VA Tech Wabag: Buy

The stock of water and waste treatment solutions provider, VA Tech Wabag (VA Tech), has been beaten down by 30 per cent since July, pushing it far below its IPO issue price. Apart from declining during the recent market correction, the stock also reacted negatively after the company's management mentioned a slowdown in its overseas operations. The reaction appears overdone.

For one, 70 per cent of VA Tech's order book is tilted towards the domestic market with the rest quite diversified across geographies. The group's multi-geography presence means that it is unlikely to be badly hit by slowdown in any one region. Two, the domestic market for water and waste treatment, both in the industry and municipal segments, continues to be robust.

VA Tech's superior technical skills and tie-up with overseas players, wherever required, makes it well-placed to tap domestic opportunities. Three, VA Tech's strong cash position and low debt status, makes it a safer mid-cap bet given the market's aversion to leveraged companies.

Investors with a two-three-year perspective can consider taking limited exposure to the stock of VA Tech. At the current market price of Rs 346, the stock trades at 10.5 times its expected consolidated per share earnings for FY-13. Factoring in a slowdown in overseas operations, we expect FY-12 performance to be muted with an expected price earnings multiple of 14 times.

Overseas exposure

With subsidiaries as well as branch offices in as many as 24 locations overseas, VA Tech's global revenues account for close to 40 per cent of sales. The overseas segment though, has seen a slowdown in revenue and orders recently due to the following: One, the political unrest in the MENA region as well as the slowdown in some of the European countries has meant slower order flows from those regions. Two, outstanding orders of about Rs 300 crore (9 per cent of total order book of Rs 3300 crore) in Libya also faces uncertainties on the execution front.

While a slowdown in overseas revenues may, therefore, be inevitable over the next one year or so, VA Tech appears to be taking the right steps to combat the same.

The company has been steadily shifting its order book to non-MENA regions, with Switzerland and Czech Republic contributing to a chunk of the order book.

Added to this, the company has made inroads in markets such as Sri Lanka, Philippines and Oman (joint venture), bagging key projects in each country; the Rs 360 crore water treatment and distribution system order in Sri Lanka being notable. VA Tech has also been judicious in not building too optimistic a picture of its order book. While it has not brought to book orders worth Rs 540 crore that it further bagged in Libya, it has another Rs 600 crore of domestic orders in hand. The company as a policy does not count orders unless the same are backed by advance money/letter of credit. VA Tech's Libyan projects are all insured for political and financial risks through export credit insurance in Austria (subsidiary location).

Domestic developments

The slowing overseas operations have meant that VA Tech needed to look inward for opportunities. The company has been successful in mooting ideas and bagging orders for water and waste treatment projects, for which there is abundant scope especially with municipal corporations. Engineering Procurement and Construction (EPC) contracts and operation and maintenance contracts for municipalities accounted for 38 per cent and 30 per cent respectively of the domestic segment order book as of June 2011.

However, long-term development and maintenance contracts are capital-intensive. As VA Tech prefers an asset-light model, the company has an alliance agreement with Sumitomo Corporation of Japan (for equity contribution with VA Tech bringing technical qualification) to tap the capital intensive Concession business model, which would provide annuity revenues and superior margins in the long term. The companies have already signed up for two projects in Gujarat.

Lower proportion of revenue from overseas also holds the risk of hurting profit margins. Conscious of this, VA Tech has been keeping a tight rein on costs in key projects such as the Chennai desalination plant at Nemmeli. In its annual report, the company has stated that it has been able to expand margins in its Nemmeli project as a result of such monitoring. Better negotiations with vendor (ABB) for equipment costs, improved design and engineering and lower bank charges for guarantees being some of the measures that can be expected to bring margin expansion in the project.

We expect this to prospectively (56 per cent revenue already booked from the desalination project) contribute to overall EBITDA margins. The June quarter saw VA Tech's standalone EBITDA margins at around 5.5 per cent. However, EBITDA margins are expected to close at around 9 per cent for the fiscal. Revenue flows and earnings have traditionally been lumpy for the company with the second half of the fiscal accounting for a chunk of revenues and earnings expansion. Investors can, therefore, brace themselves for subdued quarterly performance in September.

For the three years ending FY-11, VA Tech's consolidated revenues expanded 26 per cent annually to Rs 1,232 crore while profits soared 76 per cent annually to Rs 52 crore. Much of the growth though, came inorganically and is unlikely to be repeatedly demonstrated.

Given its low leverage and cash-rich status, the company is once again scouting for acquisition candidates either to add new technology or markets to its basket.

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