India Ratings and Research (Ind-Ra) believes that engineering procurement & construction (EPC) companies have been facing doldrums majorly on account of a rise in steel and cement prices, while the impact of the second covid wave on the execution profile is marginal.
Profitability Susceptible to Raw Material Price Fluctuations: The EPC sector witnessed a decline in the EBITDA by 10%-12% yoy in FY21, majorly on account of a decline in the revenue coupled with an increase in manpower management costs and commodity prices. The EPC sector had seen a recovery in 2HFY21, after getting impacted in 1HFY21. Ind-Ra in its Construction Outlook for FY22 had estimated revenue growth of 15%-20% yoy for EPC players, backed by a demand recovery along with the size of the unexecuted order book. Ind-Ra believes that the second covid wave may not result in a change in Ind-Ra’s earlier estimates, given that 1Q is generally a lean season for the EPC sector coupled with absence of any country-wide lockdown.
As per the Ind-Ra rated sample set, the cost of raw materials (CORM) would constitute around 60% of the revenue for EPC companies in FY22. However, though this proportion would vary based on the subsegment and the subcontracting expenses, generally high rated players have CORM in the range of 55%-57% against low rated players (BBB category and below) which have a higher CORM at 70%-72%. This variance is majorly on account of the ability of high rated players to perform complex projects which would contribute higher margins compared to low rated players who are majorly into subcontracting the portion of works generating lower margins. However, high rated entities would have better ability to subcontract on a back-to-back basis which would result in higher ability to pass through the volatility in raw material prices than lower rated players.
Surge in Steel Prices since FY21 is Concerning: The EPC sector has been facing the brunt of increase in domestic steel prices since FY21. Typically, the order book visibility of the EPC sector ranges between 2.5x-3x of revenues. EPC players usually try to build in increases in raw material prices in their bids by estimating fluctuations based on past trends which makes them susceptible to any sharp price surges. The recent surge in steel prices is a cause for greater concern for players who have a substantial quantum of unexecuted order book, awarded prior to FY21.Ind-Ra had considered Rebar (Delhi/NCR (12-25mm, IS 1786-500Fe)) and Rebar (HRB-400, Rizhao) FOB China as proxies for domestic and global steel prices respectively.The average domestic steel prices surged 26% yoy in FY21 and 23.5% in 1QFY21. The prices reached record levels of Rs 56,000/MT in May 2021 and dipped to Rs 52,000/MT in June 2021.
Marginal Rise in Cement Realisations; Profitability Still Intact: Cement realisations increased marginally by around 2.1% in FY21, majorly on account of supply-side disruptions due to covid-led lockdowns. Thereafter, the prices got stabilised due to an increase in demand on account of a revival in the infrastructure segment.The marginal rise in cement prices has not impacted the profitability of EPC players due to the available cushion while placing bids. While diesel, pet coke and coal prices are increasing, the prices of cement might remain resilient at the existing levels which would help EPC players to manage their quotes while placing bids.
Sensitivity Analysis: Ind-Ra did a sensitivity analysis on the fluctuation of cement and steel prices for its rated portfolio EBITDA for FY22. Ind-Ra’s assumptions include the understanding that high rating category players would have around 70% of the orders backed by price variation clauses (PVCs) whereas low rating category players would have around 35% orders on PVCs. On blended basis, out of the overall cost of raw materials, Ind-Ra's sample has around 60% contracts backed by PVCs.
Though the impact of price increase would be severe for BBB and below rated players, Ind-Ra believes that even the A category and above rated players would face the heat unless their liquidity profiles are adequate to manage their obligations.
Based on the discussions with some of the rated issuers, Ind-Ra was informed that the concerns have been tabled before the Ministry of Road Transport and the Ministry of Steel to consider the inclusion of cost escalation clauses for even the back-dated projects awarded prior to FY21. Furthermore, few companies have started working on fixed-price annual contracts with large domestic steel manufacturers to manage the uncertainties better. Some other players have started being more agile with their commodity hedging strategies.
Ind-Ra believes that EPC players with a higher quantum of unexecuted order book prior to FY21 and low ratings remain susceptible to steel price fluctuations and may see significant erosion in their margin profiles which could weaken their credit profiles in short to medium term.
