The engineering and construction (E&C) sector has outperformed the broader market for the second year in a row in 2022, and global brokerage house CLSA believes the stars are aligned for 2023 as well. The sector has emerged from the pandemic with stronger balance sheets, more rational cost structures and higher order inflows.
CLSA believes 2023 could be a year to buy users of materials and hence, the E&C sector stocks could be re-rated and may outperform this year, as in 2022.
"Business visibility (BTB 3x), an order pick-up and margin visibility are rerating catalysts. We adjust earnings and raise our target prices for our E&C coverage," said CLSA.
The brokerage has adjusted earnings and raised its target prices for L&T from ₹2,350 to ₹2,570, indicating an upside of 22 percent.
Meanwhile, for Nagarjuna Constructions, it has upped the target from ₹101 to ₹118 (upside 28 percent), for J Kumar Infra, the target has been raised from ₹364 to ₹385 (upside 40 percent), for IRB, from ₹306 to ₹360 (upside 19 percent), and for BHEL, from ₹43 to ₹57 (downside 28 percent).
Its top picks for the segment are L&T and Nagarjuna Constructions.
Reasons for outperformance
According to the brokerage, the outperformance over the past two years is because India’s E&C players (ex-defence plays) and developers have emerged stronger from a Covid-hit FY20-22 in terms of balance sheets and cost structures, and are now seeing a revival in backlogs, stronger execution led by construction, and expanding margins from Bharat Heavy Electricals (BHEL).
The government capex for infrastructure has led to the strong performance of the sector in the past few years and as elections draw nearer, this infra allocation is likely to be further ramped up, which is another major positive for the space. Historically, government budgetary expenditure goes up the year before a general election.
Further, the revival of private capex is visible, with L&T winning its biggest private order in four years, helping it to sustain its backlog at double-digits, noted CLSA. Book-to-bill (BTB) bounced to 3.1x (2.9x 2QFY22), supporting execution visibility until FY25, it added.
The brokerage believes the sector is likely to continue its robust performance in 2023 as well. Let's take a look at its rationale for the same:
Capex to rise ahead of elections: Government capex has sustained an E&C backlog in the absence of private Capex in the past three years, but it has not grown much initially due to revenue pressure from Covid and a rise in materials in 2022 that made many projects seek fresh approvals for higher costs, noted the brokerage.
However, the government awards picked up 12-18 months prior to the 2019 general elections and the same could happen in 2023, which is the last window before the ordering embargo comes into effect in Q1FY24 for the April-May 2024 elections, it forecasted. Robust tax revenues, benign materials and election should drive government orders in 2023, added CLSA. Besides, 9 states are also set for elections in 2023.
Middle-East, industrial and private capex should drive orders: As per the brokerage, Middle-East capex should be supported by past under-investment plus energy transition. Further industrial capex is also picking up, with select industries like steel reaching over 80 percent utilisation and the capacity addition is likely to double over FY22-25 for steel and cement, it highlighted. PLI capex should begin after a one-year delay, but much of the capital goods could be imported, added CLSA.
Adani group is set to lead the private capex revival with its ambition across the infrastructure and green energy space, noted CLSA. It further pointed out that Aramco expects higher capital expenditure in 2023 & ahead. L&T Hydrocarbon has been a significant beneficiary of Aramco’s capex uptick.
Meanwhile, L&T’s energy order backlog almost doubled over FY18-22, led by rising oil prices, added CLSA. It also expects cement capacity addition to go up by 92 percent in FY22-FY25CL over FY19-FY22 and capacity addition of steel to go up by 111 percent in FY22-FY25CL over FY19-FY22.
Margin expansion on materials price fall: The brokerage expects strong orders and execution to translate to EPS, led by benign materials prices as steel, bitumen, and diesel prices have fallen 18 percent, 15 percent, and 5 percent from their recent peaks, respectively, raising the prospect of faster execution with visible margins in 2023, said CLSA. It expects its coverage universe to report robust 13-58 percent EPS CAGRs over FY23-25.
Q2 performance: India’s E&C sector saw strong performance in Q2FY23 despite elevated material prices, up 13 percent YoY. Construction and non-power capital goods Ebitda grew 17 percent YoY, driving E&C Ebitda growth of 8 percent YoY, said CLSA.
Power capital goods Ebitda declined 4 percent YoY, with ABB and Siemens the only companies to post growth. Meanwhile, NCC and JKIL saw strong Ebitda growth of 22 percent and 32 percent despite material pressure.
Sector PAT grew 36 percent YoY driven by strong growth from construction companies. L&T, NCC, JKIL and IRB managed to grow profit 37-64 percent YoY, added CLSA.