FCC

The Order Book Chase

2018-09-01

Total order backlog of the engineering and construction firms was Rs.8.1 trillion at the end of FY18. Of the whole order backlog, almost 62 per cent was contributed by the construction companies, followed by 24 per cent of capital goods companies catering to the energy industry. The road sector has emerged as an important contributor to the entire order book in FY18, thanks to a record rate of projects by the National Highway Authority (NHAI) and the Ministry of Road Transport and Highway. The orders of NHAI were two times higher than order value in FY18 as compared to last year. India's progress at scaling up its infrastructure is shown in its decreasing power deficits, high passenger growth for airports, rising renewable capacity and large metro train projects in progress. The government is leading the build-up in view of growing urbanisation. With a size of USD 2.8 trillion, India is the seventh largest in the world and third largest in terms of purchasing power parity. In the fourth quarter of 2017, India grew at 7.7 per cent. In 2018, it is projected to grow at 7.4 per cent. Nevertheless, India's infrastructure deficit is simply too large to eliminate any time soon. The government estimates infrastructure investment of USD 4.5 trillion will be needed through 2040. That's substantially more than India's Gross Domestic Product (GDP) 2017 of USD 2.6 trillion. Macro roadblocks that could strain the government's budget or reduce project returns for the private sector include currency weakness and global trade protectionism. Rising inflationary strains can push up interest rates, while elections scheduled for 2019 could fuel political and policy uncertainty. With all the above elements taken into consideration, the question arises: Whether India can bridge the infrastructure deficit and examine the diverse regulations and peculiarities of different sectors? INFRASTRUCTURE TODAY addresses these and other related issues in this story. Is funding the key issue? Infrastructure takes time to build and perhaps, more so in India than for many other countries. Projects suffer delays and cost overruns due to complex land acquisitions and environmental issues. And in all democracies, societal considerations play a part too. But the need for a better infrastructure isn't disputed. The World Economic Forum's 2017-2018 Global Competitiveness Report ranked India 66th in terms of infrastructure, marginally up from 68th place in 2016-2017. Stakeholders expect this ranking to improve noticeably over the next five years. The Indian Government believes ample infrastructure funding is available. But some leading financiers consider otherwise, as suggested at Asian Infrastructure Investment Bank's 2018 summit. Many domestic banks saddled with bad assets (including from infrastructure and power sectors) will lend only selectively, constraining available capital. During his recent visit to India's financial capital, Prime Minister, Narendra Modi said, 'We are applying novel public-private partnership (PPP) models, infrastructure debt funds and infrastructure investment trusts to fund infrastructure.' He further added, 'India is trying to develop brownfield assets as a separate asset class for infrastructure investment. Such assets, having passed the stages of land acquisition and environment and forest clearances are relatively de-risked. Hence, for such assets, institutional investments from pension, insurance and sovereign wealth funds are likely to be more forthcoming.' 'Over the five-year period of 2017-2022, India will need USD 750 billion for energy, transportation and urban development and we have budgeted infrastructure spending USD 90 billion for 2018-19,' announced Piyush Goyal, Minister of Railways,  Coal and Corporate Affairs, The Government of India. According to S&P Global, private investor demand for Indian infrastructure assets is significant for specific sectors and the right assets. In particular, private investments lead the way in renewables and airports because of favourable economics. Investors generally prefer sectors where regulations or growth prospects provide greater visibility on cash flows. For other sectors such as railways (including bullet trains), the government spending and the government-to-government loans may remain the key source of funding. Varied regulatory conditions In India, regulations are diverse. Regulated utilities and airports face heavy regulations, while independent power producers, renewables and ports largely operate based on the competitive market forces. Utilities benefit from a regulatory framework that has been stable for two decades; other sectors lack long track records or a framework. The regulatory mechanism for utilities and airports is technically based on similar grounds, ie., assured returns on equity. However, because of differences in the maturity of regulations and timeliness of implementation, the cash flow trends for companies in the two sectors vary sharply. Under their long-established framework, utilities have full pass-through of costs. In contrast, airports face long delays in the implementation of tariffs and ambiguity in tariff components. However, if regulatory resets become timely, airports in India could also benefit from assured returns. Earnings growth The rating agency expects earnings growth to remain protected for utilities at about 9 per cent annually from fiscal 2018 (ending March 2018) to fiscal 2020 due to full cost pass-through. The revenue growth was weak from 2015-2017 due to lower coal prices, but earnings remained solid, driven by capacity growth. Abhishek Dangra, a Primary Analyst with S&P Global at its Singapore office, expects a sharp drop in revenue and earnings for airports between 2018-2020, even though passenger traffic is likely to grow by a strong double-digit. Regulations seek to provide stable target returns over the five-year regulatory period. Strong growth during 2015-2017 led to over-collection of revenues, a situation that persisted due to delayed tariff resets. Tariffs in 2018-2020 will, therefore, fall sharply to offset the over-collection in previous years. In case of construction and infrastructure companies, they are set to clock a 20 per cent compound annual growth in revenue till the year 2020, as per a CRISIL study of 66 companies. These companies account for more than 80 per cent of the debt in over 300 companies that CRISIL rates in this sector. The buoyancy in growth will be driven by the government focus and spending on road construction. Fiscal 2018 was particularly frenetic, with 17,000 km road projects- the highest ever in a year- being awarded by both, the Ministry of Road Transport and Highways and NHAI. The pace of construction, at 27 km per day, was twice that of fiscal 2014. And over 90 per cent of these contracts were based on the hybrid annuity (HAM) and EPC models. Construction is expected to accelerate to 32 km per day by 2020 given NHAI's sharp focus on the award of projects under the Bharatmala programme. More than half of these are expected to be under HAM. 'We expect topline growth for these companies to sustain at 20 per cent in this fiscal, and the next two backed by strong order books,' said Sachin Gupta, Senior Director, CRISIL Ratings. 'Together, these companies are estimated to have an order book of Rs 1.3 trillion last fiscal, which, at over three times the revenues of these companies in fiscal 2018, provides high revenue visibility.' CRISIL's analysis shows HAM projects being awarded over the next two years will need about Rs 700 billion of funding through an optimal mix of debt and equity. For this, players will have to raise an additional Rs 120-150 billion of equity to invest in new HAM projects, given the limited-playing field and the fast pace of project awards anticipated. But this shouldn't pose an issue because the market sentiment for the sector is positive and therefore, private equity interest is high. Sushmita Majumdar, Director, CRISIL Ratings added, 'To maintain growth in the order book and credit profiles, companies will need to raise funds either by selling HAM assets, or through the capital market, or from private equity funds. We are already seeing evidence of this.' In the past two to three years, this sector has seen over Rs 120 billion being raised through divestment of road assets. E&C's sizable growth According to a report by CLSA, the entire engineering and construction order backlog increased by 12 per cent, following adjusting for the effects of the Goods and Services Tax (GST). The reported backlog of the companies has been suppressed in FY18 because it excluded excise and other taxation components after the execution of GST. Total order backlog the E&C firms was Rs 8.1 trillion at the end of FY18. Of the whole order backlog, almost 62 per cent was contributed by the construction companies, followed by 24 per cent of capital goods companies catering to the energy industry. The order backlog picked up in the second half of FY18 due to the momentum in the road construction and projects from power and transmission segments. The order inflow was slow in the first half of the fiscal. This led Larsen & Tubro (L&T), India's largest infrastructure company, to cut the order inflow guidance in the first half though it ended the year with 7 per cent higher order inflow at Rs 1.5 trillion. L&T's order book growth was mainly aided by the public sector projects. Consequently, the share of the domestic orders in the total order inflow increased to 76 per cent in FY18 from 70 per cent in the previous year. The domestic order flow grew by 15 per cent in FY18 to Rs 1.17 trillion. Meanwhile, the road sector has emerged as an important contributor to the entire order book in FY18 thanks to a record rate of projects by the National Highway Authority (NHAI) and the Ministry of Road Transport and Highway. The orders of NHAI were two times higher than the order value in FY18 as compared to last year. As a result, the order backlog of construction companies such as Sadbhav Engineering, Nagarjuna Construction, Dilip Buildcon and IRB climbed by 72 per cent, 80 per cent, 36 per cent and 51 per cent, respectively, in FY18. Meanwhile, for the road sector, the overall awarding is expected to reach new heights in FY19. NHAI awarded 7,400 km in FY18. More than 6,000 km was awarded in the last quarter of the fiscal year itself. However, given the current share of EPC and HAM, the same level of award cannot be sustained post FY19. Thus, CRISIL Research expects awarding to fall to approximately 5,000 km level FY20 onwards. The research agency expects awarding momentum to be high in the coming years on account of a strong pipeline of projects, backed by the Bharatmala Pariyojana, and delegation of increased autonomy to NHAI. Awarding in FY19 is expected to be higher than that post FY20 on account of increased push prior to Lok Sabha elections. Currently, most of the HAM players are looking for selling off equity stake in operational as well as under-construction projects, including newly awarded HAM projects. If this trend of selling an equity stake in under-construction projects continues, giving bandwidth for the eligible players to bid for new projects, the share of HAM projects in future could increase, thus increasing the total awarding by NHAI. Six players- Dilip Buildcon, Sadbhav Engineering, MEP Infra, IRB Infra, Ashoka Buildcon and Welspun Enterprises- constitute more than 60 per cent of the total HAM awards in FY18. The number of bidders in HAM projects have been limited to five to six bidders given the cautious approach undertaken by banks towards lending for HAM projects. On account of the high number of projects floated on HAM, and limited bidders, the bids have remained non-aggressive. Most of the HAM projects in FY18 were awarded at a higher price than NHAI benchmark cost. The investments in transmission and distribution from the Power Grid Corporation and state electricity boards boosted order backlog of KEC International and Kalpataru Power by 57 per cent and 25 per cent, respectively, in FY18. India's largest power equipment company, BHEL also recorded 12 per cent growth in order backlog. The buoyancy in the orders is likely to continue in the current fiscal based on the commentary of the companies after the March quarter results. L&T has guided for 10-12 per cent order inflow growth, while BHEL expects revenue of Rs 320 billion in the current fiscal. Capex expectations SCP Global expect capital expenditure to remain high for Indian infrastructure players across sectors. However, leverage trends vary. Rated utilities will likely to maintain elevated capex of about USD 8 billion annually, but the commissioning of new capacities and regulated returns on investment should increase earnings. Construction of large express highways (like Delhi-Vadodara, Nagpur-Ahmedabad-Bengaluru, Delhi-Katra, etc.) is expected to commence from FY19-20, the spending on which is likely to be in the range of Rs 200 billion-Rs 300 billion per highway by central as well as state governments. That apart, the government's integrated conservative mission, under its Namami Gange Programme, is expected to take off in FY20 and the design order for its plants has been placed. Meanwhile, about 60-70 per cent of land acquisition for the Mumbai-Ahmedabad bullet train project has been completed and work on the same is likely to start by FY19 end. Annual spending on the project is likely to be approximately Rs 200 billion. In case of airports, S&P Global anticipate higher leverage for rated airports in 2018-2020. The Delhi Airport is set to incur significant expansion capex of more than Rs 80 billion and Hyderabad Rs 20 billion, spread over the next few years. At the same time, delays in implementation of tariff adjustments will result in lower tariff rates. Without timely recovery of future capex costs through tariff adjustments, credit metrics may come under pressure. Airports have seen very strong growth in the past three years, achieving passenger traffic targets three to five years ahead of their planned initial estimates. Rising income levels, competitive airfares compared to rail and growing connectivity support the growth in domestic and international travel. Macro-economic factors The infrastructure sector has a high correlation with the overall economic environment. Apart from regulations, economic activity, interest rates and demand growth can significantly influence cash flows and in some cases even project viability. Regulated utilities are the most resilient; while renewables, ports, and airports will be most at risk to unexpected macro shocks. Experts believe that the power sector is moving towards equilibrium in demand and supply from a deficit situation. However, the fortunes will vary for thermal and renewables. Under the National Electricity Plan 2018, Indian projects that power demand will grow at a compounded annual growth rate of over 6 per cent until 2022. Planned coal capacity additions are likely to exceed retirement and new addition requirements, even up to 2027. As a result, overall system Plant Load Factors (PLF) will decline. Weaker demand and healthy capacity additions in the past few years has helped bridge the power deficit gap. PLFs are a measure of a plant's generation vs. the potential capacity. PLFs for coal power plants, on the other hand, have fallen due to three main issues- weaker demand, rising share of renewables and fuel supply issues. A regulatory review is due in 2019 and any significant unexpected variations to the current strong framework could be negative. Favourable regulations with grid priority and long-term contractual power purchase agreements together create the right setting for large institutional investors. High investment needs to support growth have been largely met by major international investors and debt. Lower returns due to falling tariffs, weak operating performance and high leverage remain the key challenge, in our view. That said, there has been an unprecedented step-up in the pace of infrastructure development in India in the recent years, driven by the government spending. Private sector investment in infrastructure, however, remains muted. It's critical that script changes and patient private capital is encouraged, which can be done only through win-win frameworks.