Aggressive bidding and high raw material prices will drag down the operating profitability of road EPC (engineering, procurement and construction) contractors by 200-250 basis points (bps) to a decadal low this fiscal.

The credit profiles of road EPC players, however, will remain stable, supported by deleveraged balance sheets, prudent working capital management, and steady cash accrual, with strong awarding in the past two fiscals supporting revenue growth.

A Crisil analysis of 20 EPC players, which constitute 70% of the road sector revenue, indicates as much.

The National Highways Authority of India (NHAI) awarded ~6,300 km last fiscal, up 30% on-year, of which ~55% was under the hybrid annuity model (HAM). Relaxation in bidder financial and technical capacity criteria led to peak HAM awarding of ~3,500 km in fiscal 2022, up from ~2,600 km in the previous fiscal.

Additionally, to fast-track construction by awarding to a larger pool of players, package sizes were pruned ~30% in the past two fiscals compared with order sizes during fiscals 2016-20. As a result, mid-sized¹ regional players won ~40% of HAM awards in fiscals 2021 and 2022, vis-à-vis ~25% during fiscals 2016-20.

Says Aniket Dani, Director, Crisil Research, “Limited competition in HAM projects had supported healthy profit margins of road EPC players between fiscals 2018 and 2021. The changes in bid eligibility criteria and smaller package sizes have intensified competition, especially last fiscal. Average bid premiums nosedived to ~4% last fiscal from ~16% earlier. Proposed changes in networth eligibility criteria² and additional performance security for abnormally low bids³ may moderate the competitive intensity.”

The intensified competition and steep surge in the prices of key raw materials - steel, bitumen and cement - had shrunk the operating margins of road EPC players by 200 bps last fiscal. Prices of these key raw materials surged 26%, 60% and 4% respectively in the previous fiscal and are expected to remain elevated this fiscal as well. Raw material cost forms 45-50% of overall cost of road EPC players and hence the margins will remain sensitive to any significant increase in prices. Though a large number of contracts have built-in escalation clauses, these kick in with a lag.

An expected moderation in input prices may improve margins next fiscal. However, the improvement will be restricted to ~100 bps with execution of aggressively bid contracts.

Says Anand Kulkarni, Director, Crisil Ratings, “Despite the declining profitability, the balance sheets of road EPC players will remain healthy. Revenue will grow 13-15% this fiscal, backed by robust order books, as reflected in the order book to revenue ratio of over 3 times. Healthy accrual and limited debt will support comfortable leverage, with total outside liabilities to networth ratio seen ~1.1 times this fiscal. Hence, the credit profiles of players should remain stable despite the current headwinds.”

Competitive pressures notwithstanding, moderation in input prices will remain critical for profitability and accruals. A prolonged Russia-Ukraine war and its impact on commodity prices may affect credit profiles and will bear watching.

1 Mid-size players: Revenue of <Rs 1,500 crore
2 Adjustment in networth calculation by deducting balance equity commitment in all under construction HAM projects
3 Bids at a discount of over 20%