[sustran] INFRASTRUCTURE OVERKILL : DEAD END?

[Vinay Baindur]

http://business.outlookindia.com/article.aspx?281901




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COVER STORY
Dead End?
Anxiety gives way to desperation as leveraged road developers put unviable
projects on the block. What’s worse is that there are hardly any takers
SHABANA HUSSAIN<http://business.outlookindia.com/peoplefnl.aspx?pid=13917&author=Shabana+Hussain>

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.



A third of all projects awarded by the NHAI in the past five years are on
the block for a complete or partial sale


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.

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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?

"Projects that NHAI is tendering don’t have high traffic potential and will
need higher government grants"*Virendra Mhaiskar, Chairman, IRB*"We will
only bid for lucrative projects this fiscal and focus on our existing Rs
15,000-crore road portfolio" *A Subba Rao, President and group CFO, GMR
Group*
------------------------------
"A majority of the bidders were EPC contractors who bid for toll roads with
aggressive traffic assumptions"*S* *Nandakumar, Senior director, global
infrastructure and project finance, Fitch*"There was a general euphoria.
The economy was projected to grow at 8% and we got carried away by that"*E
Sudhir Reddy, Chairman IVRCL*
------------------------------
"The idea was to bid for several projects, make a portfolio and list it.
But listing in this environment is not possible" *Bhavik Damodar, Head,
infrastructure transaction services KPMG India*"The existing promoters have
a rosy picture. The buyer has a different opinion of how the growth will
happen" *Vinayak Chatterjee, Chairman Feedback Ventures*
------------------------------
"Unless the developer has equity in place, it will be very difficult to
lend to aggressively-bid projects" *KR Kamath, Chairman & MD Punjab
National Bank*

*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). 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.

**


About 65% of projects after 2009 were awarded on premium basis, compared
with just 25% in FY09


**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.

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*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). 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.



While no roads company has defaulted on its debt so far, the possibility
cannot be ruled out


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.



If projects won in a less competitive environment are not making money,
More recent ones have little hope


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.



If a sale does not happen in the next six months, projects now fussing over
valuation could be sold at a discount


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.”

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.”



Only 97 bidders have applied to the NHAI for qualification in 2012 compared
with 114 applicants the previous year


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.

<http://cms.outlookindia.com/Uploads/outlookbusiness/2012/2012088/page_90_20120818.jpg>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.