Indian Road Sector: High on Highways: Spark

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Sector brimming with opportunity; large players to emerge as winners
With an estimated US$ 1tn of investments earmarked for the 12th plan, the Govt. envisions infrastructure
development as the biggest thrust area necessary to enable India leap-frog into the next phase of development.
The road sector in particular is in focus and will account for ~15% of this expected infra spend translating to a US$
150bn opportunity. Hence we are positive on the road sector.
NHAI – the nodal agency on roads - is at the forefront driving investment in highways through programmes like
NHDP. Spurt in BOT opportunities, simplicity of bidding and execution & high traffic-growth expectations have
lured the private players to take part in the sector & they are expected to corner an ever-increasing share of the
future road projects as well. Of them, the larger players are to specifically benefit due to the recent changes in the
NHAI bid guidelines like the networth criteria, JV stipulation, restriction on number of projects in pipeline etc.
Finally, the planned mega highway projects will also present a niche opportunity to these larger players.
We prefer IRB over ITNL, albeit marginally, due to an in-house construction arm and more profitable
road stretches

 We prefer the integrated model with construction capabilities like IRB’s model as it enables tighter control on costs and
completion-time than a model like ITNL’s which restricts itself to project management only on the construction side
 IRB’s construction arm scores over ITNL’s as it has strong revenue visibility (Rs. 72bn construction orderbook), RM cost
advantages and strong equipment base of >Rs. 4bn while ITNL’s construction arm does not possess any such
construction capability and serves more as a project aggregator. Thus margins on pure construction of ITNL’s is only ~10-
12% as against the ~14% of IRB’s
 We also prefer a player with a profitable roads-portfolio like IRB than that which is well-diversified geographically and
revenue model-wise like that of ITNL’s. IRB’s roads portfolio is likely to generate a cumulative EBITDA of >Rs. 50bn and
PBT of ~Rs. 15bn over FY12-15E. On the other hand, ITNL’s roads portfolio is not as attractive from a profitability
perspective with cumulative EBITDA of ~Rs. 57bn with corresponding PBT of ~Rs. 4.9bn over the same period
 We also view favourably IRB’s ~13% overall market share with NHAI projects that have been awarded in FY08-10 vis-àvis
ITNL’s track record which is lower at ~5% overall market share during the same period. This in our view makes IRB a
stronger contender for the upcoming mega road projects, which is likely to be a niche opportunity
 In the light of increasing opportunity in the BOT road projects space and strong networth possessed by both these players
(at comfortable range of ~Rs. 20bn) we foresee a virtuous cycle of more projects garnered by both IRB and ITNL in the
future and hence a growing order-book and a growing networth
Viewed on an absolute scale we revise our stance on IRB to ‘Add’ (from Sell) and we initiate coverage on ITNL with
an ‘Add’ rating. However, on a relative basis we rate IRB as ‘Outperform’ while we rate ITNL as ‘Underperform’
given our relative preference for IRB’s business model.


Key findings following the bidding
debacles of late 2008
 Not all projects are viable on tolling
basis with realistic traffic growth
assumptions. 38 out of 60 projects
had no bidders during this phase.
 Requirement to rebid single-bid
cases delays the project award
process.
 There is merit to increasing the VGF
from the 10% limit imposed.
 The BK Chaturvedi committee
undertook a detailed study of several
road stretches and concluded that
 Only 35 projects out of the 70
projects could be viable on toll
basis. Thus a greater focus on
annuity projects.
 Going beyond the aforesaid 70
projects and looking at the
remaining 133 projects, more
than 90 projects may not be
viable on toll basis.


Potential beneficiaries of the mega
high way projects
 A total of 10 mega highway projects
are being planned by the Govt. Of
these, NHAI has asked for
qualifications for only two projects,
one in Apr’ 2010 and another during
Jun’2010.
 This initiative of the Govt. coupled
with the recent change in networth
criteria, implies that only the larger
players with networth of >Rs. 20bn
would be eligible for these projects,
each of which is over the Rs. 40bn
TPC mark.
 We think established players such
as IRB, ITNL and Reliance
Infrastructure will be key
beneficiaries of this new initiative
from the Govt.
Moreover, the Govt. has outlined a
new expressway programme which
plans to build >18,000kms of
greenfield expressways by 2022, in a
phased manner. Again we expect the
larger players to garner a lion’s share
of these upcoming opportunities
within the sector.

#1 Comparison of business models of IRB and ITNL


Both IRB as well as ITNL have an integrated development model possessing both ownership of road assets and an EPC arm which works almost exclusively
for the roads segment. However, while IRB has construction capabilities with an equipment bank of >Rs. 4bn, ITNL’s EPC segment does not possess any
construction capabilities. Thus IRB captures the greater part of the value chain of Designing, Constructing, Financing, Operating and Maintaining a road asset.
Thus we have reason to prefer the business of IRB over ITNL, albeit marginally.

#2 Portfolio of Road Assets

30,000ft view of the road asset portfolios of IRB and ITNL – We view the portfolio of IRB in slightly brighter light
 Comparable scale - Road asset portfolios of the two companies are comparable to a large degree with IRB possessing 6,109 lane kms and ITNL having
>10,000 lane kms of roads. However, viewed on a stake-adjusted basis, we note that the portfolios of the two companies are comparable with IRB at a
shade under 6,000 lane kms and ITNL at a shade under 7,000. Thus there is little to differentiate between the two companies based on scale.
 Diametrically different on source of projects, maturity of asset portfolio and revenue mix - IRB has a total of 14 BOT toll projects with 6 of those
projects in the construction stage. All the projects secured by the company over the last 2-3 years have been from NHAI. On the other hand, ITNL has a
total of 22 road projects with 11 on annuity basis and 11 on toll basis. Of the 22 projects, 12 are under construction, of which 7 are on toll and 5 are on
annuity. Moreover, only 5 out of the 12 projects under construction awarded by NHAI, reflecting the company’s reliance on State sector for its projects.
We prefer IRB’s relative maturity of projects (9 projects generating strong revenues and profits) which we believe will allow the company to bid
for more projects (and win) in the near term as well as its focus on NHAI projects which are more likely to get commissioned on time (NHAI
places greater emphasis on LA than the States and there is greater clarity on the terms of the contracts).
 IRB is expected to commission projects with costs totaling to ~Rs. 60bn over the next 3 years whereas ITNL is expected to commission projects worth Rs.
108bn (stake adjusted) over the next 4 years. Viewed on the basis of equity to be infused over such periods, we observe that IRB is expected to infuse
~Rs. 15bn whereas ITNL is expected to infuse only ~Rs. 13bn. Thus we believe the costs (in equity terms) to be incurred by the two companies is similar
but the leverage (and hence risk) on the ITNL balance sheet is expected to be greater. Prefer the conservative financing pattern at IRB.


IRB’s development portfolio is characterized by advanced stage projects, conservative financing and high profitability
 As discussed earlier, the development pipeline of IRB is fairly advanced with Surat-Dahisar expected to be commissioned during FY12 and the other five
projects of the company expected to be commissioned during FY13. This reflects in the equity requirement of the company peaking over the next couple
of years and then tapering off (subject to new project wins).
 Overall, we expect IRB to commission projects with a total cost of ~Rs. 60bn over the next 2 years. Put together, these projects require a further Rs. 15bn
in equity and Rs. 45bn in debt, indicating a DER of 3:1. We consider these levels of leverage to be normal for the roads sector, particularly given the
company’s strong relationships with bankers and proven ability to financially close debt for projects even during the financial crisis. Moreover the cash
profits from the company’s EPC division boosts the ability of the company to fund the equity and effective serves to reduce the leverage on the balance
sheet.
 The aforesaid investments into development of toll roads will enable the company grow their BOT revenues from under Rs. 8bn in FY10 to just a shade
under 25bn by FY15E, representing a 3x growth in revenues over a five year horizon. Over the same period, we expect the PBT of the toll projects to
improve from Rs. 3bn in FY10 to almost Rs. 5bn by FY15E, representing a relatively moderate PBT CAGR of 9%. This reflects the relatively high
competitive intensity in bidding for toll projects that prevailed during 2008 (growth negatively impacted due to Surat-Dahisar project).
 Cumulatively, we expect IRB’s toll road projects to generate EBITDA of ~Rs. 59bn over FY11-15E and a PBT of ~Rs. 18bn over the same period, largely
reflecting the strong cash flow generation potential of the toll rights owned by IRB.


ITNL’s development portfolio is characterized by early stage projects and aggressive financing
 The relatively large development pipeline of ITNL is at a nascent stage with two large ticket sized project (Chenani-Nashri and Jorbat-Shillong) being won
only in mid 2010. Totally, there are 12 projects of which 3 have not achieved financial closure. Thus the company’s focus should remain on financial
closure of projects and execution.
 Overall, we expect ITNL to commission projects with a total cost of ~Rs. 108bn over the next 4 years. Put together, these projects require a further Rs.
14bn in equity and Rs. 93bn in debt, indicating a DER of 7:1. We consider these levels of leverage to be aggressive for the roads sector, despite the
company’s strong relationships with bankers and proven ability to financially close debt for projects even during the financial crisis.
 The aforesaid investments into development of BOT roads will enable the company grow their BOT revenues from under ~Rs. 6bn in FY10 to just a shade
under 23bn by FY15E, representing a ~4x growth in revenues over a five year horizon. Over the same period, we expect the PBT of the toll projects to
drop from Rs. 488mn in FY10 to a loss by FY15E due to the high leverage on the projects. The negative PBT is despite positive cash flow from the
projects.
 Cumulatively, we expect ITNL’s BOT road projects to generate EBITDA of ~Rs. 57bn over FY11-15E and a PBT of ~Rs. 4.9bn over the same period,
largely reflecting the significant impact that interest and depreciation charges are expected to have on the financials of the BOT segment of ITNL over this
period. However, we note that the company prefers to keep profitability of the BOT segment by carving out profits through the upfront fees as well as O&M
expenses as that is a more tax efficient method.

#3 – Market Share Dynamics and players we prefer


While the private players can tap on opportunities presented by NHAI as well as State highways, we believe players with a bias towards NHAI projects are likely
to benefit from limited competition (given the established bias towards larger players), comparatively less delays (80% of LA to be done before project is
handed over to the developer) and greater clarity in project terms as well as the bidding process (NHAI is more transparent as compared to the States).

#4 – Contribution of the EPC Segment

EPC segment is an integral part of the business model of both companies but only IRB leverages construction capabilities of EPC segment
 IRB’s two main business segments, toll roads and EPC, truly feed into each other with the construction segment providing control over project execution
as well as construction costs. Modern Road Makers, the 100% subsidiary of IRB which executes the construction contracts for IRB, has a construction
orderbook of Rs. 72bn as well as an O&M orderbook of Rs. 23bn, resulting in a total orderbook position of Rs. 95bn. This orderbook provides adequate
visibility for construction revenues beyond FY13E. This subsidiary possesses a strong equipment bank of ~Rs. 4bn that is capable of executing projects
worth Rs. 25-30bn each year, in line with the revenue potential. We like IRB’s EPC segment for its construction capabilities as well as strong
revenue visibility.
 ITNL, on the other hand, does not possess any construction capabilities. The parent entity outsources the construction to third party contractors, who are
either pure contractors or own minority stakes in projects. The company has worked with contractors such as KMC Constructions and Ramky
Infrastructure in the past. Thus ITNL’s role in the project is limited to overseeing project execution and charging an upfront fees for securing finances for
the project. We estimate the 100% in-house construction orderbook of ITNL at Rs. 97bn (representing the unexecuted portion of the projects in hand).


While IRB is likely to be under greater pressure to book orders over the next year we think opportunities are abound
 As discussed earlier, IRB has a strong orderbook that is to be executed over the next two years. We are confident that the construction segment can
double revenues from ~Rs. 19bn in FY11E to ~Rs. 37bn by FY13E. However, for securing revenue visibility beyond FY13E, the company will need fresh
orders over the next year. That said, we believe IRB is well placed to secure fresh orders either under the BOT model or even as a pure contractor.
 ITNL too has a strong construction orderbook of ~Rs. 97bn which provides adequate revenue visibility up to FY14E, given the company has a lot more
projects in pipeline as compared to IRB. ITNL, the parent company does not possess any construction capabilities and enters into back-to-back
construction contracts with independent contractors for executing the abovementioned works. Revenues are booked as and when certain milestones are
achieved by the contractor. In addition the company also books an upfront fees (3-4% of project cost) for advisory work as well as for securing finances
for the project. However ITNL is not well positioned to take up cash contracting projects as its EPC arm is dependent on the BOT arm unlike IRB where
the construction segment is capable of functioning independently.
Scale to be comparable but construction margins to be a shade better for IRB
 Construction revenues for the two companies are likely to be comparable at >Rs. 30bn during FY12E. We expect the construction segment of IRB to
report EBITDA margins of ~12.5%, which we think is reasonable given the structural cost advantages such as access to own aggregate mines, ownership
for a sizeable equipment fleet, favorable project locations and low working capital strain. ITNL’s construction margins, we expect, will settle at 16-17% as
against the 36% expected during FY11E, which is a function of the upfront fees recognized. Excluding the upfront fees, we expect steady state margins of ~10%.

#5 – Financials

IRB benefits from strong visibility in both segments. Balance sheet to remain healthy over the foreseeable future. Return on capital to remain attractive at >15%.


ITNL’s revenue visibility is reasonable but the profitability of the road projects owned by the company are not that attractive.
Profitability is derived mainly from the construction segment. Return ratios are average in comparison to IRB.

#6 – Valuations – Sticking with DCF but introducing a terminal value for the construction segment

We view the integrated development of road projects on a holistic basis and value the company on DCF
 Road projects: The business of owning and operating BOT road projects (toll / annuity) represents a low-risk, steady cash flow generating business.
While toll roads have the potential to increase revenues with traffic growth, annuity road projects have the potential to securitize cash flows during periods
of low interest rates. Either way, the revenues and profitability of these projects are highly predictable with only modest potential for either positive or
negative surprises. For these reasons we prefer to value these businesses on DCF (FCFE basis), with CoE of 12-16% depending upon revenue model
and stage of completion of the project. We value the road projects (all have achieved financial closure) of IRB at Rs. 174 per share whereas we value
ITNL’s road projects at Rs. 115 per share (Rs. 8.4 for projects not achieved financial closure).
 EPC business: We differ from consensus in the way we value the EPC businesses of these companies. We prefer sticking to DCF valuations for this
segment as well but think it is appropriate to introduce a terminal value for the construction business, tempered for the margin and working capital
advantage provided by in-house construction business. Moreover, we restrict terminal value of the construction business to 66% of the overall valuation of
the business. On this basis, we value the construction business of IRB at Rs. 82 per share (FY12E EV/EBITDA of 6.3x and P/E of 8.6x) and that of ITNL
at Rs. 167 per share.
 Other businesses: We value the other businesses of the companies at the equity investments therein. Other business and cash contribute negatively to
the valuation of IRB whereas they contribute Rs. 24 per share to the valuation of ITNL.