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KEC International Rating: buy; Margins are likely to improve in H2FY23

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KECI’s Q1FY23 Ebitda margin was lower than our estimate; working capital rise and losses led to higher debt levels. However, we expect profitability to improve in H2FY23F on lower commodity prices and completion of legacy loss-making Brazil projects.

EBITDA margin to improve from H2FY23F onwards, reaching ~10% in Q4FY23F: Commodity prices (in particular steel) have corrected. Current steel prices have declined by 17% from the Q1FY23 average levels. Further, the share of orders procured during the high-commodity-price regime is likely to increase going forward, thus providing further support to gross margins. Ebitda margins for civil and railways were already at ~10% levels in Q1FY23. With a decline in commodity prices and narrowing of losses in SAE, T&D Ebitda margins are likely to reach 10% by Q4FY23F.

Strong order pipeline to support order inflow growth of ~17% y-o-y in FY23F, we estimate: Management estimates a strong tender pipeline of ~Rs 1.1 trn in the near term supported by a strong pipeline in railways, T&D orders from MENA and a strong tender pipeline in the civil and oil & gas segments. With a win rate of ~20%, potential order inflows could be ~Rs 220 bn (we estimate Rs 200 bn for FY23F or 17% y-o-y growth).

Working capital (WC) levels to normalise from FY23-24F: WC is elevated at 148 days as of end-Q1FY23, due to: 1) payment mechanism-related issues at Railways (shift to milestone-based billing), which is expected to normalise by H2FY23F and 2) losses in the SAE projects. We also expect normalisation of WC levels over FY23-24F, as the share of lower-WC non-T&D segments sales increase in the sales mix.

Trading at 10.2x FY24F EPS of Rs 39.9; maintain Buy: We value KECI at 13x H1FY25F EPS (unchanged) of Rs 43.6 to arrive at our new TP of Rs 566, implying 40% upside, and maintain our Buy rating. Our target P/E multiple is based on our 18% sustainable ROE estimate. Key risks are a rise in WC, a sharp rise in commodity prices and delayed order inflows.