The Big Story. New models hitting the road

It’s generally been a bumpy ride for road projects, with infrastructure funding challenges and weak toll revenues.

But after the 2014 parliamentary elections that saw a new government take over at the Centre, a series of changes were made to the rules governing road projects — from extending the time for premium payment to three years after project completion, to the 5:25 rule to refinance projects after five years. This helped boost confidence among investors, to some extent.

Also, the Centre decided to foot the bill itself so as to spur highway construction. Increasingly, roads were laid using construction models under which the government assumed the risk of revenue collection arising from the fluctuation in traffic volume. This helped highway construction increase from 1,435 km in 2013-14 to 6,397 km in 2015-16.

With the fortunes of the road segment looking more promising now, you, as an investor, might be tempted to take a look at infrastructure stocks and even bet your money on them.

But before you do so, here are some issues you need to understand. For instance, what parameters do the Centre and the different authorities apply when choosing one road construction model over another? What are the constraints in executing each model? How should an investor evaluate the risks before investing in a company? Here are some answers.

Engineering, Procurement and Construction (EPC)

Before the advent of the public-private partnership (PPP) model — in which the risks and returns from a road project are shared — projects were built through the engineering, procurement and construction (EPC) format.

Companies adopting this model for road construction faced almost no risk, barring the road construction risk. But the margins of these companies were also much lower.

For instance, the net profit margin of Dilip Buildcon, a major EPC player, was just about 5 per cent in FY16. Investors who prefer lower risk can consider these companies.

Under this format, the government authority that owns the project hires one or more private companies (or another public company) to construct the project. Private players bid for the projects and build it within a pre-specified cost and time. The asset is owned, operated and maintained by the government authority.

These projects, often conceptualised by the Central and State governments did not have an immediate profit motive but were often intended to boost economic activity, ease trade and act as an enabler to increase industrial activity in a particular region.

Risk: The company that wins the construction contract builds the road using a fixed price or item rate contract. In a fixed price contract, the private player who builds the road takes the risk completely to construct the asset for a pre-specified sum of money. Variations in raw material, labour and other expenses are managed by the constructor.

In the case of item rate contract, the cost of construction is submitted to authorities at pre-specified time intervals. The submitted bills are paid back to private contractors. Here, unlike the fixed price contract, the risk of price fluctuation in raw materials and other expenses are borne by the government agency.

But in many of the projects, the cost assessed by the project granting authority may vary considerably from that of the private players. This can be attributed to time delay between assessment by the government appraiser and start of the construction of the project after the bid is accepted. These differences are often negotiated through price variation clause, which gives partial allowance for the government body to have a share in the expense variation, both favourable as well as unfavourable.

This does not mean the private contractor will not own any risk. The built road should meet certain performance standards as defined in the contract documents for a pre-specified period of time (2-3 years) — called the defect liability period. The private party is liable for any shortfall in quality during this time period. Also, when the competition in the EPC space increases, it may lead to bids at lower price, thus cutting the margins.

Company scorecard

Many companies have a mix of EPC and other form of road contracts in their portfolio. Over the last three years, the EPC order book of many listed companies has witnessed sound growth. For instance, between 2013-14 and 2015-16, the order book of EPC major Dilip Buildcon more than doubled to ₹10,778 crore.

Similarly, the order book of KNR construction was at ₹4,238 crore at the end of December 2016. This is more than four times its 2015-16 revenue (of ₹995 crore). The 2015-16 revenue is 11 per cent higher than its 2013-14 revenue.

Another EPC major, PNC Infratech, reported revenue of ₹2,395 crore for 2015-16, about 76 per cent higher than 2013-14 revenue. With the Centre planning for major projects under Bharat Mala and coastal connectivity scheme, similar in scale to the erstwhile Golden Quadrilateral and North-South-East-West corridor projects, we can definitely expect a significant proportion of road construction through this format.

For instance, of the 4,171 km of roads constructed by the NHAI in 2015-16, nearly 75 per cent is through EPC. Though there are issues due to land acquisition, the Centre is focussed on increasing the rate of road construction to about 20,000 km per annum over the coming years. A sizeable portion of this is expected to go to EPC players. But, currently, the stock price of some of the major players in this space seems overvalued. Investors can consider buying these stocks factoring in corrections from a long-term perspective.

The price to earnings ratio for KNR Construction, PNC Infratech and Dilip Buildcon is currently 23, 17 and 28 times, respectively; this is much higher than their three-year average.

Build, Operate and Transfer (BOT)

Unlike EPC where the investor has no capital commitment in the asset, BOT players invest a sizeable portion of their equity in the asset created. So, an investor in search of higher return and assumehigher risk should opt for stocks of companies operating under this format .

Here, the private player owns the asset and recovers his investment through toll charges or collects a fixed annuity from the government for a contractually pre-specified period of time (typically 15 to 30 years).

The fundamental assumption behind this framework is that a private player is equally capable of assessing economic conditions and offering better value for money, even in case of mammoth infrastructure road projects. But considering that a road is a public good and involves multiple stakeholders, it is equally important for government to negotiate and decide on the terms and conditions of the contract before building the project.

Risk: The private player, besides owning the project, is also responsible for operation and maintenance once the project is commissioned. If the project is expected to have a rate of return (through toll collection) greater than the commensurate risk (construction, regulatory, operation and maintenance, expected traffic flow and revenue collection and political risks) taken by the private player to build and operate, the private player pays an upfront premium or a yearly premium (often a per cent from its gross toll collection) to the government agency as compensation. Also, in case of BOT-toll model, the private players are expected to own the traffic risk, often considered the tie-breaker for the success or failure of the project. Historically, investors in this segment expect their annualised rate of return to be 16-18 per cent. IRB Infrastructure Ltd is one of the most successful players in this segment.

With the new government taking over, investors were eased of their pain, albeit partially, through the premium deferment clause (for the first three years from the start of operation of the project). Despite this, the number of takers for this format has come down from the 2012 highs. With revenue projections subdued, especially during the initial years of the project, premium, interest and debt repayment are cause for concern.

However, this problem is mitigated in the case of BOT-Annuity contract. Here, the contracting authority pays a pre-specified sum of money semi-annually or annually to the private player and the traffic risk is completely borne by the government body (contracting authority). But the catch is, the purchase agreement should be honoured by the government authority.

Company scorecard

The valuations of companies such as IRB Infrastructure (IRB), a major player in the BOT-Toll format, are attractive enough. Although, IRB’s order book saw a drop from ₹11,348 crore in 2013-14 to ₹9,745 crore in 2015-16, it increased to ₹12,011 crore at the end of December 2016. With a healthy revenue and profit, the price to earnings ratio is about 14 times, just equal to its three-year average. Besides, with the successful investment trust offering from the company, its debt burden should be further eased.

Similarly, Ashoka Buildcon, another major BOT and EPC player in the road sector, had an order book of ₹6,220 crore as of December 2016, more than two times its 2015-16 revenue. With a strong diversified portfolio, the company’s price to earnings ratio, at 47 times, is trading much higher than its three-year average of 34 times. Investors should wait for corrections before eyeing this stock.

Hybrid Annuity Model (HAM)

The hybrid annuity model framework was conceptualised to bring back private capital into road building. The first half of 2016-17 saw more than six times’ increase in HAM projects awarded compared to a mere 350 odd km awarded in 2015-16. So, in what way is this hybrid model different from the rest? Simply put, these are contracts that help adapt features from several contract models to arrive at the most suitable model given the macro-economic and local environment. Under HAM, the Centre builds 40 per cent of the road project through the EPC format while the rest is built using the BOT-Annuity format.

Risk: The operation and maintenance responsibility rests with the private player for the contracted period of time. Just like the BOT-Annuity contract, the government pays a semi-annuity/annuity premium to the developer, thus shouldering the traffic risk.

Though the private player needs to finance part of the road construction, a well assured return from the government body for a pre-specified period of time is a comfort factor. But with the number of hybrid annuity projects increasing and the government assuming the traffic risk at a consolidated level across many HAM projects, the risk of payment may well be back-ended. So, this short-term bias to increase the length of highway network may pinch the pockets of the exchequer in the long term.

Company scorecard

However, many players have started bidding for these projects to diversify their revenue risks. So, with companies in the EPC, BOT and O&M segments, such as Dilip Buildcon, MEP Infrastructure, Sadbhav Infrastructure and PNC Infratech, winning projects in this segment, a commensurate adjustment to the return expectations for these companies needs to be factored in over the long run.

Operate, Maintain and Toll (OMT)

The government authority often maintains projects through various contract models such as short-term tolling, long-term tolling and operation & maintenance & Toll (OMT) contracts with private companies.

Risk: For investors, it is a safer bet compared to BOT projects. Most of these concession contracts vary anywhere between one and 15 years. While the short-term and long-term tolls carry very minimal risk, the private player assumes the traffic risk in the OMT format. In all the three cases, the toll revenue is shared with the government at a pre-specified proportion.

Company scorecard

MEP Infrastructure Ltd, the only listed road player in this segment, operates across all three formats. The revenue from operations increased from ₹1,198 crore in 2013-14 to ₹2,007 crore in 2015-16. For the nine months ending December 2016, profit after tax was at ₹97 crore compared to a loss of ₹28 crore during the same period a year earlier.

The valuations of stock price, at ₹68 per share, are about 70 per cent higher than a year earlier. Although the current price to earnings ratio may seem cheap at 10 times compared to its historical average of 13 times, the historical valuation needs to be taken with a pinch of salt owing to past depressed earnings .

Infrastructure Investment Trust (Inv-IT)

This is the new kid on the block. Inv-IT helps companies monetise healthy revenue-generating infrastructure assets comfortably, thus easing debt burden.

The trust, usually sponsored by an infrastructure company, is required to invest 80 per cent of its investments in revenue generating asset. The rest can be invested in under-construction infrastructure asset or securities of infrastructure companies. IRB Infrastructure Ltd, a major road developer, is the first to come up with a successful Inv-IT, oversubscribed more than eight times.

IRB transferred six of its revenue generating road assets to the fund, which is managed by the investment manager appointed by IRB and the asset managed and maintained by a project manager.

However, with 90 per cent of the distributable cash flow from the projects mandated to be distributed to investors, yields are subjected mainly to the risk of traffic flow and the ability of the project manager to add new revenue generating assets.

Our take

Besides IRB, MEP Infrastructure has also been given the go-ahead by SEBI to create Inv-IT fund. Although the initial estimate of 11-13 per cent yield for IRB Inv-IT fund may seem lucrative, the minimum secondary market lot size of ₹5 lakh per unit should be a dampener for the average retail investor.

But a high net worth individual can definitely consider exposing his portfolio to this investment vehicle.

Toll-Operate-Transfer (TOT)

But going forward, investors and private players can be expected to benefit more as the Centre increasingly contemplates projects bid through the Toll-Operate-Transfer model.

The Centre is expected to identify close to 75 projects (4,500 km total length) with annual toll collection of close to ₹2,700 crore for this TOT model.

Through this TOT model, the Centre can transfer the road asset to a private player who will maintain and collect tolls for a period that can span anywhere from 25 to 50 years (or even more) for a one-time upfront premium payment.

The incrementally increasing lengths of highway network envisioned by the Centre through Bharath Mala and Port connectivity projects can be expected to be partly financed through this TOT model. MEP Infrastructure will be one of the frontrunners to benefit from this.

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