XLRI JAMSHEDPUR

Indian Infrastructure
Sector
Developing a Complete Sector Report
( Assignment of FAPC Course)
GMP Term-III
Group 1

Himadri Singha 019

Soman Mohapatra 051

Hozefa Bharmal 078

Piyush Pati 094

Subhadip Das 110

Submitted to Prof. S.Sengupta

 Indian Infrastructure Sector 2010

Background

Our analysis of 5 top companies in the infrastructure and construction space underlines
the impressive growth inflection in the industry over the past few years. We expect
growth to remain robust as opportunity increases. The key driver will be large
investments planned in India’s infrastructure, industrial, and real estate sectors in the
next five years.

Execution risk will be the biggest risk in the construction industry, in our view. We
believe companies with established execution abilities and a more diversified portfolio
will be able to manage the risk better than others.

Many construction companies in India have negative operating cash flows, rising capex,
and higher investment requirements in subsidiaries. Hence, we believe they will need
additional funding. However, companies under our analysis have a low net debt-equity
ratio, averaging at 0.53. Therefore, we believe these companies can meet most of their
future capital needs through debt.

( The five companies we have taken for analysis purpose are L&T, Lanco, IVRCL,
Nagarjuna Construction & Gammon India, based on Market Cap and Turnover)

Infrastructure Sector- A Growing opportunity

The Indian infrastructure, industrial, and real estate sectors are experiencing strong
capacity growth. India’s GDP for 2009-10 is now being estimated at 7.4% on the back of
strong Q4 economic performance. India’s GDP growth for 2010-11 is now being projected
around 8.5%. Core industries and infrastructure services are showing signs of recovery.
With the Government emphasising the need to focus on infrastructure (especially for
roads, power and ports), this sector is expected to show significant signs of growth. We
believe this investment boom is driving strong growth in the industry. The Planning
Commission has projected that investment in infrastructure would almost double at US$
1025 billion in the 12th Plan, compared to US$ 514 billion in the 11th Plan. Of the US$
1,025 billion, 50 per cent is expected to come from private sector, whose investment has
been 36 per cent in the 11th Plan.

Listed below are some key trends in the infrastructure sector. For our analysis, we have
considered the performance of 5 infrastructure/construction companies over the past
Five years.

Order books and revenue growth have picked up significantly. Five companies
recorded an average revenue growth of 24% during FY06-FY10.

Some of the companies have long working capital cycles. Hence, strong growth in
the industry has caused many players to have negative operating cash flows.

The industry is incrementally becoming more capital intensive — capex of the 5

companies increased from INR3.9 billion in FY06 to INR23 billion in FY 10.
 Indian Infrastructure Sector 2010

Manpower remains one of the key concerns as shortage of skilled labour

continues. However, employee productivity has increased in the industry in the
past two years. We believe an increase in the ticket size of projects has also helped
mitigate adverse impact of the shortage to some extent.

Equity dilution has resulted in a decrease in promoter holdings for many companies in
the sector. Because most companies have a comfortable leverage, we expect them to meet
their funding requirements via additional debt.

2005-2010: Growth Story of Infrastructure Sector:

Infrastructure Sector showed tremendous growth in last Five years.

Year FY 06 FY 07 FY 08 FY 09 FY 10
Turnover (Crore) 20,011 25,583 36,359 51,160 57,897
Turnover Growth Rate (%) 27.8 42.1 40.7 13.2

Turnover (Crore)
70,000
60,000
50,000
40,000 Growth of Five Top
30,000 Turnover (Crore) companies are taken
20,000 together
10,000
0
FY 06 FY 07 FY 08 FY 09 FY 10

Turnover of five companies together almost tripled to INR 58000 Cr in 2010 March from
INR 20000 Cr in 2006 March.

Turnover Growth Rate

60.00 Growth Rate between
2009 and 2010
40.00
Turnover Growth plummeted drastically
20.00 Rate due to recessionary
0.00 effects in 2008-09.
FY 06 FY 07 FY 08 FY 09 FY 10

EBITDA margins have expanded significantly over the last four years. Overall average
 Indian Infrastructure Sector 2010

EBITDA margins have expanded significantly over the last four years. Overall average
EBITDA margins expanded from 12% in FY06 to around 18% in FY10.

Year FY 06 FY 07 FY 08 FY 09 FY 10
Average EBITDA Margin 12.14 13.74 14.87 15.44 17.48

Average EBITDA Margin

20.00
17.48
15.00
15.44
13.74 14.87
10.00 12.14
Average EBITDA Margin

5.00

0.00
FY 06 FY 07 FY 08 FY 09 FY 10

The key drivers of this margin expansion are:

A favourable demand-supply scenario for construction companies. This has

resulted in favourable pricing environment for construction players across the
industry.

The average project size is increasing given the significant operating leverage of
the companies. For e.g., the minimum project size for L&T has increased from
INR500 million three years ago to INR2 billion currently. Both NJCC and IVRCL
have set a threshold limit of INR1 billion in bidding for projects.

Cost control initiatives by companies like L&T, Gammon and Nagarjuna

Construction.
 Indian Infrastructure Sector 2010

Sector Profitability:

Return on Equity

RoE (%)
ROE has grown to 22 in FY09 on
25.0 22.0
18.8 strong order booking and growth
20.0 19.2 impetus to sector given by
15.0 18.2 government. But recessionary
16.7 pressure has brought it down.
10.0 RoE

5.0

0.0
FY 06 FY 07 FY 08 FY 09 FY 10

Return on Capital Employed

ROCE is flat for the 5 years. PAT and

RoCE reserves and surpluses have grown
30.0 simultaneously.
25.6
25.0 24.3
24.6 24.5 RoCE
20.0 23.5

15.0
FY 06 FY 07 FY 08 FY 09 FY 10

Sector Solvency:

Current Ratio

A healthy CR is maintained. Going

Current Ratio forward companies in the sector
2.0 would be able to raise short term to
1.8 maintain operating Cash Flow
1.5
1.6 position, which is an immediate
1.4 1.4
Current Ratio requirement for this growing sector.
1.4
1.4
1.2 1.3
1.0
FY 06 FY 07 FY 08 FY 09 FY 10
 Indian Infrastructure Sector 2010

Sector Outlook

Rising complexity means larger players have an edge

Complexity in the construction sector is rising and project sizes are increasing. For e.g.,
earlier road projects awarded by the National Highway Authority of India (NHAI) had an
average length of 15-20 km (in the Golden Quadrilateral phase). Currently projects
awarded have length in excess of 100 km. Similarly, large and technologically complex
projects are being awarded in the power, port and airport sectors. As the construction
period is included in the concession period, timely completion of the projects has a
substantial effect on the internal rate of returns (IRRs). Hence, an increasing number of
projects have now an aggressive timeline attached to them. Hence, we believe larger
construction players that have the technical expertise and proven track record in
execution hold an edge.

Significant industry inflection after FY05

Almost all construction players have been aggressive in growing their order books over
the past five years. The average order book for the industry has grown by a CAGR of 43%
over FY06-FY10. The total order book for companies under analysis has increased 4.2x
between FY06-FY10.

Order Booking (Crore)

L&T Lanco IVRCL NCC Gammon
FY 06 24857 3200 6000 5428 5800
FY 07 36882 5200 7107 7302 7000
FY 08 52680 13017 12241 11380 9000
FY 09 70000 10393 13682 12197 12967
FY 10 114882 25713 23400 15370 14500

140000

120000

100000
FY 06
80000 FY 07
FY 08
60000
FY 09
40000
FY 10
20000

0
L&T Lanco IVRCL NCC Gammon

Based on our analysis, the average order for companies has grown at a CAGR of 43%
 Indian Infrastructure Sector 2010

over FY06-FY10.

160.0 149
140.0
120.0
100.0
80.0 68.4 Order Booking CAGR (FY
06-10)
60.0 46.6
40.5 38 Revenue CAGR (FY 06-10)
40.0 26 29.7 27 25.7 32
20.0
0.0

However, revenue growth for most companies has been lower than the order book
growth (Lanco is an exception as it is a new company), which indicates that the execution
cycle is getting longer, in our view. We believe the execution rate is slowing down for
projects due to increasing complexity. The timelines for projects are also expanding due
to greater time spent in resource mobilization, land acquisition and obtaining regulatory
clearances. Hence, this has caused the order backlog ratio to increase from 2.26 in FY06
to 3.35 in FY07.

Certain players like NJCC and IVRCL have been aggressive in addressing growth
opportunities. Both companies were much smaller than L&T, HCC and Gammon India
around seven years ago. Now, they are around the same size to Gammon India and HCC.
Similarly Lanco also started as a small company but it came into prominence as
developers when they bid and won large development projects.

Spreading across segments

Over the past three-four years, companies have started moving up the value chain. For
e.g., players who were earlier doing only civil construction work are also doing electrical
and mechanical projects today. Most of them are diversifying into different segments as
well. For e.g., NJCC now has a presence in nine segments compared with four in FY05. The
new segments include metals, oil and gas, power and irrigation.

Companies are able to pass on the increase in commodity prices

Raw materials contribute almost half of the construction costs. Steel and cement are the
key raw materials used in the industry. The industry saw a huge inflection in raw
materials costs during FY06-FY10. Cement price rose 49% and Steel price rose 87% in
between FY 06-FY 10. But steel average Raw material cost for the sector remained almost
constant at 32-34% in last Five years. As a probable reason, we can say that the raw
materials cost impact caused companies to move away from fixed-price contracts
to flexible contracts, which include cost escalation provisions. We estimate that around
70-80% of companies’ order books today have pass-through contracts for cost
 Indian Infrastructure Sector 2010

escalations. Companies have also started using hedging techniques to guard against
unfavourable raw materials price movements. A detail comparison is show below:

Cement Price Steel Price (Rs./Ton)

(Rs./Bag) 60000 50000
50000 52000
300 40000 45000
242 34800
200 30000
202 228 237 Cement 27700 Steel Price
20000
100 163 (Rs./Ton)
Price 10000
0 (Rs./Bag) 0
FY FY FY FY FY FY FY FY FY FY
06 07 08 09 10 06 07 08 09 10

Raw Material Cost as a Percentage of Sales

40.00

38.00

36.00
Raw Material Cost as a
34.00 33.18 33.52 Percentage of Sales
32.77 32.43
31.86
32.00

30.00
FY 06 FY 07 FY 08 FY 09 FY 10

Employee costs are also rising

In the past five years, there has been a significant increase in employee costs due to
increase in manpower requirements and rising wages. Especially companies like Lanco,
NCC and IVRCL, employee cost has risen significantly. According to management,
competition for engineers from the IT industry has led to higher attrition levels, and,
hence, higher wages for employees. But still Sector average is almost constant at 5-5.5%
of sales. A detail comparison across the industry is given below:
 Indian Infrastructure Sector 2010

8.0
Employee Cost as % of Sales
7.0 7.1
6.2 6.5
6.0 6.0
5.9
L&T
5.0
4.0 4.5 Lanco
4.0 3.9 3.9
3.9 IVRCL
3.5 3.7
3.7 3.6 3.4
3.0 2.9 NCC
2.8
2.3 2.6 Gammon
2.0
1.8 1.6
1.3 1.3 1.2 1.4
1.0

0.0
FY 06 FY 07 FY 08 FY 09 FY 10

Industry is getting more capital intensive

We have seen that Employee cost for the sector is almost constant at 5-5.5% since last
five years. The reason being industry is getting more capital intensive. Based on our
analysis, capex for the five companies together has increased from INR3.5 billion in FY06
to INR22 billion in FY10. Given the visibility in growth and increasing complexity of
projects, companies prefer to own their equipment rather than rent or lease.

Need for Funding

Construction is a high working capital business. Therefore, operating cash flows have
been negative or very less for many companies given strong growth in business. Negative
operating cash flows are accompanied by increasing capex and investment in subsidiaries
that take up projects as developers. This necessitates additional funding.

30.0 120

25.0 22.9 110

22.2

21.0 100
20.0 22.8
90
15.0 80 17.1
82 82 Working capital days
76 80 WC as % of Sales
10.0
70
61
5.0 60

0.0 50
FY06 FY07 FY08 FY09 FY10
 Indian Infrastructure Sector 2010

Given the buoyancy in the capital markets, companies have resorted to equity issuances.
The overall equity issuance has been INR 5 billion over the past five years for companies
under analysis. This has resulted in promoter stake declining over a period of time.

Different Accounting Policies

Accounting policies are significantly different across most construction companies. One of
the most important policies with respect to the construction industry is the Revenue
Recognition policy. We believe it can vary. The most common method of recognition is
the “percentage of completion” method. Under this method, the company can recognize
revenue by two means:

In the first method, companies start recognizing revenue (costs plus proportionate
margins) only when the outcome of the construction job can be ascertained
reliably. Until that time, the job is termed as work in progress (WIP). Companies
like L&T, NJCC and HCC follow this method.
However, the threshold after which the company recognizes margins varies from
company to company. For e.g., Gammon starts recognizing margins when 10% of
the project cost is incurred, while for L&T the threshold limit is 25%.

In the second method (followed by companies like IVRCL), companies start

booking revenue (cost plus margins) from Day 1 of the project. Hence, they do not
have any WIP quantity in their balance sheets. However, they state unbilled
revenue as part of other current assets, which represents revenue due to be
earned by the company, reduced by the revenue portion already billed from
clients.

Revenue Recognition Model Revenue Recognition Model

for L&T, NCC, Gammon for IVRCL

Source: a report by Nomura Holdings

WIP method is a more conservative accounting policy because it takes care of the initial
execution risks of projects. For example, in the recognition Method 1 the company will
book margins only when the costs incurred for the projects reach the threshold limit. In
Method 2, the company starts booking cost plus margins right from the start of the
project.
 Indian Infrastructure Sector 2010

For this difference in accounting policy, it’s not wise to compare all operating parameters
in a likely manner.

Capacity Utilization is almost 100%

Though it is very difficult to calculate the Capacity Utilization of any infrastructure

company, we can use its Asset Turn Over Ratio as a proxy of capacity utilization.

Asset Turnover Ratio

10.00 8.50
8.00 6.43
6.27
6.00
6.87 6.68 Asset Turnover
4.00 Ratio
2.00
0.00
FY 06 FY 07 FY 08 FY 09 FY 10

How Money is spent:

We have studied the value added statement of last five years for all five companies. Below
stated is the detail of how money has been spent for last five years.

Figures in the chart are % of Total Value Added

Govt Govt

16.9
Employee 20.7 Employee
37.8 31.6
23.5
Internal
26.4 Internal
14.5 Financer 9 Financer
12.3
7.3 External External
Financer Financer
(Banks) (Banks)
FY 09-10 FY 06-08
Gross Sales: 10905 Cr Gross Sales: 5463 Cr
Value Added:2379 Value Added: 1103 Cr

From above chart we can conclude that Growth investment has increased substantially in
FY 09-10 than in FY 06-08. At the same time tax payment, employee cost and dividend
payment proportion are reduced.
 Indian Infrastructure Sector 2010

Future Outlook

Investment opportunity in Indian Infrastructure Sector

India, the second most populated country of more than 1100 million has emerged as one
of the fastest growing economies. In 2009-10 India’s economy-GDP grew by 7% due to
global recession. In the previous four years, economy grew at 9%.The Indian economy is
expected sustain a growth rate of 8% for the next three years upto 2013. With the
expected average annual compounded growth rate of 8.5%, India's GDP is expected to be
USD 1.4 trillion by 2017 and USD 2.8 trillion by 2027.

The robust current growth in GDP has exposed the pitfalls and inadequacies in the
country’s infrastructure sectors. The strong population growth in India and its booming
economy are generating enormous pressures to modernize and expand India’s
infrastructure. The creation of world class infrastructure would require large investments
in addressing the deficit in quality and quantity.

In the next five years of planned infrastructure investment in India in some key sectors
are (at current prices): Modernization of highways -US$ 75 billion, Development of civil
aviation US$ 12 billion, Development of Irrigation system- US$ 18 billion, Development of
Ports-US$ 26 billion, Development of Railways- US$ 71 billion, Development of Telecom-
US$ 32 billion, Development of Power -US$ 232 billion. Thus in the eleventh five year plan
,investment in the above sectors (Aviation infrastructure ,Construction infrastructure,
Highway infrastructure ,Power infrastructure, Port infrastructure ,Telecom infrastructure
) will be US$ 384 billion (Rs 17,20,000 Crores) considering the huge infrastructure
market potential in India. Domestic and global infrastructure funds have exposure to
Indian infrastructure sectors.

Infrastructure sector targets for Eleventh five year plan ending 2012

Electricity: Additional power generation capacity of about 90,000 MW , reaching

electricity to all un-electrified hamlets and providing access to all rural households
through Rajiv Gandhi Grameen VidyutikaranYojna (RGGVY)
National Highways: Six-laning 6,500 km of Golden Quadrilateral and selected National
Highways, Four-laning 6,736 km on North-South and East-West Corridors, Four-laning
12,109 km of National Highways, Widening 20,000 km of National Highways to two lanes,
Developing 1000 km of Expressways, Constructing 8,737 km of roads, including 3,846
km of National Highways, in the North East
Rural Roads: Constructing 1, 65,244 km of new rural roads, and renewing and upgrading
existing 1, 92,464 km covering 78,304 rural habitations.
Railways: Constructing Dedicated Freight Corridors between Mumbai-Delhi and
Ludhiana-Kolkatta, 10,300 km of new railway lines; gauge conversion of over 10,000 km
 Indian Infrastructure Sector 2010

and doubling, Modernization and redevelopment of 21 railway stations, Introduction of

private entities in container trains for rapid addition of rolling stock and capacity, Metro
rails and world class stations
Ports: Capacity addition of 485 million MT in Major Ports, 345 million MT in Minor Ports,
construction of jetties and berths, Port connectivity ,channels deepening and port
equipment.
Airports : Modernization and redevelopment of 4 metro and 35 non-metro airports,
Constructing 7 Greenfield airports, Constructing 3 airports in North East, Upgrading
CNS/ATM facilities ,Establishing training facilities and MRO
Telecom and IT : Achieving a telecom subscriber base of 600 million, with 200 million
rural telephone connections, Achieving a broadband coverage of 20million and 40 million
internet connections
Irrigation: Developing 16 million hectares through major, medium and minor irrigation
works
Urban Infrastructure: Urban renewal projects for selected cities; one million plus cities,
state capitals and places of historical, religious or tourist importance under Jawaharlal
Nehru National Urban Renewal Mission (JNNURM).
Rural infrastructure :As per Bharat Nirman action proposed in rural infrastructure for
irrigation, roads, housing, water supply, electrification and telecommunication
connectivity
Construction and Real Estate infrastructure :Development of residential and retail real
estate ,Green buildings ,construction of SEZs, Infrastructure projects, Infrastruture
facilities for Common wealth games 2010
Pick-up in Infrastructure Investment (Present and Expected)
 Indian Infrastructure Sector 2010

Risk:

Execution Risk:
Prices of raw materials, sub-contracting costs, or other inputs; a delay in the supply of
raw materials and inputs Costs of raw materials, sub-contracting, consumable and spares,
as well as other inputs constitute a significant part of operating expenses. Ability of
construction companies to pass on the increases may be limited in the case of fixed-price
contracts or contracts with limited price escalation provisions. Some of the execution
risks include:

Unanticipated increases in the cost of raw materials, fuel, labour or other inputs;

Unforeseen construction conditions, including the inability of the client to obtain
requisite Environmental and other approvals, resulting in delays and increased
costs;

Delays caused by local weather conditions;

Suppliers’ or subcontractors’ failures to perform.

High working capital requirements and hence potential to raise capital

This business requires a large amount of working capital (to finance purchases of
materials, hiring of equipment and engineering, construction and other work on projects,
among others). However, market conditions and other factors may not permit the
companies to obtain financing on acceptable terms, which will have an adverse effect on
businesses.

Delays associated with the collection of receivables from clients

The operations involve significant working capital requirements and a delayed collection
of receivables could adversely affect the liquidity of construction companies.

Dependence on contracted labour force

The construction industry is labour intensive and mostly relies on an external agency and
certain sub-contractors to meet their labour requirements. Any strained relations with
these agencies can severely affect the business requirements.

Dependence on a number of key managerial personnel

The performance of companies in the sector will depend largely on the efforts and
abilities of the Board of Directors, key managerial personnel. The loss of key personnel
can have a material adverse impact on the businesses.

Dependence on sub-contractors for timely and successful completion of projects

In the construction business, the companies increasingly sub-contract different parts of a

construction contract. Hence, the completion of contract will depend on the performance
of sub-contractors. Execution risks using sub-contractors include:
 Indian Infrastructure Sector 2010

Sub-contractors hired may not be able to complete the project construction on

time, within budget or to the specifications and standards that have been set in the
contracts;

Delays in meeting project milestones or achieving commercial operation by the
scheduled completion date could increase the financing costs associated with the
construction and cause the company’s forecast budget to exceed or result in
delayed payment to the company by the client, invoke liquidated damages or
penalty clauses, or result in termination of the contract;

Sub-contractors may not be able to obtain adequate working capital or other
financing on favourable terms as and when required to complete construction;

Industry risks

Demand for construction services in India depends on domestic, regional and global
economic growth. The construction business is dependent on the level of domestic,
regional and global economic growth, and is directly linked to consumer spending on
fixed assets. Hence, fluctuations in economic or business cycles, or other events that could
influence GDP growth, may have a material adverse effect on the business operations of
the players in this industry, in our view.

Interest rate fluctuations

Changes in interest rates could significantly affect the financial condition and results of
operations. With a huge dependence on debt for PPP projects, any significant rise in
interest rates will increase the financing cost of these firms, which in turn, may adversely
impact the results of operations, planned capital expenditures and cash flows.

Long-term infrastructure development projects have development,

implementation risk:

Typically, infrastructure development projects involve agreements that are long term in
nature. Long-term arrangements have inherent risks associated with them because they
can restrict the company’s and the relevant project’s SPV operational and financial
flexibility. These risks may not necessarily be within the control of the project SPV. As
revenue structure under each project is generally set over the life of the project (and
fluctuates are subject to the built-in adjustment mechanisms contained in concession
agreements or power purchase agreements), profitability of a project SPV is largely a
function of how effectively the project SPV manages costs during the term of those
agreements. In the case of toll road projects, which have no fixed revenue, profitability of
the relevant project SPV and ability to service debt payments are also dependent on
traffic volumes and toll levies.

Regulation risks

Changes in safety, health and environmental laws and regulations

We believe environmental regulation of industrial activities in India will become more

stringent in the future. The scope and extent of new environmental regulations, including
their effect on operations, cannot be predicted with certainty. The costs and management
time required to comply with these requirements could be significant.
 Indian Infrastructure Sector 2010

Changes in legal and tax regulations

Changes in the operating environment, including changes in tax law, could impact the
determination of tax liabilities in any tax year. The central and state tax schemes in India
are extensive and subject to changes from time to time. Any adverse changes in any of the
taxes may adversely affect profitability of the companies.

Changes in the regulations of various sectors like power, oil & gas

Lately, a lot of construction companies have diversified into various segments in the
process and infrastructure space. Hence, to improve business flow, companies will have
to adapt fast to regulation changes in these various segments.

Capital Structure

The companies in this sector have low debt equity ratio. Recent government policy now
allows having additional Rs. 20000 of tax exemption saving for infrastructure bond. This
additional deduction of Rs. 20,000 on investment in infrastructure bonds, will lead to
mobilization of individual savings for infrastructure development. Going forward we
predict that debt/equity ratio will go up as capex requirements are increasing for the
sector. Capex and investment in working capital are two most important things for
sustainable growth. Infrastructure spending is likely to grow from Rs. 20.56 Lacs crores
in XIth plan to 41 Lacs Crores in XIIth plan. Some of means by which fund is being raised
are tax incentive savings from individual, FDI route, and debt availability for the sector.