Traversing Across Sectors

Elecon Engineering Company Ltd. (EECL) is one of the largest manufacturers of material handling equipment (MHE) and industrial gears in Asia. It offers a range of products and solutions in this segment for various industries such as those related to power, chemicals, steel, plastic, elevator-making, palm oil, marine engineering, cement, sugar, mining, petroleum, coal handling and fertilisers. It also manufactures wind turbines in 50 and 60 hertz (hz) frequencies.

Strengths EECL, with its dominance in the MHE space, is a leader in industrial gears with a market share of 25 per cent. Moreover, EECL’s diverse product portfolio, which spans across almost all the industries in the core sector, helps the company distribute its risk well.
The company procures orders based on both projects and products. Products constitute 40 per cent of EECL’s existing order backlog, which will help keep margins stable as products typically have higher margins than projects. The margins of the company have remained almost stable over the last five years with operating profit margin and net profit margin averaging 16 per cent and 6 per cent respectively. According to a report by IDFC Securities, over FY13-14, margins are again expected to remain stable, at around 15 per cent, on account of efficient cost-control and rational bidding.
Being a part of the Elecon group – that largely focuses on engineering sector – adds to the operational strength of EECL in terms of sourcing some of the inputs like castings from the group companies. There is also intra-outsourcing among the group companies.
* Emtici Engineering Limited (EEL), part of the Elecon group and which holds 23 per cent stake in EECL, is the sole marketing agent for the company and markets MHE and gear division products of EECL, and also provides after sales service.
* Another group company, Eimco Elecon (India) Limited (EEIL), where EECL holds 16.6 per cent stake, is engaged in manufacturing, marketing and servicing equipment for mining and construction sectors. This gives EECL the exposure to mining and construction sectors. Several other group companies, with operations largely concentrated in engineering, give further operational strength to it.
* The company has entered into an agreement with CKIT Conveyor Engineers, South Africa, for pipe conveyor and trough belt conveyor technology, along with technology for idler frames. In addition to it, EECL entered into a technical collaboration with Renk AG, Germany, to design and manufacture gearboxes for vertical rolling mills to be used in cement and coal industry.

Growth prospects
Elecon acquired Benzlers-Radicon from David Brown Gear Systems Group, UK, along with other divisions for `1.32 billion in October 2010. The acquisition was made by the company’s 100 per cent subsidiary, Elecon USA Transmission Ltd. The group specialises in standardised gears, gear boxes, screw jacks, worm gears, and gears for heavy equipment. It has been funded through 77 per cent debt (`1 billion) and the rest from internal accruals.
The acquisition is expected to strengthen the industrial gear business of the company by enhancing its product portfolio. Further, with merely 10 per cent of the revenues from non-Indian markets in FY11, these acquisitions would offer the company a platform to grow its non-domestic revenues to a larger international base and also geographically diversify its revenue stream, especially to markets like the US, the UK, and Sweden.
* EECL also has a presence in wind energy segment. It successfully commissioned 600 KW wind turbine at Newburyport in the US in 2009. With buoyancy in the wind energy sector, EECL is contemplating introduction of multi-megawatt range of wind turbines in the near future, besides the present range of 600 KW.
* The company has a current order backlog of around `16 billion which is 1.2 times its consolidated revenues and augurs well for FY13 revenues. However, order intake in FY13 would be critical to provide visibility to FY14 revenues and earnings.

Concerns
Its profitability took at hit in FY07-09, primarily due to its dependence on core sectors such as power, steel, cement and mining. Although it managed to grow its revenue by a compounded annual growth rate (CAGR) of 21.5 per cent over five years, it was accompanied by a rise in debts which reached an all time high of `592.1 crore (FY09). However, in the past two years, debt levels have not risen much despite an increase in both execution and capital expenditure (capex), largely due to efficient working capital. Debt levels fell marginally from a peak of `592 crore to around `530 crore in FY11. According to the IDFC Securities report, the debt levels are expected to remain largely flat over the next two years as operating cash flows would suffice for both capex and working capital requirements. EECL incurred a capex of `900 million in FY12 and expects to spend `50-60 million in FY13 for capacity expansion in the gear segment.
* The MHE business is working capital intensive on account of large execution period and also a significant portion of billed amount is held back as retention money by the client. Timely execution of projects is imperative as it has a fall-back impact on EECL due to delay or cancellation of orders or in accepting delivery. This in turn may elongate the operating cycle and could put pressure on profitability.
* EECL’s working capital block is higher compared to peers primarily on account of higher inventory days (required for gear division). It maintains an inventory of around 102 days compared to average inventory days of 32.6. There is a a limited scope of its reduction as retention money rises with higher execution. However, the management is undertaking capacity expansion in the gear division to make its manufacturing process leaner.
* Order inflow momentum slowed in H2FY12 as order finalisations have been taking longer due to a sluggish macro environment and execution issues. Despite EECL’s `50 billion worth of live enquiries at hand, inflows are likely to remain muted over the next 2-3 quarters due to slower investments in industries like power, steel and cement.

Valuations
The stock’s price-to-earnings (PE) ratio is at 30.9 per cent discount to its five-year median PE of 11.7. Based on earnings per share growth of 23.8 per cent, its price-to-earnings to growth (PEG) comes at 0.3 times. Its RoCE and RoNW have averaged around 21.6 per cent and 27.85 per cent respectively over FY07-11. The near-term prospects do not seem bright for the sector owing to slowdown and deferrals in capex activity of clients. However, with an established set-up, EECL would be among the key beneficiaries of increased investments or revival of the industrial capex cycle in sectors such as power, cement, mining and steel, which contribute significantly to its bottom line. Moreover, management’s focus on margins and working capital could provide further upside to earnings. WI