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Safal Niveshak StockTalk #12: Engineers India

Welcome to the twelfth issue of Safal Niveshak StockTalk.

After covering Tata Investment Corp. last time, this time I’ve researched on Engineers India Ltd. (EIL), India’s leading engineering consulting company, which is now also strengthening its presence in the engineering projects space.

Before we dive deeper into EIL, here is a brief overview of the sections of this report.

  1. About EIL
  2. Safal Niveshak’s 20-Point Checklist
  3. Intrinsic Value Assumptions
  4. Risk Statement
  5. Financial & Market Snapshot
  6. “Should I Buy EIL?” Checklist

1. About EIL

EIL is India’s leading engineering consultancy and projects company, with a major presence in the petrochemicals space. The company also undertakes large scale engineering projects like setting up refineries and petrochemical projects from scratch. Over the past 10 years, EIL has grown its sales and profits at average annual rates of 23% and 29% respectively.

2. Safal Niveshak’s 20-Point Checklist

Keeping in mind the simplicity aspect that is otherwise missing in other company analysis reports you would come across, I’ve analyzed EIL by answering 20 important questions that span its:

  1. Business performance,
  2. Financial performance,
  3. Management quality, and
  4. Competition.

Here is the complete 20-point checklist with my explanations.

Before we move ahead, here are the symbols that I’ve placed against each checklist point and that will tell you at a glance whether I have a positive or negative view on that particular point.

   Indicates my positive view
   Indicates my negative view

Let’s get started.

A. Business

1. Can I, in simple words, explain what the company does?
Yes. EIL is India’s leading engineering consultancy and projects company with a major presence in the petrochemicals space. The company also undertakes large scale engineering projects like setting up refineries and petrochemical projects from scratch.

2. Does the business have high uncertainty?
Not high, but uncertainty exists. This is because the company being a consultant and project developer depends on capital expenditure from other industries like petroleum refining, petrochemicals, and oil & gas pipeline developers. While the company is trying to diversify its presence across other industries and countries, the fact remains that its growth will largely depend on infrastructure spending in India and globally, which is always mired under some uncertainty (led by political issues, capital availability, and interest rates).

The company currently has an order book (orders received but not yet executed and converted into revenues) of Rs 44 billion, which is almost same as its FY12 full year sales. However, one concern here is that this order book has shrunk from the FY11 levels of Rs 74 billion, which is a testimony to the weak state of infrastructure spending.


Data Source: EIL

One more concern for EIL is its large dependence on lump-sum turnkey projects (LSTK; large scale projects that are entirely developed by the company). This is the uncertain part of the company’s business, as revenues are not recurring (unlike consultancy business) and tend to be high in a year when the company has executed some projects and low when the projects are just in their initial stages.

Have a look at this chart and you would know where I am coming from…


Data Source: EIL

As you can see, while the share of LSTK in EIL’s total sales has increased manifold in the past, it has been volatile if you exclude the latest four years. Even if you look at the current order inflows of the company (see chart below), the uncertainty in the LSTK business comes out clear.

Anyways, I would not read too much into this 1-2 years’ volatility in order inflows of LSTK as this is the nature of this business (depends largely on the state of capital expenditure in a country). I would be concerned if this turns out to be a trend, or if the orders do not pick up even when the industries rebound, which they should.

3. Has the business got an enormous moat?
Not enormous, but EIL’s long-term presence and history of execution of consultancy and engineering projects has helped the company create a good reputation in the industry, especially in the petroleum and petrochemical sectors. While the government’s backing has also helped it secure prestigious orders in the past, it has been its ability to turn around projects within timelines that has created a good brand for EIL.

As far as the financials are concerned, EIL has always been a zero debt company, earns high return ratios, has maintained decent gross margins, and has minimal working capital requirements. These are also sources of moat for the company.

Especially when it comes to its working capital, the company is in a sweet spot. It funds its entire working capital (debtors plus inventory, the latter being negligible) via advances it receives from customers. See this chart…


Data Source: Ace Equity, Safal Niveshak Research

This keeps the balance sheet clean and helps the company consistently earn a high rate of return from its operations.

4. Does the business generate strong free cash flow?
Yes. In fact, EIL has seen just one year of negative FCF over the past 10 years. Minimal capital for expansion and high return rations have helped the company consistently generate positive and rising FCF (except in FY12, when FCF was positive but low owing to a sharp rise in “unbilled revenue”, which pertains to work completed for which a bill has not yet been issued to clients).


Data Source: Ace Equity, Safal Niveshak Research

5. What is the bargaining power of suppliers and buyers?
EIL’s key clients are from the oil & gas sectors (petrochemicals, pipelines etc.) and the company has an entrenched position here. However, despite this, it faces competition from other EPC players. Thus I do not see it having much bargaining power against its clients. However, given has EIL is a respected name and is a major client, it has some bargaining power against its suppliers.

B. Financial Performance

6. Does the business have a consistent sales and profit growth history and is there room for future growth?
Yes, except for some interim volatility during the FY05 to FY08 period. EIL has grown its net sales and net profit at average annual rates of 23% and 29% over the past 10 years. The growth has been especially strong over the past four years. Given the weak order inflows over the past one year, while there has emerged some near-term uncertainty, I see things picking up again for EIL when there’s a pickup in capex spending by its client industries.


Data Source: Ace Equity, Safal Niveshak Research

7. Are gross profit margins higher than 40%?
Gross profit margin (GPM) suggests the true profitability of a company’s operations. Buffett would generally like a company earning >40% margin, but this is true largely of consumer goods companies. As for EIL, the average GPM for the last 10 years has been around 30%, which is a reasonable number. However, the margins have come off in the recent years. This is largely owing to the rising share of the LSTK business that is less profitable than the consultancy business. As a matter of fact, while PBIT margins (PBIT stands for profit before interest and tax) for the consultancy business stood at around 42% in FY12, the same for the LSTK business stood at 10%.

Data Source: Ace Equity, Safal Niveshak Research

8. Is its operating cash flow higher than net profits?
Largely yes! Over the past 10 years, EIL has had 8 years when the operating cash flow was higher than net profit. However, in FY12, the operating cash flow was lower than net profit due to (as I mentioned above) sharp rise in unbilled revenue.


Data Source: Ace Equity, Safal Niveshak Research

9. Is the debt to equity below 0.5 times?
Yes. EIL is a debt-free company.

10. Is the current ratio greater than 1.5?
Excluding cash and current investments, EIL runs a negative working capital business as advances from its customers more than take care of the cash blocked with its debtors. As a general rule, a current ratio of 1.5 or greater suggests that a company can meet its short-term operating needs sufficiently. However, a business like EIL with a negative current ratio possess the advantage of getting “free” money (advances from customers) to fund its operations.

11. Does the company have a good dividend history?
In terms of dividend payout (amount of dividend paid as percentage of net profit), EIL has averaged around 45% over the past 10 years, which looks like a very nice number. However, it’s important to note that this is a PSU which is owned 80% by the government. So the government has its say in the dividend policy (which comes good when the government needs some easy money), which was clear from the 135% dividend that the company declared before its FPO on FY10.

12. Is the Altman Z score > 3?
Yes, the number for EIL is 5.4, which makes it safe against any possible bankruptcy. Read more on the Altman Z-Score.

13. How capital intensive is the business?
Not capital intensive. EIL works on a negative working capital plus it does not have high capex commitments.

14. Has it got a high and consistent return on capital and return on equity?
Yes. EIL’s average return on capital employed and return on equity have been around 34% and 22% respectively over the past 10 years, which are reasonably high numbers, and suggest the management’s good capital allocation skills. However, with competition seeping in, and with higher share of the LSTK business, I see these ratios coming under some pressure in the future.


Data Source: Ace Equity, Safal Niveshak Research

C. Management Quality

15. Is the management known for its capital allocation skill and integrity?
EIL has been a great performer on the capital allocation front all these years. The management has guided the company well over the past few years, so the track record in terms of integrity seems fine. Even as far as the capital allocation part is concerned, we have seen how the company has continued to maintain a high return in equity (average of 22% over the past 10 years; 38% in FY12). So, overall, I’m comfortable with the management and its capability to guide the company in the future.

16. Has there been any substantial equity dilution in the past?
No, EIL has seen no major equity dilution over the past few years.

17. Are management’s salaries too high?
Given its PSU nature, EIL does not pay lavish salaries to its top management. The combined salary plus benefits of the company’s top six men is just 0.3% of its annual profits, which is a small number.

18. What has management done with the cash in the past?
As discussed above, EIL has generated good amount of cash from operations in the past. A part of this has gone towards dividends to equity shareholders (largely the government), plus a large part also lies as cash and investments.

Despite a large amount of cash in the books, the biggest issue I see here is the involvement of the government, which has been a poor cash allocator in the past. Now with the announcement of a subsequent FPO of EIL, where the government would be looking to sell a 10% stake, there might be another round of special dividend that will suck out some more cash from the company.

So, overall, while the management has been prudent in allocating cash well in the past, the promoter is what I am concerned about.

D. Competition

19. Does the business face high competition?
Yes for LSTK, as is clear by just 10% PBIT margin that EIL earns in this space. Consultancy remains a low competition space for EIL though.

20. Has the management focused on market share or profitability in the past?
A combination of both, which is good.

3. Intrinsic Value Assumptions

Before I move into calculating the intrinsic or fair value range for EIL, let me make one thing very clear.

Intrinsic value isn’t a definite figure but just a ‘calculated’ value. In fact, the calculation of intrinsic value of a business mostly throws up a highly subjective figure. And this figure changes as estimates of variable like future cash flows are revised (given that the future is unknown).

Anyways, what I have done here is rather than arrive at a single intrinsic value figure for EIL, I have calculated the value using three different methods and then arrived at a ‘fair value range’ for the stock.

1. Net present value based on a 2-stage 10-year DCF
The discussion about the calculation of net present value using a discounted cash flow model (DCF) can be found in the 7th lesson of my free course on investing – Value Investing for Smart People.

I have done a 2-stage DCF analysis for arriving at the intrinsic value for EIL.

As a reference, here is the formula for calculating the NPV:

NPV = CFi / (1+k) + CF2 / (1+k)2 + … [TCF / (k – g)] / (1+k)n-1

Where:
PV = present value
CFi = cash flow in year i
k = discount rate
g = growth rate assumption in perpetuity beyond terminal year
TCF = the terminal year cash flow
n = the number of periods in the valuation model including the terminal year

I have calculated EIL’s future cash flow for the next 10 years, assuming 2 different rates of growth in cash flows of 10% (years 1-5), and 8% (years 6-10). My base FCF for EIL is Rs 4.5 billion, which is the average FCF earned over the past few years (excluding adjustments for unbilled income from operating cash flows).

As for the discount rate, I’ve assumed it at 14%. Lastly, my expected terminal growth rate for the company’s cash flows – expected growth in cash flow after 10 years and till eternity – is 2%.

Based on these numbers and after reducing the net debt (debt minus cash), the present or discounted value of future cash flows for EIL is coming at Rs 248 per share, which is also the stock’s intrinsic value using this method.

2. Earnings Power Value (EPV)
After DCF, the second most reliable measure of a firm’s intrinsic value is the value of its current earnings. This method is known as ‘Earning Power Value’ or EPV. This value can be estimated with more certainty than future earnings or cash flows, and it is more relevant to today’s values than are earnings in the past.

The formula for EPV of a company is:

EPV = Adjusted Earnings x 1/R

Here, ‘R’ is the cost of capital.

EIL posted an adjusted EPS (earnings per share) of around Rs 19 in the trailing 12-monthe (last four quarters) period. If the company’s profits were to stagnate and remain at Rs 19 per share going forward, and applying the EPV formula here, I multiply Rs 19 with 1/14% (14% is the approx. cost of capital for EIL). What I’ve also done additionally for EIL, given its relatively small base as compared to other EPC firms and thus a potential to grow faster, I’ve multiplied this EPV value by 1.5 to arrive at the intrinsic value.

This gives me a value of Rs 205 per share, which is EIL’s intrinsic value as per the EPV calculation.

3. Pricing relative to 10 year average P/E ratio
True value investors, as Graham has prescribed, won’t pay a price based on the stock’s latest P/E or the company’s latest earnings. They will take a much longer term view…as long as 10 years.

Here, I have attempted to estimate the intrinsic value of EIL using the company’s last 3 years average earnings and last 10 years average P/E ratio. So the formula is:

Last 3 Years Average EPS x Last 10 Years Average P/E Ratio

EIL’s average P/E ratio for the past 10 years has been around 25 times, while its last 3 years’ average EPS has been Rs 16 per share. Based on the formula, EIL’s intrinsic value is coming to around Rs 395 per share.

Fair Value Range
Based on the above calculated intrinsic values for EIL, I can arrive at a ‘fair value range’ for the stock. Here is how I calculate it:

High End of the Fair Value Range = [Average of above four intrinsic values] Low End = [(Average of above three intrinsic values) – (0.5) x (Std Dev)]

Based on this, the fair value range for EIL’s stock is Rs 235 to Rs 285. Assuming a margin of safety of 25% to the average of this range, the comfortable buying price for EIL’s stock comes to Rs 195 using the intrinsic values calculated above.

Given that EIL’s current price of Rs 228 is around 18% higher than the above calculated comfortable buying price, I won’t buy the stock till it falls to (or near to) my buying price.

By the way, if you have noticed, I have not valued EIL using the Graham number, which I otherwise use as away to calculate intrinsic valuations. The single reason I’ve avoided using this number with EIL is the company’s asset light business model, which means a suppressed book value that is a key variable in calculating the Graham number (Graham Number = Square Root of (22.5 * Tangible Book Value per Share* Earnings per Share)).

4. Risk Statement

One of the biggest concerns I have with EIL is the potential mis-utilization of cash. The company generates a lot of free cash flow as its working capital and fixed assets requirements are very low. It has used a large part of this cash in the past to pay dividends. But then, the dividend policy is largely guided by the government (promoter), which gave itself a 100% dividend just before the FPO in FY10.

While this is not a big reason to cast aspersions on the company’s cash allocation strategy, as the overall business has been generating good returns, the very fact that the government is at the helm of affairs is a worry. This is especially given that the government is facing a huge fiscal deficit and might use the cash from PSUs to fund a part of this deficit.

As far as EIL’s overall business is concerned, while I see revenue coming under pressure in the medium term (as suggested by weak order inflows), strong operating margins and high other income (given the huge cash on balance sheet) should limit the impact on profits.

Anyways, despite these near-term issues, I believe EIL’s asset-light model makes it a safe business to have in one’s long-term portfolio, if bought at the right price.


5. Financial & Market Snapshot


Data Source: Ace Equity, Safal Niveshak Research


Data Source: Ace Equity, Safal Niveshak Research

    
Data Source: Ace Equity, Safal Niveshak Research


6. “Should I Buy EIL?” Checklist



Your feedback is important
So that was my take on EIL as part of the Safal Niveshak StockTalk initiative. I’ve tried to be as comprehensive in my analysis, while trying to keep the report very simple. Let me know what you think of this report and the improvements therein.

Also let me know your feedback on the entire report in the Comments section below.

Disclaimer: The author of this report, or any of his family members, does not own the stock(s) mentioned herein. The opinions in this report are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stock(s) mentioned or to solicit transactions or clients. The information in this report is believed to be accurate, but under no circumstances should a person act upon the information contained within. I do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.

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About the Author

Vishal Khandelwal is the founder of Safal Niveshak. He works with small investors to help them become smart and independent in their stock market investing decisions. He is a SEBI registered Research Analyst. Connect with Vishal on Twitter.

Comments

  1. Even i track this co,good company with nice management, but its cmp is only its fair value. So it is resting in my watch list 🙂 technofab engnrng is also in same business, available at low p/e. Do you track that?

  2. Tirthankar Ray says:

    The need of the hour for EIL is to diversify its consulting niche to other areas .The challenge ( trouble :)) I see is :Government’s intervention in its internal decision making process. Government will safeguard other companies ( Like GAIL ) to avoid cannibalization /Competition. If in case EIL beats this barrier , I see great future ahead.

  3. well Vishal.. I was waiting fro a long time for the StockTalk… Thanks vishal

  4. Thank you for the much awaited stock talk.
    EIL seems interesting being a services company (and hence asset light) but being Govt owned is indeed a risk (the Govt’s track record of keeping small shareholders interest in mind is rather dismal).

  5. Thanks for the analysis,Vishal.

  6. Sudheendra says:

    Hi Vishal
    Very Useful analysis.
    I was trying to apply your methods for Intrincic value calculations for some stocks. I found that for Asian Paints, my valuations (DCF, EPV, DDM and Grahm no) are coming way below the market price. So wondering if I am missing something. Appreciate your advice here.

  7. Vishal, how do you calculate the approx cost of capital of any company? Is it given in the annual report or do we have to calculate it.?

  8. Ramesh Bhanu says:

    Hi Vishal,

    Do you always use Annual reports as your data source or you use services from third parties? (I see Ace Equity as data source sometimes on your blogs).
    I am looking for a reliable data source. Free sites like MoneyControl, Economic Times and India Infoline sometimes goof up numbers.
    Any help on this matter will be helpful.

    Thanks

    Ramesh

  9. Vishal,

    Going through the cash flow statements for Engineers India, i notice that there has been a drastic decrease in the cash flow from operating activities for FY12.I see that you have mentioned that it is due to sharp rise in unbilled revenue. So,where exactly would this be recorded in the cash flow statement in the annual report for FY 12?

    Thanks,
    Nishanth

  10. Got that , thanks. Please excuse if this is a rookie question , but why do we check that operating cash flow is higher than net profits ? Maybe VIshal can answer this one ,as I checked it and saw from past 2 years it’s the other way around.

    • EIL 2012 financials is the best example why we check operating cash is higher than net income. Balance sheet and income statement work on accrual accounting. So this huge unbilled revenue is added as current assets in balance sheet and as revenue in income statement but the important thing is that we dont have that cash in our bank and the cash flow statement tells us that with the negative (35,605.21).

      Companies use this technique to inflate earnings, so if you find a company which has higher net income but lower operating cash flow year on year, you should probably stay away from such companies. In EIL’s case most of the years its operating cash flow was higher than net profit which is good.

  11. Thank you Krish, that certainly helped. So they are booking the revenue earlier , which shows up in the net income statement , but the actual cash coming into the bank comes in later , so thats why we have this disparity.So if we see a consistent trend of operating income higher than the cash flow from operations (say over 3 years so) ., that’s a sure shot avoid.

    • Yes, consistent trend of income higher than CFO is not good.

      Nestle is good example of CFO being higher than net income consistently

      i.imgur.com/nT80p.png

      • Thanks, Krish. How do we calculate free cash flow ? Is it Cash Flow Operations – capital expenditures? (Ignoring Depreciation)

  12. Now it is heading for Rs.100; But I do not have the confidence to buy it. I do not understand important details of this report, like

    “Is its operating cash flow higher than net profits?”
    Why is that important?

    • Nishanth says:

      Amit ,to your question — Operating cash flow or Cash flow from operations trend and net profits trend should be similar and parallel over a long period of time , preferably 10 years.If there is substantial divergence in the 2 , it can mean questionable earnings quality or very aggressive accounting practices. Now for Engineers India, for a 10 year period , 7 out of those 10 , cash flow from operations have been greater than net profit , which is a good sign.

  13. Hi Vishal,

    Given the stock has fell a fair bit in the last one year, this looks like an attractive buy now.

    I think one of the reasons is potential divestment of the Govt. of India which has been in news – but still that cant justify trading at 8-8.5x PE levels. Appreciate your thoughts on this matter.

    Regards,

    • Nishanth says:

      Ashish,

      Maybe this might help. EIL has recently hit a 3 year low , due to multiple reasons. One of them is the divestment as you mentioned above. Others include 1) the stock has recently gone ex-dividend and the share price adjusts downward 2) EIL has been having a sluggish financial performance recently with not much orders getting added to the order book 3) EIL recently recommended cancellation of one of it’s major contracts carried out by Fernas Construction , on the grounds that Fernas Construction submitted false experience certificates and obtained the contract through fraudulent means.

      Now as to the 3rd reason, this should actually be a positive signal to a small investor , as it shows the management is willing to forgo a substantial contract and earnings in exchange for sticking to its ethics and principles.And we all know how rare that is in Indian companies:)

      Now the second reason is a serious reason. But is it a structural long term trend of declining earnings for EIL? I believe no.As we all know , infrastructure capex spending is on a decline in India and will be so for some time more, for sure. Will it pick up ? It should ,as otherwise our country will grow. Will EIL benefit ? It will, for the reasons VIshal has outlined in his report below.

      Finally , is it a good time to buy ? When do you buy a good or great company ? When everybody is optimistic and happy about it and its share prices trade at all time highs? (Eg:GSK Consumer ,Asian Paints,Nestle,Colgate etc) or when everybody is pessimistic about earnings and scared that it might go even lower ? The answer is obvious , is it not?.If you are convinced through your research that EIL will overcome this earnings downturn , it makes the decision easy for you.(or vice-versa)

      We have established that EIL is a good company and will not go out of business, rather will prosper over the next 10 years in accordance with the Indian economy.And it is trading at the lowest valuations in its listed history.If you don’t buy it now , when will we buy it? Can it go further ? Absolutely. What is the bottom price ? I have no idea and i don’t care. Neither should you , the only thing yoyu should think about is whether the market is offering this business to you at a good discount to its intrinsic value. If you feel yes, go ahead and buy.If no , sit tight.Should you sell your house and buy this business ? No , because nothing in this world is a sure bet.Can you put 10% of your portfolio into it ? Depends on your risk tolerance and comfort level , which is a personal decision.

      I established via my research that the current price or lower is a good time to buy into this business. Am I scared by short term volatility ? No. I have an intended holding horizon of 10 + years as well, so i started buying this business.

      Now , I will stop my gyan 🙂 and the rest lies in your hands.All the best!!

      • Thanks Nishanth.

        Agree with most of what you have outlined. I’m developing my investment thesis further. The Company has cash on books of ~Rs. 70/share. Its likely that for next couple of years Company will not report growth in numbers – stagnant to slight de-growth with ~EPS of conservatively say Rs. 17/share based on current order book. Is it then correct to assume that with a strong visibility of Rs. 104/share “in the bag”, I’m getting the future cashflows of this company at Rs 53/share.

        This number corresponds to 2% degrowth every year in free cashflows for next 5 yrs. No growth thereafter and no terminal growth rate. Assumed a 15% discount rate. A scenario, though possible but with low probability I would say.

  14. Nishanth says:

    Yes , what you said is correct..although lets take the cash per share to be half , to be even more conservative.

  15. Jignesh Sanghvi says:

    Superb checklist. CMP of EIL is well below its intrinsic value less margin of safety.

    Sounds to me a must BUY 🙂

  16. Shiv Kumar says:

    Is the government’s proposed OFS a positive or negative for EIL? I have not holdings on this one, but plan to buy into this one after exiting one company. I am not sure whether to buy this in one go or do so in a staggered manner.

  17. “As far as the financials are concerned, EIL has always been a zero debt company, earns high return ratios, has maintained decent gross margins, and has minimal working capital requirements. These are also sources of moat for the company.”

    Are these sources for moat or are they results of the moat of the company….

  18. Mahendra says:

    Superb analysis of eil. I am holding about 8 % of my portfolio in this stock at an avg price of 235 and am planning to add more on the current decline. My only issue with the analysis is on the moat. I believe that eil has a very strong most because it is a preferred vendor for most of the PSU oil cos which are into hydrocarbons band oil and gas pipelines. With a new govt in place activity in this space should pick up and eil should be a major beneficiary. At this price eil makes for a compelling investment case with low valuations, high return ratios, good dividend yield, strong moat and an imminent business cycle revival.

Trackbacks

  1. […] Originally Posted by kkrules11 Hi Folks, Anyone can give me info about EIL for short term. Thanks in advance. Karthik Here you go Safal Niveshak StockTalk #12: Engineers India […]

  2. […] see a lot of this happening with a lot of people who bought BHEL and Engineers India at “my” base intrinsic values of Rs 180 and Rs 195 […]

  3. […] Safal Niveshak StockTalk #12: Engineers India https://www.safalniveshak.com/stocktalk12-engineers-india/ Nov 26, 2012… research report on Engineers India Ltd., India's leading engineering … The company currently has an order book (orders received but not yet … […]

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