Thematic Report: Indian Road Infrastructure Sector

1. Preamble
This report is first of our series of reports based on broad investment themes which will play out in next 5-10 years. In our opinion, Government is expected to implement radical measures and provide impetus to these currently ailing sectors. In this report we have laid out the current state of the industry, analyzed expected changes which are likely to have a positive impact on the sector and the key players.

2. Current Status
India has the second largest road network across the world at 4.7 million km. This road network transports more than 60% of all goods in the country and 85% of India’s total passenger traffic. Road transportation has gradually increased over the years with the improvement in connectivity between cities, towns and villages in the country. In India, sales of automobiles and movement of freight by roads is growing at a rapid rate. In order to create an adequate road network to cater to the increased traffic and movement of goods, Government of India has earmarked US$ 1 trillion for infrastructure during the 12th Five-Year Plan (2013–17) to develop the country's roads. However, currently the sector is marred with various problems such as Backlog of NHAI projects, debt laden companies, lack of funding from banks as projects are not bankable and the sector not being able to attract private capital due to unfavorable risk reward equation with inadequate returns along with considerable execution risk.

1. The highways sector is struggling to roll out stalled projects worth INR 3.8 trillion (approx $58 billion) but the developers in many cases are now shying away. According to CRISIL, nearly half of the road projects being constructed under the BOT model with a sanctioned debt of INR 459 billion are at a high risk of not being completed. Nonetheless, Cabinet Committee on Economic Affairs (CCEA) has approved a one time fund infusion (INR 13.50 billion) to revive physically incomplete and languishing 15 national highway (NH) projects in the country.
2. After steel sector, roads account for the second largest NPAs (followed by power) for the banking sector (a fallout of 75 National Highways that are at a standstill because of uncompetitive rates). Banks which have been recklessly financing road projects without necessary due-diligence were also to be blamed for this problem and there are reportedly about 70 projects that have received funding at escalated costs. Banks released large upfront amounts to the developers who used the money in other sectors without worrying about delays in the road projects. Hence, the sector lacks funding from banks as projects are not bankable.
3. Only 1/3^rd of the capital is being invested by the private players due to lack of returns along with higher risk (execution and financial risk). There is enormous financial impact on the road projects in the light of global slowdown such as decline in revenues from projects due to decline in traffic, increased financing cost, time and cost overruns on project due to delays in bidding and financial closure and hence it will likely lead to loss of developers interest.
4. To top it all, regulatory setbacks and delays in uptick in public investments are the biggest risks. The key issues in land acquisition and unfavorable changes in the policy framework resulted delay in awarding activity of road construction projects which screwed the sector. Some key reforms such as those on the land acquisition process need parliamentary approval. Although the government has the requisite majority to overcome a lack of majority in the Upper House of Parliament (Rajya Sabha), in a joint session, it needs to steer the legislative agenda adroitly given the possibility of delaying tactics that could be employed in the Upper House.

The bulk of the sharp increase in outlays in the FY16 budget for the highways and railways sector is proposed to be funded by enhanced borrowings from public institutions. Increased borrowings will fund 66% of the incremental outlay for railways and 92% in the case of roads. Public institutions in these sectors such as the National Highways Authority of India (NHAI) and Indian Railway Finance Corporation (IRFC) would have to create new financial models to support the enhanced borrowing levels. Delays in the finalisation of new institutional arrangements could hamper the expected improvements in ordering activity.

The ramp-up in ordering activity in some well-identified projects has so far been underwhelming. For example, the MoRTH (Ministry of Road Transport and Highways) has been able to award road projects totaling only around 2,500 km of the 5,500 km FY15 target by January 2015. Similarly, the Dedicated Freight Corridor (DFC) has not awarded any new track orders so far in FY15, and the budget announcement of a 750 km target for FY16 was below expectations.

Share Price Performance of key players vis-à-vis sensex (5 years, rebased to 100)

Source: Bloomberg

2.1 Market Size

The value of roads and bridges infrastructure in India is projected to grow at a CAGR of 17.4% over FY12-17. The country's roads and bridges infrastructure, which was valued at US$ 6.9 billion in 2009, is expected to touch US$ 19.2 billion by 2017. The financial outlay for road transport and highways grew at a CAGR of 19.4% in the period FY09-14.The plan outlay for 2015-16 stepped up budgetary support for Road Transport and Highways to INR 429 billion (US$ 6.47 billion).

2.2 Key Players in the Sector

Source: Maxim Research

3. Twist in the tale

1) Tweaking the model to get the sector back on track       

This year, the government plans to award 10,000 kms of roads by March 2016. That’s a far cry from 2013 when the central government could only award 1,300 kms. To revive the road sector, the Modi government decided to rely on a tried-and-tested model of construction: the Engineering, Procurement and Construction (EPC) model. In this model, the construction of the road is executed by the private developer, but funded by the government. This method is different from a decade-long practice adopted by successive governments since 2002 to build roads under the “Build, Operate and Transfer (BOT) model.” Under the BOT model, private developers invest their own money for constructing roads. They recuperate the investments through toll collection or by fixed annual revenue from the government.

Since 2012, facing a slowdown in the Indian economy and rising interest cost, many private developers had stayed away participating in the BOT model. The Modi government also devised a new hybrid annuity model in April this year, where it would share project costs with the private sector in a 40:60 ratio. Under this model, the government provides 40% of the project cost to the developer to start work while the remaining investment will have to be made by the road contractor. The government is now awarding between 23 and 24 kms of road projects daily.  The government is also constructing 6,300 kms of roads, which translates to 18 kms of roads every day. In the next year, this will be raised to 23-24 kms.

A number of old projects that were awarded between 2010 and 2012 are on slippery ground, according to credit rating agency CRISIL. This includes 5,100 kms of under construction roads that run the risk of remaining incomplete, and another 2,400 kms of operational roads, which are struggling to service their debt mainly due to lower than expected traffic. These projects were awarded between 2010 and 2012 on the BOT model. Their combined debt stands at Rs45,900 crore ($7 billion). The government is making efforts to ensure that some of these projects get going through a number of schemes including an exit policy and reworking contracts. Since April 2014, the government has put into place an easier exit policy, which allows companies to leave if they find a certain project unviable. Still, the government will have to handhold the private sector into investing until roads become attractive once again. According to CRISIL, Public sector funding will have to drive growth of highways in the near term because of the weak financials of private developers and limited capacity to take up more projects.

2) Government to award road projects worth INR 1.26 trillion in FY16

The government has set a target to award 273 road projects covering a length of approximately 12,900 km worth of ~INR 1.26 trillion ($19.5 billion). during FY16 under various schemes of the Ministry. National Highways Authority of India (NHAI) will spend the highest ~INR 720 billion, followed by ~INR 240 billion by National Highways Development Project (NHDP). In comparison, NHAI and MoRTH awarded only 5,000 kilometres in FY15 (as against planned 8,500 kilometers) and 1,933 km in 2013.  The NHAI is implementing development projects on 48,648 km of National Highways under different phases of NHDP. Out of this, work on 33,351 km has already been awarded.

3) Make in India campaign to boost the infrastructure sector

The government of India has launched major initiatives to upgrade and strengthen highways and expressways in the country. During the next five years, investment through Public Private Partnerships is expected to be in the region of $31 billion for national highways. The National Highway Authority of India (NHAI) and the Ministry of Road Transport & Highways had sanctioned projects for 3,700 kms in 2013-14. The NHDP is focusing on the widening, upgradation and rehabilitation of 47,054 kms of National Highways, which is one of the largest in the world and a seven-phase programme (~ $60 billion).

4) Financial support

INR 378.8 billion has been allocated towards the proposed investment in the National Highways Authority of India and state roads which includes INR 30 billion for the North-east. INR 143.89 billion has been allocated towards the Pradhan Mantri Gram Sadak Yojana. INR 5 billion has been allocated to set up an institution to provide support to mainstreaming Public Private Partnerships in India called 3P India.

The FII investment limit in infrastructure corporate bonds was raised from USD 5 bn to USD 25 billion. Companies enjoy 100% tax exemption in road projects for 5 years and 30% relief for the next five years. Capital gains of up to 40% of the total project cost to enhance viability. Financial institutions have received government approval to issue tax -free bonds for a total value of USD 9.2 billion in FY15. The India Infrastructure Finance Company (IIFC) is to provide long-term funding for infrastructure projects. Interest payments on borrowings for infrastructure are now subject to a lower withholding tax of 5%. Infrastructure Debt Fund income is exempt from income tax.

5) Improved Investment Prospects

The Public Private Partnership model will continue to be the preferred way of executing the NHDP projects. Priority  expressway  project  for  implementation  on  the  Public  Private  Partnership  Mode  are  as follows:

Potential opportunities

Source: Industry

The Special Accelerated Road Development Programme for the North-eastern region (SARDPNE) is aimed at developing road connectivity between remote areas in the North-eastern region with state capitals and district headquarters - a three phase project; facilitating connectivity of 88 district headquarters in the North - eastern state to the nearest national highways.

6) Robust NHAI projects ahead:

• NHAI’s total target for the ministry of roads and surface transport is 9,000 km in FY15. It’s road awards target for this fiscal year is 5,400km, out of which 4,600 km would be implemented through the state public works departments (PWDs) and the ministry itself. NHAI plans to award 2,100 km of BOT, 2,500 km for EPC and the remaining 800 km in the hybrid annuity model (HAM).
• NHAI has awarded three BOT projects and six EPC projects in this fiscal. It targets to award 20,000 km of projects within the next 2-3 years through the BOT, Hybrid Annuity and EPC routes. NHAI’s investment spends were INR 210 billion in FY15 and are estimated at INR 450 billion for FY16.
• All this ensures road sector to become growth driver for Infrastructure sector. We think companies like KNR, IRB and MEP would some of the beneficiaries to grab the opportunities.

3.1 Proposed Hybrid model of concession will be positive change for the sector

As per the proposed hybrid model of concession, revenue risk which encompasses execution risk (related to land acquisitions), regulatory approvals would be borne by Government (NHAI).The bid parameter will be project cost (TPC) and 40% will be funded by NHAI while remaining will be contributed by concessionaire on a suitable D/E mix. NHAI has identified 17 projects to be awarded in Hybrid Annuity mode in FY16.

Risk Sharing Matrix - Modified MCA + Hybrid Model

Source: IL&FS Company Data

3.2 Government Initiatives:

Government is introducing new policy initiatives, like the rescheduling or deferment of premium payable to the government and the Cabinet Committee of Economic Affairs (CCEA) approving the new exit policy norms in the road sector according to which developers can now sell 100 % stake in any project two years after completion. We believe, such initiatives would ease the liquidity position of developers encourage to bid for more projects.

• Government has introduced Contractual Service arrangements to attract Private sector participation in the development, financing, operation and maintenance of infrastructural facilities for public services.
• Favorable budget allocation to MoRTH and NHAI - The conversion of existing excise duty on petrol and diesel of INR 4 per litre into Road cess will bring additional INR400 billion for roads.
• An RBI rate cut by 50bps is favorable although banks have only recently transferred ~10-20 bps savings to the borrowers. The further softening of interest cycle likely to reduce the borrowing costs.
• Infra bonds which are exempted from the requirement of CRR, SLR is likely to bring down cost of funds in the longer run.
• Establishment of National Investment & Infrastructure Fund which initiates a corpus of INR200 billion to raise debt to be infused as equity in infrastructure projects.

Indian highway sector is brimming with hopes of revival driven by policy initiatives in the recent past that have eased equity sourcing and improved execution, according to Fitch Group's company India Ratings & Research. Rescheduling of premiums and the 5:25 refinancing schemes have provided some respite to the special purpose vehicles (SPVs) with a forlorn hope of restoring their financial health. The introduction of the hybrid annuity model and infrastructure debt funds further highlights the government's focus on addressing the rising need for devising an efficient and flexible financing path.

4. Outlook

4.1 Aggregate investment in Roads to nearly double over the next 5 years

In the FY2015-16, Infrastructure investment is expected to increase to $11.61 billion (INR 755 billion) from the Central funds and internal resources of Central Public Sector Enterprises.

Sources: NHAI, MORTH, CRISIL Research

4.2 Major infrastructure segments could witness a large uptick in order inflows

We estimate order award activity from large identifiable segments will more than double over FY15-17 compared to FY12-14. Railways, highways, metros and urban infrastructure should record high growth.

Source: Various government publications and media reports

4.3 National Highway –Order awards to pick up gradually from current low levels

NHAI has awarded a total of 27 projects measuring ~3,091 kms in FY15 v/s 1,522 kms in FY14. Out of the 3,091 kms awarded by NHAI in 2014-15, only 24% (5 projects) were on BOT mode. NHAI has also terminated stuck projects to aid future awarding.

Sources: CRISIL Research,, NHAI

Source: www.nhai.org

5. Finding diamonds in the rough

As the sector hitherto has been marred with many problems, it reflected on the valuation of the listed players. However, with the recent government initiatives (target of achieving 20 km of road laying every day) which should help in the revenue visibility, we believe the prospects of the sector are trending northwards.  As discussed earlier, various structural measures are: the ministry of road transport & highways recently amended certain clauses pertaining to dispute resolution, payment of back-end premiums and provision of completion certificates in the model concession agreements for build-operate-transfer (BOT) and engineering, procurement and construction (EPC) projects. These amendments are expected to reduce project implementation delays, increase efficiency in resolving disputes and ensure timely completion of projects. Seen as a step in the right direction by the ministry, the amendments could help companies rationalize their operating costs. However, the heightened competition in the sector might play a spoilsport for individual gains and remains a risk to the profitable growth of road developers.

Bigger has not been better thus far…..

Infrastructure firms, executing large projects are struggling with project delays and crushing debt while on the other hand, a number of relatively smaller engineering, procurement and construction (EPC) firms are coasting along, helped by strong balance sheets, tight cost controls and conservative bidding strategies. The share price performance shows asset-light companies such as KNR Constructions Ltd (KNR), PNC Infratech Ltd (PNC), ITD Cementation India Ltd (ITD) and J. Kumar Infraprojects Ltd (JKIL) are rewarding investors with high returns. On the other side, the stocks of asset-heavy infrastructure firms such as IL&FS Transportation Networks Ltd (ITNL), GVK Power and Infrastructure Ltd, GMR Infrastructure Ltd, IVRCL Ltd, Gammon Infrastructure Projects Ltd and Hindustan Construction Co. (HCC) Ltd, with a collective debt of over INR 1 trillion as on 30 September, 2015 have fallen between 13-56% in the past year. In the last one year, stocks of relatively small EPC firms have gained, with KNR rising 98.28%, ITD 123% and JKIL 74.29%. PNC, which went public in May, has seen its stock rise about 48.1%, helped by cost controls and a regional bidding strategy.

The EPC sector is undergoing a radical transformation in the listed space. Old stalwarts such as Gammon, HCC, and IVRCL are being discarded in favor of new ‘kids’ on the block such as JKIL, KNR and PNC. Asset owners (GMR, GVK and Lanco) are being ignored due to keen interest in asset-light EPC companies such as NCC, ITD and JKIL as the market does not intend to reward leverage this time. The asset-light construction sector has outperformed all other sectors in infrastructure since the Narendra Modi-led government came to power. The lower the percentage of assets deployed towards asset-heavy businesses, the lower is the debt burden on the company. In the last two years, regional road contractors seem to be gaining market share at the cost of larger peers. This can be seen from the growth in market share of companies like KNR, G R Infraprojects Ltd, Dilip Buildcon Ltd, PNC and others who have managed a 41% combined market share in the last two years.

Although the market expects the smaller EPC firms to continue to deliver strong performance for the next few years, while weak growth, falling profits and highly leveraged balance sheets hurt large and asset-heavy entities, we remain positive on bigger players. We believe that the new structural changes will benefit the entire sector and will be especially beneficial to the hitherto laggards given that they adapt to the new policies and remain nimble footed. Given the Government’s concentrated efforts in reviving the sector and the key measures such as a proposed policy to extend the contract period if a delay has been caused to the project by the government, permission for full equity divestment after two years of completion for all BOT projects, and one-time financial assistance to revive "physically incomplete and languishing" BOT (toll) national highway projects, we believe existing large players will benefit significantly. Below, we profile a few key players.

IL&FS Transportation:

IL&FS Transportation Networks Ltd (ITNL) was incorporated in 2000 by IL&FS, an infrastructure development and finance company, in order to consolidate their existing road infrastructure projects and to pursue various new project initiatives in the area of surface transportation infrastructure. IL&FS Transportation has grown into the largest BOT road asset owner in India with approximately 14,667 lane km in its portfolio (comprising 31 BOT projects, with presence in 17 states). It is a market leader in the Transport Infrastructure Sector with presence also in Metro Rail, City Bus Services and Border Check-posts. In addition, ITNL’s International operations are primarily in the road segment and spread across Spain, Portugal, Latin America, UAE and China. In March 2008, ITNL commenced international operations through the acquisition of Elsamex S.A. (Elsamex), a provider of maintenance services primarily for highways and roads in Spain & other countries. In 2013, ITNL signed a MoU with a Japanese expressway development company, Nippon Expressway Company (NEXCO East) to work on PPP projects. ITNL emerged as the lowest bidder for two highway projects in Maharashtra worth $692.43 million in June 2015.

IRB:

IRB Infrastructure Developers Ltd (IRB) was incorporated in 1998 and is one of the leading Infrastructure development company in India in road and highway sector. It is engaged in the business of road infrastructure projects, Real Estate, and Other segments. It is involved in the construction, development, operation, and maintenance of roads. It undertakes development of various infrastructure projects in the road sector. The company secures contracts by submitting bids in response to tenders, together with its subsidiaries. It has strong in-house integrated execution capabilities to undertake at least seven projects simultaneously. It is one of the largest Built Operate Transfer (BOT) portfolio in the country, total length of ~10,036 Lane kms as BOT operator. It holds market share of 13.17% on the Golden Quadrilateral. Presently it has 23 operational BOT projects.

MEP:

MEP Infrastructure Developers Ltd. (MEP) was incorporated in the year 2002. It has a pan-India presence with 12 states in the country. It is an established and leading player in infrastructure sector in the country. The company focuses on pure Toll Management and Operate, Maintain & Transfer (OMT) operations in the roads including highways (constructed by third parties). MEP acquires only the right to collect toll in exchange for revenue share or payments to the authorities, on completed roads for a set number of years. The roads are constructed by the third party like NHAI or State highway authorities.