The construction industry in the country has, in recent times, been bogged down by low margins, negative cash flows from operations, rising interest costs on high working capital, execution delays and poor corporate governance.
LOW MARGINS
Most of the Indian construction/EPC (Engineering, Procurement & Construction) majors, operating in sectors such as urban infrastructure, water supply, waste water management, irrigation, roads, bridges and buildings, work on EBIDTA (operating profit) margins of 10 per cent or less and net profit margin of 2 to 4 per cent.
Till now, these firms have been focusing on turnover volumes rather than margins. This strategy of building order books and focusing on turnovers is a simple one. Winning large orders based on pre-qualifications and clocking high growth rates in turnovers by partly sub-contracting such orders to smaller contractors has been the trodden path of the construction majors, as opposed to the more difficult route of improving margins, ensuring timely execution or technology upgradation.
NEGATIVE CASH FLOWS
But following the tightening of liquidity and raising of interest rates by the Reserve Bank of India over the past couple of years, there have been increasing delays in payments by clients of construction companies. That includes private as well as government or semi-government clients.
As a result, the sundry debtors-to-sales ratio has gone up to about 90-180 days for many EPC companies. Also, most clients retain 10-15 per cent of order value (equivalent to about 30-45 days of sales) as retention amount or performance security deposit till the defect liability period (which is typically 18 months of satisfactory performance after the completion of the project/order) is over.
Add to these, the works in progress, raw material inventory, earnest money deposits submitted, etc, and the gross working capital cycle would work out to anywhere from 180 days to 365 days of sales.
This is a pretty long working-capital cycle. And that explains why most construction majors have very large negative cash flows from operations.
rising INTEREST COSTS
Till two years ago, there was also plenty of risk capital available. Riding on high growth rates in order books and turnovers, the various EPC and infrastructure companies in India were able to periodically raise equity funding in the form of IPOs, qualified institutional placement or private equity at very high enterprise valuations.
The situation has dramatically changed now. The doors for equity funding are completely closed for EPC companies due to changing investor perceptions and lacklustre primary markets.
As regards debt funding, the cost of debt going up significantly has itself made it almost unviable. Moreover, due to suspected fudging of accounts by EPC companies and corporate governance issues, many banks have become cautious in lending to EPC/construction companies.
These firms also have substantial off-balance sheet liabilities such as bank guarantees submitted to clients for various purposes, from securing advances given by client to contract performances. In the changed macroeconomic situation, the fees charged by banks for such guarantees would always increase due to increased risk perception.
As a result of all these factors, for many construction companies, interest and bank charges have gone up to about 5 to 10 per cent of their sales. So even if EBIDTA margins may be in the range of 10 per cent, the net margins have fallen to insignificant levels.
Unable to service the debt repayments and interest charges, it is not surprising that many EPC companies are now knocking on the doors of the Corporate Debt Restructuring or CDR Cell.
COMMODITY PRICES
Recessionary trends in the global economy have helped significantly bring down prices of steel, cement, pipes, electro mechanical items and other commodities. However, this may not necessarily translate into improvements in margins for the EPC companies. The reason for this is the pass-through clauses for price escalation/reduction of major raw materials, which have to be passed on to the clients.
As much as 90 per cent of total order book of construction majors incorporates such pass-through clauses (based on Star Prices, RBI Price Indices, etc).
Only about 10 per cent of total order book may have fixed price contracts that give limited scope for margin improvement on account of easing commodity prices.
BOOT PROJECTS
Many construction companies, in addition to their main business of cash contracts/EPC contracts, have also forayed into Build Own Operate Transfer/Build Operate Transfer) projects in core infrastructure sectors such as roads, ports, power and airports. These projects are either in the public-private-partnership (PPP) mode or via incorporation of separate special purpose vehicle (SPV) subsidiary companies.
Many of these BOOT/BOT projects have now become millstones around the companies' necks. Even for BOOT projects where financial closure has already been achieved, banks and financial institutions are delaying disbursements, thereby adversely affecting their completion.
For those projects where financial closure has not yet been achieved, the interest rates have gone up significantly, resulting in their reduced internal rates of return or financial viability.
In any case, even achieving financial closure has become very difficult for many BOOT/BOT projects.
Due to all the above factors, the share prices of many EPC/construction companies have gone down substantially during the last one year or so.
Only investors with ample risk appetite can take contrarian calls for investment in such firms today.
(The author has worked as CFO in EPC companies. The views are personal.)