Wednesday, 23 March 2022

Contractors’ margins are under threat by rising raw material costs

How rising raw + building material prices and higher borrowing costs are expected to impact Egyptian infrastructure players, according to analysts: Building material prices in Egypt have been soaring over the past few weeks, pushed up by higher energy prices, raw materials, and freight and shipping costs, with both manufacturers and contractors feeling the pinch, we reported last week. These rapidly rising prices have extended beyond steel and cement, touching other key raw materials used in infrastructure projects — including iron ore, copper, aluminum, coal, limestone, wood, clay, brick, and sand. Add to that the Central Bank of Egypt’s (CBE) decisions earlier this week to raise interest rates by 100 bps and let the EGP slide against the USD, and infrastructure players are going to be under pressure.

Prices are already up — but probably haven’t peaked yet: Locally, cement prices have increased “somewhere around 10%” since the war in Ukraine began at the end of February, Arabian Cement CEO Sergio Alcantarilla told us. Globally, “cement price inflation this year could average 70-100%, while steel could be north of 40%,” Ahmed Soliman, head of the industrials sector at CI Capital, tells Enterprise. We’ve already seen rising inflation domestically, impacted by global price increases. “Now we’re going to see a second wave coming from the local front from the EGP devaluation,” Noaman Khalid, associate director at Arqaam Capital, tells Enterprise.

These price movements are due in large part to market uncertainty and panic, which then leads to supply disruptions, Mohamed Magdi, vice president of investment research at Beltone Financial, tells Enterprise. Many commodities are being hoarded — almost everything from coal to steel — notably in Europe, off the back of supply shortage fears. Very high energy costs will also lead to industrial production shutdowns, as we saw last year with urea production plants being shut in Europe, Magdi says.

Egyptian infrastructure companies exposed to the price changes work across several sectors: Companies working on infrastructure essentially comprise real estate companies; manufacturers producing industrial goods used in infrastructure projects — like Elsewedy Electric, Ezz Steel, or cement manufacturers — and contractors working on development projects in areas like bridge construction, desalination, or transport — usually contracted by the government, Khalid says.

Different industries will feel the impact of cost increases differently, making it difficult to accurately quantify cost increases across the board, says Soliman.

For instance, raw material costs make up only 30-50% of real estate projects’ costs, so raw material price inflation of 50% won’t translate into a 50% increase in total project costs, Soliman says.

But utility infrastructure projects will likely see a large cost increase from raw material price hikes, he says. Utility projects — like sewage treatment, desalination, power distribution and transmission — have cost structures that rely more heavily on raw materials. “Within power projects, in particular, you’d expect to see a substantial rise in the cost of the project, aligned with raw material cost increases,” says Soliman.

Within each sector, the price shock will likely hit smaller contractors the hardest, “with their margins under pressure,” Mohamed Saad, vice president of research at Prime Securities, tells Enterprise. If the situation continues into 2H2022, several smaller contractors could face bankruptcy, predicts Magdi. Many will struggle to sustain their projects in a high-price environment, associate vice president at EFG Hermes Ali Afifi tells Enterprise.

Larger contractors — like Orascom Construction or Hassan Allam — are expected to see a measure of protection, since they generally have fixed margins, meaning they won’t really be hit, says Afifi. But what could be affected is their working capital: “They’ll still have the same profitability profile, but maybe with higher debt. They might use some debt to close the financing or cashflow gap, but they’ll recover.” This is what we saw last year, when copper and aluminum prices soared, he adds.

This then raises two big questions: Who will absorb the price shock? And will projects be delayed?

Most believe larger contractors will take a big hit from the price shock, and see sizable margin pressures. “I don’t think the government will change the investment cost or contract value for its infrastructure projects,” says Magdi. Still, precisely gauging the impact on margins is challenging, because no one knows how much companies may have stockpiled building materials, he adds. One analyst who had previously thought inflation costs would be passed on to the end consumer — generally the government — reviewed their stance in light of this week’s rate hikes and devaluation. “Cost inflation is likely to be shared in the short term given the sharp cost increases,” they said, speaking off the record.

Non-government end consumers may not yet be feeling the impact of higher prices, especially if companies are repricing, notes Khalid. We’ll see very different prices in the coming months, he adds.

Expectations about how this all impacts project deliverability vary: Smaller construction projects like new malls or compounds will likely continue, but with completely repriced offerings, says Khalid. But the government’s main infrastructure projects could be delayed by a couple of months, or a year, he says. Afifi essentially predicts the opposite: That real estate projects are most likely to slow down. Larger infrastructure projects with signed MOUs, that haven’t yet started, could be delayed by three-six months, but those that have started will continue, he says.

High-impact infrastructure projects in key sectors are too high a priority to be put on hold: The Sisi administration simply won’t allow some projects, like the high-speed rail, to be delayed, believes Magdi. Water projects — including desalination and revamping our aging water network — are essential, believes Afifi. These and transportation projects are too important to see a slowdown, he adds. Any water infrastructure projects are now key to our security, and highly unlikely to be delayed, says one source speaking on condition of anonymity. Infrastructure spending remains a big priority, says Soliman.

What happened last year in the face of (admittedly milder) price hikes seems to back this up: Building material price increases seen last year didn’t actually impact contractor project deliverability, notes Soliman. Large contractors like El Sewedy and Orascom even saw an estimated increase of around 20-40% to their key project backlog last year — even with raw material price hikes, Soliman says. Orascom’s pro forma backlog increased 15% y-o-y to USD 8.9 bn as of the end of 3Q2021, while proforma new awards rose 85.8% y-o-y to USD 1.7 bn, according to the company’s earnings release.

But the impact of the price hikes on the broader macro climate could affect infrastructure project spending — at least in the short-term, some believe. Higher spending on importing raw materials will increase our current account deficit, says Saad. And now the CBE has hiked interest rates, we could expect more of a contractionary approach to fiscal policy, to control inflation. “So we could see the biggest infrastructure funding source — the government — slowing down spending, to try to temper potentially alarming inflation rates,” Saad adds. Both the government and consumers will likely temporarily reduce spending, says Soliman. We might expect new investments and new project awards to slow for a while, until there’s further clarity on global economic dynamics, he adds. “And then later, spending could resume.”

Your top infrastructure stories for the week:

  • French shipping company CMA CGM is reportedly looking into making an undisclosed investment in the Ain Sokhna port.
  • The Transport Ministry signed several agreements with Abu Dhabi Ports Group that will see it manage and operate a multi-purpose terminal in Ain Sokhna port and a river port in Minya Governorate.
  • MB Engineering EV charging subsidiary Sha7en has signed an agreement to manage and operate 30 EV charging stations owned by Revolta Egypt.
  • The 114-km canal carrying agricultural wastewater to the El Hammam treatment plant is expected to be completed in a year, said Irrigation Minister Mohamed Abdel Aty.

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