Accelerated pace of Investment in Infrastructure (Road, Power, Railways, etc.,) holds the key for achieving higher growth rates on a sustained basis in India. Not only this, such a strategy will kick start the much awaited investment/CAPEX cycle too. In view of this, the current Govt. has identified Road Sector as one of the top three CAPEX themes.

Going forward, the sector is expected to witness USD 30 to 35 Billion investments annually.

Govt. finances are constrained as well as Private sector’s appetite to finance such projects is also very limited, in view of their horrid recent experiences. As such, this sector offers significant opportunity to invest to global Private Equity/Sovereign funds. During the last few years, even conservative investors like Pension funds have evinced high level of interest in operational projects, with established cash flows.

These projects currently offer IRRs ranging from 13% to 15% in Indian Rupees terms. The ones not yet operational (carrying completion risk) offer even higher rate of returns.

As such, we are talking of 10% IRR in USD terms, even after accounting for 3 to 4% hedging costs. From the risk reward perspective, operational road projects with little risk to cash flow offer very attractive investment opportunity indeed!

Recent Experiences in the Road Sector not so Good

Public Private Partnering model (PPP) had become very popular during the years 2007 to 2012 for not only road but also other infrastructure projects such as Power Generation & Transmission. Government along with the Industry chieftains as well as the financers (banks) had welcomed the PPP model with much enthusiasm and fanfare. Big investments were made thereafter.

However due to multiple reasons, euphoria soon gave way & turned into despair. With passage of time, many Infrastructure companies with exposure to PPP model were priced for bankruptcy in the Equity markets. Investments in Build Operate Transfer (BOT) Road projects, to the tune of USD 15 Billion are on the block.

What went wrong?

Euphoria soon turned into despair, as problems arose on several accounts:

• In their Euphoria Private players lost their sense of balance and not only did they bid very aggressively but also completely over leveraged their balance sheet.
• In its haste and eagerness to move fast, the Government put up the projects for bidding, without acquiring the Right of Way (ROW) and obtaining other clearances like Forest & Environment. This ultimately led to delays and execution inefficiencies making the projects unviable.
• Large amount of money got blocked in litigations further straining the stretched balance sheets of the developers.
• Concession Agreement needed certain fine tunements (1) Provision for automatic termination, if Condition Precedent is not met in defined time frame (2) Exit clause unnecessarily restricted change of hands (3) Further the risk on account of alternate route was not adequately dealt with in the past

However, the Road Sector has witnessed strong turn around this year

For last three years, the government has been completely focused on ironing out issues hampering the sector. By now, most bottlenecks have been cleared, through suitable policy initiatives on multiple fronts.

• Execution Hurdle has been addressed by awarding projects only after 80% of the land has been acquired. Further mechanism to ensure Faster Forest & Environment clearance has been put in place.
• There has been a shift from BOT Toll to Hybrid Annuity (HAM) Model which is far more friendlier to the over leveraged developer
• Further, necessary changes in Model Concession Agreement has been made to incorporate provision for Deemed termination of contract if condition precedent is not met as well as provide for less onerous Exit Option
• The approach to Litigation is far friendlier now. For instance, If Arbitrator has awarded a decision favouring the developer, it has been decided that 75% of the disputed amount will be cleared, even though Govt. may decide to go for appeal.
• Further various Initiatives have been taken to address Funding constraint: (a) As regards funding, Govt. has made arrangements to raise additional funds by increasing Cess to be used for financing Road projects. (b) Besides Govt. has decided to raise funds by selling toll collection rights [Toll operate and Transfer model (TOT)] for existing Highways. (c) Further as Framework for INVIT has been put in place, it will now be easier to mobilize private capital

What is happening now?

Daily Highway construction has gone up from 12 Km per Day in FY 13-14 to a whopping 28 Km/day IN FY 17-18. Currently, 50% of the projects are being given out on EPC basis and the remaining 50% by way of Hybrid Annuity model (HAM).

In the HAM model, while the Govt. finances 40% of the project cost, the developer invests the remaining amount as well as quotes an annuity for a defined time frame. As compared to BOT model that was very popular in the past, HAM model not only lowers the financing requirement, but also some of the risks like traffic as well as revenue leakage are transferred to the Govt.

What Risk to cash flows should be factored in the Financial Model?

Various risks incase of operational projects are outlined below:

• First there can be leakage in toll collection because of corruption of internal staff. The leakage in Revenue can also be because of the unwillingness of the commuter to pay.
• Second there are risks to traffic flow because of alternate route coming up in future. For instance traffic flow on many routes will be impacted when Bharat Mala project/Dedicated freight corridor is operational.
• Third we need to be conscious of various other risks. For instance, mining ban had severely impacted traffic in many areas.

For projects, which are not yet operational, project completion risks such as Right of Way, Forest & Environment clearance etc., needs to be factored in

The severity of these risks needs to be estimated and accounted for in the financial model.

What types of Investment Opportunities Exists in this space?

• Investing in shares of Listed Companies: Dilip Buildcon, KNR Construction, Sadhbhav, Ashoka Buildcon, PNC Infratech, ILFS Transport, IRB etc.,
• Opportunity to Invest in INVIT: Investing into listed INVIT (IRB) or the ones that will be listed going forward. Existing IRB INVIT offer 14 to 15% IRR.
• Buying Road Assets from the overleveraged companies: Road Assets both operational and partially executed projects, owned by overleveraged companies are on the block(About USD 15 billion.
• Participating in the ongoing Toll operate & Transfer (TOT) Opportunity (10 Billion USD)
• Evaluate Partnering opportunity in Hybrid Annuity (HAM) projects that are being bid out as Indian Players need financing partners

Listed Companies: Picking the Potential winners

The Indian road companies have two distinct businesses:

• EPC business for most companies is currently valued at 18 to 20 times FY- 19 earnings. As the project award is going to be buoyant, for the next 4 to 5 years, these companies are expected to grow their earnings at 18 to 20% CAGR. Earning multiple looks reasonable in the context of the expected growth rates.
• PPP Business, is valued, based on Discounted cash flow basis. Past BOT portfolio are bets on economy picking up.

Going forward, we expect competition to be moderate for HAM and toll road projects, resulting in lucrative IRRs for the projects being awarded. This will help developers like Sadbhav Engineering, PNC Infratech and Ashoka Buildcon. While, Dilip Buildcon is well placed in the EPC segment, it is fairly valued with Earnings multiples of around 20.

The strategy should be to build exposure to the sector on a sell off, at about 10% lower levels. The model portfolio can have 4% exposure to this sector.

What can we help with?

We can help with Sector Analysis in terms of opportunity size, Competition, growth, risk etc., as well as help evaluate individual investment Opportunities too.