Investors can give the initial public offering (IPO) of transformer-maker M AND B Switchgears (M AND B) a miss. Demanding valuations, entry into risky solar-power-generation business and poor profitability in the mainstay transformer business besides extremely small scale of operations make this offer unfit for retail investors. The offer price band is Rs 180-186. With earnings per share of Re 0.50 (on pre-offer share capital) for fiscal year (FY) 2011, the offer is at a significant premium to listed peers. One can expect further earnings dilution after the IPO. The capital-intensive nature and slow payback of solar-power projects are likely to keep growth prospects muted for a couple of years at least.

The company and offer

M AND B manufactures power and distribution transformers as well as furnace and other special-purpose transformers. The company's plant in Madhya Pradesh can generate up to 5,109 transformers of various capacities and class a year, the 132-kV class being notable. The company now seeks to enter solar-power-generation market. It is going about this in two phases — the first involves a photovoltaic power cell project with capacity of 2 MWp (mega watt peak); the second phase under plan is for 4 MWp. It seeks to raise Rs 90-93 crore through this offer to predominantly fund the second phase of the solar project. The offer would expand the pre-issue capital by 33 per cent. Net worth would jump from Rs 15 crore to about Rs 105 crore after the issue. The last preferential allotment made to promoters in December 2010 was at Rs 10.25 a share.

Rationale

M AND B went for massive expansion in FY-11, more than doubling its installed transformer capacity. While the 37 per cent capacity utilisation in FY-11 may improve (as expanded capacities would have come on stream by mid-year), the company's strategy of expansion does not appear prudent for two reasons. One, its utilisation was less than 70 per cent in FY-10 providing enough scope to improve production without ramping up. Two, the domestic transformer sector has been suffering from a prolonged downturn as a result of slowdown in the power sector and intense competition from Chinese players. Realisation pressures and poor operating-profit margins have been plaguing larger players such as Emco and Bharat Bijlee. M AND B's EBITDA (earnings before income, depreciation and taxes) margin (excluding other income) declined to 7.7 per cent in FY-11 from 9 per cent in FY-10. This level of profitability was possible as a result of income from repairs and from trading. A 12 per cent decline in sales to Rs 34 crore in FY-11, despite 44 per cent of revenue coming from higher class of transformers, suggests that realisations are under pressure. For the year ending FY-11 net profits shrunk 16 per cent to Rs 0.7 crore.

The rough climate in the transformer business appears to have prompted the company to move to what is considered a more opportune segment now — solar-power generation. However, solar photovoltaic projects require deep pockets with the capital cost of development being Rs 18 crore a MW (thrice the capital cost of wind energy).

The company has not tied up with any customer for the offtake (expected to go commercial by March 2012) of the power generated and aims to sell it in the open market. This makes the future revenue stream extremely volatile. It also hopes to generate a significant portion of its revenues by selling renewable energy certificates (RECs). These certificates may have takers, given the mandate for each State to generate a minimum quantum of renewable energy or buy the RECs. However, besides just two recognised exchanges to trade these, the price of an REC has been revised to Rs 9,300-13,400 from April 2012 from Rs 12,000-17,000 now. With massive grid-connected projects coming up, any further downward revision could delay payback for M AND B's solar projects.

The company's first phase of 2 MW is not yet financially closed because of pending negotiations with the banker. The second phase, being predominantly funded by equity, may also significantly dent returns. Thus, the open-ended nature of projects in a segment that the company is new to significantly enhances risks.

The company is not highly leveraged and the current offer would bring its leverage to negligible levels. However, its credit rating from ICRA on long-term borrowings at LBB- (as of August) is non-investment grade and suggests high risk. This may reduce further borrowing capacity in a tight-credit environment. This could also be one reason why the company is tapping equity.

Market cap after listing will be Rs 180-186 crore in the offer-price band. The offer closes on October 5.

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