The decline in stock prices of road companies is in contrast to the scale-up in order backlog of their construction business and contractual support from NHAI against external variables. We have done an assessment of the HAM model and the way companies have bid—which reaffirms that construction companies with good execution track-record would be able to realise the big scale-up in their backlog in revenues. We prefer Sadbhav Engineering and Dilip Buildcon on this count.
Hybrid annuity mode of award covers for external risks over full period of exposure
Unlike build-operate-toll, the hybrid annuity mode (HAM) of award aims to insulate the bidder from variation in cost inputs (inflation, interest rate) and traffic. Put in technical terms, the bidder only needs to provide an NPV of cost of construction and of O&M.
Sector is undervalued; scale-up in execution the key acid test for achieving FC
The EPC business of construction companies trades at low 9-12X FY2020e EPS. Key downside risk to estimates is from large 30-40% share of order backlog of HAM projects yet to achieve financial closure (FC). Given such projects have been bid well, the key risk that lenders would assess is the ability of the EPC contractors that are partnering with concessionaires to scale up operations to complete the said projects without any cost/time overruns. We do note the risk to financial closures of select projects based on (i) limited ability of select concessionaires to scale up operations and (ii) lending constraints. Most of the HAM projects were won in Q4FY18 and thus clarity on FC would emerge in Q2FY19.
Unwarranted divergence between stock performance and backlog performance
The recent decline in stock prices of key road EPC companies is not commensurate with the order backlog performance that these companies have shown since end-FY2017. This suggests that the market is skeptical about HAM project wins achieving financial closure. Such skepticism is unwarranted as an analysis of the recently won HAM projects by key companies in our coverage, i.e. Ashoka Buildcon, Dilip Buildcon and Sadbhav Engineering, suggests that the corresponding equity IRRs will be in range of 14-19%. Further, the HAM model inherently mitigates key risks of inflation and interest rate faced by road project developers through the escalation clause and floating rate interest payments received from NHAI on outstanding annuity balance. We believe these aspects will allow HAM projects to achieve financial closure.
