Elecon Engineering

Investments can be retained in the stock of Elecon Engineering, an established player in both material handling equipment (MHE) and industrial gears business. At the current market price of Rs 112, the stock trades at about 11 times its likely FY-10 per share earnings, down significantly from its peak of Rs 330 in January. While much of this fall can be explained by the broad-based selling in the market, the stock was also beaten down in anticipation of slowing demand and contraction in margins for the company, as there was a sharp run up in steel price during the period.

These concerns have, however, partly receded with the company’s good first quarter earnings performance. In the June quarter, not only did Elecon manage to strengthen its order-book; it also bettered its profit margins. This lends confidence to the company’s ability to grow despite challenging macro environment.

Further, Elecon’s entry into new businesses — windmills and windmill gear boxes — while currently insignificant in terms of revenue contribution, holds potential to deliver strong long-term growth, thus making it worthwhile to remain invested in the stock.
Fragmented user base

Unlike other infrastructure and capital goods companies, Elecon caters to a fragmented user industry base made up of power, steel, cement, sugar, mining and ports. This may explain why the company has so far not encountered any significant slowdown in the overall demand for its products. Apart from the power sector and, to some extent, cement, no other sector contributes significantly to the company’s overall revenue pie. That the company is now slowly increasing its focus on the steel sector (recently bagged Rs 400-crore worth orders from Bramhani Industries) may help it weather any slowdown in the cement sector, where the capex cycle may be nearing its peak.
Results

For the quarter-ended June 2008, Elecon registered a 30 per cent growth in sales and 15 per cent increase in profits. On a segmental basis, while the MHE division grew by 58 per cent, the gears division witnessed a sedate growth of 8 per cent.

On the margins front, however, the company’s performance was commendable. Despite mounting pressure on input costs, Elecon improved its margins by 2 percentage points to about 17 per cent. Price escalation clauses for orders secured from NTPC and SEBs (State electricity boards) and higher margins for the remaining orders helped it improve margins. And given that steel, its primary raw material, is showing signs of cooling down, Elecon may well be able to sustain margins at the current levels in the coming quarters too.
Buoyant order book

The strong growth in Elecon’s order-book is testimony to the continuing demand for its products. At the end of the first quarter, Elecon had an unexecuted order-book of Rs 1,399 crore (1.7 times FY-08 sales), of which Rs 1,158 crore (83 per cent) came from its material handling division; on a year-on-year basis, this marks a growth of over 61 per cent in its order-book. However, there was a 37 per cent drop in orders booked during the quarter. This is in sharp contrast to the same quarter last year when the revenues booked had increased by a whopping 139 per cent. High base apart, the drop this time around can be partly attributed to delays in booking orders in the quarter.

While this can also be construed as slowdown in demand, that the company has, in the recent past, procured large orders and has suggested that it has quite a few orders in the pipeline, may provide some relief.
New business initiatives

Elecon’s entry into windmills and windmill gear boxes holds tremendous long-term growth potential, given the global supply constraints for gearboxes. While Elecon is yet to forge a technical tie-up for the same, it has indicated that the formal agreement should be in place by the end of this quarter.

The management has said that it has begun prototyping for windmill gear boxes of about 1 MW range for its customer. Further, it has already installed six wind turbine generators in Gujarat and supplied four in Maharashtra. The windmill gear box division is expected to be fully operational by next quarter.

The success of these new initiatives is extremely critical for Elecon as its revenue guidance for the next two years takes into account contribution from these businesses as well.

And since there have been delays in this regard — one of the reasons for the stock’s plunge — progress on execution and order booking in this segment may be key triggers to the stock price. Any further delay will pose a downside risk to the company’s revenues.
Concerns

Any significant slowdown in the economy, leading to a sharp slowdown in capex across sectors, can hamper the growth prospects of Elecon. While the company has remained unscathed from the impact of a slowing economy, the lag effect of higher interest rates may soon catch up.

On this score, growth in the company’s order-book provides comfort on revenues over the next two years, by which time there may be more clarity on the economy front. Till such time, trends in order-booking in the coming quarters need to be watched closely.