Is The Infrastructure Sector Poised For A Comeback?

In the past one year, the Nifty Infrastructure Index has outperformed the broader Nifty 50 Index on an absolute basis. The Infrastructure index has given returns of 63 per cent, whereas, the broader indices have given returns of around 52 per cent.

Markets are Optimistic

Some individual stocks from the infrastructure sector such as Larsen and Toubro (L&T), and Dilip Buildcon have almost doubled in the past year. The L&T stock is trading at a record high. The markets appear to be quite optimistic regarding the prospects of the companies in the infrastructure space.

For the past few years, the infrastructure sector had been a laggard in the markets. Low revenue growth, combined with high leverage had caused investors to pretty much give up on the sector.

The pandemic was the proverbial nail in coffin that caused a precipitous fall in the stock prices. Even today, the sector has low valuations in relation to the broader markets. Nevertheless, the sector appears to have better days ahead.

A Leg Up from the Government

The Union Finance Minister, Nirmala Sitharaman, had announced a 35 per cent hike in capital expenditure during Budget for the financial year 2022. The capital expenditure for the year was pegged at around Rs. 5.5 lakh crore. Government spending is an important factor for the infrastructure sector, constituting a major part of the companies’ order books.

India’s largest infrastructure company L&T has an order book of which 85 per cent of orders are from the Centre, states or public sector enterprises. In contrast, the private sector just contributes to 15 per cent of the company’s order book.

Most PSUs are asset-heavy businesses that require large investments in fixed assets to grow.

In addition, these companies are given capital expenditure targets by the government. Most PSUs operate in sectors that have benefited from the recent rise in commodity prices. With the global commodity shortages, several PSUs are looking to augment their capacity to meet the demand.

Capital expenditure is encouraged by the government, as it has a high multiplier effect, creates jobs, enhances production and results in high economic growth.

Usually, states are quite reluctant to engage in capital expenditure as the heavy spending often results in overshooting the fiscal deficit target. In the last 20 years, states have failed to cut capex targets.

In some years, the cut in capex targets equalled almost 0.5 per cent of the Gross Domestic Product. Consequently, the government introduced some incentives to encourage states to meet their capital expenditure.

Each state that meets the capital expenditure targets gets to borrow additional funds will get to borrow up to 0.25 per cent of Gross State Domestic Product. Such an incentive scheme encourages a push for infrastructure expenditure.

“To become eligible for incremental borrowing, States were required to achieve at least 15 per cent of the target set for 2021-22 by the end of the first quarter of 2021-22, 45 per cent by the end of the second quarter, 70 per cent by the end of third quarter and 100 per cent by 31st March 2022,” said a government press release.

Inflection Point?

Despite the increased governmental spending on infrastructure, infrastructure companies continued to face labour shortages and project disruptions during the first half of 2021. These factors caused the recovery in infrastructure to be delayed for a while.

However, as the country opens up and labour shortages ease, these companies are poised to bounce back with the increased governmental spending.

In addition, the government has launched the Gati Shakti programme to expedite infrastructure projects, create jobs, lower costs, increase connectivity, monitor projects, and serve several other purposes.

Through the National Infrastructure Pipeline, the government will be spending Rs 100 lakh crore on infrastructure. The National Highway Authority of India has over 4,000 kilometres of road-building contracts to be handed out.

The real estate sector has been booming, with new property registrations hitting a decadal high in Mumbai. As global companies adopt a “China plus one” strategy, and rearrange their supply chains, Indian manufacturing sector could be a major beneficiary.

The private manufacturing sector has seen low capital expenditure over the past few years. The production-linked incentive scheme has attracted interest from larger players that want to augment their production capacities to benefit from the scheme.

In a note, brokerage Prabhudas Liladhar has highlighted that several major mid-cap companies whose operations are mainly restricted to India have strong order book visibility. The order books are around 3.5 times of the trailing 12 months' revenue, indicating a healthy position.

According to Motilal Oswal, L&T has focused on deleveraging during the Covid crisis, rather than focusing on growth. Such prudent financial behaviour allows them to benefit from the up-cycle in infrastructure.

Several other companies like PNC Infratech, and Capacite Infraprojects have followed a similar strategy to deleverage.

Margin Pressures Remain

Nevertheless, a major cause of concern for all infrastructure companies is the rise in key commodity prices. Prices of steel, cement, copper and other building materials have been on a bull run for the past few months.

As a result, most infrastructure companies have seen a fall in margins. Larsen & Toubro has seen its operating margins fall from 22.3 per cent in the first quarter of financial year 2021 (FY21) to 13 per cent in the first quarter of FY22.

IRB Infrastructure has seen its margins fall from 51.7 per cent to 45.8 per cent during the same period.

However, some of the companies do have price escalation clauses or have “cost plus” contracts, allowing them to reduce the impact of commodity price volatility.