Thursday 31 January 2008

Shriram EPC - IPO Analysis

Investors with a high-risk appetite and a two-three year investment horizon can consider investing in the initial public offering of Shriram EPC (SEPC). However, we would be more comfortable if the offer is priced at the lower end of the price band.

Given the company’s wide-spread exposure to businesses such as renewable energy, process & metallurgy and municipal services, SEPC appears well set to leverage on the strong demand for both its product as well as service offerings.
Valuation

Foray into higher-capacity wind turbine generators, bio-ethanol plants and increasing bias towards execution of turnkey projects also suggest strong prospects.

However, the offer is expensively priced. In the price band of Rs 290-330 the offer is priced at about 22-25 times the likely FY09 per share earnings.

This is backed by SEPC’s presence across high-growth business verticals and its robust order book (about Rs 2,270 crore).
Business verticals

SEPC’s business can be broadly classified under two categories — Engineering, procurement and construction (EPC) projects and manufacture/sale/maintenance of wind turbine generators (WTG). The company’s EPC business focuses on three segments — renewable energy, process & metallurgy and municipal services.

The renewable energy EPC projects mainly consist of biomass-based power projects, co-generation power projects and bio-ethanol plant projects. In the process and metallurgy EPC projects, SEPC focuses on providing turnkey solutions to sectors such as power, steel and cement. The company typically bids for these projects in consortium with foreign players who provide the technology back up, while SEPC provides for manpower, onsite construction, commissioning and testing services.

It also provides cooling tower and air-pollution control systems through Hamom Shriram, its joint venture company with Hamom group.

Through its municipal services division, SEPC undertakes turnkey projects for water and waste management and executes pipe rehabilitation projects.

The WTG division, apart from manufacturing 250KW-class WTGs, also does installation, commissioning and maintenance of turbine generators. SEPC has formed two joint ventures with Netherlands-based Leitwind to establish presence in high-end WTGs (1.35 MW WTGs). These joint ventures, using Leitner’s gearless WTG technology will manufacture and subsequently market and sell these WTGs .

This business may hold potential given the growing demand for windmills and the supply constraints for gearboxes. However, weighed against this, Leitwind’s technology is not yet established . SEPC’s limited exposure to export market may also pose challenges.

SEPC plans to use the proceeds from this issue for investing in its associate companies, such as Orient Green Power and Leitner Shriram Manufacturing.
Growth drivers

SEPC’s foray into providing EPC services for process and metallurgy, given its positioning as a complete engineering solutions provider may help it gain traction in this market.

These projects, which typically enjoy high margins, may also help SEPC better its operation metrics.

Besides, the company’s focus towards executing EPC projects in other sectors may also help it diversify and scale up revenues. While so far it had primarily executed EPC projects in the captive power and metallurgy segments, a recent order win worth Rs 570 crore from the cement sector points to broader revenue streams.

The company’s unique exposure to various sources of renewable energy also presents significant potential for revenue growth over the long-term. While it is an established player in biomass-based EPC projects, its foray into bio-ethanol is relatively new.

Cracking the bio-ethanol market may take sometime since these projects require a sound technology base and features established overseas players. SEPC may have to partner with global players for sourcing technology.

While finding the right partner may take time, SEPC’s partnerships with leading global players in its other business divisions infuse some confidence on this front.

The company’s recent order to build a 280 KLPD (kilo litres per day) bio-ethanol plant in Czech Republic in consortium with a leading European player is a case in point.

Further, SEPC’s move towards ownership of power generation assets through its associate company, Orient Green Power may also have potential for significant earnings upside over the long-term.

Among other initiatives of SEPC, wastewater management and pipe rehabilitation while insignificant currently, hold good potential.

SEPC’s revenue has grown at an annual compounded rate of about 99 per cent over the last two years, albeit on a small base. Earnings, during the same period, grew by about 51 per cent. Profit growth may accelerate significantly if SEPC’s entry to high-growth and high-margin segments pays off.
Concerns

While SEPC is attempting to offer a one-stop shop for engineering solutions across segments, it has to tackle competition from established players such as L&T, Praj Industries and Thermax in each of those areas.

This may force SEPC to competitively price its service offerings and may squeeze its margins to an extent. Further, the company’s relatively smaller scale of operations may render it unfit to bid for many of the high-value turnkey projects, unless it stikes successful global partnerships.

Moreover, since the company sub-contracts most of the peripheral material requirements for such projects, it may not have complete control over project costs.

This may put to test SEPC’s ability to effectively manage its cash flows given its high working capital requirements. Overall, execution risks to this offer are high.

The offer closes on February 1.