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RBI study paints a grim picture of states’ ability to spend on infra capex

In its 2020 study of State Finances, the RBI has raised concerns over the states’ ability to continue with large capex as revenues dwindle and revenue expenditure rises. To put in context, states have had a 63% share in combined government infra spending historically; we expect this to settle at 42% going forward. We had earlier argued in our deep-dive report that India does not have the fiscal space for a big-bang infra stimulus as the debt overhang is not transient and may haunt till FY25E. We now estimate combined government infra spend CAGR of just 4.9% over FY19-25E (vs. ~20% over FY13-19) as we cut state infra spend estimates by 9-17% for this period.

The slowdown directly impacts growth opportunities for our coverage companies. For example, as of Sep’20, L&T carries 38% of its order backlog from states, 14% from Center and 30% from PSUs. The National Infra Pipeline also does not look encouraging as our analysis shows that <20% of the overall pipeline is close to tender-ready stage. L&T and PNC Infratech are our top picks only on the basis of relative comfort within the sector.

* Most states will face a revenue deficit in FY21 as against a budgeted revenue surplus: Given the inter-linkage between growth and tax revenues and the fact that tax revenues fall faster than GDP, tax revenues are likely to remain low for the next few years, as per RBI. RBI highlights that worsening of state finances is not temporary but will last for several years.

* Even as states’ GFD/GSDP exceeds 3.2% in FY20 and 4% in FY21E, they have not built enough cushion for macroeconomic threats: The borrowing limit acts as a soft constraint for states; capex will in turn be sacrificed to maintain GFD within 4% of GDP. Our analysis of the Top-10 states in terms of infra spends suggests that their infra spending exceeds GFD, which means that states are borrowing not only for capex but also for revenue expenditure.

* States may have to face the difficult choice of putting investment projects on hold: Given the multiplier effect, this will inevitably entail growth losses in a vicious circle feeding itself. As per the RBI, states have a tendency to cut back their capital expenditure by almost 0.5% of GDP, on an average, to meet fiscal deficit targets. UP, AP, Rajasthan, TN and Telangana have consistently missed capex targets (except for Transport, Energy and Housing, all other segments have consistently suffered). Actual data from CAG shows that state infra capex has declined ~8% in FY20 and over 40% YTDFY21 despite an extremely low base in H1FY20. Even the Center’s capex is down 18% so far YTDFY21.

* States’ fiscal position will be further affected by a surge in guarantees: Guarantees issued by state governments rose to as much as 3% of GDP (mostly relating to DISCOMs). Historically, it is a precursor to an actual increase in debt. Even post-UDAY, DISCOMs continue to impart a significant downside risk with no visible signs of a turnaround. Farm loan waiver and income support schemes are further curbing states’ ability to spend on Infra.

Sector valuations no longer compelling; L&T and PNC our top picks

* Given foreseeable challenges, no easy reforms forthcoming and recent run-up, valuations of the stocks in the sector are no longer compelling. Even the stocks that appear cheap on FY22/23E have earnings that benefit from the existing strong order backlog, which may not sustain and thus, benefitting from a cyclical peak.

* Our top picks in the sector are determined by a relative safety rather than an absolute growth potential: 1) L&T - medium-term pain offset by a likely market share gain and valuation comfort at ~13x adj. FY22E P/E (bottomed at 7x in 2008); 2) PNC Infratech - among the few construction names to generate OCF/FCF with a strong 3.1x FY21E book:bill, trading at 8x adj. FY22E P/E.

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