Highway Development: Near term challenges; smoother times ahead:: MSFL research

Please Share:: India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��

 Roads & Highway development presents a structured, planned & definitive opportunity of ~` 1365bln (USD 26.25bln) to EPC & BOT developers. Dissecting this opportunity, we find that the scale, size & regional distribution of majority of balance projects may not be attractive for a BOT developer. Also, the competitive intensity of bids has challenged all industry players alike & warrant caution. In our opinion, these bids assume a consistent availability of cheaper source of finance which in itself is unsustainable over a longer time frame. We believe capital markets shall, in the long run, create a valuation differential between aggressive company managements and those with conservative & sustainable strategy. Hence, we like companies with business model & management style which does not encourage excessive risk taking, have projects with longer concession tail & are able to consistently generate positive FCFE with minimal support from the parent entity.
Definitive opportunity, award activity has already peaked
Highway development under the planned NHDP presents an opportunity of ~` 1365bln (USD 26.25bln). While we don’t deny the size & certainty of the opportunity we are concerned about limited projects fitting the size & scale of a PPP development. The regional spread too is not quite encouraging. Also, we expect FY12 to see peak of awards in near term.
Competitive pressures – no respite in near term
The recent bids by developers belie their stated IRR objective. Also, the expectation of gradual decline in competitive intensity has been proven otherwise. Supply side constraints along with demand side factors of declining order backlog/sales, lower asset utilization & scope for financial leveraging has attracted the breadth of the construction players to road projects particularly the NHAI project awards. Hence, we expect the competitive intensity to remain at elevated levels in near term restricting IRR’s of projects to lower teens.
Takeout essential (debt &/or equity), equity requirement to pull plug on competitive intensity
We estimate an equity requirement of ` 2687bln over the next 3 years for projects currently under implementation. Additionally, ` 339bln of equity shall be required for projects which are expected to be awarded in the next 2 years. In our opinion, this shall be the sole factor for pulling the plug on the competitive intensity of the sector.
Challenging times to continue; Valuations offer comfort
The competitive intensity, amongst other reasons has led to underperformance of the sector with broader markets. The current average valuation of 1.5x P/B offer significant comfort from further downside. We initiate coverage on Ashoka Buildcon & ITNL with a Buy rating, downgrade IRB Infra to Hold, maintain Buy on Sadbhav Engineering. Sadbhav Engineering continues to occupy the top slot in our pecking order of stock selection.

• Definitive opportunity, declining scale & PPP economics

Highway development under the planned National Highways Development Program presents an opportunity of ~` 1365bln (USD 26.25bln). While we don’t deny the size & certainty of the opportunity we are concerned about limited opportunity fitting the size & scale of a PPP project. The regional spread too is not quite encouraging. Our conclusion is based on detailed analysis of projects based on type of development (2/4/6 lane), length, cost, & geography through which the road passes. Unless the Greenfield expressway projects takeoff in a major way, the near term opportunity presents lesser number of commensurate project opportunity for large BOT developers.

• Sporadic award activity to continue; timely borrowing by NHAI key to project awards

So far, the NHDP awards have been characterized by irregularity due to poor feasibility reports, land acquisition problems, NHAI finances, & other policy related issues. Even though the B K Chaturvedi committee recommendation did attempt to address this issue and have recorded better pace of land acquisition, we have not witnessed a marked improvement of the same. Project restructuring resulting in bid cancellation has been the other reason for bunching up of awards. Lack of long-term sources of finances too has prevented faster implementation of NHDP. Premiums received on recent project bids are expected to support NHAI’s finances post completion of awards. We estimate a gross borrowing requirement of ` 350bln for completion of NHDP awards (our estimate excludes cost of development of 1000kms of Phase VI under NHDP). While timely borrowing is essential for project awards, we expect project restructuring to result in average time cycle of project awards remaining high.

• Vehicle addition comforting for toll road operators

Viability of toll-based projects depends on the traffic growth. As per our Auto Analyst, Mr. Ronak Sarda, Light Commercial Vehicles (LCV) segment is expected to register 15% CAGR over FY11-13E, whereas Heavy & Medium Commercial Vehicle (H&MCV) segment is expected to grow by 10% during the same period. We believe these growth rates coupled with Indian economy growing by 7-8% Y-o-Y, would ensure sufficient growth for toll based stretches. On the passenger car movement, since India has one of the lowest penetration levels worldwide, traffic growth from cars would supplement CV traffic growth. Note that CVs contribute the most to total revenue collection of Indian toll roads (around 70% of total toll collection).

• Competitive pressures – no respite in near term

The recent bids by developers belie their stated IRR objective. Also, the expectation of gradual decline in competitive intensity has been proven otherwise. We view the competitive intensity as interplay of demand-supply dynamics and the fragmented nature of the construction/infrastructure industry. Supply side constraints of lower all round capital formation measures in the economy, absence of awards by other construction intensive infrastructure & industrial sectors along with demand side factors of declining order backlog/sales, lower asset utilization & scope for financial leveraging has attracted the breadth of the construction players to the road / highway sector particularly the NHAI project awards. Market share analysis indicates that established players have won majority of the awards over the last 3 years further frustrating the new entrants. Hence, we expect the competitive intensity to remain at elevated levels in near term restricting IRR’s of projects to lower teens.

• Road Infra lending – Systemic leverage high, is incomprehensible

Advances to infrastructure sector have grown at a CAGR of 36.2% over the last 4 years due to GoI’s thrust on infrastructure development through PPP. Credit to infrastructure sector stands at 32.1% of outstanding industry credit as on Dec’11. During the same period, the advances to road projects have grown at a CAGR of 37% taking its share in infrastructure lending to 18%. Recently, there has been a discussion on bank’s lending to road developers based on an inflated project cost resulting in higher systemic leverage potentially risking the entire banking system along with NHAI’s finances and future development plan. Having factored in a 35%/40% higher cost of project as compared to NHAI/State RDC estimates, a construction period of 3.5yrs & a 75/25 Debt/Equity funding structure we find that cumulatively the bank lending to road exceeds our debt draw down estimates by ` 341bln. Failure to explain the cumulative difference of ` 341bln assumes significance in the light of such amount being 6% of the outstanding infrastructure credit (exclusive of advances by Infrastructure NBFC) to roads. We are unable to comprehend the exact reason for such high leverage of the sector.

• Takeout essential (debt &/or equity), equity requirement to pull plug on competitive intensity

As an extension to our discussion on high systemic leverage we believe takeout of bank loans by long term finance and takeout of loans at developer level by equity is becoming increasingly essential to de-risk the system. Assuming the project cost to be 30% higher than the NHAI estimate & a funding mix of Debt:Equity-70:30 we expect an equity requirement of ` 2687bln over the next 3 years for projects currently under implementation. Additionally, ` 339bln of equity shall be required for projects which are expected to be awarded in the next 2 years. In the absence of a stable secondary market most of the developers have started to look at the PE route for raising capital. Hence, we believe takeout by equity is essential for avoiding any adverse systemic fallout of the leverage. Also, in our opinion, this shall be the sole factor for pulling the plug on the competitive intensity of the sector.

• Four important parameters we look at to grade companies

We look at four important aspects to grade road developers

 Company’s presence in the industry & its track record

 Strong financial position

 Third party EPC capability / Interdependence between EPC & BOT business

 Cash flow generation

 Concession tail/Asset maturity

• Roads & Highways Sector – Neutral on sector, Sadbhav Engineering, our top pick

The Indian Roads & Highways presents an opportunity of ~` 1365bln (USD 26.25bln) involving development of ~18,534kms. Although a significant opportunity, declining scale of projects & high competitive intensity lowers the profitability, hence neutral on the sector. Players like ITNL, IRB Infra, Sadbhav Engg, Ashoka Buildcon etc are expected to capitalize on the opportunity in the near term. We initiate coverage on ITNL & Ashoka Buildcon and retain Sadbhav Engineering as our top pick in the sector.

• IRB Infrastructure (Hold, Target Price: ` 171, CMP: ` 168, upside 2%)

IRB Infrastructure posses some of the best stretches across industrial corridors of Mumbai-Pune & Mumbai-Gujarat in its portfolio. However, bids in the past and its recent bid for the Ahmedabad- Vadodara highway have been aggressive eroding the IRR’s of the project. Also, we believe a strong inter-dependence of EPC & BOT business for IRB Infrastructure encourages risk taking. A declining scale of opportunity & aggression in bids risks higher multiple ascribed to its EPC arm.

• IL&FS Transportation (Buy, Target Price: ` 249, CMP: ` 209, Upside 19%)

ITNL’s portfolio, as compared to its peers, has a balance mix in terms of Toll/Annuity, State/Central, etc. IL&FS’ parentage accrue other benefits like its experience in Indian infrastructure and funding support to company’s growth. We believe in the company’s strong project evaluation process and eventually the return generation capacity enabling it to support growth without any dilution. Also, longer duration of its portfolio is likely to support its valuations.

• Sadbhav Engineering (Buy, Target Price ` 186, CMP ` 138, upside 35%)

Sadbhav Engineering has demonstrated excellent ability in negotiating a challenging phase for the industry by being ahead of its industry peers in project & business lifecycle management. We like company’s strong execution record & financial position along with an EPC capability which is not entirely dependent on the BOT arm for orders and has consistently generated positive CFO. A medium maturity profile of assets, disciplined bidding & lower requirement of any support for operational projects strengthens our investment thesis. Also, timely capital infusion provides sufficient bandwidth for growth. Hence, Sadbhav Engineering is our top pick in the sector.