With the markets becoming upbeat over beaten down sectors, infrastructure stocks are back in the limelight.
But we think that the best way to benefit from infrastructure growth is to bet on the financiers to the sector.
The stocks of IDFC, Power Finance Corporation (PFC) and Rural Electrification Corporation (REC) have run up by more than 50 per cent from their December lows following reform announcements by the government.
However, the stocks of these companies are trading at a 25 to 30 per cent discount to their historical average price-to-book value.
Therefore, we suggest investing in these stocks in declines. Investors who already have exposure to these stocks can continue to hold on from a more than three-year horizon.
Charged by Reforms
A series of reforms have been initiated by the government to bring infrastructure investments back on track.
Power sector prospects, for one, are looking up after Coal India agreed to sign fuel supply pacts for 20 years, tariff hikes by most State electricity boards (SEBs) and expected financial revival package for these entities.
But for power generation companies, issues such as un-remunerative power purchase agreements, governance issues, and lack of fresh equity capital due to lower profitability of operational projects may continue to limit gains.
Similarly, in the case of road projects, issues relating to environment, execution delays and land acquisition delays continue to drag this sector.
Four reasons why
Given this backdrop, investing in lenders to infrastructure offers a lower risk option. The reasons are four-fold.
One, the demand for infrastructure significantly outpaces supply. This makes for large fund requirements in the infra space.
For instance, even after accounting for lending by banks and fund raising from other sources, the funding gap for infrastructure in the current Five Year plan (2012-17) is as high as 45 per cent or Rs 14.6 lakh crore. This, assuming that the infrastructure financing companies (IFCs) will grow at 20 per cent compounded annually for the next five years.
Two, with some banks exhausting exposure limits for infrastructure financing, new opportunities open up for specialised infra financing companies.
Infrastructure sector accounts for around 15 per cent of the total bank credit. A high proportion of restructured assets in sectors such as power may also cap banking sector exposure to the sector. This means infra financing companies can choose good projects without hampering growth.
Three, IFCs have maintained growth even in the current turbulent environment. Over the last five years, the top three IFCs saw a growth of 23 to 27 per cent in their loan book. This has shot up to 25-30 per cent in the latest June quarter.
But banking sector loans to infrastructure, which grew at 34 per cent in the last five years, have slowed recently. As of June end, the loan book growth declined to 11.5 per cent year-on-year.
IFCs have dealt with stalling growth in infrastructure in different ways.
PFC has been helped by a pipeline of sanctioned but yet to be disbursed loans.
REC has relied heavily on short-term loans to State utilities backed by the State government’s guarantees. IDFC, on the other hand, is looking at refinancing existing projects and also at renewable energy and transmission projects for loan growth.
L&T Infrastructure is also looking at renewable energy and captive projects for loan book growth.
Diversified lenders such as IDFC and L&T Infra have plenty of other avenues for loan book growth. This takes care of near-term growth for these companies.
Four, during the five-year period, the profit growth of infrastructure financing companies has closely tracked loan book growth. The profit growth of PFC, REC, IDFC and L&T Infrastructure Finance was at a compounded annualised 22 per cent, 33 per cent, 28 per cent and 121 per cent, respectively, in the last five years. This compares with a very similar 23 per cent, 25 per cent, 27 per cent and 121 per cent growth in their loan books.
This suggests that a 22 per cent loan book growth (according to Planning Commission estimates) may translate into a high rate of growth for these companies. Yet they trade at single digit or low double-digit price-to-earnings multiples.
Risks
Asset quality risks are a factor with IFCs as they are with banks. The non-performing assets (NPA) of IFCs currently appear to be under check. The loan book is also completely secured. But this is partly because of less stringent NPA recognition norms for IFCs as compared to banks.
In power projects, for instance, if the recent tariff hikes for SEBs are not sustained, then the debt may continue to pile up and SEBs may require further bailouts. Falling output of gas from the KG D6 remains a risk to gas-based power projects.
In the near term, falling load factors of private power producers are a concern. Private sector PLF at 63 per cent in April-August period is down from 78 per cent a year ago. This factor has to improve for these projects to recover costs and improve profitability.
But the risk is lower for IFCs because they can manage to get their debt serviced even at less than optimal load factors (given the normative debt:equity is 70:30).
Another positive aspect is that when IFCs restructure loans they make sure that there is no loss on a net present value basis, unlike banks which take a haircut.
Finally, IFCs such as PFC and REC use an escrow mechanism to recover payments from SEBs, where they manage to recover their dues before other costs. This somewhat reduces NPA risks.