We reiterate a buy on the stock of water treatment and waste water management player, VA Tech Wabag. Improved order flow scenario, healthy balance-sheet and positive impact of overseas cost rationalisation measures improve the prospects for the company’s earnings growth. Investors with a two-three-year perspective can take exposure to the stock.

At the current market price of Rs 511, the stock trades at 14 times its expected consolidated earnings per share for FY-13. While this may seem to be at a premium to regular engineering, procurement and construction (EPC) contractors, VA Tech’s presence in relatively high-end work, its strong technology base and geographic diversity justify the premium.

Business focus

VA Tech recently restructured its business to focus on products rather than geographies. With this, it will now focus on industrial water treatment, municipal water treatment and desalination. While VA Tech has already established itself in desalination projects as well as industrial water treatment, it has tapped the local opportunity in municipal waste water treatment quite well in recent times.

Some of the key projects, which are in the pipeline, include sewage treatment plants at seven sites in Mumbai, and municipal orders in Delhi, Karnataka, Tamil Nadu and Orissa.

With a sound technology base and tie-up with partners for contract work, VA Tech appears well placed to tap the order flows in the municipal space.

Besides local orders, the company also expects orders worth about Rs 800-1,000 crore (€120-130 million) from countries such as Turkey, Saudi Arabia, Romania, Czech Republic and Philippines. Its tie-up with Sumitomo of Japan can also be expected to generate some orders.

Overall, VA Tech has guided Rs 2,000-2,400 crore of fresh orders for FY-13. This, along with current order book of Rs 3,400 crore (two times FY-12 revenue), improve the company’s revenue prospects. Its revenue guidance (in the high teens) can be expected to convert into earnings growth of about 30 per cent in FY-13.

Margins to improve

VA Tech’s sales expanded 17 per cent to Rs 1,438 crore in FY-12, while net profits expanded 40 per cent to Rs 74 crore. While the pace of growth was good, the company saw a marginal dip in EBITDA margins to 9 per cent.

But this was primarily due to a change in accounting for variable pay. In FY-12, in addition to the fiscal expenses, the company also booked variable costs pertaining to the previous year. Adjusted for the previous year’s expenses, margins were at a higher 9.5 per cent.

That said, there is still scope for profit margin improvement for a couple of reasons: one, the company’s revenue from operation and maintenance (currently at 14 per cent of overall sales) is set to increase, with projects like the Chennai desalination plant close to completion. This segment has profit margins as high as 18 per cent compared with 10-12 per cent from EPC projects.

Despite lucrative margins locally, high costs in overseas markets have so far muted overall profit margins. This too is set to change.

After its acquisition of the Austrian parent, VA Tech has been on a decentralisation drive. Instead of one centralised office in Austria, the company has been setting up local offices in emerging market regions where it has projects. Also, these offices are now manned with local staff. In the last two years ending FY-12, the company saved over nine million euros on overhead costs and hopes to see further reduction. These factors can support EBITDA margins.

With low debt and escalation clause for inputs in long-term contracts, VA Tech has escaped the high pressure on interest costs and raw material costs seen by other engineering players.

Risks

While the company has started getting payments for the Chennai desalination plant, initial delay due to lack of funding from the Centre stretched its working capital a bit. Similar delays in other municipal projects cannot be ruled out.

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