Monday, August 27, 2012

Building on uncertain times

August 27, 2012



In 2011-12, the construction industry, like most other sectors of the economy, could not completely insulate itself from the backlash emanating from the continuing economic downturn. Revenue growth was a muted 12 per cent, a far cry from the levels seen in the industry's heydays in the last decade when hitherto unknown players — some of whom are currently industry leaders — rocketed themselves to fame in the capital market with astounding revenue and margin growth. The effects of the downturn were compounded in 2011-12 by a slowdown in capital investments.



The construction industry's fortunes are linked closely to the pace of economic growth, with infrastructure (roads, airports and power) and industrial segments (automobiles, metals, textiles and oil & gas) being the primary drivers. Like other investment-cycle-linked sectors, the construction industry also has a high beta with respect to economic growth. During the last boom (2003-04 to 2007-08), the industry grew at a spectacular 29 per cent compounded annual growth rate (CAGR), propelled by large spends in infrastructure, particularly roads, airports and power. But with sharp decline in gross domestic product (GDP) growth — 5.5 per cent expected in 2012-13 — we expect the construction industry to grow at a mere 10 per cent in 2012-13.



Impacting margins



The major segments that will fuel growth include roads, urban infrastructure and power transmission. With close to 100 per cent construction intensity (proportion of construction in total project cost), the roads sector continues to be the highest contributor to revenues.



The structure of the industry, too, is gradually changing due to demand dynamics, and impacting player revenues and margins. In the past 10 years, the BOT (build-operate-transfer) model has found greater acceptance in infrastructure projects such as national highways, ports, airports and power generation units. (A BOT model is a public-private partnership wherein the investments to develop the project are made upfront by the developer, who also later operates it for a pre-determined period. At the end of this period, the project is transferred to the public entity.) As a result, the size of the BOT opportunity in construction is expected to only increase, and EPC (engineering, procurement and construction) players with an established BOT presence will garner a larger share of the business.



Because BOT projects require huge investments, only large and mid-size players will have the financial wherewithal to enter this space. The size of EPC contracts is also growing, which will make it even more difficult for small players to bag orders. The profile of the smaller players is, thus, getting restricted to sub-contracting work in key segments such as roads and power. Increasing mechanisation in the construction sector, particularly in the execution of road projects, is also working in favour of large players because most small players do not have the requisite machinery.



The profitability of construction companies has been under pressure in the past two years due to a host of other factors. For one, the share of lower-margin segments such as roads in the overall business has risen, with the increased opportunity that has unfolded.



Second, the level of competition in the industry has also mounted significantly in the past few years. This is amply reflected in the aggressive bidding seen in national highway road projects, which has adversely impacted margins. Third, commodity prices (prices of cement and steel, which are key raw materials used in construction) have risen by an average of 12 per cent in 2011-12. Lastly, base interest rates went up by close to 70-80 basis points in 2011-12 as compared to 2010-11. Crisil Research foresees a 0.5-1 percentage point fall in operating margins in 2012-13 to around 12 per cent. The fall in net margins will be even greater due to the higher interest burden because of the increase in working capital. In the past, large players have enjoyed better operating margins than small players. During 2007-08 to 2010-11, for instance, the operating margins of large players were around three percentage points higher than those of small players, and this differential trend will be sustained in future too.



Diversifying exposure



The financial muscle and technical competence of large players enable them to diversify their exposure into segments such as power, oil & gas, and ports, where the technical complexity involved is greater. This also translates into higher margins in these segments compared with a lower-margin segment such as roads. Consequently, smaller players have greater exposure to lower-margin segments such as roads and railways. This is in addition to these players being largely involved in sub-contracting work where margins are lower.



For players to ride out the rough times, and maybe even thrive, it is important to develop and effectively leverage financial strength and technical capabilities to be able to compete strongly in both EPC and BOT projects. Due to heightened competition and the fragmented nature of the industry, there will always be pressure on margins, but this can be obviated by improving cost and execution efficiencies and perhaps less aggressive bidding.
News From: http://www.7StarNews.com

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