Small and mid-sized road construction companies in India will face major challenges in the next couple of years in getting new orders, according to a recent report by India Ratings and Research. The research underlines the reduction of government EPC orders as one of the challenges that can become a growth barrier for such companies. BOT (Build, Operate, Transfer) and HAM (Hybrid Annuity Mode) are more complex models of projects. The smaller players may not be able to compete with the bigger and financially stronger firms.
Road Construction Sector Dynamics Change
The Indian road construction sector is changing dramatically. The government increasingly uses BOT and HAM models for awarding new projects. Although these models provide many benefits, their deployment necessitates a significant up front capital outlay which may not be affordable to some small and mid-sized enterprises. The more they rely now on alternative models of project financing, the slower has been the traditional EPC order flow from entities like the NHAI and MoRTH.
The same changes will bring about stiffened competition in the EPC sector. Big balance sheet construction companies are most likely to reap the fruit of this shift, thus leaving the small ones vulnerable to the new environment. Being less capitalized, smaller firms are not so well-prepared to undertake the risks of BOT and HAM-type projects, making it very tough to win new orders.
The Financial Challenges of BOT and HAM Projects
The BOT and HAM models call for a different project finance approach, where the developers take on more long-term risks. In these models, road construction companies must put in place significant amounts of upfront capital to bid on projects, which places them at risk of execution as well as funding risks. In BOT projects, financial difficulties are compounded by slow financial closures and toll risks related to revenue generation with toll collections over an extended period.
Further, even though 80% of the land required by such projects is usually secured way ahead, clear occupation of the project site continues to remain an issue for most of the developers. This makes delays in project initiation and, at times, creates unease among the lenders too, thereby further aggravating the fund raising exercise by the smaller developers.
The Advent of Long Term Business Models
Despite these challenges, the shift toward BOT and HAM projects is not totally adverse to all players in the sector. In fact, these models provide a more stable, long-term revenue stream for companies that can manage the risks involved. BOT and HAM projects typically take 15 years for a concession period, providing developers with steady cash flow over an extended period.
Some mid-sized road EPC players have already begun to shift to the BOT and HAM models while garnering some order as well. This ensures these players remain competitive in the growing market dominated by large companies, which are better financed. A good credit risk profile, therefore, and a clear vision about growth in the long term, become necessary to shift to the longer-term models. The smaller firms will have to go to the larger developers for BOT and HAM EPC contracts if it does not make this transition.
Increasing Competition and Margin Pressure
As the Indian Government decides to again focus on BOT and HAM models, there is expected to be a strong alteration in the competitive profile for the road construction industry, pushing the smaller players towards struggle maintaining profitability as this increase number of projects through BOT and HAM models increases the pressure of the operating margin and it becomes quite hard for those with weak financial profile to obtain the project.
According to Abhash Sharma, Senior Director and Group Head Ratings at India Ratings, those that have stronger credit risk profiles and long-term business strategies would survive. Those who cannot adapt would be forced into subcontracted EPC work on bigger developers’ projects, which would not be as profitable.
Challenges in Geographic and Client Concentration
Another challenge for mid-sized EPC players is that they are dependent on a concentrated client base and geographic regions. Most of such companies operate in specific states or sectors, which gives them regional economic downturn as well as client-related exposures. A large chunk of their revenue (40% to 60%) is mainly generated from a few prime clients, which makes these companies vulnerable to changes in their demand.
Mid-size firms also suffer in the area of working capital management. Such issues are usually based on credits supported by letters of comfort as well as elongated cycles of working capital if low credit rating firms. A firm facing external sources is not stable to cope with current competition and uncertainty over its finance stream.
Conclusion: Stepping on the Pavement Ahead for Small and Mid-Sized Players
To a short word, the road construction sector in India faces too many changes that would, more than likely, prove rather trying for the smaller as well as mid-size players. Higher competition, financial risk as well as high capital requirement accompanied by a shift from the earlier EPC to BOT or even HAM models is resurfacing the industry. However, financially sound companies, and more importantly, with long term strategies, and capable to cope with new models shall thrive, while small-sized businesses would hardly have easy days from hence onwards as the pressure created on the latter by giant rivals through better competitiveness will not abate.
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