By Geetanjali Kedia

Since the beginning of February 2011, one of the worst performing sectors has been infrastructure with CNX Infra Index, comprising 25 stocks, falling 9.1% when NIFTY fell 5.5%, in the last 7 trading sessions from 1^st February. Companies with 'infra' in their names, such as Lanco Infra, IVRCL Infra, IRB Infra, GMR Infra, GVK Power & Infra have nearly collapsed by 20-40% in a matter of about 30 trading hours!

So what is it that has dramatically changed in the last few days, so as to radically transform the outlook towards this sector, key for India's growth and development? We have thrown light on some keys pointers, which may help understand the dynamics of the infra space.

Firstly, its the hybrid business model of many companies, including names such as IVRCL Infra, Nagarjuna Construction, Lanco Infratech, IRB Infra, Ramky Infra, Ashoka Buildcon, Madhucon Projects, which is being punished by the market. These are essentially contracting companies engaged in engineering, procurement and construction (EPC) activities, being very working capital intensive. Lately, these companies have embarked on asset creation wherein they procure capital assets in the form of BOT (build operate transfer) projects or large land parcels for realty venture, leading to acute stress on the already scarce working capital, and  even on the balance sheet. These EPC-cum-BOT companies have not been able to manage working capital effectively, as short term funds are diverted for long term use, which leads to delay in customer payment, increase in inventory cycles and many other liquidity issues.

Second point is the order book race which these infra companies have got into.  Like the hoard to acquire land parcels by realty companies, these infra players concentrated merely on increasing their order book size in the past, to as high as 4 years, in some cases, without strengthening the execution capability proportionately. Many of these companies even started accepting overseas contracts at wafer-thin margins, in order to stay ahead in the order book race. Classic case to this is Punj Lloyd, which bagged numerable overseas contracts that ultimately became loss making or even unviable, largely due to cost overruns and bad workmanships.

The third culprit is the fixed price contracts, which generally makes up about 15% of the total order book of all these above-mentioned companies. Although these contracts incorporate escalation for price rise in key inputs such as cement and steel, they do not budget for exceptional price rises in other inputs. To give a small example, shortage of a primary input like sand, which is considered to be in amply supply, has lead to its price rising nearly three-fold in just last 3 months. Moreover, these contracts are executable over long-time horizon of 3 to 4 years. So inflation rates, which have shot-up exceptionally higher to 15-18%, as against the budgeted 7-8% by most companies, lead to severe margin cuts all across. Also, prolonged delay in project execution only adds to the manpower, interest and material costs, which companies are unable to finally bill to the clients. In contracting work, like one gets rewarded for early and timely completion, one is penalized for bad workmanship and delays, as well.

Next, surging inflation, as a pre-cursor to hardening interest rates, has only done further damaged the availability of funds as well as cost of capital. In a county deprived of basic infrastructure facilities to support rising population, tremendous capital needs to be made available. Also, since infra is a long-gestation game, all this capital needs to be effective from the long-term point of view.

Another point which needs mention is the increasing regulatory interference and diversion from stated policy documents, sometime in the guise of public interest and sometimes even otherwise. Airport developers GMR Infra and GVK Power are the perfect examples, where the regulatory bodies keep amending broad contours of contract, such as changes in fee structure, cap on non-aeronautical charges that can be levied by airport operators, policy for new airports in the vicinity of existing ones etc. leading to uncertainty of future profitability of these airport projects. We have even seen some of the annuity-based BOT projects ultimately become unviable (Bandra-Worli Sea Link) due to delay in execution, regulatory road-blocks and other such issues.

Thus, the infra space, as a sector, is going through a rough patch on the stock markets. India's infrastructure story, which experts from within the country and abroad, at some point in the past, were gung-ho about, seems to be losing sheen.

So, what can be done, or undone for that matter so that this sector can return to its previous glory? We suggest the following measures which companies can undertake in order to restore investor confidence:

1. Do away with the hybrid business model, especially the real estate bit, wherein contracting companies divert short term funds to acquire land banks and SEZs
2. Either build an execution capability commensurate with the order book inflow, or as a severe measure, curtail the order book to a pipeline of 18 to 24 months
3. Avoid, to the extent possible, fixed cost elements in the order book, so as to insulate contracts against inflation

Bottomline is that most of the infra stocks, mercilessly beaten down on the bourses, are ruling much below or at their fundamental values. It's a bad phase which the sector is going through, which hopefully, should tide over soon.