Infrastructure stocks have been battered in the market on concerns about poor order inflow or delay in execution. While the concerns are not unfounded, some of the attractive companies in the sector are at a steep discount to their average valuations. The stock of IL&FS Transportation Networks (ITNL), one of the largest road developers in the country, lost 25 per cent from its IPO in March 2010.

A well-balanced mix of toll and annuity road projects, rich experience of its parent (the IL&FS group) in financing and conceptualising road projects, a strong order-book that provides earnings visibility for the next three years and diversification into urban infrastructure projects bode well for high earnings growth over the next couple of years. Investors with a three-year perspective can consider buying the stock, especially on any broad market dips.

At the current market price of Rs 205, the stock trades at 12 times its trailing consolidated earnings and nine times its expected consolidated earnings for FY-12. Its current valuation is also at par with its smaller (in terms of revenue) peer, IRB Infrastructure Developers.

Currently both road developers and contractors trade at similar valuations. We believe road developers deserve a premium compared with pure contractors, given the former's steady cash flows from operating toll/annuity roads. This factor attains greater importance during periods of slowdown as well as tight liquidity or high interest rates.

Balanced mix

ITNL has a 50:50 mix of toll and annuity projects (totalling 22 operational and under execution) that provide a balance between risk and steady returns. While projects such as the Chennani-Nashri highway in Jammu and Kashmir (under execution), which are prone to the risk of volatility in traffic volume, have been awarded on an annuity basis (where revenue flow is fixed irrespective of traffic volumes), the more lucrative stretches such as the Rajkot Jetpur and Vadodara Halol project in Gujarat have a toll model. In this model, ITNL adopts a de-risking strategy of auctioning some stretches where it feels toll collection could be volatile.

Hence, in times of slowdown, ITNL's revenue stream may be less prone to blips in traffic compared with players such as IRB Infrastructure Developers. However, on the flip side, this also means that ITNL's growth may be capped, especially in roads, which may eventually show high traffic. However, we believe this strategy may be necessary to hedge against downside risks; given that players are often caught on the wrong foot in toll forecasting.

Visibility from order book

ITNL's order book of over Rs 12,000 crore, over five times the FY-10 revenues, suggests enough scope for revenue growth over the next three years. Unlike earlier times, when it bagged a number of state road projects, 70 per cent of ITNL's current order book is from the NHAI. This also means that the company would be well-qualified to bag some of the larger projects to be awarded by NHAI.

The company may close this fiscal with order-book far lower than the Rs 20,000 crore it had expected earlier this year. However, given the tougher qualification and financial closure norms, not too many players may be in the fray for large projects, when they are awarded. For now, execution delays, rather than order flow slowdown, should be the key factor that investors may have to watch out for.

Even as the company made headway on road Engineering Procurement and Construction (EPC) projects and toll operations, it has attempted to diversify into non-road segments. These orders account for close to 12 per cent of the current order book and include the Nagpur City Bus Service operations on a Build-Own-Operate (BOO) basis, couple of regional airports and the Gurgaon rail project. The company may draw more from the expertise of its Spanish subsidiary, Elsamex, in the road maintenance and water supply to expand its non-road portfolio further.

ITNL's revenues tend to be lumpy, rising as and when EPC revenues are booked and falling when a completed EPC project moves to the toll/annuity kitty. For the quarter ending December, ITNL's revenue declined by 17 per cent sequentially as a result of completion of some projects and new projects being at a nascent stage. Nevertheless, as toll collection in key projects grew 7-12 per cent, the company managed to maintain its EBITDA margins at 29.7 per cent. However, going forward, the margins may dip as EPC revenues (which have lower margins) begin to contribute significantly to revenues.

ITNL is comfortably placed on its existing projects, as most of them are financially closed. The current debt-equity ratio of 2.4, while seemingly high, is not unusual for developers, which hold a large portfolio of roads in the execution stage. Currently, 12 projects are under construction or undergoing financial closure. The SPV route used for the projects also de-risks the parent's balance-sheet. The bigger risk for the company are delays in projects, as it subcontracts them so as to maintain an asset-light model. The subcontractors have so far been prominent names and are often given contracts on fixed-price basis.

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