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Margin drag continues

* KEC International reported EBITDAM of 4.4% at the consolidated level, which was lower than our (5.5%) and consensus estimates. Standalone EBITDAM at 6.2% surprised negatively and was down 200bps QoQ, while margin impact due to SAE was largely known. This was on account of the impact of high-cost inventory, execution of some legacy projects at a faster pace, and issues around project execution in Afghanistan. Softening commodity prices will have a positive impact in the coming quarters. Further, SAE is expected to break even by 4QFY23 and return to normalized margin levels for FY24.

* On the positive side, revenue growth was stronger at 13% YoY for the quarter, largely due to 65% growth in the civil segment. Inflows at Rs105bn YTD increased by 25% YoY.

* We have cut down our FY23 EPS by 43% due to delayed margin improvement in SAE and lower standalone margin, though long-term margin expectation (9.5-10%) remains intact. We expect EBITDAM of 8.7%/9.7% in FY24E/FY25E. We have pruned our FY24E/FY25E EPS by 8%/5%, respectively, and our Sept-23 TP stands at Rs505 (earlier Rs540). We maintain BUY on the stock.

* Revenue and inflows – Key positives: KEC International reported 13%/20% YoY revenue growth for 2QFY23/1HFY23 at the consolidated level. While T&D growth continues to be at 7-8%, civil growth at 65% continues to be the key driver. YTD order inflows stood at 25% at Rs105bn, driven by T&D, civil, and railways. Order book (Rs276bn) along with L1 currently stands at Rs340bn. T&D/Civil/Railways account for 44%/32%/18% of the order book. Given the current revenue run rate and good inflow in H1FY23, the company has increased its revenue growth guidance to 20% from 15%.

* Margin, especially standalone, was a negative surprise: SAE loss has been the key drag for the company in the past two odd years. More than Rs3bn of EBITDA loss has been realized at SAE level in the past six quarters. This is expected to break even in Q4FY23 and return to normalized margin levels in FY24. Standalone EBITDAM at 6.2% was a negative surprise, with 200bps contraction sequentially. High-cost inventory, issues in Afghanistan, and legacy projects led to the same. All these are expected to ease out in the future quarters. Hence, we have assumed EBITDAM to reach 8.7%/9.7% by FY24E/FY25E.

* NWC at elevated levels, expect normalization over the medium term: Gross debt at the end of Q2FY23 stood at Rs59.2bn vs. ~Rs44bn YoY, but it was down by Rs1.56bn sequentially. NWC stood at 148 days, which is at elevated levels. Management expects improvement in NWC to reach normalized levels (110 days) by FY24. By FY23 end, debt is expected to be lower by Rs5-7bn due to lower inventory and better collection.

* Valuations and outlook: We maintain our BUY rating on the stock with Sept-23 TP of Rs505 (earlier Rs540). Risks include delay in margin improvement.

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