Sector Thematic - Infrastructure - Betting on Conservatism - HDFC Securities

Parikshit D Kandpal, CFA, Institutional Research Analyst, HDFC Securities.

Despite strong ordering momentum, we are seeing emergence of headwinds to the Indian highways program. Substantial dilution of bid qualification has exposed the sector to low quality, inadequately funded developers taking large order inflow market share. This has the potential of de-railing the NH program, creation of sub quality infrastructure, time and cost overruns and eventually higher cost to completion and defaults. Financial institutions are playing at the party with reckless sector lending, benchmarking the developer's risks under the garb of NHAI AAA rating. We remain cautiously optimistic as HAM projects are being bid like EPC projects, which shall lead to equity shortfall and execution delays. EPC players with strong balance sheets, conservative bidding stance, and secured funding stand to outperform as the dust settles.

Substantial dilution in bid qualification poses systemic risk

Post COVID-19, we have seen substantial dilution in the NH bidding norms; whilst this was initially done to support developers, the same has not been rolled back. This resulted in smaller developers with limited understanding of risks taking up higher market share of orders awarded. Our analysis shows some of these developers have net worth lower than the cumulative HAM equity requirement, whilst a few don't even have capital for upfront equity infusion and are in the market to raise NCDs to fund equity. This poses a strong challenge to project execution and may result in cost escalation and delays/defaults.

Financial institutions joining party, limited understanding on pricing risks may squeeze sectoral funding in mid term Flush liquidity, low cost of funding, and limited avenues for credit growth have led to PSU banks stepping up lending to the sector, irrespective of developer quality. Decentralized decision making, absence of in-house project finance teams, lackadaisical approach to risk have made it easy for developers to raise HAM debt. It has become L1's market and there is limited 40-50bps rate differentiation between best and middling developer. Tier 1 private banks have become cautious, seeing aggressive bidding, high inflation, and rising interest rates.

Asset monetisation, robust awarding and strong tier-1 balance sheet are some of the tailwinds

Government's intention of expanding highway programs augurs well for project awarding. With debt embargo on NHAI (Capex to be funded by budgetary support), we expect its balance sheet to improve. Asset monetisation may further strengthen NHAI balance sheet as sovereign funds have shown strong interest in recent NHAI and private road projects. Tier-1 developers continue to remain cautious and seem to be choosing balance sheet over growth. This augurs well for long term rerating and asset creation.

Valuation multiple near trough, rerating contingent on reduction in competitive intensity

Tier-1 infrastructure developers are trading at ~8.5x 1-yr forward valuation. The recent correction presents an attractive entry point for strong balance sheet players. We expect competitive intensity to reduce as middling players' order books are full and in recent bids we are seeing that fewer companies and bids are below cost. Infrastructure asset creation is top priority of the current government, which may lead to robust ordering over the next decade. TOP PICKS: GR Infra, KNR, PNC Infra, HG Infra and NCC. Within the Capital Goods: L&T, Cummins India and Kalpataru are our preferred picks.

Source : Equity Bulls

Keywords

Thematic Sector Infrastructure HDFCSecurities