Railway engineering stocks could be good long-term compounding bets

– Railway engineering stocks offer huge potential for growth
– Robust order book provides strong revenue visibility
– Delivering strong revenue and earnings growth
– Asset light business model with negligible debt
– Plenty of cash in the books and strong return ratios

Within the construction and engineering space, railways have been in a sweet spot, thanks to growing revenue visibility because of a strong order book. Execution, too, has been robust and companies continue to deliver strong growth.

Among our highest conviction ideas are two important PSU companies from this space — IRCON International (IRCON) and RITES — which  remain attractive because of their strong growth prospects, robust order book, competitive advantages, negligible debt, highest return ratios in the industry, asset-light business model and attractive valuation accompanied by a good 4-5 percent dividend yield.

A quantum jump in investment and orders

The government has stepped up its capital investment on railways from about Rs 1 lakh crore in 2015-16 to Rs 1.48 lakh crore in 2018-19 and is targeting an investment of Rs 1.6 lakh crore in 2019-20. Dedicated freight corridors, capacity augmentations, gauge conversion, high-speed rails, station development, metro and suburban railways and other avenues have opened up a huge opportunity.

IRCON was sitting on an order book of close to Rs 17,600 crore in 2015-16, which now stands at close to Rs 32,400 crore – almost 7 times annual sales.

Similarly, RITES, which is present in the railways engineering space and other businesses such as the construction of roads, bridges, locomotive leasing business and exports of rolling stocks, has seen a spurt in its order book from Rs 4,800 crore in 2016-17 to the current level of  Rs 6,000 crore, which is 3 times its annual revenue. In its investors’ call in November, the RITES management said it’s likely to close the current year with an order book of close to Rs 8,000 crore.

Strong traction in execution

Helped by a robust order book, which provides strong revenue visibility, both the companies have been growing at a fast pace. RITES and IRCON are execution agencies that undertake orders from the government and PSUs on a turnkey and consultancy basis. Because of the increasing order book, both the companies have seen a steep improvement in execution. RITES, for instance, over the last four quarters, has delivered an average 51 percent year on year (YoY) growth in revenue.

In the first half of the current fiscal year, RITES has recorded a 66 percent YoY growth in revenues and IRCON has seen a growth of 32 percent. IRCON is a pure railways play, considering that the segment accounts for 93 percent of its revenue. More importantly, the managements of both the companies remain upbeat about execution, particularly in the second half of the current fiscal year because of increased activity, which was affected because of the excessive monsoon in the September quarter.

Capital allocation

What’s more, these companies are gradually deploying cash in the business or returning it to the shareholders in the form of a dividend. This will gradually support growth and rectify their return ratios which are currently depressed because of the cash in the books.

To put it in perspective, RITES is sitting on free cash of about Rs 1,500 crore (total cash of Rs 3,500 crore). The cash is almost 145 percent of its equity capital deployed in the business. Thankfully, RITES is deploying cash into the secured and more remunerative businesses such as exports of rolling stocks and leasing of locomotives. In Q2 FY20, the leasing business saw 24 percent year on year growth and exports jumped to Rs 262 crore as against a meagre Rs 70 lakh revenue in the corresponding quarter of 2018-19.

Attractive valuation

In terms of valuations, both the companies are trading at about 6-8 times their one year forward estimated earnings, which are quite attractive particularly in light of a current dividend yield of close to 4-5 percent.

Moreover, the valuation should also be looked at from the perspective of huge growth opportunities in the long run and their strong positioning in this space.

Both have a solid balance sheet and generate consistent free cash flows from operations, which can easily allow them to sustainably grow over the next few years at a reasonable 15-20 percent.

Key risks

The biggest risk in these companies is execution and their ability to manage the cash cycle efficiently. Besides, one should keep track of margins and the working capital cycle which could come under pressure in case of changes in government policies, thus threatening their balance sheet strength.

Source: Moneycontrol

1 thought on “Railway engineering stocks could be good long-term compounding bets”

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