HCC-BUY



With the approval of cost variation claims and impending completion of the Bandra Worli Sealink, the worst is probably over for HCC.




The impending completion of the Bandra-Worli Sealink is likely to expand profit margins.

Vidya Bala

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A strong order pipeline, improved profit margins, benefits from recent business restructuring and removal of uncertainty surrounding the unique Bandra-Worli Sealink project, provide better visibility to the earnings growth of Hindustan Construction Company (HCC).

Investors with a four-five year perspective can consider investing in the stock. At the current market price, the stock trades at 11 times the company's estimated per share earnings for FY-10. This valuation is on a par with a number of peers.

While the current market price is an attractive entry point, investors can consider adding the stock on dips as the stock market is expected to remain volatile in the near future.

Clarity on issues

Hindustan Construction has for long been haunted by huge cost variations arising from delays experienced in the massive Bandra-Worli Seaklink (BWS) project in Mumbai. This had led to muted margins and subdued growth in the bottomline over the last few years.

The company's operating profit margins deteriorated steadily from 13.5 per cent in FY-2004 to 9.1 per cent in FY-2007. The delays also led to suboptimal utilisation of resources given the capital intensive nature of the project. The worst is probably over. For one, the Cabinet has approved about Rs 160 crore of cost variations, as of 2003. Adjusting for inflation, the company is likely to receive a higher amount. Such a write-back would provide relief to the losses of about Rs 220 crore that have so far been booked. Two, the project is expected to be complete by June 2009.

With the approval of the claim, the company is unlikely to book any significant losses on the project. It is likely to improve margins, which may already benefit from the higher margin hydro power, water supply and irrigation projects that make up the current order-book.

Improved financials

The company's results for the year-ended FY-2008 already show improvement. Revenues grew by a healthy 31 per cent on a standalone basis to Rs 3,083 crore. Net profits, after adjusting for additional tax payments (on removal of Section 80IA benefits) made in FY 2007, grew by 37.2 per cent.

More important, operating profit margins steadily improved over the four quarters, and stood at 11.8 per cent for FY 2008. These improvements are positive, coming on the back of the likely completion of the BWS project, a favourable shift in revenue mix and higher contribution from hydro power projects when compared to FY-2007.

Strong order pipeline

HCC's order-book grew by a mere 9 per cent on a year-on-year (YoY) basis, reflecting the slowdown seen in a number of engineering and infrastructure companies. However, the current order book of Rs 10,200 crore provides adequate visibility on revenues, provided projects are executed on time. Given the execution challenges faced by infrastructure companies, added to raw material and interest cost hikes, an order book size that is less imposing and more achievable, may provide greater comfort.

The order intake in 2008 has also seen a doubling of water-related projects and a marginal dip in road projects. This could also aid in margin expansion in the coming years.

Restructuring

HCC has undergone some business restructuring that has led to the birth of a separate subsidiary for BOT projects. The company already has a subsidiary for real estate. With this, its businesses can be broadly classified as construction services, BOT and real estate.

In the former, the company has again created focussed businesses for transportation, hydro and nuclear power, integrated special projects and water-related and irrigation projects.

The creation of the subsidiary is likely to lighten up the balance-sheet and allow the company to bid for and fund BOT projects that require sizeable capital. The creation of focussed sub-segments may allow the company to scout and bid for more specialised projects in the respective segments. Opportunities that may arise in nuclear power projects are a case in point.

On the real estate front, while the company's prestigious Lavasa project has attracted investment from the likes of Axis Bank, we have not factored in any revenues from this long gestation project. Upside from this project could, however, be significant.

Concerns

Higher interest cost and leverage, in a rising interest rate environment, is an area of concern for HCC. HCC's debt-equity ratio of close to 2:1 is higher than major peers. However, this can be partly attributed to the difference in the nature of projects handled by the companies. HCC, with a high proportion of hydro power projects, has a higher working capital requirement, especially in the initial phase of the project. Further, hydro power projects also require heavy fund deployment into assets.

This is evident from the company's gross block nearly doubling between 2006 and 2008. Borrowing for the purpose of procuring assets may, therefore, be higher. In the near term, depreciation of the rupee may result in forex losses on the FCCB exposure.