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Margin headwinds ahead; retains core strengths

The 40-50% surge in steel, aluminum and copper prices in YTDCY22 are fresh margin headwinds for KEC given that ~20% of its backlog comprises of fixed price orders. That said, SAE’s losses are unlikely to continue beyond Q4FY22 which offers cushion. YTD FY22 order inflows have been robust at Rs153bn strengthening the backlog to Rs244bn (Dec-21; 1.7x TTM revenue). We maintain our execution estimates but cut FY23E/24E EBITDA margin estimates by 110bp/40bp to 8.8%/9.8% (9MFY22: 6.9%). Despite near term margin headwinds the stock appears attractive from 2-3 years’ horizon. Credible track record, good governance and diversification into technologically enabled areas are key strengths. Maintain Buy with revised TP of Rs550.

Fresh surge in commodity prices to dampen margin recovery

The pressure points exist from exposure to Steel, Aluminium and Copper in KEC’s fixed price Power T&D orders from the MENA region which comprise ~20% of the backlog. While KEC hedges its exposure to aluminium and copper, the exposure to steel remains unhedged for want of suitable hedging mechanism. Also, these hedges are usually taken upon receipt of LOA for the underlying project. This means a sharp rise in underlying commodity prices in the interim can add to margin pressures despite hedging. Domestic T&D orders and orders in the railways and civil segments have price variation clauses.

SAE’s losses to reduce on completion of legacy projects; to cushion commodity impact

SAE incurred PBT loss totalling to ~Rs4bn since Q1FY21 due to Covid related disruptions and higher input prices. KEC has had to fund losses of ~Rs2.5bn YTD FY22 in SAE. With expected completion of the 3 loss making EPC contracts under SAE by Mar-22 such losses are unlikely to continue. As such, EPC orders comprised only ~Rs2bn of SAE’s backlog of Rs12.2bn in Dec-21. The balance orders are for supply of towers which entail lower execution risks (though still exposed to commodity risks). On a yoy basis, absence of SAE’s losses should help cushion the impact of higher commodity costs on margins.

Robust order inflows improve revenue visibility; WC likely to normalize in Q4

KEC’s YTD order inflows have been robust at Rs152bn (FY21: Rs119bn) led by the Power T&D and Civil segments. KEC continues to rapidly scale up its presence in metro rail, data centres, factories, water pipelines and O&G pipelines. Order backlog at Rs244bn (1.7x TTM revenue) as on Dec-21 has strengthened. Working capital remains elevated at 141 days as on Dec-21 but is likely to normalise by Mar-22 due to seasonal improvement in collections as well as unwinding of elevated receivables from Railways

Lowering earnings on margin pressures; stock remains an attractive medium term bet

We lower our FY23E/FY24E EBITDA margin by 110bp/40bp to 8.8%/9.8% leading to EPS downgrade of 16%/5%, respectively. Despite near term margin headwinds the stock remains attractive from 2-3 years’ horizon (trades at 14.8x/10.7x FY23E/FY24E earnings). KEC is among the few credible names in the diversified E&C space with strong management, good governance and diversification into technologically enabled areas. Maintain Buy with revised price target of Rs550 (implies 14.6x FY24E EPS).

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