McNally Bharat Engineering: Buy

Investments with a two/three-year horizon can be considered in the stock of McNally Bharat Engineering (MBE), a turnkey material handling company.

An expanding order book, possible expansion in operating margins, shift in product mix in favour of high-margin businesses such as steel sector applications and equipment point to strong earnings growth in future.

This apart, given MBE’s established market presence, it may be one of the leading beneficiaries of the increased focus on infrastructure and the ongoing capex boom across industries.

At the current market price, the stock trades at about 23 times its expected FY-08 earnings per share on a fully diluted basis.
Investment argument

Buoyant trends in infrastructure and capacity expansions across MBE’s user industries such as power, steel, minerals and coal, to name a few, are likely to translate into improved business prospects for the company. Apart from providing turnkey solutions, MBE also manufactures equipment used in construction, mines and metal production.

Anticipating a rise in demand for such equipment, McNally has embarked on an expansion and modernisation drive for its plants in Kumardhubi and Bangalore.

This apart, it plans to set up a greenfield plant in West Bengal for heavy fabrications at a cost of Rs 22-25 crore. While it could take about a year or two for contributions from these expansions to kick in, they could deliver a potential boost to earnings.

Another significant pointer towards McNally improving prospects is its bulging order book. Pegged at Rs 1,125 crore (as on May 2007), its order book is about 2.2 times its FY-07 revenues.

In addition, McNally has bid for orders worth Rs 7,500 crore. Notably, it has emerged the L1 bidder in Rs 2,000 crore worth orders. The order book, which comprises mainly orders from steel sector applications (about 50 per cent), also points at a shift in revenue-mix towards segments that enjoy higher margins.

While this shift will help better its margins, it will also help MBE tap a considerable portion of the capex boom across such sectors.

In this context, the capex plans of SAIL (MBE’s main customer) of about Rs 42,000 crore for its various steel plants over the next five years offer MBE a potential market to scale operations.

Markedly, all these steel plants are located near MBE’s factories, giving it a logistic advantage over its peers. This apart, the strict pre-qualification norms in the steel sector, which are currently met by only MBE and L&T, are also likely to give MBE an edge.
Financials

For the year ended March 2007, MBE’s revenues grew 51 per cent while its earnings more than doubled on a sustainable basis; both the product and project businesses grew by more than 60 per cent each.

On an operational front, margins declined marginally to about 5.0 per cent. This could be attributed to the losses incurred after MBE withdrew from the highway construction business on facing disputes relating to land acquisition.

This apart, margins also were dented as the company had executed earlier orders at low margins.

Given that the loss from the road construction business was a one-time affair and with the change in the composition of the order book in favour of higher contribution segments, one can expect the pressure on margins to eventually ease.

In this regard, the management’s guidance for a double-digit margin for FY-09E also provides confidence.
Concerns

The long gestation period of McNally’s projects tend to reduce flexibility on pricing; as contracts may be locked in for a period of the contract.

Moreover, since its projects are completely dependent on the capex cycles of its user industries, any delay in execution from the user industries’ side could also affect earnings