Equity Master Report - Avoid
Reasons to apply
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1. Presence in strategic sectors: BEML has a diverse portfolio of products which caters to different core segments of the economy such as mining, steel, cement, power, irrigation, construction, road building, defence equipment, railways and Metro transit systems. It is not dependent on any single sector for its revenues. BEML's products are used in sectors like coal, steel, cement, railways and power, and this enables it to capitalise on the positive trends witnessed by these sectors, in view of focus of the government on developing infrastructure. Some of the projects in the pipeline are the Golden Quadrilateral, the National Highways Development Project, Pradhan Mantri Gram Sadak Yojana, North-South and East- West corridors, metro rail projects in major cities and river-linking projects. These projects are expected to generate significant demand for BEML's products in the future.
2. Leading Metro coach manufacturer: BEML has established itself as the leading metro coach manufacturer in the country and has successfully delivered 188 metro coaches to Delhi Metro Railway Corporation (DMRC) till date. It is well placed to play a big role by supplying coaches for the upcoming metro projects in the country in cities such as Mumbai, Chennai, Bangalore, Hyderabad, Ahmedabad and Kochi, as well as Phase II of the Delhi Metro. Metro transport will be introduced in all cities in India having a population of more than 3 m. In view of this, the estimated requirement of Metro coaches in the coming 5 years is expected to be very substantial. The company already has an order book of 2,000 coaches. To cater to this huge demand, BEML's new Metro Fabrication Hangar will be coming up at the Bangalore unit.
3. Diversifying into new business: In FY07, BEML forayed into two new businesses with a view to diversify revenue streams, improve profitability and leverage on upcoming business opportunities. It has opened new technology division and trading division. The technology division offers end-to-end solutions and services across the whole product development cycle including designing, modelling, analysis, simulation, prototyping, testing and documentation. The divisions started operations in May 2006 and as on 31st December 2006 it generated revenues of Rs 44.9 m, all of which have been realised from inter divisional services.
Reasons not to apply
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1. Revenue concentration and negative operating margins: The Ministry of Defence is BEML's largest customer for defence products. Similarly, a substantial proportion of its sale of railway products is currently made and is expected to be made to a small number of customers such as Indian Railways, Delhi Metro Railway Corporation and other metro rail transit agencies. The number and value of defence and railway products that it supplies is likely to vary from year to year depending on the government policies and budgets for defence and railway or metro transport. More importantly, the operating profit margin for railway products sub-segment of business has been negative during the past 5 years mainly due to limited discretion in the fixation of selling price and unavailability of raw material supplies at competitive prices, which is adversely affecting BEML's operations. In FY06, railway products contributed to about 5% of total revenues out of which about 72% was derived from metro coaches, which is a segment that has yet to breakeven. The overall business performance of the company (as seen in the adjacent chart) has also been very volatile in the past.
On the positive front, BEML is likely to enjoy some savings in employee costs due to the ongoing VRS scheme.
2. Opening up of defence sectors and problems associated with metros: The company generates almost 30% of its revenues from the defence sector. The defence sector has been opened up for private sector players and BEML will face increased competition from other manufacturers both in India and overseas. To make matter worse, the liberalization of imports will also invoke more competition in earthmoving equipment and railway products. Secondly, BEML's joint venture with CCC based in Brazil is likely to take off on a slower trajectory as multinationals like Caterp illar and Komatsu are already actively present in the Brazilian market. Thirdly, the company is largely dependent on the success of metro projects across the nation. Given the uncertainty in the implementation of the development projects, project delays would lead to cost overrun causing a setback to the financials of the company.
Comparative Valuations & Comments
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At the upper end of the price band of Rs 1,020 to 1,090, the stock of BEML has been offered at 31 times its annualised FY07 earnings. This makes the issue aggressively priced as compared to its peers in the domestic and international markets. While the valuations and financial history of the company does not support this, we also do not envisage the company to be able to match up the same in the foreseeable future as well. Consistency in performance and lack of independency in operations (due to restricted framework of government regulations) are our main concerns with regard to the company.
Another point worth noting here is that the Rs 5.3 bn that the company plans to raise through this issue could have been partly funded by raising debt (debt equity ratio is currently 0.1 times and would go upto 0.5 times in the absence of the equity issue) and partly through cash (Rs 2.7 bn in December 2006) in its books. Considering that debt is a cheaper source of funding as compared to equity, the equity dilution would pare the company's return ratios going forward. We would therefore recommend investors to '''''''''''''Avoid''''''''''''' this issue given better alternatives available in this sector.