Elecon Engineering Limited - A good stock to own

Company Background

Elecon Engineering Limited (EEL) is one of India’s largest manufacturer of Material Handling Equipments (MHE) and Industrial Gears and Power Transmission products. MHE systems primarily comprise of various conveyor systems. EEL is one of the largest manufacturers of industrial gears and was the first company in India to introduce modular design concept, case hardened and ground gear technology. EEL is the gear supplier of choice to core sectors like Sugar, Cement, Steel, Fertilizer, Plastic Extrusion and Rubber. They are the only manufacturers of Vertical Roller Mill Gear for the power and cement industry.

Investment Thesis

Turn around in capex cycle has meant that the order inflow has stabilized. EEC has acquired the Benzler-Radicon business from the David Brown Gear Systems Group for a consideration of ~132cr. The company proposes to fund 80% of the acquisition through debt. That means an additional debt burden of 105 cr. This acquisition provides EEL with access to European markets.

The order book is robust. The outstanding order book position on Jan 31, 2011 is 1690 crores. This includes 420 cr added in Q3 FY11. Out of this, MHE orders are 1350 cr and gears are 340 cr. EEL has also submitted bids worth 5000 cr and expects a hit ratio of 20-25%. With the existing order book, there is good revenue visibility for FY12.

Financials

	FY10	FY09	FY08	FY07	FY06
Sales	1109.36	1030.84	927.85	816.6	507.75
Other Income	18.72	-7.89	0.88	0.89	-0.32
Op Profit	168.45	180.72	154.75	123.75	73.45
EBDIT	187.17	172.83	155.63	124.64	73.13
PBT	94.68	92.05	107.57	87.76	45.48
PAT	66.18	57.45	67.2	54.9	27.88
EPS	7.13	6.19	7.24	17.75	48.85
Depreciation	33.12	22.15	14.2	12.22	9.43
Interest	58.71	58.23	33.86	24.66	18.22
Effective Interest Rate(%)	11.26%	9.83%	8.27%	8.69%	8.86%
Tax	24.14	30.65	31.47	29.5	13.09
Effective Tax rate (%)	25.50%	33.30%	29.26%	33.61%	28.78%

Assets	847.68	867.5	646	471.57	308.41
Networth	326.1	275.4	236.72	187.9	102.67
Debt	521.58	592.1	409.28	283.67	205.74
Net Block	344.34	282.91	177.15	122.27	84.55
Cap WIP	17.88	28.11	15.92	4.47	10.66
Debt/Equit Ratio	1.60	2.15	1.73	1.51	2.00
Book Value	35.12	29.66	25.49	60.76	179.87

Debt-Equity Ratio is likely to go up after the acquisition. Increased debt of 105cr would mean an additional interest outgo of around 10-12 cr.

Net Cash (Operations)	170.11	71.25	-20.22	-62.13	-40.51
Net Cash (Investment)	-60.21	-135.33	-79.32	-40.82	-41.73
Capex	84.32	140.1	80.53	43.75	104.64
Free Cash Flow	85.79	-68.85	-100.75	-105.88	-145.15
FCF/Sales(%)	7.73%	-6.68%	-10.86%	-12.97%	-28.59%

Interestingly, EEL has turned net free cash flow positive in 2010 and has turned positive operational cash flow from 2009 onwards.

Dupont Analysis
OPM(%)	15.18%	17.53%	16.68%	15.15%	14.47%
NPM(%) -- (A)	5.97%	5.57%	7.24%	6.72%	5.49%
Asset turnover(avg) -- (B)	1.31	1.19	1.44	1.73	1.65
RoA(%)	7.81%	6.62%	10.40%	11.64%	9.04%
Financial Leverage -- ( C)	2.60	3.15	2.73	2.51	3.00
RoE(%) -- (=A*B*C)	20.29%	20.86%	28.39%	29.22%	27.15%

Quarterly Results

	Q1	Q2	Q3
Sales	247.17	280.91	302.39
Other Income	0.01	0.4	20.55
Op Profit	37.91	39.96	49.65
EBDIT	37.92	40.36	70.2
PBT	19.16	19.95	48.03
PAT	13.32	14.21	36.82
EPS	1.43	1.53	3.97
Depreciation	8.92	9.75	9.83
Interest	9.85	10.66	12.34
Tax	5.84	5.74	11.21
Effective Tax rate (%)	30.48%	28.77%	23.34%

Risks

Political instability may reduce the pace of infrastructure development and may harm the growth for the company.

Input cost of steel is important for margins and any sudden and large increase in prices may impact margins.

Valuation

Stock is currently at 68.95 (NSE closing price) and PE of 19.34 (based on FY2010 EPS) and 7 (based on TTM EPS of 9.85). So, it cannot be termed as expensive. Expected FY12 EPS is around 11-12, with an estimated PE range of 10-12, the expected price range is Rs 110 – Rs 144.

I would not be surprised if I see atleast a 50% price appreciation in one year. The downside risk seems to be limited to 10%-15%.

Joke of the Day: Income tax on Satyam's non-existent profits

The Indian Income Tax department has sent a notice to Mahindra Satyam to pay up Rs 616 crores as tax on income that was later revealed to be fudged by the great magician Ramalinga Raju. The desperation of the IT department to garner revenues from whatever means possible is resulting in such hilarious acts.

Needless to say, Mahindra Satyam has said that they will contest this claim in court. So, obviously the IT department is unlikely to get any money at all on this account. What is interesting to see is the complete hands-off approach from the Ministry of Corporate Affairs and the Government of India who jumped in to put in place a caretaker management and sold off Satyam (or what remained of it) to the highest bidder. Shouldn't the Government have stepped in and instructed the IT department to stop making itself a laughing stock?

Negative Newsflow and their Impact on Indian Equities

I have not posted for a few weeks. And the markets have not gone anywhere in that time. There has been a great amount of news flow, mostly negative, from all over the world. The great disaster in Japan, revolts in Egypt, Libya and Bahrain. With the fear that it may spread to other authoritarian regimes in the Middle Eats, the price of crude has gone up. Investors are a fearful lot these days.

I am really concerned about the situation in Japan. I have a personal liking for Japan and its people as it was the first foreign country I had visited in my life. The great damage that the Tsunami and the earthquake has done is immeasurable in monetary terms. Also, I am afraid of a nuclear fallout in case the explosion in the nuclear reactors there cannot be controlled. The implications are too horrific to contemplate.

I was asked about the impact of the Japanese catastrophe on Indian equities by a friend. Here is my worst-case-scenario:

Japan is not able to contain the nuclear reactors from exploding. They would need huge financial reserves to rebuild the country and decide to sell the $800-$850 billion holding of US Treasuries. With that kind of selling, there is unlikely to be any major buyer around the corner. With no buyers, the US bond prices fall like nine pins and others join in the selling to prevent significant losses to their treasuries. If large holders of US bonds like China (which holds more than one trillion dollars) start selling it would spell doom for the US dollar. If the dollar collapses, the economic recovery process in going to be stillborn.

The revolts in the middle-east also have a important consequence on global oil supplies. If there is political turmoil in Saudi Arabia, then the cat will really be amongst the pigeons.

The tsunami of corruption issues hitting the UPA government is bringing to the frontpages issues that people knew were true anyway. It is not something that is new to the people. These, at most, will cause temporary changes to political behavior but I doubt if it will have any lasting impact. I remain skeptical on this issue.

By nature I am an optimist. So, I hope that all these will not come to pass. With that in mind, I am continuing to buy my identified stocks. The only difference is I have reduced the quantum of buying and increased the time between each buy.

I still believe that the best years for India are yet to come. So, keep the faith.