IPO . Should you invest in the IPO of Mazagon Dock Shipbuilders?

Investors can avoid the IPO of Mazagon Dock Shipbuilders (Mazagon). A defence PSU, Mazagon manufactures and supplies destroyers, submarines and other warships to the Indian Navy and the Coast Guard.

Despite being a dominant player in the warship-building industry, the company’s financial metrics are mediocre.

Over FY17 to FY20, while the top-line grew by 12 per cent (CAGR) to ₹4,978 crore, the growth in the bottom-line has not been too inspiring.

Also, given its sole dependence on the Ministry of Defence, the company’s revenue growth hinges on the Centre’s defence outlay, which has seen tepid growth in recent years.

The management plans to tap export and repair orders to utilise the excess capacity. However, the company has not bagged any export orders yet, and repairs and refit constitute only about 2 per cent of the current outstanding order book (as of July 2020).

Its position as a key supplier, a strong outstanding order book (worth ₹ 54,074 crore), assured profitability, thanks to higher share of nomination-based contracts (as against competitive bids), and healthy cash reserves are positives though.

Through the IPO, the Centre is looking to divest 15.17 per cent of its stake in the company.

At a price band of ₹135-145, the company is valued at 6.3-6.8 times its FY20 earnings.

While the valuations may be lower than other listed defence PSUs — Garden Reach Shipbuilders & Engineers, and Cochin Shipyard (currently trading at 14 and 7.4 times, respectively) — the offer seems unattractive considering the muted growth prospects of the company.

Weak growth prospects

The company’s strong outstanding order book — worth ₹ 54,074 crores — does not guarantee linear revenue visibility. That is because shipbuilding projects have a minimum two-year gestation period after the order is awarded. Another reason is that after the gestation period, it takes anywhere between six and eight years to build a warship, and the company’s revenues are recorded based on the execution of projects.

The company’s operations have not been resumed fully after the lockdown due to travel restrictions and social-distancing guidelines issued by the government.

Manpower shortages (sub-contractors) and the travel restrictions for foreigners (equipment suppliers and technicians) have added to the troubles.

In FY20, with just about 10 days of lockdown, the company booked a loss of ₹12 crore due to the pandemic.

Further growth in order book hinges around the Centre’s budgetary allocation. The allocation of ₹3,37,553 crore for defence (excluding pensions) in the 2020-21 Budget represents a growth of just about 6 per cent (over 2019-20).

Of the total allocation, capital outlay on defence services is ₹ 1,18,555 crore for new weapon systems and modernisation (up 10 per cent y-o-y).

Besides, about 63 per cent of the defence budget is allocated to the Indian Army; the Indian Navy, the major revenue contributor for the company, gets 13 per cent allocation.

Given that the budgetary allocation may be modest, Mazagon’s management now plans to increase the focus on refit and repair orders. Currently, refit and repairs contribute 3.5 per cent to the revenues (FY20) and the company plans to expand this to 15-20 per cent in the next five years.

The company also plans to export to Latin America, Africa, South-East Asia, West Asia and Scandinavian regions.

While both these strategies will aid margin expansion, the company is yet to tap these segments. For instance, in the current outstanding order book, there are no export orders and only two refit and repair orders, constituting just 2 per cent of the entire order book.

Also, the dried-up kitties of most economies the world over, post the pandemic, could delay the export order potential for Mazagon.

Hence, investors can wait until there is more clarity on the growth drivers.

The company bags orders from the Indian Navy on a nomination basis, which helps maintain steady mark-up on contracts. However, the company’s EBITDA margins declined from 25 per cent in FY17 to 17 per cent in FY20 due to increasing cost over-runs.

The company’s net profit has been quite volatile. In FY18, profit fell to ₹496 crore, down 17 per cent from FY17.

While the profit inched up by 7 per cent in FY19, it was largely on account of one-time reversal of employee-related provision (created in the earlier years).

In FY20, the company’s profits fell 10 per cent (y-o-y) to ₹477 crore. This was due to a one-time reversal of deferred tax assets worth ₹ 160.7 crore (on adoption of lower tax regime) and exceptional loss of ₹12 crore. Even excluding the impact of the one-off items, profit was up 2 per cent only (CAGR) over FY17 to FY20.