KEC: Likely to deliver strong growth  HSBC Research

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KEC: Likely to deliver strong growth
 Expect sales growth to remain strong in FY12-13, but a likely
change in project mix may reduce margins, lowering EPS growth
 We lower our FY12-13 EPS estimates by c9-10% and TP to
INR86 from INR105 due to our cautious view on margins
 Trading at 4.9x FY13e PE, the stock remains attractive even on
our conservative estimates; hence we reiterate OW


Investment thesis
KEC witnessed strong growth of c60% in its order
intake and c42% in its order book last year, which
should result in strong sales growth in FY12 and
FY13. In addition, we expect the order inflows to
remain relatively strong in FY12, driven by growth
in MENA and SAE Tower related orders and ramp
up in its smaller businesses, Cables and Railways.
Overall, we forecast order intake to grow by
c13.5% in FY12 and c28% in FY13. Given that
there are a couple of big orders in KEC’s order
book with longer lead times of c3-4 years, we have
reduced our execution rate assumptions for FY12-
14, driving our sales growth forecast of c23% for
FY12 and c19% in FY13.
We believe that its margin is likely to decline this
year driven by the change in project mix, with an
increasing contribution from the lower margin
businesses of Cables and Railways. However, it is
difficult to gauge the potential decline at this stage,
as 1Q FY12 margins did not show any signs of
weakness. We currently assume EBITDA margins
will decline by c90bps to c9.9% in FY12 before
picking up to c10.1% in FY13. We note that
weaker-than-expected margins remain the biggest
risk to our current estimates and investment case
for the stock. We are currently c25bp below
consensus on our FY12 margin estimates.
In addition, we expect the interest expense to
increase significantly in FY12 compared to last
year, driven by increased debt levels due to the
SAE acquisition. Due to the reduction in margins
and increase in interest, we forecast earnings to
grow by only c14% in FY12 in spite of much
stronger sales growth. However, we expect
earnings growth to pick up sharply in FY13 and
FY14, driven largely by the anticipated
improvement in margins.
We note that even with a moderate growth in
FY12, the stock remains attractively valued,
trading at a 6.3x FY12e PE and 4.9x FY13e PE
compared to historical trading average 12m
forward PE of c12.4x for the last 5 years). We
note that during the crisis of 2008-09, the stock
had de-rated to an average 12m forward PE of
c6.1x during the worst 8 months of the crisis

(September 2008 to April 2009). Therefore, we
believe the stock retains potential for appreciation,
even if we assume that market sentiment will
deteriorate to levels seen in the 2008-09 financial
crisis. Hence, we reiterate our OW rating.
We have revised our FY12e and FY13e EPS
down by 9% and 10%, respectively, driven by our
slightly more cautious view on execution and
margins. Consequently, we reduce our 12-month
forward target price to INR86 from INR105.
We highlight the key bull and bear factors related
to KEC below.
Bull factors
 Strong order book at c1.8x FY11 sales
 Top three companies in terms of market share
in power grid orders
 New businesses are delivering strong growth
 SAE Towers is performing better than expected
 Better working capital management compared
to peers
 Valuation looks attractive


Bear Factors
 Margin decline is likely to constrain growth
 Balance sheet remains highly leveraged, thus
increasing financial risk premium
 Relatively higher exposure to fixed price
contracts
 Significant exposure to international markets
poses currency risk
Valuation
Our target price of INR86 is derived from our
preferred EVA valuation methodology, assuming a
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 will trade at a 12-month forward
PE of c6.3x on 24-month forward EPS of INR13.6.
Under HSBC’s 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%. This translates into a Neutral
rating band of 6% to 16% around the current share
price. Our 12-month target price of INR86
suggests a potential return of c54% (ex-dividend),
which is above the Neutral rating band; hence, we
reiterate Overweight on the stock.
Risks
We highlight the key risks related to our
investment case below:
 Delay/cancellation of transmission projects
 Excessive pricing pressure
 Expensive acquisition

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