The Union Budget 2017-18 saw a generous outlay of about ₹64,900 crore for road projects, 24 per cent higher than that earmarked for 2016-17 (based on revised estimates). The increased allocation along with the ongoing policy reforms in the sector augur well for road players.
But while the challenges in the road-building space are fewer now, competition has intensified over the last two years. An analysis of the projects bid out under the EPC (engineering, procurement and construction) format, in particular, reflect the growing competition within the space, impacting margins for a few large players.
Policy reforms
The last three years have seen a slew of changes in the road construction space. Importantly, the pace at which roads have been laid has increased significantly from a mere 8 km per day in 2014 to nearly 18 km a day towards the end of 2016.
Some of the challenges that impeded growth have been addressed by the Centre over the last two years. In 2014, a slowdown in domestic and export demand, growing non-performing assets in the banking system and fewer takers for long-term contracts (build- operate-transfer format) played spoilsport. Besides, the Centre only built 1,244 km of highways through the pure construction format.
But a slew of policy measures — such as extension of start of the premium payment to three years after completion time and the 5:25 rule for refinancing projects — brought back confidence among road players.
Besides, the Centre increased the network of highways to be laid through a pure-construction EPC format. Also, the new hybrid annuity model — where 40 per cent of the project is carried out through EPC and the rest by the BOT-annuity mode — has found many takers. This is because, under the BOT-annuity format, the demand risk is borne by the government while the operator gets paid a pre-contracted sum annually. The roads laid in 2015-16 were about 6,029 km, nearly twice that rolled out in 2014-15.
While the sharp pick-up in the pace of construction has aided growth for road players, growing competition in the bidding space has pressured margins.
Aggressive bidding
On successful pre-qualification of companies eligible to bid for a project (based on their technical expertise and prior experience), interested players submit commercial bids. Commercial bids indicate the total cost they would like to bid for the project.
Initially, the project granting authority assesses the total project cost through an independent engineer. The difference between the lowest-cost bid obtained from private players and the assessed project cost indicates the variation. The variation can happen due to increased competitive bidding, where the players may decide to take a cut on their margins to win a project or due to differential raw material costs (because of the time lapse between the assessments carried out by the independent engineer and actual bidding of the project).
For the fiscal year 2016-17 (till January), an analysis of all EPC projects showed a negative 3 per cent variation in the cost of projects that were bid for. This, in turn, means that companies bid at a cost that was 3 per cent lower than that estimated by the authorities. While this may not seem alarming, the variation is much larger in select projects. Close to 40 per cent of the 32 projects showed a negative deviation of 20 per cent or more. This is despite a lower number of players participating in the bidding process than in earlier years.
Margin pressure
Between 2015 and 2017, a total of 250 plus projects with a project cost of around ₹14 lakh crore was bid for in the EPC format. Listed companies with a sizeable market share appear to have been bidding aggressively over the last two years.
For instance, Larsen & Toubro (L&T) with a market share of 10 per cent of the total bids (in terms of costs) saw a negative 12 per cent variation. This means that L&T has bid at a cost 12 per cent lower than the cost estimated by the authorities. Similarly, recently listed EPC major Dilip Buildcon, with an 8 per cent market share, has bid at a cost 13 per cent lower than the assessed cost.
Bidding has also been competitive within smaller players. Gayathri Projects, which holds a 5 per cent market share, has a (-)2 per cent variation. Other players, such as Ashok Buildcon, KNR Construction and PNC Infratech, with less than 3 per cent market share each, have also seen increased competition.
The aggressive bidding impacting margins is well reflected in some of the companies’ financials. The profit margin before interest and tax for Larsen & Toubro’s infrastructure segment for the nine months ended December 2016 was 6.5 per cent. This was lower than the 6.8 per cent reported during the same period a year earlier. Similarly, Dilip Buildcon clocked a net margin of 4.9 per cent for the nine months ended December 2016, vis-à-vis 5.8 per cent a year back.
Other players such as Gayathri Projects and Ashoka Buildcon have been able to offset some of the margin pressure through improved efficiencies in their operations and a good mix of short-term and long-term projects.