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On road to gradual recovery, pressures expected to continue over short term for Indian Construction Sector: ICRA

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Oct 31, 2014: The Indian construction sector, which over the last few years had faced challenges arising from weak investment cycle and delays/uncertainties in policies leading to weak order inflows as well as slowdown in execution, is expected to get a much needed push with a stable Government at Centre having infrastructure development as one of its core agenda. The slowdown in the sector is evident from modest 1.6% increase in the construction GDP in FY14, marginally better than 1.1% in FY13 and sharply lower than 10.8% growth achieved in FY12. The Gross Fixed Capital Formation (GFCF) which is an indicator of investments remained sluggish in FY14 due to delay in project execution as well as weak pace of new project announcements in the earlier years. Commissioning of projects also witnessed a decline from Rs. 3.6 trillion in FY13 to Rs. 2.2 trillion in FY14. Similarly, new project announcements declined by 17% in FY14 led by sharp contraction in private sector projects due to subdued business confidence and inordinate delays in getting approvals. With the political stability and focus towards infrastructure, sentiments have improved and new projects announcements by the private sector are likely to pickup.

However, despite multiple steps taken to remove implementation hurdles, on-the-ground improvement is likely to take some more time as there are number of structural constraints like uncertainty associated with land acquisition, approvals, limited avenues for long term funding as well as structural issues impacting viability of infrastructure projects, which need to be sorted out for project implementation to gather pace. As of June 30, 2014, projects involving investments of ~Rs. 9 trillion were stalled. While many projects could have been stalled due to overall weak macro-economic environment and difficulty in achieving financial closure which besides increasing the uncertainty on the projects’ viability had also reduced the risk appetite of developers, implementation hurdles are also a key reason for many stalled projects. Besides stalled projects, there are sizeable projects which are slow moving or facing some implementation issues including prolonged delays in getting clearances, as well as difficulty in land acquisition. In January 2013, Project Monitoring Group (PMG) was set up in the Cabinet Secretariat to help such projects, both in the public and private sectors, by way of support in clearing the implementation bottlenecks. Till September 2014, PMG had accepted 461 projects with estimated investments of Rs. 21 trillion which were facing implementation hurdles. With the help of Cabinet Committee on Investment (CCI) issues related to 175 such projects worth Rs. 6.37 trillion have been resolved. However, another 286 projects with an investment of Rs. 14.6 trillion are still facing various bottlenecks which is impacting their progress.

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According to Mr. RohitInamdar, Senior Vice-President, ICRA, “There have been several sector specific concerns which have impacted investments in new projects as well as implementation of on-going projects. The power sector accounts for an overwhelming share of stalled projects, even though the Government has taken several policy actions in the past couple of years. The sector has been facing difficulty in getting feedstock – primarily coal and gas. The coal industry has struggled to ramp up production as a result of which many power plants had to import coal leading to sharply higher imports of coal (up from ~105 million MT in 2011-12 to ~171 million MT in 2013-14). The sector has also been facing difficulties in getting long term power purchase arrangements amid poor financial health of state utilities. Additionally evacuation, transmission and logistic bottlenecks have also dampened new investment environment. Similarly, the iron and steel sector has also been facing raw-material risks (iron ore and coal) as one of the key issues which along with slow demand growth has dampened investment climate. The road sector which had been in focus for high bidding interest has also been facing challenges on multiple fronts including issues with viability of projects already bid out on account of aggressive bidding and significantly lower actual traffic, execution bottlenecks due to delays in getting right of way and clearances as well as difficulty in arranging financial closure. As a result, work on 81 National Highway projects covering ~9,442 km which have been awarded was yet to start as of May-2014, with many of these projects awarded more than two years back.

While expediting land acquisition and simplifying clearance process could help in reviving some of the stuck projects, funding challenges also need due attention. Regulatory bottlenecks and R&R issues have emerged as major roadblocks that have throttled capacity creation and thus supportive policies that include faster clearances related to environment, forests and mining plans from various ministries and authorities would be a key priority for enabling faster ramp up of production from coal mines. Besides sorting out structural issues, faster implementation of some high impact projects could have positive effect on the construction and capital goods sectors. A case in point could be the Dedicated Freight Corridor project; with more than 81% of land already acquired and a large proportion of the funding tied up, awarding of additional packages can be a thrust area for the new Government.

Although infrastructure development is one of the focus areas of the Government to achieve higher GDP growth, huge funding requirement coupled with high Fiscal Deficit will make the Government dependent on the revival of private sector investments to meet the growth targets. Recognizing the need to kick-start investment cycle, the new Government in 2014-15 Budget (presented in July 2014) had focussed on capital asset creation. The budget has renewed the thrust on public sector investments by increasing capital investment target of PSUs from ~Rs. 1.4 trillion FY14 to Rs. 2.48 trillion in FY15 as well as made appropriate allocations towards a slew of infrastructure projects across highways, rural roads, ports, gas grid, waterways, and Urban infrastructure segments. Implementation of the announced projects is expected to bolster the order-books of construction companies. To revive private sector investments, incentives like extension of 80 IA benefit for power sector, investment allowance for manufacturing companies, development of convention centres under PPP mode, augmenting warehousing capacity and proposals to increase investments in affordable housing have been made. Furthermore, to encourage lending to infrastructure projects by banks with some pre-emption of regulatory requirements of CRR, SLR and Priority Sector Lending as well as flexible structuring to absorb potential adverse contingencies have also been made.

Mr. Inamdar added, “Given the execution challenges and stressed liquidity position of many players in the sector, the recovery in the construction sector is expected to be gradual. In the near term, high interest rates will also be a drag for the construction sector as most of the players in the sector are highly leveraged. Ability to raise funds via stake sale in subsidiaries, monetization of assets, or dilution of equity could help in improving liquidity and capital structure. Many companies including GMR Infrastructure, Jaiprakash Associates, NCC Ltd, IVRCL etc. have either raised or are have plans of raising funds through equity route like Qualified Institutional Placement (QIP)/Rights Issue/warrants/preference shares or sale of stake at the SPV or holding company level to reduce borrowings. On the execution side, faster clearances and land acquisition process will aid in recovery. ICRA expects revenue and profitability pressures to continue in near term post which the construction activity will be dependent on improvement in investment cycle and GDP growth which would also be dependent on Government’s consistent and determined approach towards economic reforms.

Over the medium to long term, construction spending is expected to witness robust growth driven by the need for public infrastructure to support the growing economy, and increasing urbanization which will drive the housing demand. Construction companies are also expected to witness significant opportunities in the railways, ports, urban infrastructure, airports and roads sectors. In railways segment, the Dedicated Freight Corridor (DFC) project is expected to provide significant opportunities to construction companies as the first phase of the project which involves corridor of 3,300 km with estimated cost of Rs. 1 trillion has been started. In the ports sector, multiple projects on PPP basis are under proposal. In urban infrastructure, construction of metros continues to present opportunities for construction companies with projects under execution in eight Indian cities and at various stages of approvals in at least another six cities. In the airport segment, proposal for development of low-cost airports in tier-2 and tier-3 cities will present sizeable business opportunity. Similarly, in the roads sector, Government’s focus towards upgrading national and state highways is expected to add to the order inflows for players in this sector. With the PPP route for awarding road projects facing weak response, National Highways Authority of India (NHAI) is likely to offer projects primarily on EPC mode in the medium term which would add to the construction sector order book.”

Performance of construction companies
The last two years have been marked by weak order inflows for major construction players as the capex/investment cycle had slowed down significantly. While order inflow for most of the players had remained muted in FY13 and FY14, some players like L&T Limited were able to grow their overall order book through a higher focus on overseas orders. While the industry overall had sizeable pipeline of orders in hand, many orders could not start for want of regulatory approvals and other allied issues. The order book to revenues ratio for companies in ICRA sample has been largely stagnant over the past five quarters implying muted new order inflows.  Some traction is expected in the current financial year with improving sentiments and fastening of regulatory process, which is likely to result in improved participation from private sector.

Slow build-up of fresh orders as well as execution bottlenecks - land acquisition, regulatory clearances, shortage of skilled labour, and key raw-materials had adverse impact on the construction activity. Slow billing coupled with fixed overheads impacted operating margins. Combination of falling operating profitability, lower mobilization advances and longer cash conversion cycle has led to weak cash-flows from core construction business. On the other hand working capital requirements have continued to remain at elevated levels for most of the construction companies. This, coupled with the need to support the BOT projects, has resulted in an increase in debt levels and dented net profit margins on account of increased interest expenses. Given the challenging environment, construction companies had been increasingly focussing on measures for cost rationalization including capex deferrals. Significant emphasis is also on settling outstanding claims including waiving off interest due on arbitration awards in order to expedite cash realization from outstanding claims. Many companies are also looking to raise equity to improve their balance sheet and liquidity position.