Wednesday, January 18, 2012

>KEC International: Likely to continue to witness strong order growth in its new businesses (i.e., power systems, water, cables and telecoms) as the company ramps up from the current low base.

Strong visibility on revenue growth. KEC today announced new orders totalling INR12.5bn, taking the total order book to INR90bn (c2x FY11 sales). The order book is likely to drive strong revenue growth of 20-25% in FY12-13e, as the majority of these orders are scheduled for delivery over the next 18-24 months. In addition, management noted that the tender pipeline remains strong, both in domestic and international markets. Other sector players have made similar comments and believe that there is strong visibility on at least domestic transmission orders, as Power Grid is likely to ramp up its ordering activity. In addition to transmission, KEC is likely to continue to witness strong order growth in its new businesses (i.e., power systems, water, cables and telecoms) as the company ramps up from the current low base. Overall, KEC now appears likely to outperform our sales growth forecasts of 23% for FY12 and 19% for FY13.

FY13 profitability likely to beat estimates. Management estimates the overall margin on the new orders announced today at c10%. While the margin on the transmission business is likely to remain stable, the margin on new businesses is expected to continue improving (as the new orders demonstrate). Our current estimates are for the overall margin to contract from 10.8% for FY11e to 9% in FY12e due to mark-to-market losses booked in Q2 before expanding slightly to c9.7% in FY13 (versus the consensus estimate of c9.6%).

The new orders, however, suggest that KEC may beat these estimates, registering a margin of c10% in FY13. Overall, we see potential upside to our estimates going into FY13, with the biggest, albeit unlikely, risk being a further depreciation in INR. Attractive value. Our current forecasts call for EPS to surge c43% in FY13e and 38% in FY14e after a decline of c8% in FY12e, driven by the normalisation of margins due to a reversal of mark-to-market losses, the risk to which remains low. With such strong, resilient growth and a large order book, the stock’s valuation looks attractive at a c3.5x FY13e PE; therefore, we reiterate our OW rating and target price of INR80. Our target price is derived from our preferred EVA valuation methodology and implies a 12-month forward target multiple of c6.4x PE on a 24-month forward PE of INR12.5. We believe that the quarterly growth in earnings, continued order announcements and peaking of the interest rate cycle could act as key catalysts for a stock re-rating.

Valuation and risks
Our target price of INR80 is derived from our preferred EVA valuation methodology, assuming target sales growth of c9%, through-the-cycle operating return margin of c9.5% and WACC of c12.3%. Our target price implies that 12 months from now the stock should be trading at a 12-month forward PE of 6.4x (compared to the current 12-month forward PE of 4.2x) on 24-month forward EPS of INR12.5. Under our research model, for stocks without a volatility indicator, the Neutral rating band is 5ppt above and below the hurdle rate for India stocks of 11%. Our target price implies a potential return of 122.5% (including a dividend yield of 3.3%), above the Neutral band; therefore, we are reiterating our Overweight rating. Potential return equals the percentage difference between the current share price and the target price, including the forecast dividend yield when indicated.

Key downside risks related to our investment case include:

  • Delay/cancellation of transmission projects
  • Excessive pricing pressure
  • INR depreciation or commodity hedging-related losses.