Why are India's large construction companies failing to fully capitalise on the country's vast push to improve its infrastructure? The opportunity is certainly compelling: $1 trillion of investments in irrigation, roads, power, ports, rail and other sectors are projected for the 12th Plan period (2012-2017). Our analysis suggests that even if only 65% of this investment fructifies, the opportunity for private construction firms could be $60 to $70 billion annually, resulting in over 20% growth each year.
Yet, despite this lucrative opportunity, barely a handful of construction companies have created positive shareholder value in recent years. Construction firms grew, on average, at a rate of 25-30% between 2006 and 2010. But that growth in contracts and revenue hasn't translated into shareholder returns.
We have identified several major challenges preventing many companies from delivering on shareholder expectations. Among these are short-term slowdowns in certain sectors, the rise of a new class of challengers, and the increasing complexity of infrastructure projects. To meet these barriers, we've also identified strategies that can help winners pull away from the pack. These include better capital management, expanding services into new segments, and partnering with foreign companies that may bring new skills into their portfolios. By identifying the barriers to profitability, construction firms can fulfill the promise inherent in the sweeping opportunity before them, for themselves and their shareholders.
Short-term slowdown: The construction sector faces a short-term term slowdown, as well as increased commoditisation across several business lines, marring what would otherwise be a rosy scenario. Projects in power, irrigation and rail—which form 60-70% of the infrastructure construction market—have slowed for several reasons. In power, hydropower projects are held up by environmental and rehabilitation issues, while coal shortages and lack of distribution reform are significantly delaying many coal-powered thermal projects.
These challenges may last another 12-18 months, and then the situation is expected to improve. In roads, early signs of recovery are already visible. The government has awarded projects worth around R450 billion in the first 8 months of FY12 and looks on course to reach its planned target of 20km a day within 3 years. This is significant progress, compared to the lull in road construction over the past 2-3 years.
Competition from scores of low-cost players: Lured by the sector's potential, these nimble players bid aggressively to win projects, putting pressure on margins. Aggressive pricing by second-tier and third-tier players over the past 2 years in road and metro projects forced the bigger participants to rethink their pricing strategies. In the Chennai metro bids, the winning bids were 10-15% lower than those from the next lowest bidders.
Expect more small players as private sector participation increases to about 45-50% during the 12th Plan, up from about 37% currently. We see this trend in the power sector, especially in thermal projects. One private sector thermal project attracted more than 15 bids, including one-third from relatively new engineering, procurement and construction (EPC) bidders. The recent slowdown in construction of thermal plants, due to coal supply bottlenecks, could reduce the number of bidders in the short term but, given the huge opportunity, we expect the market to become even more competitive in the next 3-5 years.
Slow growth of EPC contracts: While more projects are being awarded through the EPC route—as opposed to piecemeal contracts—in thermal, nuclear, oil and gas, and ports projects, industrial and hydropower are seeing far fewer EPC contracts. In these two verticals, customers tend to be choosier about the price they offer to vendors, preferring to break down projects into smaller packages rather than going in for large EPC contracts.
The rise in complexity: Projects are getting bigger and more complex—more than 60% larger across most verticals. New requirements such as 6-lane roads, mechanised laying of rail tracks, and taller hydropower dams compel companies to improve their engineering and project management skills. Those that don't raise their game will have to compete in less complex and more commoditised sectors.
Weak capital management: Finally, many construction companies in India have consistently failed to manage their working capital efficiently and this has been compounded by challenges around claims realisation. There are players that carry net working capital to the tune of 70-80% of annual revenue on their balance sheets. This puts a huge strain on their cash cycles, resulting in either increased interest burden or delays in supplier and subcontractors' payments, which has the cascading impact of increasing costs.
We found the following guidelines useful for construction companies looking to move ahead of the competition, and delivering consistent shareholder value and improved financial results:
Expand the addressable market: Construction companies can counter the short-term slowdown by foraying into new segments within core verticals, or by entering new verticals such as power, industrials, and oil and gas, which together account for 65-70% of the market, and are expected to grow faster than other segments. For instance, Simplex has achieved significantly faster growth in the last 5 years through strategic diversification into new verticals such as hydropower.
Focus on big customers: Potential winners should also focus on large customer accounts and implementing key account management capabilities to capitalise on increasing private sector participation in infrastructure. For instance, a leading nationwide engineering and construction firm recently implemented a customer-relationship management system to focus on larger accounts.
Track EPC projects: Companies looking to provide greater returns to shareholders should look at building EPC capabilities, with a strong focus on verticals where EPC is set to get a higher share of projects. Take thermal. Most greenfield thermal projects being set up by new private developers are expected to be awarded through the EPC route in the coming years. It is, therefore, critical for construction players to build capabilities across different thermal segments.
Partner or acquire to build new capabilities: Firms seeking to break away from the pack need to develop new capabilities such as specialised subcontracting, large project management and EPC. To do so, they must consider both organic and inorganic growth through acquisitions, joint ventures and partnerships.
This is already happening. Take the joint venture between Afcons Infrastructure and Russia's Transtonnelstroy which won two projects for the Chennai metro last year, for a total of R26 billion. Similarly, in thermal power, several Indian players have formed joint ventures with foreign technology partners to build BTG manufacturing capabilities: BGR Energy-Hitachi, L&T-Mitsubishi Heavy Industry and Bhel-Alstom, to name a few.
Manage working capital more aggressively: The best players track their project costs on a frequent basis (for example, cost-to-company methodology at each project level). This enables tight cost control on projects. Construction firms also need strong project and contract management to ensure progress as per plan, and rapid turnaround from invoicing to collection. This also minimises claims.
For construction firms looking to take advantage of the compelling India infrastructure story as it unfolds, the next few years will be crucial. The future leaders will take on these challenges immediately, while quickly implementing the actions needed for rapid growth. For the winners, the time to start was yesterday.
Gopal Sarma is a Bain & Company partner and heads the firm's infrastructure practice in India. Deepak Jain is a manager at Bain and is a member of the infrastructure practice. Both are based in New Delhi
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