KEC International: Buy

The capex/replacement spending in the power sector across various countries augurs well for the earnings growth of KEC International, which has a presence in 15 countries globally. The planned merger with two group companies is likely to provide synergy in operations and capture market share in the telecom infrastructure space. With almost zero debt and high return on equity, the company's financials also appear superior to a number of peers in the transmission and distribution (T&D) segment.

Given the current market volatility, investors can buy the stock in small lots and use any dips to accumulate. At the current market price of Rs 542, the stock trades at 17.7 times its trailing earnings on a standalone basis; it trades at a post-merger valuation of 12.9 times its expected earnings for FY-09. Invest with a two-three-year perspective, so as to capitalise on the likely order flow from the Government spending in this sector in India and the T&D upgradation in the Middle East and North African (MENA) markets.

Strong standalone

KEC International's business operations have been robust over the last two years, with the return on equity surging from 26 to 48 per cent as a result of increased profitability in domestic and overseas projects. The company was one of the early movers in key markets such as Oman, Ethiopia and other West Asian and African markets. As a result, international orders account for 75 per cent of its order book of Rs 3,250 crore.

The company has also capitalised on the domestic scenario by moving into rural electrification and distribution segments. KEC's execution period on an average was about 14.5 months in FY-07.

The rising share of distribution projects in the company's order book is likely to lead to a further reduction in the execution cycle period.

Further, at the global level, with the Gulf Co-operation Council (GCC) and the MENA spending heavily to meet their power demands, KEC is likely to emerge as one of the key beneficiaries, as there are strong pre-qualification requirements in the region, leaving little room for new players. KEC's joint venture with the US-based Power Engineers has enabled the company to foray into the US and Canadian markets.

The replacement capex in the T&D space expected in these countries throws up further opportunities for KEC to expand its order book.

merger Positives

The company has approved a plan to merge two group companies RPG Transmission (RPGT) and National Information Technologies (NITEL) with itself.

There could be some long-term benefits for KEC through these amalgamations.

RPGT undertakes power transmission and rural electrification projects — a business similar to that of KEC. This listed company had a turnover of over Rs 370 crore and net profits of Rs 25 crore in FY-07. There are strong positives in this merger. One, KEC and RPGT share similar operations.

The merger is likely to bring about efficiencies in operating costs and create a larger tower manufacturing capacity.

Two, RPGT has a larger domestic presence with active participation in rural electrification projects. KECs order-book is increasingly tilted towards international orders.

The combined order-book of Rs 3,800 crore (excluding Rs 1,200 crore of L1 orders) would now be more diversified, thus mitigating the risks from foreign exchange transactions. Further, post-merger, KEC would have a bigger balance-sheet that would enable it to comfortably bid for projects awarded through the Build-Own-Operate-Transfer (BOOT) model.

The other group company, NITEL provides turnkey solutions in the telecom infrastructure space.

The company, with a turnover of Rs 117 crore in FY-07, recently won orders under the Universal Service Obligation (USO) for setting up telecom towers in three circles at a cost of Rs 100-120 crore.

The company would receive quarterly subsidy and reimbursement of operational costs for five years, post which it would charge the telecom utilities commercial usage rates.

Given the steady revenue stream expected from this business, coupled with the strong growth potential for telecom infrastructure business (on the back of outsourcing of such operations by utilities), integration of this company with KEC appears to be a positive diversification move.

Further, usage of common facilities (for tower manufacturing) may also result in economies.

Merger scheme

Under the scheme approved by all the three companies, KEC would issue four shares for every nine held by the shareholders of RPGT. This is fairly in line with RPGT's market capitalisation on the date of approval.

Similarly, shareholders of NITEL would get two shares of KEC for every 15 shares (of Re 1 each) held by them.

Further, as KEC itself holds shares in RPGT, this investment would be transferred to a new company called MP Power Line that would be subsequently listed. Existing shareholders of KEC would receive two shares of KEC for every 25 held by them.

Risks

As most of the spending is done by state utilities and the Centre, any slowdown in order flow as a result of political changes would affect KEC's revenue growth.

However, the company's geographical diversification is likely to provide some support to revenue flow against slowdown in one region.

Client concentration risk is high in the T&D business and timely recovery of dues could be a challenge, impacting cash flows.