CFA Institute Research Challenge Hosted by Indian Association of Investment Professionals (IAIP) Indian Institute of Management (IIM), Tiruchirappalli Date: 29-10-2014 Sector: Water and Waste water Treatment Exchange: NSE | Ticker: WABAG Industry: Water Industry 1 USD = 61.91 INR; 1 EUR=70.27 INR SELL Current Price Target Price: (27th Oct 2014):INR 1594 INR 1353 15% Downside: GOOD COMPANY BUT TIME TO LEAVE THE PARTY st We initiate coverage on VA Tech Wabag Ltd. with a SELL recommendation with year-end (31 Market Profile Volume Weighted Avg. March 2015) target price of INR 1353, which implies a downside of 15% from the current 1593 market price as on October 27th, 2014. Price (INR) 52 week Price Range Healthy growth in both topline and bottom line 485-1748 In the last four years, the Company’s revenues and net income grew at a CAGR of 16% and (INR) 26% respectively. The Company’s improved performance comes from 1) its strategy of Average Daily Volume 68619 pursuing opportunities in high growth emerging markets and 2) improving operating margins Current Shares through labor arbitrage i.e. moving labor away from high cost European countries to low cost Outstanding (Mn) 26.8 destinations. (2014-10-28) Company strategies paying off Market Cap 42666.7 (2014-10-28,Mn INR) Wabag has built its strategy around five pillars-1) Asset light business model through which Free Float the company is present in the design, technology and O&M (Operations & Maintenance) 30,558.6 (2014-10-28,Mn INR) activities of the value chain but has outsourced the construction work. The low Cap-ex helps in pursuing more growth opportunities 2)Higher exposure to municipal segment (64%) which Lower Price Band (INR) 1,310.6 is less affected by economic cycles, 3)Investment in technology. The company owns more Upper Price Band (INR) 1,965.9 than 100 patents, 4) offering end-to-end water solutions for its clients and 5) reducing costs Dividend Yield 0.49% by moving labor from higher cost to lower cost countries. P/E (Current) 39.7 Growth to continue The Company is in a sweet spot due to 1) presence in a high-growth industry and 2) a low P/B (Current) 5.4 debt/equity relative to peers and 3) rich technical know-how enabling it to grow faster. EV/EBITDA (Current) 20.6 But time to leave the party We have arrived at the target price of INR 1353 using a combination of 3 stage Dividend Source: National Stock Exchange (NSE) Discount Model, Discounted Cash Flow model and Residual Income model. The stock price of Risk Profile the company has run up significantly over the past year with YTD returns being 211%. Though Qty. Traded 68,619 the fundamentals of the company are strong and it has good growth prospects going forward, Deliverable Qty. 61,999 we believe that the current stock price more than factors in all these positives. Hence the % Delivery Qty. to 90.35% trailing PE multiple of 37.4 is not justified and going forward, we expect the stock price to Traded Qty correct. VaR Margin 43.3 Investment Risks The major upside risks to our target price are-1) increased tie-ups with construction firms Applicable Margin Rate 48.3 having access to low cost credit enabling the company to aggressively pursue growth Extreme Loss Rate 5.0 opportunities, 2) successful foray into the Latin American market which holds significant market potential, 3) Reallocation of capital at group level and 4) Reduction in raw material Source: Bloomberg and NSE costs as a percentage of revenue. Indexed Prices : Nifty vs Wabag 400 WABAG 350 NIFTY Key Ratios 2012 2013 2014 2015E 2016E 2017E 2018E 300 Net Profit Margin 5.7% 5.3% 4.6% 4.9% 5.2% 5.5% 5.7% 250 Return on Equity 12.9% 12.0% 12.3% 14.0% 15.9% 17.5% 19.0% 200 Current ratio 1.53 1.55 1.49 1.44 1.41 1.39 1.37 150 Quick ratio 1.51 1.47 1.29 1.40 1.37 1.35 1.33 100 Asset turnover 0.81 0.86 0.92 0.96 1.00 1.03 1.06 Equity turnover 2.24 2.26 2.65 2.87 3.06 3.21 3.32 Jun-14 Sep-14 Aug-13 Nov-13 Debt to equity 0.06% 0.36% 5.33% 4.20% 3.21% 2.37% 1.67% Mar-14 Source: Bloomberg, Student Research Source: NSE 2 Investment Summary Strong fundamentals in a growing industry: VA Tech Wabag has become a formidable player in the global water treatment industry after acquiring its Austrian parent in 2007. In this market which is expected to grow at a CAGR of 30% between 2013 and 20181. VA Tech Wabag has created a unique competitive advantage for itself, combining the 90-year old Wabag brand with rich technical expertise (over 100 patents) and the lower costs of operating from India. The strategy of entering emerging markets along with cost rationalization has helped the company grow its revenues from 12,237 Mn INR in FY’10 to 22,386 Mn INR in FY’14 at a CAGR of 16% and net profits from 414 Mn INR to 1040 Mn INR in the corresponding period at a CAGR of 26%. Performance: We expect the company to outperform the industry going forward given its strong balance sheet (asset light business model with debt-to-equity ratio of 5.33% as of FY’14), robust order book position (book-to-bill ratio of 2.39 at the end of FY’14) and rich technical knowhow combined with lower costs. We expect the company to post topline growth of 22% in the year’s up to FY’19, resulting in net profit margin expanding from the current 4.6% to 6% and RoE expanding from 12.3% to 20.4% Expensive Valuation: However the valuations have run up in the past 1 year with YTD returns being 211.2%. At the current Market Price (CMP) of INR 1594, the stock trades at a multiple of 31.79 times to the estimated FY’15 EPS. This we believe, more than prices in all the positives and ignore potential risks. According to our calculations, we have arrived at an end of the year (31 March 2015) fair price of 1353 INR, implying a downside of 15% from the current levels. Major upside risk: The major upside risks to our target price comes from the following factors: 1) Increasing tie-ups with partners who have access to low cost credit, 2) Successful Foray into Latin American market, 3) Reallocation of capital at group level and 4) Reduction in raw material costs. VA Tech Wabag EPS VA Tech Wabag DPS (In INR) (In INR) 25 21 107.08 120 20 17 83.42 100 13 15 80 65.08 10 50.14 8 60 42.67 7 10 33.64 5 40 27.90 5 20 8.49 0 0 2012 2011 2012 2013 2014 2013 2014 2015E 2016E 2017E 2018E 2015E 2016E 2017E 2018E VA Tech bags Dividend of INR 8 2.5 Bn INR per share project in Tanzania VA Tech VA Tech posts 164 reports Mn INR 19.7% profit jump in net profit 1 GlobalSource: Water Money Intelligence control, Bloomberg, Student Research 3 Business Description (See Appendix 3,8&9) Fig 1.Shareholding Pattern (30-06-2014) VA Tech Wabag Ltd., headquartered in Chennai, is an end-to-end water treatment solutions provider. With 18 subsidiaries and presence in 20 countries, the Wabag group’s offerings include Promoters municipal Drinking water, municipal sewage, industrial water, industrial effluents, desalination and 20.64% recycling. The company commands roughly 14% market share in India where it is the market leader 29.43% FII and about 1% globally where the industry is highly fragmented. 21.33% DII 28.55% The firm is organized into three groups -1) Municipal Water Group (MWG) which takes orders from Others government bodies, 2) Industrial Water Group (IWG) which provides water management solutions to demineralization plants, reverse osmosis plants and CPU plants used in industries like steel, petrochemicals, fertilizers, power et al. and 3) Operations Business Group (OBG) which is Source: Money Control responsible for operating and maintaining of plants Company Strategies Fig 2.Geography- Revenue Break up (2013-14) 1. Global brand with a local connect: Water is a highly localized business and knowledge of local conditions gives a significant competitive advantage. This is one of the reasons for the industry to be highly fragmented at the global level. As the technology is becoming complex, India global companies can gain an advantage by using best practices across geographies. VA Tech Wabag 49% 51% Overseas is pursuing this strategy by building local sales teams and hiring engineers from India. 2. Asset light business: The value chain in the business of water treatment involves design, technology, construction and operation & maintenance (O&M). In order to keep the business asset light, the company outsources construction activity to third parties. In order to Source: Annual Report participate in BOOT projects, WABAG is going for alliances with companies that have access to cheap capital. It is a unique strategy, as its competitors have construction subsidiaries that Fig 3.Project- Revenue Breakup undertake the civil construction. While the competitors made losses due to economic downturn (2013-14) and project delays, WABAG is in a better financial position to bid for new projects. 3. Focus on the Municipality Segment: Majority of Wabag’s revenue (64%) comes 20% EPC from the municipal segment.