THE BIG STORY. Back on the road

Road project developers have been hitting potholes over the last few years. This was due to a whole range of issues, from delays in clearances, to non-availability of adequate funds, difficult terms in contracts and falling traffic.

There are, however, signs that the sector may have turned the corner. Traffic volumes have picked up — there was a 5-6 per cent annual increase in 2014-15, compared to a dip in the previous year, according to data from India Ratings.

Also, sale of medium and heavy vehicles — typically considered a lead indicator of road traffic growth — zoomed 27 per cent year-on-year in the April-August 2015 period. Road project execution rate picked up pace, with 5.5 km per day completed in the June quarter of 2015 — a jump of 38 per cent compared with the same period a year ago.

These improvements have been thanks to a wide range of policy initiatives by the government. These measures, along with the fall in interest rates, will aid the growth prospects of the sector, though there are some niggling near-term issues.

And investors are already taking note. Shares of listed road developers, which were beaten down in the last few years, have rallied briskly. KNR Construction is up 120 per cent in the past year while Sadbhav Engineering is up 40 per cent.

However, in many cases, expectations may be running ahead of ground-level improvements in the fortunes of companies. The rising tide of better policy and benign interest rates may not lift all developers. Given the long history and magnitude of issues, it is likely that the recovery will be selective. So, investors must evaluate companies on a few key metrics while picking stocks.

There is a shift in the model used for awarding toll road contracts. Projects are granted through one of two models — engineering, procurement and construction (EPC) where the authority makes the payment and the developer’s responsibility ends with delivering the completed project, or build, operate and transfer (BOT) where the developer pays for the project and earns returns from toll collection for the duration of the concession. Companies such as KNR Construction and Gayatri Projects are EPC players while Sadbhav Infrastructure Projects and Ashoka Buildcon also develop toll roads.

The EPC model is not capital-intensive, but revenues can be lumpy. The BOT model requires capital to be locked in for a long period but revenue from tolls tends to be more predictable.

So, which is better? Investors had bet on EPC players in the past due to lower risk; also, most of the projects awarded by the National Highways Authority of India (NHAI) were on construction contracts. However, BOT players may start to see better traction, especially with the introduction of a new contract method — hybrid annuity model — for projects granted from October 1, 2015. The new model is a mix of the EPC and BOT models where the road authority will provide an initial grant of up to 40 per cent of the project cost. The developer has to chip in with the rest and complete the project.

The cost borne by the developer will be repaid annually over a period of the concession contract (10-20 years) through a fixed annuity payment.

The model can be a game changer for a few reasons. For one, there were disconnects between the preference of road authorities, such as the NHAI, and developers. Authorities prefer the BOT model as it requires lower capital outlay for them; but bitten by delays and toll revenue issues, developers were shy to bid on new BOT projects.

Data from India Ratings shows that 21 highway projects worth ₹26,000 crore failed to attract bids over the last two fiscal years.

As a result, the NHAI had to go with EPC contracts; from nearly an all-BOT road model during 2008-09 and 2012-13, the share of BOT dipped below 15 per cent in 2013-14 and 2014-15.

The new model will help revive developer interest in BOT projects. The hybrid model is a win for developers as it removes traffic growth risks.

And this should also help raise funds from lenders. Additionally, higher equity contribution from the government means lower equity requirement from their side. This should ease the pain they face when bidding for new projects. So, from a long-term perspective, BOT-heavy road developers, such as IRB, Ashoka Buildcon and Sadbhav Infrastructure Projects, may be worth considering.

Also, compared with developers such as L&T, IDPL and GMR who have a finger in many infrastructure pies, road-focussed developers may be safer bets as the outlook is still murky for other infrastructure sectors, such as power.

A developer’s ability to complete the road projects is certainly one criterion to look at. In the past, projects faced inordinate delays due to issues in acquiring land and getting other clearances. Nearly 50 per cent of all under-construction projects are estimated to be stuck, according to CRISIL; Some 15 projects of 1,150 km have missed their completion timeline by over 30 months. Others, such as the Solapur-Bijapur project taken up by Sadhav, had to be terminated due to issues in clearances and land acquisition. And delays can be expensive — India Ratings estimates that losses can be as high as ₹125 crore for a one-year delay for a 100-km project.

These concerns may ease with the new policy that allows for States to clear projects with up to 40 acres of forest land. Clearances for bridges, both under and over the road, can be filed and cleared online.

These changes could halve the time between project award and start of execution to below five months, and developers can earn revenue earlier.

Delays may also arise from paucity of funds. About 18 projects which are over 50 per cent complete have been identified by the government as stuck for want of funds and will be able to avail revenue shortfall loan for completion.

Disputes are another issue plaguing completion. Data from the road ministry shows that 112 cases involving ₹25,000 crore are pending under arbitration between the NHAI and developers, as of April 2015. And the disputes were followed by lengthy arbitration. A case in point is HCC’s dispute with NHAI that took over 20 months before it was resolved in HCC’s favour.

The new rules will ease dispute resolution. For instance, a developer can terminate a contract if the authorities default on their obligations; they are also entitled to receive the entire debt taken as well as 1.5 times the adjusted equity. These rules should aid quick closure for all parties.

Given the capital-intensive nature of the sector, investors have to ensure that the developer has a strong balance sheet. In the last few years, the leverage levels of road and other infrastructure developers have deteriorated alarmingly. A large number of them, such as Gammon, HCC and IVRCL, are currently under corporate debt restructuring scheme. Others, such as L&T, GMR and GVK, are selling assets to pare down debt. Debt service has been a problem for many BOT developers as their toll revenues were hit due to delays or low traffic. One recent example is L&T Infrastructure Development Project’s Halol Shamlaji Tollway, which defaulted on a ₹1,014-crore payment due in August as toll collections were low.

But worries may ease. Longer duration loans — up to 80 per cent of the road contract concession period with an option of refinancing every five-seven years — can be availed of through schemes such as the 5:25. Also, annuities and toll collection rights of developers can be treated as tangible securities by banks, according to the RBI.

While these measures should help developers, high debt can lower profitability and the ability to expand.

The recent policy decision to allow 100 per cent stake divestment after completion should also help pare down debt. Stake sale was capped at 76 per cent in the past and was allowed only after two years of completion. Easing stake sale, which could bring in an estimated ₹5,000 crore, will help complete projects in need of funds. It is estimated that ₹28,500 crore will be required to complete projects under construction, according to CRISIL.

Already, developers such as Ashoka Buildcon have sold some stake in their projects to private funds, such as SBI Macquarie. The capital raised from stake sale can also help developers to bid for new projects. Besides sale, assets can be transferred to a trust to form an Investment Trust or InVT. IRB, for instance, plans to form an infrastructure investment trust for Investment REIT by 2015-16 and has identified 12-14 assets.

Companies such as KNR Construction have low leverage; others such as Sadbhav Engineering lowered debt by de-merging toll road segment through an IPO. It is important for investors to evaluate the debt reduction plans of leveraged developers.

Investors in EPC companies have to evaluate the completion track record and whether the expertise is in-house. The risks are, however, higher for BOT projects where initial construction accounts for a smaller share of the overall timeline. Traffic and toll revenue projections also have to be evaluated and these depend on the expectation of vehicle traffic mix.

For instance, in mining-heavy regions, revenue would be primarily from heavy trucks and there may be risks. For example, Sadbhav’s Bijapur-Hungund toll revenue was impacted due to iron ore mining ban.

In non-industrial areas where passenger car traffic may be higher, policy change risks have to be considered. A case in point is IL&FS Transport Networks’ Warora Chandrapur Ballarpur toll road, which was told, in June 2015, to exempt light motor vehicles and State buses from tolls, by the Government of Maharashtra. While the revenue shortfall will be compensated by the government, delays in payments and other risks must be considered.

The terms of the construction contract are also important to check. In the past, high competition to win awards meant aggressive bids and unfavourable terms such as high premium sharing with the authority. Also, toll rate hikes were based on inflation; while this was beneficial in the days of high inflation, given that WPI is in the negative zone, these terms can hurt.

There were recent updates to the model concession agreement (MCA) — the contract that spells out the terms between the road developer and the authority — in August 2015. For instance, premium payments to the authority from the developer are now pushed out to three years after completion from one year earlier.

Why does it matter? Toll revenue tends to be low in early years and rises with traffic growth and toll rate increase over the years. Not paying premium when revenue is low and interest payment is high will ease stress from debt service obligations. Premium payments for 11 road projects, including Ashoka Buildcon’s Dankuni project, have been rescheduled in the last nine months. And rather than negotiating on a case-by-case basis, the new policy will provide relief to all BOT developers whose contracts include premium sharing. That said, the fixed annuity model of awarding project may offer better terms — as it removes traffic and revenue uncertainty.

Companies with toll projects in industrial growth corridors with non-inflation-linked rate hikes may be good options to consider.

Developers such as Ashoka Buildcon and Sadbhav Infrastructure, which were not over-aggressive in their bidding, may also profit in the long term as the aggressive ones leave the fray.