Kalpataru Power Transmission Ltd...Initiating coverage with a Buy recommendation

Kalpataru Power Transmission Ltd (KPTL), with a presence across transmission, railways and construction segments, continues to benefit from the ordering pickup in capex by railways, SEBs and few private players from power transmission side. The company has seen order inflows of INR 74.50 bn in FY16, which is more than the order inflows for FY14 and FY15 combined. We expect the KPTL and JMC to further benefit  massively from the current boost to the infrastructure  sector, although JMC’s road BOT projects continue to make operational losses. We rate KPTL with a Buy rating, based on SOTP valuation of INR 322, a potential upside of 28%.

Robust order book to propel core business: Kalpataru is witnessing a substantial order wins in its core business both locally and internationally (>2.0x book to bill ratio). Such a strong order book ensures substantial revenue growth visibility. Improving prospects on railway capex provides us further comfort on the growth potential of KPTL over the longer run.

Improved  working  capital  efficiency  helping  deleverage  balance sheet: Kalpataru has been able to consistently able to cut down on its debt (3rd quarter in a row). The company’s debt stood at INR 5.3 bn at the end of Q1FY17 as against INR 7.75 bn in Q1FY16. We expect the company to benefit due to improved working capital situation with release of retention money, decline in inventory and increase in creditor days. We expect the interest expenses to also decrease going forward as the company repays debt. At consolidated level, we expect the company to benefit from sale of operational non-core assets and as the losses at Shri Shubhal logistics are cut with tweaks in the business model.

Valuation, Recommendation and Risks:

We value Kalpataru using SOTP methodology and arrive at a consolidated fair value of INR 322 per share with a potential upside of 28% from the current price of INR 252 as on October 5, 2016. We thereby assign a ‘Buy’ rating on the stock.

Risks:Geopolitical stability, Customer concentration, Execution delays due to Right of way & Environmental issues, Forex fluctuations.

Company Brief

Kalpataru  Power  Transmission  Ltd  (KPTL)  is  the  flagship  company  of  the  Kalpataru  group, with  a presence in the setting up of transmission lines, EPC (Engineering, Procurement and Commissioning) of infrastructure segments like oil/gas pipelines & railways and biomass energy (owns two power plants with combined capacity of 15.8 MW). The company is a leading EPC player in power transmission lines, offering integrated solutions from designing-to-stringing of upto 1,200 kv towers and is present in over 40 countries. In addition, under the transmission segment, KPTL owns three BOOT projects - an operational asset at Jhajjar and under-construction assets in MP and West Bengal. The company also owns two real estate development projects 1) at Thane which is completed and 2) at Indore, residential cum retail project which has been launched for sale.

KPTL holds a 67% stake in JMC Projects. With a workforce of 3000 professionals, JMC is primarily engaged in the construction of industrial buildings, government buildings, residential and commercial complexes. Recently, JMC ventured into the infrastructure segment, with projects in roads and bridges. Under JMC, KPTL owns four toll collecting BOOT assets.

Through its 80% stake in Shree Shubam Logistics, the company operates in midstream agri-commodity value chain. The company has wide network of ware houses across Rajasthan, Gujarat, Madhya Pradesh and Maharashtra.

Investment Highlights

The Government push along with the latent demand bodes well for the KPTL T&D segment

India faces irregular power availability across states. Some states in the northern and western parts of the country have surplus power, while some states in the south facing shortages. This mismatch offers a tremendous opportunity to the transmission players. In addition, the current National Democratic Alliance (NDA) government has made boosting power generation a key policy priority and is aiming to double electricity generation to two trillion units by 2019. The centre has set a target of bringing 24x7 ‘power for all’ by fiscal 2019. However, it’s the India’s T&D sector that has remained under-invested. In an ideal scenario, investment in the T&D and power generation segments should be in the 1:1 ratio. But, the long-term average ratio between investments in power generation capacity addition and T&D segment over CY51-96 has remained abysmal 1:0.45. In the X and XI Five-Year Plan also, the ratio of investments has remained in the same range. And if the Government’s power for all by FY19 is to be achieved, T&D investments have to come through. In addition, it is understood that currently there is no major problem with power generation (with enough availability of coal) but with transmission as the entire power produced does not reach the consumers due to 25% leakage in AT&C (aggregate technical and commercial) losses. The government is focused on plugging this leakage, which can be done by privatization of T&D to bring in efficiency. 

T&D spending in India is expected to be around INR1, 800bn and INR2, 500bn over 12th and 13th Plans. It augurs well for KPP which has maintained market share of 12-13% over the past 5-6 years in Power Grid Corporation of India Limited (PGCIL) ordering. KPP remains the front-runner in the power T&D EPC sector, and hence, is well-placed to leverage from the opportunity.

Furthermore, KPTL also benefits from the planned capex of US$ 135bn and US$61bn to be incurred during 2014-30 in Africa and Middle East respectively (source: World Energy Investment Outlook, 2014). The expansion in regional transmission network in Africa and Middle East will supplement domestic demand and presents a large business opportunity. Moreover, funding for these orders are pre-arranged through large international financing institutions and multilateral agencies, thus virtually eliminating the risk of defaults or payment delays. It’s worth noting that KPTL didn’t faced any cancellation/delay in transmission projects in the Middle East, which was reeling under the impact of low crude oil prices.

Robust order book momentum ensures revenue visibility

At the end of Q1FY17, KPTL’s order book stood at INR 91bn (2.08xFY16 revenues), implying nearly 2 years of strong revenue visibility. The outlook for order inflow for this year is expected to be strong as many orders are expected from PGCIL and SEB’s (Tamil Nadu, West Bengal, Karnataka and Gujarat). PGCIL has placed transmission line orders worth INR 215bn for the 12th plan (from April 2013). KPTL ranks third in terms of share of PGCIL orders after KEC International and L&T. The entry barriers at Extra High Voltage (EHV) level projects and strict working capital conditions by PGCIL has resulted in top four players accounting for more than 60% share of the orders. 

Moreover, in FY16, KPTL successfully forayed into new geographies like Malawi, Afghanistan, Botswana & Mauritania after consolidating its position in the African markets where the growth outlook remains robust. The orders from Middle East and African countries where KPTL has strong presence are further expected to get a boost and we expect order inflow from the overseas market to remain sound during FY17 as the export markets are likely to improve. The company is also witnessing healthy traction in the Railways segment as well where KPTL expects an order inflow of about INR 80-85bn in FY17e. 

The company is witnessing a respectable traction even in JMC projects. The value of the order booked during FY 2015-16 was about INR 31.55 billion and value of order on hand as on March 31, 2016 stood at around INR 61.49 bn. The order-book stands distributed in Infrastructure (Urban Infra, Water & Area Development etc.), Buildings (Housing, Commercial, Institutional, Hospital etc.) and Industrial segments. In addition, JMC also has an L1 position of INR 12 bn in mid-August (post 1Q17). Current order book along with L1, gives strong visibility of future revenue growth. We believe the company has sufficient order book position to achieve the growth in both top line as well as bottom line in the coming years. Furthermore, the company has already entered into international business by securing a road project and is looking for other opportunities in International markets.

However, the company remains stressed at consolidated level

Although the company’s financials at standalone level are impeccable with significant revenue and net income growth over the last few years, the consolidated net income has taken a hit and is de-growing since 2012.

The financials at consolidated levels are affected by loss making subsidiaries especially Shri Shubham logistics and the four BOT projects under JMC projects. As the road BOT projects and Shri Shubham logistics were incurring losses due to execution delays and trading activities respectively.

Nevertheless, all the four road projects have started generating revenues on a full stretch recently and are expected to contribute positively once the operations normalize. In addition, Shri Shubham logistics which was affected by underutilization of its warehouses is expected to benefit once utilization improves due to higher availability of crops on account of better monsoon. Also, the company has rebuilt the core team at Shri Shubham which should be in place by the end of 2QFY17. Furthermore, the company is not expected to take any incremental debt any further given the significantly improving working capital efficiency at the standalone company.

Valuation

We believe that the company and the sector are benefiting from the global trend towards increased investments in the end markets. On one hand, we expect the global transmission and distribution sector to keep growing while on the other hand, we expect the domestic construction market to see renewed interest due the current government’s push to infrastructure projects. These trends bode well for KPTL standalone and JMC projects. We also expect Shubham logistics to cut down on losses as it prunes its business model. We believe given these triggers, the stock is available at an attractive valuation wherein the current valuation factors in just the core standalone business with all the other business segments ( JMC, SSLL, Road BOT, Transmission BOT and real estate) being available for free. We recommend BUY on the stock with a target price of INR 322 based on SOTP valuation. Our target price implies a potential upside of 28% from the current levels. 

We have adopted a SOTP method to arrive at our price target of INR 322. We have valued the standalone EPC business at 13x FY18E earnings while KPTL’s BOT projects have been valued using capitalization method. We used used FCFE method for valuing Real Estate projects.

1) Jhajjar KT Transco - Asset is operational since March 13, earning INR 540 mn annuity. We have assumed on a regular basis, the asset would earn a net margin of 26%; assumed INR 340 mn annual expenses (WACC =11.5%)

2)  Kalpataru  Satpura  Transco  - The expected annuity revenues of approx INR 38 cr. We have assumed INR 28 cr annual expenses on a regular basis (WACC = 11.5%)

3) Thane Realty Project - The company is earning INR 120 mn on leased space (60%). Using FCFE (WACC =12%, growth rate (a tab above inflation = 7.5%), and then subtracting Long term debt and Long term liabilities, we arrive at a value of INR 1.11 bn for Thane project.

4) Indore Realty Project - The saleable area of the project is around 0.42 mn square feet. We have assumed a rate of INR 6,000 per square feet; we then subtracted the liabilities from value of operations and arrive at a value INR 630 mn for Indore project.

JMC Projects standalone is valued for its 67.2% ownership based on 8x FY18e standalone earnings. We value all the four JMC BOT projects at 1.0x the company’s investment in those projects.

Currently the company trades at 1 year forward multiple of 20x (on consolidated basis), which is significantly above the average multiple of 12.2x and is also more than +1sd. However, as the company monetizes the loss making BOT projects, streamlines operations at another loss making subsidiary (Shri Shubham Logistics), and with improved working capital efficiency along with decreasing interest expenses as the company deleverages, we expect the bottom-line to improve significantly going forward and thus we think the stock is available cheap even at these levels.

Risks

1)  Power  T&D  investments are executed by state utilities, which, in turn, are mandated by the government. Hence, any change in the political environment can potentially impact the pace of execution in the industry, thus impacting the timing of revenue growth.

2) Customer concentration risk is high in the business, which in turn, impacts the bargaining power of transmission tower companies. Order book on March31, 2016, carries order of INR 14.30 bn crore form PGCIL which is approx. 20% of the total order size of the company at the end of FY16. PGCIL is one of the key clients of Kalpataru and any deferment or cancellation of projects could directly hit Kalpataru’s prospects.

3) Execution delays due to Right of way (ROW) & Environmental issues: Although Preservation and promotion of environment is of fundamental concern in all business activities of KPTL. Any environment issue can delay the execution time of the project which can impact revenue and margins of the company.

4) Stalled & Delayed Projects: Projects worth USD 160 Billion were stalled as of December 2015, due to delays in project approvals and raw material non-availability etc. issues. Further delays in restarting stalled projects has strained some of the infrastructure companies’ ability to meet their debt obligations, leading to a surge in banks’ gross Non-Performing Assets (NPA). The government along with the RBI has been taking initiatives to address the NPA problem.

5) FOREX rate fluctuations: Kalpatru’s T&D division realizes about 45% of its revenue from its overseas business, any adverse movement in a particular currency can adversely impact financials. In present uncertain time, it becomes more difficult to judge the market can take appropriate decision.

6)  Intense  competition: Multinational companies have made a comeback in power transmission projects in India, with parent companies of Alstom, ABB and Siemens picking up big-ticket orders following aggressive bidding. Aggressive bidding is likely to continue even in 2017, given that these companies are keen to secure more orders in India to offset the impact of slowdown in their local markets, according to sector players.

7) Volatility in raw material prices: Company’s business is significantly dependent on availability, cost and quality of the raw materials and fuels for the construction and development of projects taken. The principal raw materials include steel, zinc, aluminum conductors, copper, diesel oil, concrete, cement, metal, ballasts, reinforcement bars, electrodes and valves etc. Prices and supply of these are varied due to economic conditions, competition, production levels, and import duties etc.

Is it the right time to invest in EM equities?

In recent years, emerging markets have attracted significant attention from investors due to their increasing share in global economic output, stock market capitalization, favorable demographics and high economic growth expectations. Emerging markets are the developing economies with rapid growth and industrialization. These countries possess securities markets that are progressing toward, but have not yet reached, the standards of developed nations. Emerging markets typically have fewer and smaller publicly traded companies than developed markets. However, the securities markets in the developing world are also characterized by lower liquidity, less regulation, and weaker accounting standards than more mature markets such as the U.S., Japan, and many countries in Europe.

Why consider Emerging Markets for Investment

Emerging markets attract investors for various reasons including fast rapid economic growth, favorable demographics, growing consumption potential and offers a healthy investment diversification. Although emerging markets have been relatively more volatile than developed nations, particularly US, exposure to these markets can actually decrease overall volatility when returns of individual holdings diverge. Emerging markets have a potential to emerge as a solid investment avenues with an above-average returns on investments driven by comparatively better earnings growth.

Historical performance of Emerging Markets

Emerging markets have disappointed investors in recent years mainly on account of weaker commodity prices, sluggish exports and political instability amongst others. The corruption scandal in Brazil, China’s slowing economic expansion (GDP slipped from 7.3% in 2014 to 6.9% in 2015) and the oil-induced recession in Russia added to the woes of investors. Over the last five years, the MSCI Emerging Markets index, which tracks the stock markets of developing nations, has provided negative annualized returns of -4.7% as against a 12.3% annualized returns for S&P500. However, the long term returns since 2003 tell an altogether different story as the MSCI Emerging Market index has outperformed S&P500 index by ~200 basis points to fetch annualized returns of 11.0% by the end of 2015.

In 2016, the continued downtrend of emerging markets performance since 2011 has reversed as the emerging market equities have rallied 15.5% YTD this year, outperforming the S&P500 by 7.4%. The world’s foremost emerging markets – Brazil, Russia, India and China (BRICS) have recorded positive returns till date with the two cheapest and most hated Emerging Markets, Brazil and Russia topping the list. With 63.1% YTD returns, Brazil appears to be a clear winner among the emerging markets signaling the easing of political instability in the country. India, with better investment sentiments, generated 7.8% returns followed by 6.9% returns by China. Investors believe this positive reversal will continue for the next few years backed by the stabilizing commodity prices, recent developments in India and China along with easing political instability in Brazil, offering a potential buying opportunity.

Weaker dollar and dovish interest rate environment bodes well for the EM equities

The weaker dollar helps the movement of emerging markets as the performance of emerging markets is inversely proportional to the dollar index. Historically, many factors including strong geopolitical forces and higher interest rates in the US have led to the relatively stronger dollar as compared to other currencies, especially emerging market currencies. The US dollar index closed at $96.02 as on Aug 31, 2016, down 2.6% YTD. The Federal Reserve recently kept its benchmark rates unchanged in response to sluggish job creation in preceding months and discouraging economic data resulting in the weakening of dollar index. Amongst the emerging market currencies, Brazilian Real has appreciated 18.3% YTD, followed by Russian Ruble (10.5%) and South African Rand (5.0%) while Chinese Renminbi and Indian Rupee have depreciated by 2.8% and 1.2% respectively.

 

Going forward, the emerging markets tend to benefit provided the world’s major central banks continue to maintain their dovish stances on key benchmark rates. The markets seems of the view that the US Federal Reserve will keep rates low in the short term and may not ever raise them back to historical norms thereby helping the asset classes that benefit from low interest rates. An environment of negative yields also forces investors to rebalance their investments in asset classes from fixed income securities to equities in search of higher yields. Therefore, we expect emerging markets to continue to see growing interest, as US fixed-income investors seek higher yields overseas and equity investors expect capital to continue flowing into emerging economies.

India appears to be well positioned to benefit from the capital flows to emerging markets

India is one of the fastest growing economies in the world with expected GDP growth of 7.6% for FY2016-17 as against the 2.6% growth of world economy as cited by World Bank. The country is well positioned to achieve the targeted growth on account of improved governance and streamlined tax regimes, good monsoon, an acceptable range of fiscal deficit and improved investor sentiments after introduction of BJP Government led by Prime Minister Mr. Narendra Modi. 

Among major emerging market economies, India's growth is the highest and the Indian rupee has been a relatively better performing EM currency in the last few years. India has recently outpaced China as the world’s fastest growing economy and is expected to maintain the lead for the next few years as India’s emerging market counterparts are projected to grow at relatively slower pace. After recording 6.9% growth rate last year, the lowest in last two and half decades, China is expected to grow relatively sluggishly at 6.7% in 2016. Brazil and Russia are expected to continue facing deeper recessions given the plunge in commodity prices and weak oil revenues while South Africa is expected to grow at 0.6%. 

India seems to relatively insulated from the aftershocks of Brexit as it has lower export dependency on Britain as well as fiscal and monetary flexibility following improving fiscal deficit situation and rising foreign exchange reserves. This positive optimism is evident from the 17% CAGR in the cumulative investment inflows (both debt & Equity) in India in last decade. The FPI investments till Aug 2016 this year were recorded at INR335.01 billion.

The quality of governance is also improving quite dramatically after the Narendra Modi led BJP Govt came into power with majority in 2014-15. It can be evidenced by introduction of measures like the Bankruptcy Law and the Land Acquisition Bill, easing the norms for FDI, cleaning up the Indian banks' balance sheet, commitment to recapitalization, and streamlined tax regime with the introduction of uniform Goods and Service Tax (GST). The Government is committed to improve business environment in India by implementing a stable, predictable and congenial tax regime. This would help improve India’s current 130^th ranking in ease of doing business.

Demographically, India has the youngest population in the world with median age of 27 yrs, compared to 37 in China, 38 in US, 41 in Europe and 46 in Japan. More than one third of India’s current population (1.3+ bn) is aged between 15 and 34 years, out of which half of the population is aged at 24 yrs. Over the next five years, India’s population is expected to grow by 1.4%, as against 0.5% growth in China, 0.9% growth in US and 0.3% growth in Europe.

Powering its way on the road to recovery

Company Brief

Madhucon Projects Ltd (MPL) (NSE: MADHUCON, INR 49.25) is an integrated construction, Infrastructure development and management company headquartered in Hyderabad, India. The Company has its presence in multiple sectors of construction and infrastructure projects such as Transportation, Irrigation, Water resources infrastructures, railways, Engineering, Procurement & Construction (EPC), Turnkey projects, and smart city projects in India. A majority of the development projects are based on Public-Private Partnerships (PPP), operated by Special Purpose Vehicles (SPVs). The company reports its revenue through three operating divisions: Power Generation, (78% of FY15 operating revenue) Construction & Civil Engineering (12%) and Toll Collections (10%).

Power generation business has an operational 600MW (2 X 300MW) plant at Thamminapatnam and Mommidi villages, in Nellore district, in the state of Andhra Pradesh. The company is in a process of expanding the capacity to 1920 MW by 2020. Construction & Civil Engineering business includes EPC business and road construction business. The key projects under implementation under EPC business are Nagapattinam - Thanjavur Section of NH-67 and Patna–Koliwar Section of NH-30. Apart from EPC works, the company also has 1760 kms of Toll & Annuity projects under progress. In addition, the company is also developing various irrigation projects (amounting to INR 2072 crores) in the state of Andhra Pradesh, Gujarat, Maharashtra, Madhya Pradesh, Uttar Pradesh and Telangana.  

Industry Context

Indian economy is expected to grow at 7.5% during 2017, following a stupendous 7.6% growth in 2016. The expected interest rate cut this year will provide a fillip to private sector infrastructure spending. Considering the enhanced focus on this sector by the Indian Government, policymakers project USD 1 trillion investments in infrastructure sector in 12th five year plan (2012-17) with 100,000 kms of national highway by the end of 2017.

Power

Economic growth of a country is driven by energy, which powers nation’s industries, vehicles, homes and offices. For growth to be sustainable, energy must be both, resources efficient and environmentally-safe. The utility electricity sector in India had an installed capacity of 303 GW as of 31 May 2016, Renewable Power plants constituted 28% of total installed capacity and Non-Renewable Power Plants constituted the remaining 72%. The gross electricity generated by utilities is 1,106 TWh (66 TWh by captive power plants) during 2014–15 fiscal.  However, the current power infrastructure in India is not capable of providing sufficient and reliable power supply and more than one third of the country's population continues to live without power. Many reforms have been made for a reliable and cost effective supply of electricity in the country. On May 2016, the Government of India gave its approval for allowing flexibility in utilization of domestic coal for reducing the cost of power generation. Having a huge reserve of coal, it is logical to have more coal based thermal power plants in the country. In addition, the huge gap between demand and supply uncovers a number of possibilities and opportunities for growth in power generation business. 

Road construction

The infrastructure and construction sector remained stressed in FY15 and struggled to deal with structural issues and macro economic factors. Issues such as delays in land acquisition, delays in approvals, delays in payments, delays in settlement of claims, long working capital cycle etc., affected the progress of the projects and the companies. However, many initiatives taken by the Government such as formation of dispute resolution committees, faster clearances, easing financial norms and increased ordering under new viable models have created a robust financial and regulatory environment

Engineering, Procurement and Construction (EPC)

EPC is a popular model being adopted globally in many projects like road construction, roof-top solar projects, etc. Due to deterioration in the financial health of developers and limited capital availability, appetite for the BOT projects has reduced substantially. NHAI has taken cognizance of the same and started awarding higher number of projects through the EPC route. For FY17e, of the target of 10,000kms has been set for NHAI, ~50% are expected to be awarded through the EPC segment as against ~3,000kms awarded through EPC in FY16.

Irrigation

The increased allocation of funds for irrigation projects in Budget 2016-17 shows central governments’ focus on irrigation. The Central government budget this year highlighted a plan to fast track 89 projects which have been stranded, with INR170bn in FY17 and INR865bn over the next five years is expected to be spent on these projects. Moreover, states like Telangana (the company’s focus region) are also looking to aggressively spend on improving irrigation in the state. Telangana irrigation outlay stands at INR250bn (a 3 fold increase over FY16RE outlay of INR85bn) for FY17e. Increasing focus on irrigation is expected to create large opportunities for the EPC players.

Investment Positives

Power generation business is a cash cow

Implemented in two phases, Madhucon power business operates through two units (300MW X 2 units), which are currently fully operational. For Phase-I (2x 150 MW) of the Plant, the coal supply has been tied-up from Indonesia. 70 % of the Plant capacity has been tied-up on long term Power tolling basis with PTC India Ltd while the balance capacity is planned for sale vie a merchant route. Similarly for Phase-II (2x 150 MW), 50% of the capacity is tied-up with PTC India Ltd. on Power tolling basis and the balance capacity is exposed to short term market. Furthermore, the company is currently developing a 1320 MW thermal Power Plant in its Phase-III 2X660 MW, expected to be completed by the end of 2017.

Madhucon’s power business generated an EBITDA of INR 603 crores for FY14-15 (EBITDA margin of 38.8%). In addition, first unit of phase III is expected to start its operation within two years, increasing the production capacity of power plant by around 660 MW. The increase in capacity will result in a two -fold growth in revenue as well as EBITDA of the Power business. The cash generated from the Power business has hitherto been supporting the company’s loss making road construction business. We believe, the growth in the Power business in 2018 and beyond would be a key value creator over the longer term.    

Focus on fast growing EPC and Irrigation projects

Stringent funding requirements set by banks made Madhucon turn its focus back to the EPC business. This focus on low capital intensive cash contracting business along with efforts to divest stake in BOT projects and improving working capital situation would help the company reduce leverage levels. Madhucon has won two new EPC orders from NHAI, Nagapattinam - Thanjavur Section of NH-67 in the state of Tamil Nadu for an estimated value INR 397 crore and Patna–Koliwar Section of NH-30 for a total length of 33.250 kms in the state of Bihar for an estimated value of INR 598 crore. In addition, various irrigation projects amounting to INR 2072 crore are under progress in the State of Andhra Pradesh, Gujarat, Maharashtra, Madhya Pradesh, Uttar Pradesh and Telangana.

On the other hand, company is trying to divest most of its’ existing BOT projects as it struggles with liquidity crunch and has a highly leveraged balance sheets. The company has returned many highways and expressways projects to NHAI (Barasat-Krishnagar Expressways Limited and Rajauli-Bakhtiyarpur Expressways Limited) by issuing letters of termination. Madhucon has also sold its Madhucon Agra-Jaipur Expressways to Cube Highways and Infrastructure for INR 248 crores. Currently, the company is executing only one BOT project i.e. Ranchi Expressways Ltd. as the company couldn’t exit it due to some obligations. 

Key Catalysts

Debt Reduction and lower interest rates will ease liquidity and improve credit rating

Madhucon has default credit ratings ([ICRA] D) primarily due to significant delays in debt servicing owing to stretched liquidity profile of the company. Poor operational performance of BOT portfolio has adversely affected the financial profile at the consolidated level as reflected in cash losses over last few years, highly leveraged balance sheet, negative net worth and poor coverage indicators. Company has a debt of around INR 5700 crores on its balance sheet and divesting some of the BOT projects will help company in reducing its debt burden. With lower cash burn in the roads business, the company will utilize bulk of its free cash flow from Power business in overall debt reduction.

Another option to generate cash would be divesting a part of its power business or an IPO carve-out of its power generation business. Currently, power business is generating most of the revenue from the fully operational Phase I and Phase II plants, which has a combined capacity of 600MW. Company plans to commission first unit of Phase III by the end of 2017, which will have a capacity of 660 MW. Moreover with a new Central Bank Governor stepping in from September 2016, there is higher likelihood of more rate cuts which would be a silver lining for debt laden companies like Madhucon (1% reduction in borrowing costs can lead to savings of INR 60 crore (almost equal to FY16 net profit).

In addition, new project wins and positive news flow will boost the stock in the short run while improved transparency in reporting and increased control measures will help the company re-rate the stock over long term.

Major Risks

Delays in construction continues to be a concern that occurs from  factors outside the control of the project sponsors, such as land acquisition, regulatory approvals, inflation, and litigation etc., which can delay the timely completion of the project and increase in cost of project. This can result in additional funding, additional cost of fund etc. Further the Indian industry, in general, the construction sector, in particular, is suffering from high interest costs. To stimulate much needed growth in the real economy, RBI and the commercial banks have to further cut their interest rates. Furthermore, lack of lack of disclosure and transparency remains a major risk. The company has not declared detailed result for FY15-16 and its quarter results also contain bare minimum information about its business progress. The investors do not see much clarity about the projects and progress of the company which typically weighs on their investment decision.

Valuation

We value Madhucon Projects Limited (MPL) using EV/EBITDA based SOTP methodology and arrive at a consolidated intrinsic value of INR75.00 per share which implies a 2017e EV/EBITDA multiple of 6.5x. Our valuation factors in a decent growth in Civil engineering segment due to EPC and irrigation projects.

Bulk of the company’s value is derived from the power business. We have assumed conservative multiples by applying a discount of about 18% to its Power generation peers. By applying an EBITDA multiple of 6.7x to the power generation business, we arrive at an EV of INR 4,883 crores. Note that we have not considered the expected expansion in Power generation business. Many of the power deals in power generation sector have been valued at approx. 6-7 crore per MW.  In the year 2014, Adani power bought Avantha Power’s 600 MW thermal power project Korba West Co. Ltd. for an enterprise value of INR 4,200 crores, which values it at approximately INR 7 crore per MW. Another deal between JSW and JSPL was valued at 6.5 crore per MW in which JSW will buy 1000MW unit of JSPL for INR6500 crore. Considering a setup cost of INR 5 crores/MW for Madhucon existing plant’s setup cost comes to INR 3000 crores and the whole setup of 1920MW will cost around INR 9600 crores, which shows that the company (principally the power segment) is grossly undervalued.    

  

Below table shows the sensitivity of the company’s fair value with power Business’ 2017 EBITDA multiple and 2017 EBITDA margin.

VA Tech Wabag records steady performance in Q4’16

On May 26, 2016, VA Tech Wabag Limited (NSE: WABAG, INR 577.70, Market Capitalization: INR 32.2 billion) reported its Q4’16 results. Wabag reported revenues of INR 8.6 billion in Q4’16, down 5.5% YoY against consensus estimate of INR 11.2 billion, while standalone revenues declined 2.6% YoY to INR 5.5 billion. The decline in revenues was primarily due to Euro depreciation of 7% and delay in engineering approvals in Europe. EBIDTA increased 2.9% YoY to INR1.2 billion in Q4’16, a 110 bps expansion in EBITDA margin due to lower employee costs and other expenses. Standalone EBITDA (Indian operations) was up 6.8% YoY with 140 bps increase in EBITDA margin to 16.0% due to lower raw material costs and higher margin India International units (IIU) projects. Wabag reported net PAT of INR 685 million, down 2.8% YoY, due to higher tax paid during the quarter. Standalone PAT increased 8.2% YoY to INR 562 million.

On a full year basis, Wabag’s revenue increased 4.7% YoY to INR 25.4 billion while standalone revenues were up 23.2% YoY to INR 15.0 billion. Wabag reported EBIDTA of INR 2.2 billion (+4.8% YoY), with flat margin to 8.7%. However, standalone EBITDA was up 26.8% YoY with 40 bps increase in margin to 13.0%. Wabag recorded net PAT of INR 922 million, down 16.3% YoY, due to higher tax rate. While Standalone PAT was up 29.9% YoY to INR 1.2 billion. For FY17, the company has guided revenues in the range of INR 30-32 billion and order intake in the range of INR 40‐42 billion.

With improved order book position of INR 83.2 billion on the back of INR 50 billion order inflow in FY16, Wabag provides strong revenue visibility for the next 2-3 years. While issues persist related to execution and increased working capital blockage (96 days of sales in Q4’16 vs. 77 days in Q4’15) as the company provides much needed liquidity to sub‐contractors and vendors. We believe these concerns are transitory and VA Tech Wabag is taking steps to address these issues.

We believe Wabag is a good operating leverage play. With 20% expected growth in 2017 revenue and 100 bps+ EBITDA margin expansion, the net income is likely to double. At current CMP of INR 577.70 as on 31^st May, the stock trades at 20.7x 2017 consensus EPS/16.7x 2018 consensus EPS. The valuations are much below as compared to its historical valuations. Moreover, WABAG deserves a premium valuation due to scarcity of listed large cap pure-play water treatment comps. We remain positive on the stock.

Rebounding CV sales provides a springboard to Jamna

Company Brief

Jamna Auto Industries Ltd. (JAI), a INR 11.75 billion (USD 174 million) automotive parts company is an Indian multinational which manufactures and supplies auto suspension products -parabolic/ tapered leaf spring, lift axle & air suspension - mainly for OEMs in the CV segment. JAI is India's largest and amongst the world's top three players in Multileaf Springs. The company is headquartered in New Delhi, India. The company has its manufacturing unit in Yamuna Nagar, Malanpur (near Gwalior), Chennai and Jamshedpur and its products are sold in over 25 countries.

Industry Overview

Commercial Vehicle: The Commercial Vehicle (CV) segment in India which started  experiencing a down-cycle in FY13, started a recovery phase in FY15 with improving economic outlook and consumer sentiments under the new Government. Indian CV sales (including exports), managed to cut the decline to 1.3% in FY15, after a steep fall of 18.7% in FY14, with signs of recovery in the domestic CV segment and strong growth in CV exports as according to Society of Indian Automobile (SIAM). Domestic CV sales narrowed down it’s de-growth to 2.8% in the year after falling down 20.2% in FY14. Amongst CV sub-segments Medium & Heavy Commercial Vehicle (M&HCV) showed robust growth while the Light Commercial Vehicle (LCV) continued to experience slowdown. CV exports rebounded back to positive growth territory reporting a 11.3% growth in FY15. The CV exports have grown at 5-year CAGR of 13.8% generating a healthy 12.2% share of CV production in FY15. Consistent growth in the auto component exports is an indication of growing credibility of ‘India made’ components. The Medium & Heavy Commercial Vehicle (M&HCV) sub-segment, including export sales, bounced back to robust growth of 17.4% YoY in FY15 after two years of decline. In addition, with the presence of MNC players, as the industry places increased importance on technologically advanced and value added products, the component makers remain in a sweet spot. Also, the aftermarket will be an important growth and profitability driver for the industry with customers’ preference for quality branded products.

Auto Components: According to Automotive Component Manufacturers Association of India (ACMA), Auto component sector is estimated to cross $110bn in turnover by 2020 driven by rising domestic demand in the OEM market, expanding replacement market and plans of major global OEMs to make India a component sourcing hub for their global operations. ACMA estimates the auto component sector to grow a minimum of 8-10% in FY16.

Investment Positives

Commanding position in the market: Jamna Auto Industries (JAI) is well positioned in the leaf spring and air suspension space given its dominant presence in parabolic leaf spring market. Jamna corners 90% of the country’s parabolic leaf spring market share. JAI caters to commercial vehicle manufacturers and has a strong customer base (TATA, Mahindra, VW, Isuzu, Volvo etc), in addition to being a pioneer in the leaf spring space. Company generates 80% of revenue from India. The domestic CV sector is estimated to grow in double-digits – 10-13% by SIAM with M&HCV segment on sustainable up cycle. The on-going recovery in automotive sector augurs well for JAI. ICRA research estimates M&HCV segment to grow 12-14% in FY16 driven by replacement demand, stronger growth in infrastructure, mining, and industrial sectors, and move to BS-IV emission norms from October 2015 onwards leading to new demand. We believe the new reforms and initiatives by current government’s ‘Make in India’ campaign is expected to make India an automobile manufacturing hub. JAI is well-positioned to maximize growth and returns as it develops new growth drivers in higher margin replacement market, new value added products aided by strong cash accruals and strengthened balance-sheet.

JAI has emerged as a pioneer in adoption of new technologies buoyed by its extensive in-house research & development programmes. Company’s focus on R&D innovations has always been a priority. JAI also enters into partners with global leaders like Ridewell Corporation, USA, with whom it has collaborated for design and manufacturing of Air Suspension and Lift Axles. Over time, the company is witnessing an increase in the value of its products per vehicle. With increased adoption of portfolio of new generation products in India, we see this growing further.

Consistently strong financial performance

The company has reported strong financial numbers for FY15-16. JAI reported a top line growth of 15.2% in FY15-16 with an EBITDA margin of 12.7%, up approx. 385 bps YoY. The increase in the margins was primarily due to lower Brent crude and commodity prices. The company intends to maintain an EBITDA margin of 12.5% in the coming years and also intends to become a zero debt company by 1Q16-17. 

Catalyst

“Make in India” and “Smart City” projects push in the right direction to make India 3rd largest market for automobiles:

Indian Automotive Sector is a significant contributor to nation’s progress. As per SIAM’s Automotive Mission Plan 2006- 2016, the Indian automobile industry accounted for 7.1% of India’s GDP, 27% of India’s Industrial GDP and 4.3% of overall exports, second only to textile and handicrafts in FY14. The Government is committed to make India the third largest market for automobiles by 2016, behind only China and the US, making the sector a top priority under its ‘Make in India’ program. In order to push local manufacturing, in the Budget 2015-16, the Government increased the effective tariff rate on imported commercial vehicles from 10% to 20%, making the import of completely built units expensive. Other initiatives like reduced corporate tax rate, infrastructure focus and GST implementation will indirectly benefit the sector.

Margin expansion to drive earning growth

Given the high cyclicality in JAI’s revenue trends, EBITDA margins have also been quite volatile. The company’s average margins over the past 10 years have been at 9-10%. Now, on a medium to long term basis, JAI is hopeful that its products and market de-risking strategy will improve margin trends. An increase in the share of the aftermarket/exports, along with thrust on ramping up value-added products (parabolic springs, lift axles, etc.) will drive a structural improvement in JAI’s margins.

Key Risks

The cyclical nature of CV industry has led to significant volatility in JAI’s margins and earnings trajectory on historical basis. The company is attempting to partially mitigate the risk in two ways: (1) Growing revenue mix from non-cyclical segments and expanding its revenues from high value-added products and (2) lowering its break-even utilizations to protect significant margin erosion in down-cycle years.

JAI has a high concentration which is a key risk to the company. Tata Motors and Ashok Leyland together account for almost 65% of the company’s revenue. The long-standing consolidated nature of the Indian CV market has been an inhibiting factor for the company to de-risk its business. Nevertheless, traction in aftermarkets/ exports will provide diversification avenues for the company.

Valuation

Jamna Auto currently trades at a P/E of 17.4x (on CMP of INR 146.7), which is above the industry P/E of 16.4x. We believe the company deserves to trade at a premium to its peers (and historical valuation), given its strong earnings outlook, steady diversification of revenue base with increasing share of non-cyclical segments, lesser volatility in margins due to lowering break-even utilization and top quartile return ratios among auto component companies.Rebounding CV sales provides a springboard to Jamna.

We continue to love EROS

Eros stock witnessed a significant decline from all time high levels of INR 635 in mid-July 2015 to about INR 173 currently and is trading below its October, 2010 IPO price of INR 175 per share. The sharp correction was due to concerns raised by a short seller over accounting practices followed by the parent company (Eros International PLC). The major issues were 1) the stark increase in receivables owing to increased business exposure to UAE, 2) validation of the Eros Now user base and 3) the future cash flow viability. The parent has provided a point-to-point rebuttal to the concerns followed by Eros International’s announcement of a completion on March 21, 2016, of an internal audit review with the assistance of Skadden Arps Slate Meagher & Flom LLP. The review covered analysis of company's financial reporting areas which includes its UAE sales and revenue, amortization policy of intangibles, related party transaction with Eros International Media. Eros International got a clean chit in an independent internal review, thereby reinforcing confidence in the company's accounting policy, practices and disclosures (stock was up merely 5% on this announcement on the day of the announcement).

Eros International’s results are scheduled to be out on May 27. The company has remained confident of not having done anything wrong in this entire saga and has taken all the necessary steps to address the concerns raised by bears. While Eros currently trades at a very low one year forward PE ratio of 5.8x (vs 9.0x for its peers), we believe the concrete triggers for the company’s re-rating are- the improvement in receivables, a clear transfer pricing deal with the parent coupled with other steps such as announcing dividend payment and a possible share buyback- that would revive confidence levels in the stock. 

VA Tech Wabag - A potential multi-bagger in a niche and strategically important industry!

Company Overview

VA Tech Wabag (Wabag), a INR 32 billion (USD 480 million) pure-play water treatment company is an Indian multinational player operating in the business of water and waste water treatment solutions both in India and other emerging markets (Asia, Africa, Middle East and Central & Eastern European countries). The company provides a complete range of water and waste water treatment solutions, with product offerings spread across municipal drinking water, municipal sewage, industrial water, industrial effluents, desalination and recycle. It is a technology driven company with more than 100 patents with R&D centers located in India, Austria and Switzerland. It has a strong track record having executed more than 2300 projects executed over the last three decades.

Industry Context

Water Treatment: In the Indian context, the treatment of water has a strong business potential. A rapidly growing population demanding more water per capita (140 liters per capita per day) along with inadequate conservation & rain water harvesting has resulted in severe water shortage; a major cause for concern for the government and local municipalities across the country. Water being a scarce resource, conservation and preservation has been an area of focus for public and private sector enterprises across the globe. Governments across regions are also laying special emphasis in this direction and hence business traction is expected to improve further in the years ahead.

Sewage Treatment: Sewage treatment is currently has not been handled efficiently, however it’s now one of the top priorities for the Government in pursuit of its ‘Swacch Bharat campaign’. India is likely to spending large sums on sewage treatment, irrigation and water recycling in the forthcoming years. Central Pollution Control Board (CPCB) has reassessed sewage generation and treatment capacity for Urban Population of India for the year 2015. As per CPCB, Sewage generation is estimated to be ~62000 MLD and sewage treatment capacity developed so far is only 23277 MLD (approx 38% of demand) from 816 STPs. Cities and towns do not have adequate system for sewage collection and treatment; thus the entire waste water either falls into rivers/ lakes or remains inundated on land, causing potential risk of ground water contamination.

Furthermore, additional opportunity is expected to come under way by way of AMRUT project (earlier known as JNNURM) from various municipal corporations and state governments, Smart cities program and Namami Ganga project (It’s a hybrid-annuity based PPP model  with a INR 250 billion allocation to be committed in next 2-3 years).

These factors ensure a strong business opportunity for the VA Tech Wabag. VA Tech Wabag competes against global payers such as SIIC Environment Holdings Ltd, China Everbright Water Ltd., ELL Environmental Holdings Ltd, Sino Thai Engineering and Construction PCL and Politeknik Metal Sanayi Ve Ticaret AS in its target market and against Indian companies such as Eco Recycling Ltd, Ion Exchange India Ltd.

  

Investment Positives

1. Improved Order book position: With an improved order book position of INR79.5 billion (USD 1.2 billion), Wabag provides investors with revenue visibility for the next 2-3 years (INR 24.4 billion in FY15). Despite a challenging environment, Wabag has won orders of INR50 billion in FY16 (a beat versus company’s earlier guidance of INR35-37 billion). The beat was primarily driven by two large orders worth INR13 billion announced in March 2016 - the INR6 billion ((USD90 million) order for a water reclamation plant at Chennai and an INR7.3 billion (USD108 million) integrated water supply scheme for Polgahawela, Sri Lanka. The order book has been growing at a faster pace, although the company is now focusing on high value orders coupled with higher margin profile.

2. Asset light model: Wabag is a technology driven company and has an asset light business model, as it outsources bulk of its non-core activities such as capital intensive construction business, to external vendors. The company is currently reaping the benefits of amounts spent on in-house R&D activities and patents developed by the overseas subsidiary over the years.

3. Geographic and Customer diversity: VA Tech Wabag’s products and services are offered to a wide range of customers spread across different industries and geographies. This cushions the company against any long term adverse impact on its business performance as revenue is diversified across customers and geographies. On the flip side, presence in multiple countries exposes the company to operational and Government risks. VA Tech Wabag has taken many steps towards consolidation of sites and to mitigate the risks. The company has created a team specifically to ensure project closure and collections (with delineated closure-related incentives). Moreover, the company has set minimum contract size standards for various segments (for instance, INR500 million for Indian municipal contracts and half the amount for international projects).

Reasons for the recent stock underperformance

Wabag has declined 55% from INR943 on 18^th March 2015 to an intermediate low of INR421 on 1^st March 2016. The reasons for this fall are lower margins, euro depreciation versus INR (11% decline in FY16) and excess cash which depressed the company’s return ratios.

· The company's FY16 margins were impacted by low margin overseas projects (low-margin Turkey STP O&M contract for INR3 billion (6% revenue contribution in 9M FY16)) and higher provisioning (INR300 million provisions for Al Gubrah’s projects).

· Wabag has a significant amount of cash, almost INR2.1 billion (as of Sept. 2016) of cash. The company hasn’t been able to put this cash in use for acquisitions and hence this has depressed the return ratios.

Catalysts

Strong inflow growth along with steady project execution to result in robust revenue growth trajectory

Wabag’s order inflow is likely to be driven by domestic orders in FY17, with projects like Namami Gange, Atal Mission for Rejuvenation and Urban Transformation (AMRUT) and finalization of large municipal water and desalination projects across Mumbai and Chennai. This along with order wins in FY16 should result in an acceleration in topline growth in FY17 and FY18. Growth will be led by execution of large orders such as Petronas project, AMAS, Bahrain, Istanbul O&M and Dangote etc. Notwithstanding benign crude oil prices, projects in which Wabag operates have not been impacted.

Margin expansion on cards, cash conversion to improve

Wabag has traditionally struggled with margins in a few large projects (Turkey STP O&M, APGENCO contracts). Going forward, margins would steadily improve due to better EBITDA mix projects, higher revenue recognition of key projects, rising revenue share from O&M along with focused efforts on site closures and collections. In the last few years, profits growth has lagged revenue growth. This is likely to reverse with expected margin expansion, operating leverage from normalized depreciation, which should result in higher PAT growth.  Margin  and  cash  conversion  will  be  boosted  by  growing  share of Petronas project revenues and focused efforts on site closures and collections.

Key Risks

FX risks

VA Tech Wabag operates in international markets and hence is exposed to currency movements, however is naturally hedged to some extent as most of the costs are also incurred in local currency of the respective foreign country. Based on its target markets, it is faces FX risk from euro depreciation

Geopolitical risks – Ability to execute projects in tough geographies

VA Tech Wabag operates in different countries and hence any geopolitical instability in a country of operation (e.g. Nigeria, Turkey etc) or surrounding countries might impact its business and repatriation of funds could be a challenge.

Valuations can re-rate

Wabag has traded in the P/E band of 20-30x and P/B of 2-3x till FY14. However, in FY15, stock rerated on account of the Indian government’s thrust on water conservation and initiatives undertaken to improve the quality of water, and reached P/E of 50x. However due to global pressures and volatility in financial markets coupled with some delays in the execution of few projects, the stock has corrected substantially in FY16. We believe that this correction should be used to accumulate the stock as it provides substantial upside from current levels over a 2-3 years time frame. At current CMP of INR570 as on 23^rd May, the stock trades at 25.2x 2017 consensus EPS/18.9x 2018 consensus EPS. The valuations are much below as compared to its historical valuations. Moreover WABAG deserves a premium valuation due to scarcity of listed large cap pure-play water treatment comps. We believe improving margins and cash conversion metrics, would lead to a potential re-rating of the stock.

Disclaimer

Investment ideas issued by Maxim Research Pvt. Ltd, does not constitute a recommendation for any investor to purchase or sell any particular security. Any investor should determine whether a particular security is suitable based on the investor’s objectives, financial situation needs, and tax status. The investors should take note of the fact that stocks in Emerging markets like India tend to be more volatile and impact costs tend to be higher as compared to the developed markets. Maxim Research Pvt Ltd., its employees and affiliates may maintain positions and buy and sell the securities or options of the issuers mentioned herein (Safe to assume vested interest - long position on the stock). This is not a complete Research Document. All materials are subject to change without notice. Information is obtained from sources believed to be reliable, but its accuracy and completeness are not guaranteed.

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