Analysis on credit perspective of developers for BOT based road projects

20th July 2011 Analytical Contact Maulesh Desai Manager maulesh.desai@careratings.com (D): +91-079-40265605
Opportunities in the road sector on public-private partnership basis India has an extensive road network of 3.3 million kilometre (KM), the third-largest in the world. National highways have a total length of 70,934 KM. National Highway Development Project (NHDP), a project of National Highways Authority of India (NHAI) entails an investment of USD 60 billion towards upgrading and widening of National Highways of 54,454 KM. Out of these, about 47% of the projects have been awarded and 60% of the awarded projects were completed upto March 31, 2011. Balance 53% projects constituting construction of 28,803 KM are expected to be awarded over the next five years. These also include mega highway projects with an estimated cost of more than Rs.2,000 crore. Of the above, NHAI is expected to award projects of around 7,300 KM in FY12. Moreover, according to the decision made by empowered group of ministers, 10,000 KM of State Highways are to be converted into National Highways. More than 60% of the projected investment requirement for the NHDP is expected to be privately financed, mainly through Build-Operate-Transfer (BOT)/DesignBuild-Finance-Operate-Transfer (DBFOT) route offering huge opportunity in the sector. It is believed that more investment can come if the private sector sponsors the projects and Source: NHAI government provides viability gap funding compared to mobilising investment in the sector through cash contracts. Out of total BOT projects to be awarded, the expected mix of toll and annuity projects is 70:30. The Government of India has introduced several incentives such as tax exemptions and duty-free import of road making equipments and machineries to encourage private sector participation. Further, several policy reforms, such as permitting early exit to project sponsors, merging of equity and operations & maintenance (O&M) grants for road projects, permission for toll collection with completion of 75% of project highway (subject to certain conditions) and relaxation in pre-qualification criteria have been introduced to propel private investment in this sector. Enormous opportunities in the road sector with focus on BOT/DBFOT model of NHAI has also increased the share of such projects in the order backlog of developer-cum-contractors resulting into strong revenue visibility. Moreover, with the Governments focus on the infrastructure, most of the contractors have order backlog to contract receipt ratio of more than three

times for the year ended March 2011. NHAI has also modified following pre-qualification criteria for increasing participation in the sector: All applicants meeting the threshold technical and financial experience criteria set out in the Request For Qualification (RFQ) shall be eligible to participate in the Request For Proposal (RFP) stage. Earlier only top 5-6 applicants shortlisted based on qualification criteria were eligible to submit financial bids for the project. Threshold technical capability for claiming eligible project experience has been reduced to 5-10% of estimated project cost as compared to 10-20% earlier. Threshold technical experience score for pre-qualification has been reduced to estimated project cost of the subject project cost as compared to twice the project cost. Challenges in the project execution Out of the ongoing 109 BOT projects of NHAI with length of 10,061 KM analyzed by CARE, 57 projects were awarded during the last two years. However, the appointed date i.e. project commencement date of all these 57 projects were not yet finalized as on March 31, 2011. Historically, this takes around one year from the award of contract. Nevertheless, with increasing resistance for the land acquisition, 22 of these 57 projects are more than a year old since the contract has been awarded and were yet to receive formal appointed date as on March 31, 2011. Uttar Pradesh, Haryana, West Bengal, Kerala, Punjab and Gujarat are the major states facing these problems. Also, in balance 52 projects of 4,517 KM which were under implementation as on March 31, 2011, only 18 projects were either on schedule or have been facing delay up to six months. Delay in the land acquisition, design approval of Rail Over Bridge (ROB), construction and permission from the Ministry of Environment and Forest are the major issues hampering the project progress. Lack of clear land titles, fragmented nature of landownership, protests over land in compensation, regulatory and inconsistencies framework

continue to obstruct the development of various BOT road projects. Multiple clearances are to be required at the Centre, State and local levels, which also impair the project execution pace. Although many states have introduced the facility of single-window clearance, it is still a fact that project developers need to secure multiple approvals through various nodal agencies. Along with this, the absence of an efficient arbitration mechanism to compensate for such delays also increases the risks for construction companies. While disputes during project execution require rapid and effective settlement, in many cases, they get held up in a long judiciary process and remain unresolved for a long period. Although NHAI has taken steps to facilitate land acquisition in various states and acquires around 80% of the land before finalizing the appointed date, more needs to be done in this direction to

attract private capital towards such projects. Moreover, with the increase in order book of construction companies, availability and retention of skilled manpower have also become a major challenge. At times, delays in design approval of complex structures have also hampered project progress. Financing of BOT projects Project developers are exposed to market risk considering higher equity commitment and need to infuse upfront equity for the disbursement of debt in the Special Purpose Vehicle (SPV) project. Further, BOT projects are being implemented by SPVs and generally the developer (who is also a contractor) enters into a fixed-price Engineering, Procurement & Construction (EPC) contract with the SPV. Operating profits earned from the EPC contract partly fund the equity contribution made by the sponsor-contractor in the SPV. However, fixed-price nature of the contract in an inflationary scenario along with the time lag in generation of free cash flow would increase reliance on the other sources including debt for funding the equity contribution in the SPV. This results into increased exposure of the developer in SPVs as compared to their standalone net worth. The developers seek long-term loans with maturity beyond 12 years considering the concession period of about 17-24 years (including construction period of 30 months). However, availability of such long-term funds is curtailed by sectoral caps/exposure norms of banks, risk of asset-liability mismatches and the absence of an active corporate bond market. Moreover, limited participation of insurance companies and pension funds, which have to comply with restrictive investment guidelines even as they remain risk averse, have also affected the fund flow to the sector. There is a need to align the loan tenor and debt servicing requirements with project cash flows. Even though tail period , i.e is balance concession period beyond debt repayment tenure, provides opportunity in case of refinancing/securitization of revenue receipt post Commercial Operations Date (COD), tenor of the loan in India is on lower side compared to the international standard of 25 years for the highway projects. The Planning Commission has suggested setting up of Rs.500 billion India Infrastructure Debt Fund (IIDF) to meet the need of the long-term funds, although its successful operations remain to be seen. External Commercial Borrowings (ECBs) are gaining importance for financing infrastructure project on the back of favorable differential in overseas and domestic interest rates. Further, Non Banking Finance Companies (NBFCs) dedicated to funding of infrastructure projects named as Infrastructure Finance Companies (IFCs) have also been allowed to raise fund through ECB upto 50% of their own funds for lending to the infrastructure sector. Recently, the overall limit for fund raising through ECB has increased from USD 20 billion to USD 30 billion by the Government which is expected to augur well in raising long-term finance at lower cost. Impact analysis on the risk profile of the project SPV Although opportunities are enormous in the road sector, relaxation in some of pre-qualification criteria has increased the level of competition in the sector due to entry of many mid-sized construction players. Increase in competition on the back of bid-driven nature of the business has resulted into aggressive bidding by many construction companies during the last 1-2 years. Although toll road projects offer better

Internal Rate of Return (IRR) than annuity-based projects because of inherent traffic risk influenced by various macro economic factors nonetheless, the recent inflationary scenario augurs well for the growth prospects of operational toll-based projects in the near term, through hike in toll rates. Further, BOT projects being financed with debt-equity of 3:1 times or more are exposed to interest rate risk. Delay in achieving financial closure due to weak market scenario can also hamper the project progress. Aggressive bidding, high traffic risk, interest rate risk and delay in project progress collectively affects credit profile of the contractor/developer with increasing propensity to support the sponsored SPVs in case of cash flow mismatch. Impact analysis on the credit profile of the developer-cum-contractor CARE has considered the sample of 14 major listed construction companies executing BOT road projects to analyze their credit profile. Aggregate standalone profit and loss figures for FY10 and FY11 of these 14 major construction companies and published balance sheet figures of eight companies are considered for analysis. The financials are tabulated below which reflect moderate pace of project execution and increasing operating costs. Aggregate standalone financials for the Period Ended as on March 31 Working Results of fourteen companies Total Operating Income PBILDT Interest Depreciation & Amortization Operating Profit Other Income PAT (after Def. Tax) Gross Cash Accruals Key Ratios PBILDT Margin (%) Operating Profit Margin (%) PAT Margin (%) Interest Coverage (PBILDT/Interest) Financial Position of eight companies Total Debt Networth Debtors Inventory Cash and Bank Balance Other Current Assets and Loans & Advances Current Liabilities Net Working Capital Key Ratio Overall Gearing (times) Source: Published results; bps: basis points 2010 (12 mths) 35,098 3,907 1,304 688 1,916 317 1,478 2,166 11.13 5.46 4.21 3.00 7,205 7,647 4,161 5,990 911 6,380 8,150 9,293 0.94 2011 (12mths) 40,046 4,179 1,753 815 1,601 536 1,389 2,201 10.44 4.00 3.47 2.38 9,872 8,572 4,777 7,401 777 8,695 9,766 11,884 1.15 (Rs. Crore) Growth/ Remarks (%) +14.10 +6.96 +34.47 +18.45 -16.40 +68.79 -6.05 +1.65 Declined by 70 bps Declined by 146 bps Declined by 74 bps

+37.01 +12.09 +14.81 +23.55 -14.71 +36.28 +19.83 +27.88

Although most of the construction companies have robust revenue visibility with order backlog to contract receipt ratio of more than three times as on March 31, 2011, slower pace of project execution has resulted into relatively lower growth in the total operating income. According to the past trend, the scale, size and

complexity of projects have increased significantly but the execution capacity of construction companies including scaling up of their resources have not increased in the same proportion, which is also one of the factors in slower execution of projects. Moreover, rising commodity prices and labour cost had also affected PBILDT margins of the companies. Although construction period of the BOT project commences from the appointed date, protracted delay in the appointed date from the date of award of the projects do affect the revenue visibility of EPC contractors and also expose them to volatile commodity price risk. Rise in the interest rate along with higher working capital requirement has resulted into significant increase in interest cost during FY11 as compared to FY10, resulting into dip in the operating profit margins by 146 bps. However, fall in the PAT margins was limited to 74 bps on the back of significant growth in the other income mainly from the interest income on advances given to the subsidiaries and liquid investments/ deposits. The elongated gross working capital cycle was largely attributed to moderately stressed liquidity position of SPVs due to increase in project cost, pending approval of the change in scope/ additional work done by contractor, milestone-based payment terms with higher portion of retention money and exposure to the construction companies to irrigation projects in Andhra Pradesh. Increase in the advances given to the SPVs for the project execution/ funding cost overrun & change in scope have also increased working capital requirement. Increase in the debt level along with decline in the profitability has also affected debt protection indicators moderately during FY11. The overall gearing of the industry universe increased to 1.15 times as on March 31, 2011 despite substantial increase in the debt levels due to equity infusion through Qualified Institutional Placement (QIP), Initial Public Offer (IPO) and Private Equity by some developers. Some of the corporates have raised funds through selling minority stake of their SPVs during FY11; this trend is expected to be continued for meeting equity commitment contingent upon the buoyant equity market. Even though, SPVs are expected to be self-sufficient for debt servicing out of their revenue generation in the form of toll / annuity receipt, the debt-funded nature of these SPVs affect the credit profile of the contractor/ developer with increasing propensity to support for the uninterrupted operations of these SPVs. This risk would be elevated in case of aggressively bidded project and debt of the SPV guaranteed by developer. However, sensing this risk, many companies have transferred their BOT portfolio in a separate holding company to de-risk their EPC business. Outlook With healthy order book of most of the developers and thrust of government on infrastructure, total operating income is expected to get some momentum going forward. Nevertheless, rising commodity prices, increase in the labour cost and higher interest rate scenario are expected hit the operating profit margins of by around 150 bps during FY12. Working capital requirement is also expected to increase in line with enhanced scale of operations, higher input material prices and funding of any cost overrun /change in scope of the project. The developers opting for the aggressive bidding routes are expected to face challenges in managing operations of SPVs which possess substantially huge debt funds. This shall result into rationalization of competition with players tending to bid with reasonable margins and players with sizeable

order backlog opting to be selective in new projects. Thus, developers with good project execution skills and conservative bidding strategy are expected to be benefited in the long run with generation of healthy cash surplus and timely execution of the BOT projects. Control over operational costs with efficient project planning and implementation would also be crucial going forward.
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