One very important aspect of capital intensive sectors such as construction and engineering is they require a huge amount of capital. With the reduction in corporate tax rates, companies could expect a significant improvement not only in rates of return, but also in their cost of equity capital.
In many cases, the companies that have BOT (build, operate, transfer) projects or other assets such as roads and ports could see a higher internal rate of return (IRR) on existing projects, leading to a revaluation of those cash flows and the invested equity. Effectively, companies such as L&T would become even more attractive on a sum of part (SOTP) valuations basis.
Besides the benefits to the ongoing projects, companies now have more reasons to deploy cash or capital in fresh ones because the incentive to allocate capital now increases, the returns profile of new projects will improve and thus, the financial viability of the projects will be better, which could kickstart a new capex cycle.
Many companies will see a jump in their return ratios, including the return on equity (RoE) and return on capital (RoC). For instance, in the case of Engineers India, the company last year paid tax at the rate of 34.80 percent. Assuming the new effective tax rate of 25.17 percent, the company's FY19 net profit stands to be boosted by 15 percent. Moreover, its return on equity, which stood at 16.30 percent will come in at 19 percent. That's a significant jump.
L&T, which has been making efforts to boost its RoE, could see more gains. Now, with the new tax rates, L&T's calculated RoE for FY19 gets a boost of 288 basis point to 17.2 percent, much nearer to its target of achieving 18 percent RoE by the end of FY21, as against its actual RoE of 14.3 percent in FY19.
A very important impact of this development would be an improvement in valuations. Improving profits and better capital ratios should be appreciated by the market and thus, lead to higher valuations. Currently, the engineering and construction sector is trading at about 10-12 times its FY20 estimated earnings, which is near the low point seen during the past five years.
For more research articles, visit our Moneycontrol Research Page.
Disclaimer: Moneycontrol Research analysts do not hold positions in the companies discussed here
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