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G. Madhan

FOR companies in the construction industry, 2003 has been an encouraging year. Their stock prices rose sharply and outperformed the broad market indices comfortably; a portfolio of five key stocks from this sector saw a 100 per cent jump in value this year against an increase of a 46.8 per cent in the S&P CNX Nifty and 93.8 per cent in the CNX Midcap Index, which is a superior benchmark for this sector as the prominent construction companies fall in this category.

A combination of government initiative to develop the country's infrastructure and the housing sector boom has pepped up the prospects for growth. Companies such as IVRCL, Nagarjuna Construction and Gammon India, to name a few, have come up with fairly impressive revenue and earnings growth for the first half of financial year (FY) 2004.

Given the focus on fast-track implementation of highway projects, the likely continuation of tax incentives for housing for at least the next couple of years, the low interest rate regime, the good monsoon, in terms of quantum and spatial distribution of rainfall, and the improving trends in industrial growth and investment, the growth prospects for the construction sector appear to be bright. Besides, the thrust given in the 2003-04 Budget, physical infrastructure works in areas such as roads, railways, airports, seaports are also likely to give an impetus to this sector.

No longer sluggish

The industry witnessed robust growth during the mid-1990s, but the pace slackened by the end of the decade. However, the ambitious Golden Quadrilateral project — to link the major metros through roads, which also provided strong backward linkages for the steel and cement industries — has rejuvenated the industry.

State-level initiates, especially in Andhra Pradesh, Maharashtra, Delhi and Karnataka, have also played no mean role.

Driven by highways

Enhanced public investment in infrastructure, particularly in the development of highways, has been a key stimulant. For the development of roads, railways, airports and seaports, the Government plans to expend a whopping Rs 60,000 crore in 2003-04.

A similar, if not a stepped-up outlay, can be expected in the next fiscal, as the Government would not want to slacken investment in an election year. In the past too, grandiose plans had been outlined without being backed up by required finances and a time-bound implementation programme.

What has made a difference, especially over the past three years, is the focus on linking up nooks and corners of the country by a network of well-laid out highways in a time-bound manner that could spur economic growth; more important has been the setting up dedicated funds to bankroll these projects, which has ensured that the plans do not remain a paper.

In addition to funds through market borrowings, international funding agencies and private participation, a special cess on petrol and diesel that adds Rs 2,600 crore to the kitty (based on estimates indicated in the 2003-04 Budget), has largely taken care of funding requirements of the following two projects which would be the fulcrum of growth:

The Golden Quadrilateral Project (about 5,850 km), which is being implemented aggressively; and

The North-South and East-West Corridor projects (about 7,300 km), which is likely to provide adequate replacement once the Golden Quadrilateral project is completed next year — if work moves ahead as planned over the next couple of years.

Apart from these two projects, the Government also plans to invest in 10,000 km of roads on other highways spread over a three-year period. A third of this is scheduled for completion this fiscal.

That the progress, spurred by the special cess-based funds, has been fairly good is evident from the length of highway roads laid out. Of the total of 14,162 km of roads to be developed by the National Highways Authority of India (NHAI) over a ten-year period, 15 per cent has been completed by September 2003; work is apace on another 5,100 km (35 per cent).

... by housing too

The boost provided by the residential housing segment has been the other vital peg in the story of buoyancy in the construction industry. The sharp cut in interest rates on home loans, which are about four percentage points lower than even three years ago, tax incentives by way of deduction of up to Rs 1.5 lakh of interest from income and the continuance of 15-20 per cent rebate on the principal component of home loans have had a positive impact on this sector.

Over the past couple of years, the housing sector has witnessed growth at a rate seldom seen in the past. The about 30 per cent growth rate in disbursements of housing loans during the last fiscal as well as in FY 04 to date is indicative of the scorching pace. Most listed companies do not have a prominent presence in this space.

Robust order book

The order book position of major construction companies also confirms the sector's testimony to future growth. For instance, Larsen & Toubro, the largest construction company in India, boasts an order book of about Rs 16,000 crore. This is 32 per cent higher than its order-book level at the end of September 2002. Even mid-sized construction companies have an order book that is 2.5-3 times their annual turnover.

For instance, Gammon India has an order book about Rs 2,900 crore while Nagarjuna Construction and IVRCL have projects estimated at about Rs 1,400 crore to drive revenue growth. A sizeable order book covering revenues for at least a couple of years is vital in a business that is noted for low margins, high level of receivables and consequently, a high working capital.

Demand source shifts

The face of demand has drastically changed in the past couple of years. Demand, at present, predominantly comes from government-based projects. For instance, 70 per cent of the revenues of Engineering Construction & Contracts Division of L&T now come from government projects. A decade ago, the company's revenues mainly were dependent on private sector projects.

Mid-sized construction companies have also managed to adapt themselves quickly to this shift. For instance, IVRCL Infrastructures, which was mainly into housing sector, a couple of years back, now derives 65 per cent of its revenues from water supply projects; 98 per cent of the company's revenue also comes from government projects. Nagarjuna Construction, on the other hand, derives 95 per cent of its revenues from government contracts.

Margins under stress

The revenue growth of companies in the construction segment has been impressive in the last six quarters. The turnover of top six companies, including L&T, Hindustan Construction and Gammon India, on an average has grown over 35 per cent during the first half-year of this fiscal. However, the operating margins and the net profit margins have continued to be under stress.

Barring the likes of Nagarjuna Construction and Madhucon Projects, the profit margins of quite a few construction companies have either registered a drop or continued to remain flat. The following factors appear to have contributed to this:

The price trend of key raw materials has an important bearing on the profitability of these companies. Cement prices have appreciated only marginally in the past year — by just over one per cent, on an average. On the other hand, the price of the other critical input, steel, has been rising steadily. The prices of steel bars and rods have risen by over 17 per cent from year ago levels. This appears to have had a significant impact on the operating margins of construction companies.

The impact of such input price increase is more pronounced for companies that have entered into fixed price contracts, where an escalation clause is not included in the contract. However, the sensitivity of different players to changes in raw material costs is different. The pressure on profitability is also attributable to the nature of the projects executed. For instance, construction of roads is predominantly a high volume, low margin activity. Though the Government's initiative to construct roads has widened the revenue opportunities, margins in these projects continue to remain low. In this backdrop, to make a visible difference to earnings, companies need to aggressively pursue revenue growth. Competitive bidding, as part of this pursuit, has also exacerbated contract-price linked pressures on profitability.

With the emergence of large-scale infrastructure projects, several multinational engineering construction companies that have strong technical-expertise and deep pockets have become active. The number of local players has also risen. This too has resulted in aggressive bidding for projects.

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