A Security I Like: Engineers India Common Stock

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DISCLAIMER

(Current market price is Rupees 142.50 per share.)

Engineers India, Ltd. (EIL) is an engineering service provider with high profit margins, negative working capital and a stable, growing business. It is available at 8x P/E with cash equivalents on its books worth almost half of its market capitalization. Fiscal Year 2013 (Apr-Mar) revenue and profit were Rs. 2,822 crores and 628 crores respectively. The current market capitalization is Rs. 4800 crores (1 crore = 10,000,000).

EIL is a government owned consulting and engineering, procurement and construction (EPC) company operating primarily in the oil and gas sector in India. Almost all its work is provided by state owned oil and gas production and distribution companies like IOCL, BPCL, ONGC, GAIL, etc. The work involves contracts from customers who need engineering expertise for their infrastructure buildout, from concept to commissioning. The company’s main verticals are refineries, petrochemical plants and pipeline infrastructure. Many of its customers operate in market duopolies or oligopolies due to the highly regulated and capital intensive characteristics of the oil and gas business.

Because EIL is a company within the Ministry of Petroleum and Natural Gas (MoPNG), it enjoys preferential status among its MoPNG-controlled clients. Having said that, its long and successful history of deploying projects in its sectors makes it unique among similar service providers in India, which are mostly foreign multinationals.

EIL has two main modes of providing services: pure consulting services and lump sum turnkey (LSTK) contracts. The consulting work is done on a cost-plus basis and has very high net margins. The LSTK and other turnkey type contracts have margins in the 5-10% range. The unique history of the company allows it to maintain high margins on consulting but competition and the large material components of the turnkey projects mean lower margins in LSTK. Consulting growth is steady, but lump sum turnkey growth is expected to be higher in the good years.

EIL has, in many years, worked with a negative working capital thanks to a combination of almost no inventory carried on the books, and reported 12-15% customer advances on contracts. Capital expenditure is virtually non-existent. This results in returns on negative assets. In other words, growth can be achieved without capital infusion.

If you include cash and interest on cash in your calculations, the P/E ratio is 8x. If you strip out cash and its associated post-tax income, the P/E is approximately 6.5x. The stock could be cheap for a couple of reasons: First, the EPC industry has been beaten down badly and most companies in the infrastructure sector are stuck with huge piles of debt which they are struggling to service. Perhaps EIL, although it is debt-free, has been painted with the same broad brush. Second, EIL is planning a follow-on public offering (FPO) as part of the government’s attempt to meet its disinvestment targets. The last time the company did an FPO, in 2010, the offering was at a significant discount to the market price. Perhaps traders are expecting the same thing to happen or perhaps the expected new supply is keeping prices low. In any case, a single digit P/E multiple for a growing EPC service company with negative working capital in a country which is sorely in need of infrastructure investments appears to be too low.

The main risk is the fact that it is a company controlled by the Indian government and it has customers controlled by the Indian government. In this particular case, corruption is mitigated because there is nothing here for the crooks to steal. The value of the company resides in its 3000 engineers and technical know-how. However, there is no way to mitigate against future random acts of stupidity (from the point of view of the minority shareholders of EIL) by the MoPNG. It doesn’t help that the top management of the company changes every few years as a result of public sector undertaking procedures.

In the short-term, the FPO and a potential special dividend announcement could cause volatility in the stock. The last time the company did an FPO (2010), shares were offered at a discount to the prevailing market price and the company paid out a hefty dividend (10-20% of the market price).

After considering the risks — and regardless of any potential near-term volatility — EIL appears to be a solid long-term prospect.