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Margin improvement remains key

KEC International’s (KEC) Q2FY23 revenue grew 13% YoY to ~Rs41bn, led by healthy execution across all segments barring railways. However, EBITDA margin at 4.4% (ISEC 6.4%) was impacted mainly by higher raw material and logistics cost, continued losses at SAE Towers and execution of low-margin legacy orders. However, given the reduction in commodity prices lately and completion of SAE’s loss legacy orders, margins are expected to improve gradually over FY24. In Q2FY23, net debt and working capital days remained elevated, but is expected to improve over FY24 as execution ramps and collections improve. YTD FY23 order inflows stood at Rs104.6bn, up 25% YoY, taking the order backlog to over Rs340bn (including L1 position of Rs64bn). An opportunity pipeline of Rs1.1trn indicates order intake momentum to continue. However, due to longer than anticipated delay in margin improvement, we cut our FY23E/FY24E EPS by 42%/11%, respectively and arrive at a revised target of Rs502 (Rs566 earlier). Given that most execution related headwinds are now behind, we maintain our BUY rating on the stock.

* Non-T&D led to strong revenue growth: Both T&D and non-T&D businesses of the company witnessed healthy execution with non-T&D growing at 16% YoY. Civil business grew 65% YoY Rs7.4bn led by strong execution in metros, water pipeline and industrial projects. Management expects civil segment revenue to double in FY23 on the back of strong orderbook and tender pipeline. Railways revenue declined 13% YoY. However, a healthy order backlog (Rs50bn) + L1 position in railways is likely to drive growth in FY24.

* Margins continue to remain under pressure; to improve gradually: EBIDTA margin contracted 267bps YoY to 4.4% impacted by higher raw material costs, freight costs, losses at SAE Towers and execution of low-margin legacy orders. We expect gradual improvement in margin led by improved execution, lower raw material cost and expected improvement in SAE Towers’ profitability.

* Debt and working capital remain elevated: Overall debt (including advances) decreased marginally QoQ by Rs1.57bn YoY to Rs59bn. Working capital days decreased to 148 days as on Sep’22 vs ~158 days on June’22, though still at elevated levels. Management indicated of debt reduction by ~Rs7bn by end of FY23 mainly on account of cashflow from Afghanistan, railways and civil business segments.

* Maintain BUY: With reducing commodity prices lately and gradually improving supply chain, execution is expected to pick up over FY24 followed by improvement of margins. However, factoring in weak EBITDA margin performance in H1FY23, we have lowered our expected earnings for FY23/FY24 with a revised target price of Rs502.

Valuation and outlook

The T&D business is currently facing challenges impacted by elevated commodity prices. However, management continues to drive efforts to push execution while striking a balance with reasonable margin. As execution of earlier booked orders on elevated commodity prices picks pace and legacy projects of SAE Brazil are completed, we expect the company to see expansion in margins.

The non-T&D business continues to deliver robust growth and we believe the margin profile in those segments, primarily civil, should expand as the segment matures. The company is in a strong position to harness the recent push by the government towards strengthening the infrastructure of the country.

Factoring in lower than anticipated margins in Q2FY23, we trim our FY23E and FY24E earnings by 42% and 11%, respectively.

However, given that long-term revenue growth visibility is maintained on the backdrop of robust order backlog, we maintain our BUY rating on the stock. We assign a multiple of 18x on FY24E EPS and arrive at a revised target price of Rs502 (previously Rs566).

Key risks: Any further increase in commodity prices and any incremental challenges at SAE Towers.

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