Falling Star - McNally Bharat Engineering Company

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With rising interest rates, liquidity is becoming a problem and the capex cycle is getting impacted. The impact of expected slowdown in the capex was clearly seen in the prices of scrips of companies which we reengaged in the business of turnkey projects and EPC. One such counter which took a severe beating on the bourses is McNally Bharat Engineering Company (MBECL). The counter has taken a huge beating since January 2008 and has slipped by 60 per cent and is currently trading at Rs 107.50. But apart from the scrip’s severe beating on the bourses, certain other developments in the recent past have prompted us to do an analysis of MBECL.The first significant development relates to MBECL’s acquisition of an engineering product company ‘Sayaji Iron & Engineering’.

According to the management, the margins of engineering products are better than its projects division. MBECL is also reducing dependency on the projects division and is planning to increase the revenues from products division. Shriniwas Singh, MD, MBECL, says “Now what we are focusing on is what we never addressed earlier and that is focusing on mismatch between the ratio of products and the projects. Products used to be small segment compared to our EPC business. Now our object is to place product division properly as EBITDA is higher there”. The company also has a strong order book of Rs 2,800 crore. In addition, MBECL is not only going for expansion of its existing plants but is also building new products’ capacities. But do all these developments make it a good buy at current levels? Our answer is, although the company is going for expansion, certain risks persist with MBECL. This includes recent issue of warrants (14.53 lakh equity shares converted recently at Rs 144.29), resulting in equity dilution. The expected FCCB conversion will result in further dilution of around 31 lakh (around 10 per cent of current equity) equity shares.

If that is not enough, it is also planning for new warrant issue for further expansion. All this will only result in equity dilution. But most importantly, its new capacities will come up only after 18 months. Hence, even though the company is planning for new acquisitions and has expansion plans, we feel MBECL is a good buy at current levels, as it may face the aforesaid issues in the short-term which may further push the scrip price southward.[PAGE BREAK]

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Understanding Business
MBECL is a one of the leading engineering turnkey project execution companies in India. The area of operation includes bulk material handling, ash handling systems and mineral beneficiation plant. In its products division, MBECL manufactures wide range of equipments used in construction, mines and metal production. As regards the revenue pattern, till FY08 its projects division contributed 85 per cent of the topline while products contributed the rest. But as far as margins are concerned, while projects division has an EBITDA margin of 7.75 per cent to 8 per cent, products division has attractive margin of 17.50 to 18 per cent. Projects Division “In projects our order book stands at Rs 2604 crore,” says Singh. The management is quite bullish on the growth of projects division and stated that, “We are quite bullish on the demand side. Our bullishness is quite visible from the fact that further bids totaling Rs 4,090 crore are at different stages of decision and we expect to finalise a substantial portion of the bid into final order”. When asked about the margin pressures due to rising raw material cost, Singh said, “Most of our contracts are covered under the escalation clause but the quantum of the escalation is not commensurate with actual inflation.” Singh, however, dispelled any major impact of inflation, saying “The impact shall be kept within minimum level to keep overall EBIDTA at the level of around 7.5 per cent”. Another silver lining is that the company is trying for some export orders. But one should note that till date contribution from exports project is negligible.

Products Division
In products division, the company manufactures equipments like belt conveyers, feeders, crushers, grinding mills, sinter plant, coke oven, rolling mills, etc. Currently the order book for product division stands at Rs 196 crore. Hence, MBECL is not only going for around of expansion at its existing plants (located at Kumardhubi and Bangalore) but is also going for Greenfield capacity at Asansol. As for the products division, Singh says, “Today, all the industries are growing and we are not able to supply due to supply constraints. As a result, user industry is going to China”. He further added, “Today, if we create a capacity to deliver, we have a wider market to cater”. As regards the expansions, Singh says, “We have doubled our manufacturing capacity in Kumardhubi and building a new factory in Asansol (West Bengal) on an area of 25 acres”. [PAGE BREAK]

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The construction of new plant at Asansol for manufacturing special fabrication used in steel and power sector is going on and the first phase of new plant is expected to be commissioned in second quarter of 2009. “Another 25 acres have been allotted to us at Bangalore and the commercial production.is expected to start in the next 18 months,” informs Singh. While the capex at Asansol estimated at Rs 25 crore, capex at Bangalore is estimateded at Rs 10 crore, to be funded through internal accruals. The company is expanding its capacities, but looking at the potential of the products division, MBECL has acquired a controlling stake of 68 per cent in Sayaji Iron & Engineering based at Vadodara for Rs 59 crore. Sayaji is engaged in manufacture of equipments like crushers, grinders, concrete mixers, material handling, etc. As regards financial performance, for FY08, Sayaji posted a net sales of Rs 62 crore and PAT of Rs 8.30 crore. MBECL is planning for expansion at Sayaji with a capex plan of Rs 50 crore, which will be funded through internal accruals without giving timeline for completion of the same.

New Acquisitions
The management has confirmed they are looking for acquisitions. “We have number of proposals, in overseas markets and we are looking at two-three companies. Some of these acquisitions are in very advanced stage and others are at a very nascent stage, but I cannot disclose these at present,” says Singh. On funding of these acquisitions, the management stated that “Although there will be no immediate dilution of equity, but new warrant issue is in offing”. He further added “There are other plans, like making our product division and Sayaji a separate company and then we may offload 20 per cent in primary markets or private equity players. This will be utilised to reduce debt”. But he added that these are just plans and nothing concrete has been decided by the company.

Certain Risk Factors
Till now, we have looked at only the positive points of the company, but there are certain risk factors also. The first and most important is the equity dilution. However, while calculating EPS we have considered the recent diluted equity; but we are unable to find the impact of new warrant issues. In addition, there are certain concerns as regards its investments in [PAGE BREAK]

Jayamkondam Lignite Power Corporation (JLPC). The auditors have noted that they cannot comment on the recovery of Rs 10.80 crore from JLPC. But management has refrained from commenting anything on that Front. Another thing is there is lot of execution risk, where the company has struggled earlier. Any delay in executing projects will impact company’s growth.

Financial Performance
As regards the financial performance, forFY09 the company expects to post a consolidated topline of Rs 1,153.20 crore and bottomline of around Rs 57.75 crore (EPS of Rs 18.57) as compared to Rs 549 crore and bottomline of Rs 22.40 crore for FY08. Now looking at the poor performance of Q1FY09, where it posted a topline of only Rs132.35 crore and bottomline of Rs 4.07 crore, we think that it is unachievable for the company. We expect the bottomline to remain stagnant giving EPS at around Rs 7.20, resulting in P/E of 14.86, which is much higher as compared to its peers. Hence, we recommend the investors to stay away from the counter as we expect further dip in the scrip price to level of Rs 80.