Improvement in the overall operating environment for construction sector

Construction companies engaged in the infrastructure sector are going through good times currently, driven by government push towards infrastructure development and supported by a significant increase in infrastructure capital outlay, particularly in the roads, railways and the urban infrastructure segments. In the current cycle, construction companies have significantly boosted their order book; with most having order books over three times than last year?s operating income. As per an ICRA note on the sector, medium-sized road and irrigation projects have witnessed an average of 8-12 bids per project, with the projects mostly getting awarded at a discount to the base price. The execution pace, particularly for road projects, has also witnessed a marked improvement with steps towards reducing key bottlenecks like right of way, faster clearances, etc. These factors have helped improve the overall operating environment for the construction sector.

Most leaders in the current cycle have healthy financial and operational profiles, which are expected to support their growth over the medium term. Further, the risk profile of the prominent public-private partnership (PPP) mode of project awarding currently in use ? the Hybrid Annuity Model (HAM) ? is more balanced, as traffic risk is not borne by the concessionaire. There has been an improvement in the PPP projects in the road sector post introduction of the HAM projects.

According to Shubham Jain, Vice-President and Group Head, Corporate Ratings, ICRA, ?The learning from the last cycle has helped players in prudent risk management, while staying away from unrelated investments thus supporting their financial risk profile. The strategy to focus on bidding for cluster projects, lower sub-contracting, early completion, and tight monitoring of working capital has helped in improving the operational risk profile of the construction entities. The operating environment in the current cycle is also conducive for execution, which further supports their credit profile. These factors have also helped improve credit ratings in the sector.?

On the flip side, arranging funds for the PPP projects ? both equity and debt ? remains challenging and a key constraint for contractors who venture into the PPP projects. There are possibilities that some players with relatively leveraged balance sheet can face difficulty if the operating environment turns weak. The fortunes of the construction sector, being cyclical, are closely linked with the performance in the underlying sectors, ie, infrastructure, real estate and industrial projects. In the National Highway segment, the share of the EPC projects awarded to players, which were leaders in the last cycle, had fallen sharply, while emerging leaders in the current cycle have been gaining steadily.

Nevertheless, the construction companies remain exposed to challenges. Arranging bank guarantees is becoming a key challenge for many players, given the ramp-up in the scale of operations of many companies, and constraints on banks to increase exposure to the sector. Furthermore, as many new contractors (which were earlier pure EPC contractors) are taking up HAM projects, their ability to mobilise long-term equity required for such projects, as well as achieve debt tie-up could become challenging. The other important factor to keep track of is the working capital intensity.

?While the competition in the sector currently remains moderate, any slowdown in project tendering can increase the bidding intensity and impact future profitability,? adds Jain.