Sudhir Reddy acquired IVRCL Infrastructure and Projects in 1987. It was a civil contracting company that built culverts and hospital buildings. He was not an engineer, only a commerce graduate. Still, he saw the potential in the infrastructure construction business. Reddy was 29 then. Seven hard years and numerous small projects later, he established IVRCL as a Rs 8-crore company.
His first big break came in 1994 — a water system order for Maharashtra State Electricity Board (MSEB). IVRCL had never implemented a water system before. But Reddy completed it without any major issues. That gave him confidence to bid for a bigger and more complex water project from Cochin Refineries. Reddy did not have in-house expertise. So, he hired experienced engineers from BHEL to complete the project.
These projects gave Reddy all the momentum he needed. In the next 12 years, IVRCL powered ahead — revenues grew from Rs 8 crore to a staggering Rs 1,521 crore (in 2006). Reddy has now built a Rs 6,250-crore order book. That should help him turn IVRCL into a billion-dollar company by 2010.
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IVRCL is not an exception. Other engineering and infrastructure construction companies have a similar story to tell. It took Hindustan Construction (HCC) almost 10 years to grow from Rs 140 crore to Rs 1,000 crore in revenues (2004). But it added the next Rs 1,000 crore in the following two years. Nagarjuna Construction, a Rs 250-crore company in 2001, now has revenues of Rs 1,842 crore. It, too, hopes to be a billion-dollar company, but by 2008. Patel Engineering has grown four-fold to Rs 802 crore in four years. Simplex Infrastructure has trebled its revenues to Rs 1,345 crore during the same period. Of course, there is also the Rs 14,884-crore giant Larsen & Toubro (L&T), whose infrastructure construction business is worth Rs 4,550 crore .
Together these 10 companies (see ‘Billions In The Bag’) have combined sales of over Rs 18,500 crore from the infrastructure construction business, which could easily double to Rs 40,000 crore in two to three years. What’s more, they have a combined order book of a staggering Rs 69,624 crore. At this very moment, they are building many strategic blocks of the country’s infrastructure. These include the Bangalore, Hyderabad and Delhi airports; big parts of the ambitious metro programmes in four cities; the Bandra-Worli Sea Link and hundreds of kilometres of roads; the Kakinada port and gateway terminals at JNPT (Jawarhalal Nehru Port Trust) in Mumbai; the Kudankulam Nuclear Power Project in Tamil Nadu; the GSLV Mark-III space launch complex in Sriharikota (and even a cricket stadium for the World Cup in the West Indies!).
The Infrastructure Build-Up
That Rs 69,624-crore order book is a reflection of India’s booming infrastructure spend. Plan spending on infrastructure is expected to more than double from Rs 3,95,900 crore in the ninth plan to Rs 8,16,300 crore in the tenth (see ‘The Infrastructure Plan’). Last year alone, the government is estimated to have spent Rs 1,34,900 crore on infrastructure. That’s 80 per cent higher than what it spent in 1999-2000.
In both years, the spend was 3.9 per cent of GDP. Comparatively, China spent 9 per cent ($201 billion) of its GDP on infrastructure last year. India may have to spend at least 4.9 per cent if it is to sustain an 8 per cent GDP growth. “Estimates suggest that in the next 5-6 years, Rs 1,22,500 crore will be invested in roads, Rs 40,000 crore in airports and Rs 60,000 crore in 12 ports,” says Y.M. Deosthalee, CFO, L&T.
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But don’t mistake this for a boom yet. Says Ajit Gulabchand, chairman and managing director, HCC: “This is just the ramp up. Wait for the next 3-4 years. That’s when the real growth will come.”
That is the business environment in which these 10 companies are operating. They are among the largest listed companies in the infrastructure construction sector. They have been picked on the basis of their track record, revenue and profit growth and the quality and diversity of their order books. Look at it this way: their combined order book is as big as 8.5 per cent of the proposed infrastructure spend in the tenth plan.
The Business Landscape
Most of these companies started off as small contractors. Till the mid-1990s, many had sales of less than Rs 100 crore. (L&T and Jaiprakash were the only big exceptions.) Some like HCC, Simplex, Gammon and Patel have been around for as long as five to eight decades. Over time, they have developed the expertise to build large and complex projects. Now, many are graduating from being mere contractors to full-fledged infrastructure developers, investing thousands of crores.
Three broad business models have emerged. The first are the pure-play construction companies. They only build; they neither own nor operate the infrastructure. These include HCC and Simplex. Second, a few companies have graduated from pure construction into ownership and operation of infrastructure. The big names here are L&T and Gammon. Third, a few corporates with deep pockets and without too much construction experience are directly getting into infrastructure development.
Grandhi Mallikarjuna Rao, chairman of the Rs 1,400-crore GMR Group, is perhaps the most daring in the third category. Between 2000 and 2002, he raised Rs 1,000 crore by selling his businesses in banking, insurance, IT and brewery, and pumped it all into infrastructure development. He was the first to stay away from the less risky construction business, and focus on the pure infrastructure development model instead. He went after the really big projects like the Delhi and Hyderabad airports. In just a few years, he has invested in 12 projects with a capital outlay of Rs 12,200 crore — Rs 3,500 crore of which has already been implemented. That makes him one of the largest infrastructure developers in India. “Construction is at the low to mid end of the value chain. The real value creation is in taking the risk of the project, developing it, financing it and operating it,” says Rao.
But he is an exception. Most others had their origins in construction. Also getting directly into infrastructure development is Anil Ambani’s Reliance Energy.
The Pure Construction Model
The first big inflexion point for the construction companies came after the Golden Quadrilateral road project was announced in 1999. The government started developing almost 20,000 km of roads in the first phase alone. This led to explosive growth. Nagarjuna Construction entered road projects in 2001. Today, it earns Rs 400 crore from road projects (22 per cent of sales). Gammon India started off in hydel power, but now gets 30 per cent of its revenues from road projects.
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The action went beyond roads. Soon after IVRCL diversified into power projects, its revenues from the sector shot up from Rs 30 crore (2004-05) to Rs 300 crore the very next year.
It was at this juncture that these companies felt the need to change and mature. The first area in which maturity was needed was capital. Historically, construction companies have managed with very little capital. Till 2000, only two companies (L&T and Jaiprakash) had an equity base that was higher than Rs 20 crore and a net worth greater than Rs 125 crore.
The economics of this sector are interesting. It is not capital intensive, but working capital intensive. It does not need huge capital expenditure to set up manufacturing plants, etc., but it needs a lot of free cash to keep the projects going. “In the construction business, you could implement a Rs 1,000-crore project with a net worth of only Rs 25 crore,” says Parvez Umrigar, managing director, Gammon Infrastructure Projects. Approximately 15-20 per cent of the billing value of a project is locked up as working capital.
As the order book grew — barring two, all these companies have order books in excess of Rs 5,000 crore today — they started feeling the need for capital. To implement orders worth Rs 5,000 crore, they needed at least Rs 1,000 crore in working capital. While working capital can be funded through borrowings, they still need a substantial net worth against which they can borrow.
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That has sent these companies on a huge capital-raising binge. In the last three months alone, engineering and construction companies raised $372 million through 13 private equity deals, according to a report by Venture Intelligence India. Since 2000, the 10 companies have tapped the capital markets over 20 times and raised well over Rs 3,000 crore.
Many have sold shares at a high premium and managed a substantial increase in net worth with minimum equity dilution. For example, in the last two years, Hindustan Construction has raised Rs 560 crore share premium by diluting its equity by a mere Rs 5.6 crore.
The size of projects a company can bid for is determined by its net worth, among other things. This urgent need for net worth has forced companies to take some rather peculiar decisions. In December 2004, Gammon India raised about Rs 140 crore through a preferential allotment of shares to foreign institutional investors (FIIs). In normal course, this Rs 140 crore could be added to its net worth only when accounts were finalised after 31 March 2005 (its financial year-end). But Gammon was bidding for a few big projects and it needed to increase its net worth. So, it closed its financial year in December 2004, drafted a balance sheet with the higher net worth and managed to qualify for the bid!
Similarly, when Nagarjuna Construction raised $105 million last year, it kept off the FCCB (foreign currenty convertible bond) route and opted for a GDR (global depositary receipt) issue instead. Now, FCCBs are corporate India’s most popular fund raising instruments. A big chunk of capital raised by Indian industry recently has come through this route. So, Nagarjuna’s choice of a GDR issue puzzled many. The reason, though, was not far to seek. FCCBs are treated as debt on the balance sheet till converted into shares. So, they do not add to the net worth immediately. But GDR issues do.
However, despite the Rs 3,000 crore it has raised, the sales-to-net worth ratio of these companies (that indicates how much net worth has been added in relation to revenues) has not improved since 2002. In fact, it has dropped from 3.5 in 2000 to 3.2 in 2005. That means these companies will have to raise substantially more equity in the coming years. This is where the industry is beginning to look vulnerable.
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Analysts are beginning to ask fundamental questions about the sector’s ability to earn a decent return on capital. “Most of the time, the cash generated from operations is eaten up by working capital needs, leaving little or no free cash… . As a result of the capital-intensive, negative free cash nature of the construction business, there is constant pressure to raise capital. What adds to the misery is that these companies don’t earn much on capital, hence the sustainable growth rate is low. This magnifies the need for additional capital on a near-permanent basis,” observes a recent report by First Global (see ‘The Quest For Greater Profitability’ on page 40’). Recently, the firm downgraded the sector and several leading companies including HCC, IVRCL, Gammon and Nagarjuna to an ‘under perform’ status.
However, First Global is an exception. Other research firms like SSKI and Edelweiss continue to remain bullish on the sector. “Going forward, we expect robust growth for these companies (25 per cent revenue CAGR and 34 per cent earnings CAGR estimated over FY06-08),” says an SSKI report released in June.
The industry is not too worried. “Today, there are people who are willing to back us up for half-a-billion dollars,” says IVRCL’s Reddy. And Simplex’s director Amitabh Mundhra claims that he gets feelers from at least two private equity firms every week.
The Next Big Step
This rather easy access to capital has uncorked the ambitions of these 10 companies. Many are now moving to the next leg of the business. They are no longer content with being mere constructors; they want to be owners, developers and operators of such infrastructure projects. And they are making rapid progress.
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In 1998, Gammon India tested the waters with a Rs 30-crore bridge in Kerala. The returns were to be earned from the toll collected. Gammon chose the first project with trepidation. But since then, it has raced ahead. Today, it has 10 such projects — held by its subsidiary Gammon Infrastructure Projects — with a combined capital outlay of about Rs 3,500 crore.
Similarly, GMR Infrastructure has built a portfolio of four power projects (it owns these), six road projects (BOT) and two airport projects (BOT basis). These involve an outlay of Rs 12,200 crore. Nagarjuna Construction is planning to invest in two-three big BOT projects in the Rs 400 crore-500 crore range each in the next 3-5 years through a new subsidiary NCC Infrastructure Holdings. It has capitalised the subsidiary with Rs 50 crore and will pump in another Rs 200 crore-250 crore soon.
All this has been achieved in the last three to five years. What’s more, some of these projects have been commissioned and are already making money. “Some projects are collecting a toll of almost Rs 25 lakh per day,” says Gammon Infrastructure’s Umrigar. “Earlier, users had a natural resistance to pay tolls. We have overcome this in many of our projects. User charges have improved smartly in the last two years,” adds K.V. Rangaswami, senior executive vice-president, L&T. This has helped establish revenue streams and a clear ROI (return on investment) visibility. Six of L&T’s infrastructure projects earned a combined revenue of Rs 233 crore and a net profit of Rs 61.4 crore last financial year.
Infrastructure, therefore, can be a profitable business. Not surprisingly, the stockmarket is now excited about such infrastructure companies and rewards them with hefty valuations (see ‘The Valuation Game’).
To make the most of it, these companies are developing a three-tiered holding structure that will maximise their capital raising ability. At the top is the corporate (such as L&T and Gammon India). At the second level, there are the infrastructure holding companies (L&T IDP, Gammon Infrastructure, GMR Infrastructure, NCC Infrastructure). At the third level, each project is also housed as a separate company (often referred to as a special purpose vehicle or SPV). Equity can be raised separately at each of these three levels.
Over time, this sophisticated web of companies will enable each player to raise the thousands of crores of capital that will be needed to fund India’s infrastructure. Five years down the line, many of these 10 companies may have a billion-dollar net worth each (L&T is already in that league). This is nothing short of spectacular for an industry in which a majority of companies had a sub-Rs 100 crore net worth till 2000.
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Finally, corporate India is prying open the infrastructure development opportunity. At the very nub of this model is an interesting interplay between the infrastructure companies and financial investors. Essentially, the infrastructure companies are picking up large projects and de-risking them (by making the initial investments, seeing the project through the gestation phase and by establishing a clearly visible revenue stream). Then they ‘season’ these assets (by establishing a toll collection track record). Once this is done, they dilute equity at a high premium to financial investors. This generates fresh capital, which is then ploughed back into newer and bigger infrastructure projects. “This is a game of capital. There is infinite opportunity but capital is finite. So, the game is about getting maximum exposure with limited capital,” says Gammon Infrastructure’s Umrigar.
The fear, of course, is that this might be creating a mismatch between earnings and valuations. That may leave investors disappointed in the long run. “We see construction companies increasingly moving towards an asset ownership model. Though infrastructure ownership is a bigger pie than infrastructure creation (or construction), it is not necessarily always better. Increasing risk quotient may not at all times result in commensurate higher profits,” warns an Edelweiss Research report.
Moreover, the construction business is fundamentally very different from the infrastructure development business. In simple contracting, revenues are realised within 2-3 years. The risks are also relatively low. But for infrastructure developers, revenues will accrue over 15-25 years. That too with a high risk level. In construction, the core skill is project management and speedy implementation. But infrastructure development calls for sophisticated risk management and financial engineering skills. Finally, development also needs a lot more capital. Can the companies graduating from construction to infrastructure development make the necessary adjustments?
It’s too early to tell. Many of the early development projects like the DND Flyway (it connects Delhi and Noida) and the Coimbatore bypass initially struggled to collect the expected toll. But even they have now managed to crawl closer to financial viability.
Some infrastructure development companies like L&T have managed quite well despite initial rough weather (see ‘Profits From Infrastructure, The L&T Way’). But some have failed and are beating a hasty retreat. For example, Punj Lloyd had taken a substantial exposure to road projects. However, it ran into delays, primarily in obtaining the right of way for road contracts worth Rs 1,200 crore in Rajasthan and Assam. That hit its financials — in 2006 its sales dropped from Rs 1,429 crore to Rs 1,368 crore. Since that debacle, the company is no longer bidding for BOT or annuity projects.
To see the future of India’s infrastructure construction companies, one has to go back a hundred years. The 1900s saw one of America’s most explosive infrastructure boom. That was when the US was building thousands of kilometres of roads and railway lines. The $18.1-billion Bechtel, the world’s largest engineering and infrastructure construction company, was born in that era. Today, it has built, owned and operated power plants, oil refineries, water systems and airports in over 50 countries from Iraq to Bolivia. Becoming India’s Bechtel is the ultimate ambition for many infrastructure construction companies. But the Bechtel business model is very different from most of India’s fledgling construction companies. Bechtel is a full-fledged engineering, procurement and construction (EPC) company. It has advanced design skills in every conceivable form of construction. The Indian aspirants are only now acquiring design skills, and that too, in select areas. Strictly speaking, their model may not be directly comparable to Bechtel. Most of their revenues are earned through plain-vanilla construction. But how do they compare with the global construction majors? The Indian firms (except L&T) may not break into the top league, which includes the £8-billion Hochtief, the $3.75-billion Consolidated Contractor Company, etc. But some would make the cut as a decent mid-tier player even in the global context. They would compare quite favourably with firms like the euro 547-million VINCI, a French construction major. But as they grow, they are beginning to acquire design skills and build balance sheets that are strong enough to support towering projects. Their operational efficiencies are improving. Infrastructure projects in India are getting closer and closer to global size and quality. And even as India’s infrastructure story unravels, many of these companies are beginning to seek out opportunities abroad. Punj Lloyd has been among the most successful so far. The Rs 1,368-crore company earns 60 per cent of its revenues from international operations. It has 13 subsidiaries and 12 offices in the Middle East, South Asia, Africa and the Caspian region. L&T’s engineering and construction division already gets 20 per cent of revenues and 19 per cent of its projects from abroad. It has projects and offices in several geographies including the Gulf region, China, Kazakhstan and Tanzania. It hopes that 25 per cent of overall revenues in 2009 will come from international markets. Even smaller companies like Simplex Infrastructure nurse global ambitions. At the moment, 10 per cent of its revenues and 15 per cent of its order book comes from international markets. Mundhra wants to take this to 40 per cent in the next 4-5 years. Many are looking to acquisitions as the gateway to their international plans. Punj Lloyd’s recent acquisition of the $635-million Singapore-based SembCorp Engineers & Constructors will give it an entry into Europe, China, Iran and other South-east Asian markets. Patel Engineering made an acquisition in the US many years ago and has gained from its technology. Smaller companies like IVRCL are also looking for acquisitions in the $100-million range.
The next big opportunity is, perhaps, the Middle East. In the current $75-a-barrel oil price scenario, billions of petro-dollars are flowing into infrastructure development into the region. Geographical proximity and established business ties in the region gives Indian companies an edge. Already, several companies are implementing infrastructure projects in the Middle East. In the 1980s, a bunch of Korean construction companies like Hyundai Engineering and LG Construction used the Middle East as a springboard for their global ambitions. Don’t be surprised if India’s infrastructure builders do the same. | |||||||||
Thank you for the info. It sounds pretty user friendly. I guess I’ll pick one up for fun. thank u
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