This water treatment company is turning the corner. Should you consider it?

It was only four months ago when Bangalore was facing a 20 per cent daily water shortage. Go towards the North and you will find that severe groundwater depletion in key agricultural states is business as usual. Unsurprisingly, the alarming threat of water scarcity has quickly pulled the water treatment sector up on the government's priority list. Which brings us to the industry's market leader VA Tech Wabag benefitting from the government focus.

VA Tech is among the world's top five largest desalination (of sea water) players. The company that primarily gets orders from government entities provides drinking water treatment, municipal & industrial wastewater treatment and sludge treatment. Present in over 25 countries, it earned 47 per cent of its FY24 revenue from exports. In terms of the business, VA Tech primarily builds water treatment facilities from the ground up as an engineering, procurement & construction player (EPC). It made 83 per cent of its FY24 revenue from the EPC segment. The rest was earned from the operation & maintenance (O&M) business where the company runs and maintains its clients' existing or newly built treatment facilities.

Why are we writing about this company? It's because VA Tech's share has seen a sudden surge in the last one year, zooming 166 per cent as of July 11, 2024, after remaining stagnant over the last decade. Why the abrupt optimism? What changed? Read on as we answer these questions and analyse the company's prospects.

Before the turnaround

Before getting into the recent outperformance, we briefly look at what historically plagued the company.

• It consistently reported low single-digit EBIT margins until a few years ago due to its focus on the low margin construction part of the EPC business. And partly due to the unprofitable European subsidiaries that led to an exceptional loss of nearly Rs 290 crore in FY23.
  
• High trade receivables have been a sore point. Its five-year median receivables as percentage of sales were 51 per cent!
  
• Slow execution of long-term projects and large cash tied up in outstanding receivables from preceding orders stagnated company's revenue that grew only 2 per cent annually over the last 10 years.

Change in course

The company has enacted operational changes in the last five years that have begun to reflect positively in its financials. Here's what it changed and what it is planning to do:

• Turning to lucrative segments. It has been shifting its focus away from core construction business towards differentiated service-oriented segments that include procuring equipment, designing, and implementing technology-driven work for water treatment facilities. All this falls under the engineering & procurement (EP) part of the EPC business. The EP business now makes for one-third of the EPC vertical. The shift is letting the company concentrate more on high-margin, asset-light segments like operation & maintenance or O&M. The revenue share from this segment has gone up from 13 per cent in FY19 to 17 per cent in FY24.
  
• Divesting from two unprofitable European subsidiaries. Doing this has relieved margin pressures, driving EBIT margins from 7 per cent in FY21 to 13 per cent in FY24. This has also helped the company reduce its debt significantly from Rs 613 crore in FY19 to Rs 289 crore in FY24.
  
• Big goals on radar. While revenue has long been stagnant in the past, the company expects it to grow by 15-20 per cent annually over the next two to three years on the back of its current order book worth Rs 11,400 crore. The EP segment is anticipated to further support margins that are pegged to increase to 15 per cent from 13 per cent in FY24. The company also expects the revenue share of the O&M business to rise to 20 per cent ahead.
  
• Eyes on RoW. About 67 per cent of the company's order in FY24 came from international markets. It, thus, aims to sharpen the focus on its rest of world (RoW) portfolio, especially on short-term orders, to improve payment terms and enable fast execution of projects.

Our view

At the company's current guidance, VA Tech's operating profit is expected to grow impressively by 25-30 per cent per annum over the next two years. This will be aided by industry tailwinds and the company's focus on high-margin segments and its global business. However, these positives seemed to have already been priced in given the stock's P/E ratio has rallied from 12 times to nearly 33 times in just a year.

Hence, there's a limited margin of safety in the share now. Moreover, its tryst with high receivable days that peaked at 254 days in FY24 is not over, even as the company expects them to ease in FY25. VA Tech's heavy dependence on government spending and orders remains another key risk, along with its history of high debt and cash collection issues. Lastly, the company's large overseas presence dictates its profitability. A repeat of what happened in its European ventures elsewhere can be a severe drag on the company.

Also read: This company's Q4 net profit grew a staggering 45x! How did it pump out such gains?