The Infra Gap

With the investors coming to terms with the economic slowdown and the stock market mayhem, they have become not only cautious but more selective about which sectors and stocks to invest in. While sectors such as steel and cement are now facing the cold shoulder of the investor, it is also found that the once sought after infrastructure companies aren’t the favourites either. The counters, which commanded huge premium on the bourses, made new peaks, and looked justified even at very high valuations just a year ago, today find themselves touching new lows with sharp corrections in their valuations.

Poor Performance
The performance of infrastructure companies from a 52-week high shows that the lowest an infrastructure stock has fallen is by 63.33 per cent, while the maximum fall has been over 93 per cent. The Sensex during the same period has fallen 52 per cent (refer table on performance of infrastructure stocks). Gammon India, Unity Infraprojects and Jaiprakash Associates are the counters which have fallen the most in the infra pack at 93 per cent, 89.70 per cent and 88.97 per cent respectively. Meanwhile, Larsen and Toubro and Era Infra Engineering have slipped the least at 68 per cent and 63 per cent respectively. But if that wasn’t enough, despite such a massive fall in the prices of the scrips, there are hardly any takers for them today.

The current state of the infrastructure scrips is due to the culmination of various factors that have developed over the last one year. Economy isn’t growing at the pace it did in the last fiscal. For Q2FY09 the GDP grew at 7.6 per cent. Though this was much to the surprise of many since expectations were lower than this, the GDP growth for Q2FY09 is certainly lower than the same period last year when it grew at 9.3 per cent. Despite this growth, the expectations for the Q3FY09 and Q4FY09 are still bleak. Thus there is an apparent slowdown in the economic growth. Inflation in double digits in H1FY09 and hardened interest rates haven’t made things easier as they escalated the overall costs and impacted the margins of infrastructure companies.[PAGE BREAK]

Besides, turmoil in the financial market globally, including India, has meant that easy money for companies has dried up and hence raising funds has become difficult. Ambitious corporate projects are therefore on hold. Vinayak Chatterjee Co-Founder, Feedback Ventures, says, “The scenario for the private sector is that it has been affected by a depressing liquidity crunch and the rising interest rate which has been affecting the on going projects as well as the sentiment for new ventures. In the public sector space we find that there does not seem to be great institutional capacity or institutional energy to vigorously move ahead with implementation or projects which seem to be stuck for whatever reasons.”

In fact, these factors have affected the industrial activity too which, according a recent study, showed that in H1FY09, 97 industrial projects worth Rs 76,538 crore were shelved. This is more than double the projects during the same period last year when 40 projects worth Rs 34,400 crore were abandoned. Of the total 97 projects, 52 projects worth Rs 42,740 crore were in Q1FY09 and the balance 45 projects worth Rs 33,798 crore were in Q2FY09. Here it should be noted that though some of the projects do get shelved even during a better economic scenario due to various others reasons, the unusual jump in this year’s numbers clearly indicate that slow down is a primary culprit. While the factors mentioned above force the infra companies to go slow on their existing projects, they also restrict them to bid for new projects aggressively.

In fact, the National Highway Authority of India (NHAI) had to award projects by November 2008 but these have been delayed due to lack of response from the infrastructure companies. Hence all these have led to the sector moving out of favour of investors. Does all this also imply that infrastructure companies are now in such a bind that they cannot even wait out the storm thus leading to massive falls in their scrip prices by up to 90 per cent? Have the investors forgotten the huge order books of these companies which is what had led them to park their funds here? It is possible that some of the factors have been overplayed? Hence it would be important to find out the truth behind how the infrastructure companies are currently placed, whether they will last this ordeal and what lies ahead for them.

Fighting For Funds
With the economy slowing down, infra companies are forced to go slow on new projects as raising funds has really become a challenge with interest rates still at higher levels. Besides, it also results in project delays, which is an additional cost. In fact, banks till now were lending at around 14 per cent to infrastructure companies. At these high costs many of the large infrastructure projects could turn nonviable due to poor returns. On the other hand, the funds, which the Indian companies have been raising frequently and easily from abroad through FCCB, ECB routes etc till last year, also have dried up in the wake of the global liquidity crisis. And with the year-end approaching we don’t expect the fund flows to see any improvement. Things may improve only at the start of the next year when there could be some flows from overseas, but it is too early to predict how big a wave this would be.[PAGE BREAK]

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Keeping this scenario in mind, it would be tough for companies to achieve financial closure for their new projects, thus leading to execution delay. Amitabh Das Mundhra, Director, Simplex Infrastructures explains, “The credit crunch is more relevant to companies who do BOT projects and are acting as developers. Lenders have taken a more cautious approach, but there is availability of funds as per industry needs. As far as delays are concerned, your overhead costs and asset ownership increases, but the bigger problem is that the opportunity cost delayed for one month would mean we won’t be able to take up another project. As for Simplex Infrastructure, the projects are on schedule though minor delays keep occurring, but there is nothing unusual about it.”

HCC, which is currently in the progress of getting financial closure for one of its two BOT projects, is facing a tough time as the lenders are demanding higher rates for the projects. Says Praveen Sood, CFO, HCC, “For one of our BOT projects which is under financial closure, the bankers are asking us to jack up the rates because they say the borrowing cost of bankers has gone up. So now they are just trying to delay the process of disbursement or asking us for higher rates to the tune of 12.5-13.5 per cent. We have to take a conscious call on this since we cannot delay the projects. There don’t seem to be many options here, which will have an interest impact.”

The situation is indeed much worse as the liquidity crunch has hit major road projects. On a YTD basis (Apr-Oct 2008), though the NHAI has invited bids for 82 projects (total of 8,542 kms) with an estimated cost of Rs 67,000 crore, there has been a delay due to restrictions of number of bidders and lower bidder response in the wake of the credit crunch and execution challenge. Already Gammon India is facing a tough time to the extent that it had to suspend work in its two projects in Jammu and Kashmir and Assam in Q1FY09, while Q2FY09 too has witnessed a dragging of its projects in Bihar. That apart there was also a media report that said Punj Lloyd is facing delay in completion of the ONGC’s Heera Platform Redevelopment Project. The report said that the project was supposed to be completed by April 2008 but it isn’t as yet complete in November 2008, thereby resulting not only in deferment of cash inflows but also creating problems in terms of raising funds for upfront payment to continue with the project.

Effects Of Elections
Infrastructure development is a priority for an emerging economy like ours and any government that comes to power will focus on this. Even the current government has been aggressive on its infrastructure plans till now. But it should be noted that the year 2009 is the year of the elections. What this means is that there could be a slowdown in the number of new projects to be announced by the government. Besides, once the election is officially declared the current government wouldn’t be allowed to award any new projects or even make any assurances. This could also be seen in the previous elections held during FY04, when infrastructure companies such as IVRCL, Hindustan Construction Company (HCC) and Simplex Infrastructure had to suffer slowdowns in their order flows.[PAGE BREAK]

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The entire election process would take at least three to five months to get over while the new government that comes to power would also take its time to reassess the current scenario before announcing new infrastructure projects. Thus one can expect some amount of slowdown in the order inflow for infrastructure companies in 2009. However, this scenario usually changes with a good inflow of orders in the next fiscal following the elections when new projects start to be assigned.

Ratio Riders
The one factor that merits attention is that these companies’ debt to equity ratio (D/E) indicates their ability to raise more funds for future projects. But to our surprise we found that even on a consolidated basis, barring a few companies which had a very high D/E ratio (infrastructure companies can have a D/E of 3:1), some infrastructure majors had D/E of less than one while a few had D/E of more than 1 (refer table on D/E ratio). One of the reasons for this could be attributed to the fact that these companies have also been funding their projects not only through equity dilution, but also through internal accruals, thus keeping their D/E low.

The infrastructure majors whose DE is less than one include GVK Power and Infrastructure, Nagarjuna Construction Company and Punj Lloyd, while those whose DE is just over one include Simplex Infrastructure, IVRCL, Patel Engineering, L&T, GMR Infrastructure and Gammon India. Considering their ratios we believe that these companies are better placed to raise further capital to fund their projects and working capital requirements. Additionally, these top five infra companies (based on market capitalisation) look well placed even on their interest coverage ratios. L&T’s interest coverage ratio stands at 17.83x while that of IVRCL stands at 10.07x. Lanco Infratech, Jaiprakash Associates and GMR Infrastructure have ratios of 6.37x, 2.91x and 2.70x respectively.

However, the ground reality is something different as despite these companies’ capability to raise funds it’s the lender or banking community that is averse to disburse loans at this juncture. While the private sector banks are already cautious, the public sector banks are avoiding infrastructure companies too. To make matters worse, the overseas and private funds aren’t in an expansion mode either, thus drying up other sources of funds for these companies. Ashutosh Agarwala, CFO, Strategic Finance, GMR Group, opines, “There is a slight problem in terms of availability of finance as most banks have become slightly more conservative considering whatever is happening globally. If you have bankable and good projects, bankers are slightly more willing to finance them but definitely not at the price which one could command a few months back. As far as dollar financing is concerned there is definitely a situation wherein there simply is no availability of such funding.”[PAGE BREAK]

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Besides, what is hurting more is the increased interest cost. The interest cost in H1FY09 has increased by 200-300 basis points to around 13-14 per cent leading to an increase in the out flow of interest for infrastructure companies, thus impacting the margins of these companies. The table on the interest cost of infrastructure shows that interest cost of companies such as Gammon India, IVRCL, JMC Projects, Lanco Infratech, Larsen & Toubro and Patel Engineering has gone up in H1FY09 as compared to H1FY08. For instance, Lanco Infratech’s interest cost at Rs 51.64 crore in H1FY09 is more than its FY08 interest cost of Rs 34.47 crore. And for the fact that interest rates are yet to soften we can expect this cost to remain high, thereby keeping margins under pressure.

Plans Afoot
The current government doesn’t want to go into elections with a bag of problems. The government has set the average GDP growth of nine per cent in the first four years of the Eleventh Plan to be able to score 10 per cent growth by the terminal year (i.e. 2011-12). However, this looks a bit tough considering the fact that the government is facing a complete slowdown in economic and infrastructure growth. Thus, in a bid to stimulate the economy and provide much assistance to the credit-starved infrastructure sector, the government is mulling over some proposals.

The government aims to create a special dedicated fund with a corpus of Rs 50,000 crore, which would either be operated through IDFC or IIFCL. This is a positive sign for the sector. Sectors such as housing, irrigation and roads are being looked at by the government as priority sectors for funding purposes. The Planning Commission has taken up the matter on an urgent basis and hence one can expect some kind of a concrete result in the coming period. In fact, the government is also aiming at making more funds available to the sector by channelising the part of funds borrowed from World Bank for the infrastructure projects.

Meanwhile, there also have been reports that the Planning Commission is also thinking of subsidising loans by capping interest rates and absorbing the additional interest cost. This is something similar to the TUF scheme which is being used to promote growth in the textile sector. Though nothing is confirmed yet, if this happens it would help infrastructure companies to manage their interest cost well. Last but not the least, infrastructure companies might get easier access to overseas borrowings as it is considering a relaxation in the norms which currently prescribe a cap of 300 basis points over Libor for loan for a period of 3-5 years and a cap of 500 basis points over Libor for loans over five years. The only advantage of this would be that the companies would be able to raise funds when needed for completing pending projects, though at a high cost. However, it should be noted that these are just proposals and haven’t been finalised yet. If the government accepts either of these proposals it would take some time before they are fully implemented and the impact, if any, might be felt only from the next fiscal onwards.[PAGE BREAK]

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Survival Of The Fittest
We believe that companies with stronger order books and balance sheets might be in a better position to tide through this phase. Stronger order books give a better revenue visibility for the companies. IVRCL’s order book to sales ratio stands at 3.29x, while that of L&T, Punj Lloyd, Lanco Infratech and Jaiprakash Associates stand at 2.17x, 2.80x, 2.82x and 1.77x respectively. It could also be said that the big companies which have low debt to equity ratio and cash and liquid investments in their books would be better off tackling the near term concerns about funding working capital requirements.

Companies which have good cash and investment figures in their books as on FY08 include L&T with cash of Rs 1,560.78 crore and liquid investments worth Rs 5,552 crore. GMR, HCC, NCC have cash and cash equivalent of Rs 3,675.28 crore, Rs 339.01 crore and Rs 317.74 crore respectively. These are the companies that will safely sail across choppy seas. We also believe that the action taken by the RBI on the CRR front in the recent past is a move towards ushering in a benign interest regime. And it would continue to take adequate measures to release more liquidity in the system. However, we don’t expect the banks to reduce their interest rates so soon and hence the rate cuts by banks, if any, can be expected from the fourth quarter of 2009 with the impact being witnessed only in 2010.

With the fall of the infrastructure stocks the excess froth in the valuations has certainly vanished and at the current prices these stocks are more or less trading at FY05 and FY06 valuations. So there is certainly value that has emerged in these counters tempting the investors to buy. But we are also of the belief that low valuations don’t always mean good valuation as the current valuations might also be an indicator of deterioration of the earnings in the coming quarters. Hence, it could also be said that though the downside in these counters look limited the upside also looks capped. We don’t expect much change in the factors discussed above in the coming quarters.

Looking For Liquidity
Liquidity is what companies are looking for and we don’t see that scenario about to change much. Though the government has announced various proposals for the infrastructure sector, there is no approval for the same and even if these are green-lit the finalisation of policies will take time and so will their impact. Further, the other sources of funds are currently going through a lull phase too. Thus liquidity has more or less vanished and unless and until the markets stabilise, raising funds from the capital market looks like a tough proposition. That apart, the overseas funds, which would anyway stay away from the markets till the year end, will also reassess the situation in the coming year and would be very cautious and selective in picking projects. So only those projects which they feel are really viable and clear will attract funds.[PAGE BREAK]

S S Kohli, CMD, Indian Infrastructure Finance Corporation, says, “The current scenario has occurred due to the high rates of interest which is making it difficult for companies to have financial closures. As far as IIFCL is concerned, we have not stopped disbursing loans and we would continue to sanction loans to those projects which confirm to our scheme. But they should be viable, sustainable and the project should confirm to our newly set up risk management systems.” That apart, banks, both private and public, aren’t interested in funding infrastructure projects as the real concern for them is whether they will get back their invested money back. So when we look at these factors it’s really too early to assume that liquidity concerns could vanish in the coming year and this is even if we assume that banks might reduce interest rates in the next year. Thus, it is better to have a wait and watch approach at least for the next 4-6 months before taking any exposure to the infrastructure sector.