while the rest is to be awarded in the next few years. The National Highways Authority of India (NHAI), the nodal agency responsible for development of national highways, is expected to invite bidding for 78 projects worth Rs 1 trillion in the current fiscal.

IRB is going to be the biggest beneficiary, as it is the largest and most focused road BOT (build-operate-transfer) player. It has already executed 10 toll-based projects, while two are under construction and will contribute in FY12. The company owns some of the very high density road stretches in western India like all access routes to Mumbai, Mumbai-Pune expressway, Mumbai-Goa highway, Mumbai-Surat, Mumbai-Nashik, Pune-Nashik and Pune-Hyderabad highways. It has a 7.6 per cent share in the Golden Quadrilateral project.

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Road to success

IRB is the largest BOT road developer, ahead of such big names as L&T

Source: Angel Broking

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The company secured four new projects worth Rs 4,386 crore, spanning 383 km. Further, it has placed bids for an additional Rs 21,500 crore worth of projects and is pre-qualified for projects worth Rs 25,000 crore.

Further, its integrated business model ensures high margins and timely execution of projects.

IRB does most of the construction as well as the operation and maintenance of BOTs through its subsidiary, Modern Road Makers (MRM), which ensures higher margins. Also, most of the equipment is owned by the company. Its EPC order-book stands at Rs 9,900 crore (9.3 times construction revenues) IRB has debt only in one operational road project (as on FY09) resulting in strong operational cash flows.

The company has decided to de-risk its business model into airport and hydel projects capitalising on its construction expertise. However, there are some risks involved in the roads sector. Firstly, the sector is fraught with competition. Besides, the sector is capital intensive, requiring 70:30 debt-to-equity ratio.

Adequate liquidity and reasonable interest rate levels is a must for making projects viable. Also, the sector is heavily dependent on the growth in traffic, which is determined by the general macroeconomic scenario. And lastly, although toll rates are linked to the WPI index, any adverse movements in raw materials could impact margins as BOT are fixed contracts. The stock is currently quoting at Rs 266.