Dead end

Anuj Sharma hates rolling down his car window at toll booths. The 25-year-old bartender drives from Safdurjung in South Delhi to Sahara Mall in Gurgaon every day and the toll plaza just before the Ambience Mall in Gurgaon is a constant bottleneck. Some days it takes him more than 15 minutes to pay the fee and cross the 50-meter stretch. “I don’t want to pay for roads slushy with drain water, half-complete service lanes, narrow entry and exit points and poor signage,” Sharma complains. 

He’s not the only one. In the past three or four years, there have been numerous instances of protestors vandalising and burning down toll booths, and public interest litigation (PIL) petitions have been filed all over India against toll roads and fee collection. Vinayak Chatterjee, chairman, Feedback Ventures, an infrastructure services company, says the resentment against payment of toll is justified.

“The moment you pay toll, you are purchasing a bundle of services promised to you by the operator of a road. It is no different from, say, purchasing a railway ticket or an airline ticket,” says Chatterjee. The way out, according to him, is to clarify the bundle of services the road operator should provide.

“There should be administration and enforcement of the service level agreement (SLA) and if it isn’t done, class action suits could follow.”

Recently, activist organisation People’s Voice approached the Supreme Court against arbitrary toll collection on national highways. “Providing a smooth ride is the basic principle behind charging toll tax. But when it takes me longer than earlier to travel on a highway, why should I pay toll?” asks SP Gupta, chairman of People’s Voice. Initially covering only the NH8 Delhi-Gurgaon toll road, the PIL has now expanded to challenge 92 build-operate-transfer (BOT) road projects across India where toll is collected. The PIL names 130 people as concerned parties.

The various issues: toll booths within municipal limits, multiple taxation, absence of facilities like restrooms, trauma centres, foot over-bridges and so on, which are supposed to  be provided for under the rules. The apex court has admitted the plea, questioning why toll should be paid when roads are in such poor shape. Now there’s talk that the Centre could buy back the Delhi-Gurgaon expressway project from DSC, the present operator, and make the stretch toll free.

That will be welcome news for Sharma, but for road developers, it only serves to underline their current woes. Even a couple of years ago, the only infrastructure sector that was doing well was roads — companies were racing to outbid each other for even small stretches of highway, traffic growth projections were in high double-digits and non-infra players were queuing up to enter the sector and get their share of the promised riches (returns of around 20%).

Now, that has changed. The path ahead for India’s highway builders is full of potholes — traffic projections have gone awry, cost and time overruns are playing havoc with budgets and rising cost of credit is eroding their margins. Established players are shying away from taking on new road projects and many new entrants are looking to offload some of their existing projects — one estimate suggests that a third of all projects awarded by the National Highway Authority of India (NHAI) in the past five years are on the block for either complete or partial sale. 

Trouble ahead

Most players are either seeking a strategic investor or a compete sellout

The list includes large companies such as Madhucon, IVRCL and Navayuga Engineering as well as smaller companies such as C&C, Gayatri and Lanco. (See: Trouble ahead). Currently, some 40-50 BOT projects are up for sale and, assuming an average cost of Rs.700-800 crore per project, that’s nearly Rs.30,000 crore at stake. On its part, the NHAI, too, is not cutting operators any slack. In June, it terminated two contracts for failing to achieve financial closure — DSC and Gannon-Dunkerley hadn’t been able to sew up their finances for two projects worth Rs.2,450 crore despite a 120-day grace period after the 180-day deadline for financial closure had passed.

The projects will now either see a re-bid or be awarded to the second lowest bidder. Consolidation, then, seems inevitable. Lanco Infra and C&C want to exit their roads business completely while companies such as IVRCL Assets, Ashoka Buildcon, Madhucon, Navayuga Engineering and SREI Infra want to bring in strategic investors. What, then, is the road ahead and, more importantly, how is it that these supposedly savvy operators have been left in the lurch?

Crashing the party

The euphoria started in mid-2009 when UPA-II came to power and Kamal Nath became surface transport minister. He tripled the road construction target from 6 km a day to 20 km a day and announced his intention of awarding over 200 projects, collectively worth Rs.2 lakh crore, by FY12. In January 2011, Nath was succeeded by CP Joshi, but the momentum continued. In FY12, the NHAI awarded projects covering nearly 6,500 km, a 22% jump over the previous year and the highest under the National Highway Development Project (See: Heading for a crash).

Heading for a crash

Aggressive competition in the roads sector began from 2010

The target for this fiscal is even more ambitious — 9,500 km — but it seems very unlikely that the NHAI will manage more than two-thirds of that, given the rot in the sector. There is a cooling down when it comes to new project bids and many projects had no takers at all. 

Recently, the NHAI received a single bid for Talcher-Duburi-Chandikhol in Odisha and none for the Madurai-Ramanathapuram stretch in Tamil Nadu. The Goa-Kundapur project was put on bid three times for paucity of bidders. Eventually, it was won by IRB Infrastructure. “Even when we won the project, there were only two bidders,” says Virendra Mhaiskar, chairman, IRB. “The projects that the NHAI is tendering now don’t have high traffic potential; to make these projects viable for developers, the government will have to offer higher grants,” he points out.

On its part, GMR Infra, which bagged the Kishangarh-Udaipur-Ahmedabad NHAI project in September quoting an aggressive premium of Rs.630 crore, has decided not to take any incremental exposure to the road sector. “We will only bid for lucrative projects this fiscal and focus on our existing Rs.15,000-crore road portfolio,” says A Subba Rao, president and group CFO, GMR Group. The situation is so grim that surface transport minister Joshi recently called for a meeting of concessionaires, lending institutions and consultants. 

The conclusion of the meeting was that companies have stayed away from bidding because of poor traffic growth prospects, law and order issues, need for quicker environment and forest clearances and lending institutions’ refusal to extend support to the roads sector.

Having one too many

Trouble is, too many infrastructure companies got into the business of building roads. As the competition heated up in the past couple of years, companies started undercutting each other. “Forget making profits, the idea got condensed to just recovering fixed costs,” says Abhinav Bhandari, an analyst at Elara. “That’s when things quickly started going downhill.” The conventional way of awarding road projects is that the NHAI offers up to 40% of the cost to developers as grants to make the project financially viable. As more and more players vied for the same projects, developers started quoting bids with either very low grant requirements or, in some cases, very high premium (See: Getting carried away).

Getting carried away

Increasing competition saw most developers offering premium for road projects

Premium indicates the developer’s confidence that the toll revenue will be more than the project cost. But the confidence was clearly misplaced. “Some of us were very aggressive in bidding,” concedes Gurjeet Singh Johar, chairman, C&C Constructions, which has an order book of Rs.2,630 crore in the roads and highways sector. “Companies quoted unreasonable rates. There have been several maverick bids that did almost no good to any of the parties involved.”

A report by rating agency Crisil says road developers who paid a premium to bag highway projects are finding that their bullish projections do not match actual toll collections. BOT projects awarded by the NHAI after 2009 are fetching a measly 14% return against the 22% earned by projects bagged before 2009 through relatively modest bids.

“While the government provides assistance for road projects in the form of viability gap funding [VGF], most projects after 2009 were bagged by developers by paying a premium as they were bullish on toll prospects. About 65% of projects after 2009 were awarded on premium basis compared with 25% in FY09. In some cases the premiums even exceeding project costs in some cases,” says Ajay D’Souza, director, Crisil Research. 

Not surprisingly, new entrants to the sector are the worst affected. “Experienced developers know the nature of the business and the gestation projects are funded with cash flow from other operational projects,” says Bhandari. According to a report by Morgan Stanley, an analysis of all BOT projects awarded to date showed that many marginal players with no previous experience in managing long duration concessions or balance sheet strength to hold assets, especially during economic downturns, picked up market share.

Things got worse as traffic estimates failed to match expectations in many projects, barely managing 45% of the estimates in the crucial first year. The overestimation of traffic is largely because of optimistic assumptions of economic growth and partly because of hazy traffic pattern data with which developers bid.  S Nandakumar, senior director, global infrastructure and project finance, Fitch, points out another reason, “A majority of the bidders were originally EPC contractors who then started bidding for toll road projects on the BOT model. The primary motivation for these players was to win construction contracts. Given the generally competitive industry climate, bids were very aggressive and financing [essentially medium term bank debt] could be secured only if the traffic estimates were sufficiently attractive.”

The problem with optimistic projections is the project’s ability to service debt gets impacted if the estimates don’t pan out. Still, given the length of the concession period, most companies are willing to inject additional equity to support under-performing projects. 

But there’s a flip side: this puts immense pressure on the balance sheet and while no roads company has defaulted on its debt payment so far, the possibility can’t be ruled out. In some cases, developers are making negative returns and several have not been able to meet even their interest payment.

C&C Constructions’ Kiratpur-Kurali road project in Punjab is a case in point. Awarded in June 2007, the project is operational but making losses. C&C had taken a Rs.260 crore loan for the development and is paying Rs.30 crore of interest every year.

Currently, the company isn’t even meeting its interest payments from toll collection, which is about Rs.2.2-2.3 crore a month.  C&C is now in talks with a foreign developer to sell its 50% stake in the project. The other 50% is with Hyderabad-based BSCPL Infrastructure.

“The project could make sense for a buyer who can restructure the loan at a lower rate,” says Johar. C&C has a total debt of Rs.1,200 crore, which it hopes to trim to Rs.700-800 crore by selling its five road projects. Bhavik Damodar, head of infrastructure transaction services at KPMG India, says a company’s balance sheet can absorb only so much stress, after which the only option left is to liquidate its stake in projects and put that money in other businesses.

“Many EPC contractors had also bid as BOT developers for some large projects,” he says. “The idea was to bid for several projects, make a portfolio and list that portfolio. But in this environment, a listing is not possible.” The only other option is to sell full or partial stake in individual road projects. 

IVRCL is also looking to divest stakes in at least three road projects (Salem-Kumarapalayam, Kumarapalayam-Chengapalli, Chengapalli-Walayar) that could help it retire a debt of over Rs.800 crore and free equity capital of around Rs.300 crore.

Chairman E Sudhir Reddy agrees that the company over-estimated traffic. “There was a general euphoria over the infrastructure sector when we bid for these projects. The economy was projected to grow at 8% and we got carried away by that forecast,” he says wryly. Mails sent to Gayatri Projects went unanswered. 

Another of his Hyderabad brethren, Madhucon Projects is looking to dilute stake either in Madhucon Infra, a subsidiary of Madhucon Projects and holding company for infra assets such as BOT roads, power and coal mines, or in Madhucon Toll Highways, a subsidiary of Madhucon Infra. The company plans to raise about Rs.1,300 crore through this move, according to S Vaikunthanathan, director, finance.

Madhucon has six BOT toll and three annuity projects in its kitty, of which four toll road projects have become operational, the three annuity projects are under construction and financial closure is on the horizon for the remaining two toll road projects. “When a project becomes operational, the value of that asset goes up,” adds Vaikunthanathan. “This is the right time to dilute stake so that that money can be pumped into other projects.” According to an Angel Broking report, Madhucon has an equity requirement of Rs.570 crore for its BOT road projects. 

GMR, too, is looking at some form of monetisation of its six operational and four under-construction projects. “Our options are to dilute stake in road projects to private equity investors; raise money through an overseas business trust; or sell projects,” says Rao. “The current market is pretty expensive to raise money through a business trust, so we will have to wait and evaluate our options.” Although Gayatri Projects is also in talks for stake sales in its projects, the company did not respond to Outlook Business’ e-mail queries. 

Pratima Swaminathan of Morgan Stanley feels the lack of opportunities in the pure cash-contract space forced smaller construction companies such as IVRCL and NCC to bid for BOT assets. “These players will be unable to tie up their capital for long durations and are likely to exit the projects once construction is completed,” she says in her report.

Scavenging for road kill

While consolidation in the sector seems inevitable, it will be at a snail’s pace because there are very few buyers and they are cherry-picking projects. One of the few deals that’s happened so far is IRB’s 100% acquisition of MVR Infrastructure & Tollways in Tamil Nadu for about Rs.130 crore. And even that was a one-off. Mhaiskar says IRB would rather bid for new projects than buy in the secondary market. “We have a construction arm and by bidding, we get business for that as well,” he explains.

According to Deepesh Garg, managing director of investment bank O3, deals have been far and few because of an expectation mismatch between promoter and buyer. “Promoters have seen much better valuation but in today’s market, buyers are not willing to pay the same price,” he points out.

O3 was the banker to the stake sale in March this year by Anil Ambani in Nandi Infrastructure Corridor Enterprises (NICE) a subsidiary of BF Utilities, promoted by the Kalyani Group. Ambani sold 8% of his 11% stake in NICE for $65 million to Airro Mauritius, a fund affiliated to JP Morgan Chase.

Feedback’s Chatterjee says the valuation mismatch happens because valuation of a project is a function of toll collection. “The existing promoter has a rosy picture about all the variables moving well. The buyer has a different opinion of how the growth will happen. The complication arises because you have to estimate and discount a revenue stream for the next 20 years.” Indeed, many companies are struggling to strike the right deal for their roads projects.

SREI Infra, for instance, holds 26-49% in about 14 road projects (it typically buys stake in projects it finances). “The cash raised from the stake sale will be ploughed back into new projects,” says Sunil Kanoria, vice chairman, SREI. But so far, it hasn’t found a buyer. IL&FS Transportation Networks (ITNL) faces the same problem, but on the other side of the table. The company already has a portfolio of 23 projects spanning over 11,860 lane km spread across 16 states, worth Rs.30,000 crore. Of these, 12 projects comprising 5,453 lane km of roads are operational.

Managing director K Ramchand says the company has been approached by 20-25 sellers so far, but no deal has been struck because of the difference in what ITNL is ready to offer and what the seller wants. “The projects that have come to us have sub 14% equity internal rate of return (IRR) and that return is not good enough according to us,” he adds. Another company that’s not found any hot deals is L&T. K Venkatesh, senior vice-president of L&T BOT projects, points out that the company has its own stringent, internal benchmarks, which is why it hasn’t found a fit so far.

“We only look at projects that can improve or maintain our overall equity IRR of 18-20%,” he adds. Currently, L&T has 19 road projects in all stages of construction and the road order book is Rs.22,000 crore. Venkatesh says doing an acquisition makes sense because operational projects do not carry the same risks as a new venture due to an established traffic base. Chatterjee says that deals are happening. His firm, he says, has closed many deals. “Private equity fund led consortiums are buying from a contractor developer,” he points out. “But we are still to see one contractor developer buying another.”

Skidding through

Of 22 projects, nine will have net present value of less than one time or negative book value

With increased competition, value creation in the roads sector has become increasingly elusive. Kotak Institutional Equities recently analysed 22 operational road projects with established revenue lines (which means the projects had been awarded three-four years ago). “Many of these projects are unlikely to generate any significant value over the remaining lifetime of the concession,” says Kotak analyst Lokesh Garg (See: Skidding through). In plain speak, of the 22 projects, only seven will generate high revenue, six projects will generate reduced revenue and nine projects may even give a negative return.

“What we are trying to bring out in our report is that projects are failing to create value for shareholders,” says Garg. “If a bulk of the projects won in a less competitive environment than today are not making money, then there is even less scope for projects won in the last one or maybe two years to do so.” 

More craters ahead

The value mismatch between buyers and sellers has been aggravated by poor market conditions. Like equity funding, even debt is not that easy to come by as banks are increasingly reluctant to lend to the roads sector. That’s because as bidding becomes increasingly aggressive, it negatively impacts the IRR of the project. And since banks are naturally risk-averse, they shy away from lending, especially to smaller companies. 

Infrastructure finance company SREI Infra says it has intensified due diligence for the projects it chooses to fund. Apart from an independent traffic study, the company evaluates the group/promoter’s strength, execution skills and also conducts a deeper sensitivity analysis to test project viability. “We lend only when we are completely satisfied on all parameters,” says Hemant Kanoria, chairman and managing director, SREI. “We lend to the sector on a selective basis and have consciously kept our exposure to the sector under 20% of the total loan portfolio.” 

Road developers crib that banks are laying down increasingly stringent conditions before sanctioning loans, such as asking the company to bring in upfront its entire 25-30% equity component. “That’s a problem,” says IRB chairman Mhaiskar. “Earlier, companies could bring in equity on a pro rata basis over the duration of construction, which is much more manageable. There is no problem in arranging it upfront if you are raising equity from investors but it gets tricky when it is through internal accruals.” 

Banks, though, defend their stance. They are extra cautious in lending to projects won through aggressive bidding, especially where the developer has paid a premium. “Unless the developer has equity in place, it will be very difficult for the project to proceed. We release loans based on the developer’s ability to bring equity on time,” says KR Kamath, chairman and managing director, Punjab National Bank. That’s a thought echoed by the head of another PSU bank.

“In aggressively bid projects, sensitivity to interest rates will be higher and, therefore, flexibility will be restricted,” points out MD Mallya, chairman of Bank of Baroda. “Such projects are usually not approved.” Matters can only get worse as most banks are close to exhausting their internal limits set for lending to the infrastructure sector, which will severely limit their lending ability in the future. For the roads sector, then, that’s another pothole to be negotiated.

Elara’s Bhandari believes the situation could get increasingly desperate for road developers looking to sell. Right now, they are being fussy about getting the right valuation but if a sale does not happen in the next six months or so, these same projects could be sold at a discount. Rajeev Desai, analyst, IFCI Financial Services, says if deals do not come through, road developers will be forced to ask banks to restructure debt.

“There are only three options left. Either the developer sells it comfortably, takes a haircut or it goes to the bank for restructuring. Banks may not want to restructure debt but eventually they will be forced to, in order to complete the project,” he says. But, here again, if the Reserve Bank of India becomes stringent on restructuring of loans, the developer will have no choice but to sell its stake in projects at a loss. 

However, some projects do have a “substitution clause” in the concession agreement that in the event of a default by the developer, allows the lead lender to substitute the developer with another in consultation with the NHAI. Therefore, lenders have the option of substituting sticky developers with those that they believe are financially sounder.

But that’s easier said than done. Ganesh Ram, an analyst with Kim Eng Securities, agrees the situation will be difficult in the BOT road space this year. “Toll revenues will decline because the Indian economy is slowing down and with an increase in diesel and petrol prices, there are fewer trucks and cars on the road. This will make it difficult for existing road developers to sell their stake at a high valuation.” Overall, though, analysts agree that this year, the road sector will see some deals happening, given the weak financial situation of developers. 

Decongesting the road

Analysts expect that with the weak hands pulling out of the race, the road ahead will be cleared for the bigger and established players. With around 35,000 km of national and state highways slated to be awarded over the coming three to four years, there is enough growth potential for developers. Though Garg of Kotak expects competitive intensity to continue with relatively new names such as Atlanta-Essar, Abhijit, Essel and Tata Realty-Autostrade entering the fray, the consensus is that history is unlikely to be repeated.

Pratima Swaminathan of Morgan Stanley points out in a report that as per the NHAI not only have the number of bidders per project declined recently but also the difference between L1 and L2 bids has narrowed — indicating that developers are not aggressively undercutting. That interest is waning is evident given that the annual technical qualification details for 2012 shows only 97 bidders have applied to the NHAI for bidding qualification compared with 114 applicants in the previous year.

Besides, unlike in the past, weaker players will find it tough to raise funds, what with the capital markets expected to remain choppy and lenders becoming wary despite interest rates softening. So it is not surprising that investor interest in these shares, too, has been on the wane. From the heydays of 2010, road companies — big or small — have lost an average 70%, barring IRB and ITNL, which have come off 57% and 40%. Call it a case of choosing between the devil and deep sea, analysts are keeping their faith in IRB and ITNL, though not necessarily in the same order of preference.

Swaminathan of Morgan Stanley feels large players with good execution track record, past experience in managing assets, and balance sheet strength to meet equity funding needs will be the key beneficiaries of increased project supply, from both the NHAI and players exiting projects. Morgan Stanley is bullish on IRB, and ITNL. Garg of Kotak is bullish on L&T and IRB. As for the others, the writing on the wall just became more legible.