Equitymaster: How to invest in an infra stock?

A cursory look at the table might reveal that we are comparing companies across two different industries. This appears because of the vast RoE differential persisting between both the companies. But you might be surprised to know that both the companies belong to the same industry!

Now one might wonder what could have been the reason for outperformance by company A vis-à-vis company B. A wide RoE differential between the companies is further surprising because of the fact that both of them belong to the construction industry - typically plagued by low double digit returns on capital. Before we explain the underlying reasons for outperformance here are the names of these two companies. Company A is Ahluwalia Constructions, a small sized company with strong presence in the NCR region. While Company B is IVRCL Infrastructures, a well established player in the construction space.

Now let us dwell upon the reasons for outperformance. Construction is a wafer thin margin business. The projects are created for social benefits - typically awarded by the government - and thus have a thin spread. As a result the industry RoE falls in the range of 10-13%. This is evident from the fact the RoE's IVRCL has been able to generate over the last few years.

However, Ahluwalia Constructions' has managed average RoE of about 36.5% over the past 5 years. It should be noted that the company had very little debt on its books over the same period. Thus RoE expansion is not at the cost of stretching the balance sheet.

We identify two reasons for the above average RoEs the company generates. Making landmark buildings is the company's niche. This enables it to earn higher margins. Secondly, majority of the projects the company bags are from the private sector. Higher share of private contracts boost’s RoE’s as these contracts are bagged on a negotiated basis thus having a higher profitability.

Apart from this it is interesting to note that the company has the best working capital cycle. Ahluwalia's working capital requirements as a percentage of sales averaged at about 10% over the past 5 years. This is significantly better than the industry average which ranges between 40-50%. Better working capital management enables the company to generate cash at the operating level. This reduces reliance on debt to fund the future expansion plans. This is evident from the fact that the debt to equity ratio of the company has consistently been below 1x over the past few years.

Over the past three years the company has almost doubled its sales and is on the exponential growth path. Going forward, it has guided for a strong order inflow over the next couple of years. This provides strong revenue visibility. Superior RoEs, low leverage ratios and better working capital management distinguishes Ahluwalia Construction from the peers in the construction space. What more, the company also goes to show that shareholder value creation could be possible in as difficult an industry as construction.