My Best Pick 2016

Shilpa Krishnan

Shilpa Krishnan of Prabhudas Lilladher on why VA Tech Wabag has the makings of a multibagger

When I first travelled to Singapore in the late ’90s, I had called for bottled water at the hotel I was staying. I was pleasantly surprised when the attendant got me a normal bottle and told me it was perfectly safe to drink the tap water. When I moved here five years ago, I realised that the Aquaguard and Eureka Forbes water purifiers that were indispensable in most Mumbai kitchens, were almost redundant in Singapore, thanks to the absolutely safe potable water supplied by the Public Utilities Board.

If Singapore can emerge so strongly from a situation of severe water shortage and polluted rivers at its inception, so can Indian cities. Recently, Amaravati, the proposed capital of Andhra Pradesh, has sought to model itself on Singapore, with the latter providing the master plan. Similarly, many other cities are working towards the same goal. This humongous potential for clean drinking water supply in megapolises such as Mumbai can result in a multi-year growth opportunity for companies such as VA Tech. 

A total water technology company, VA Tech Wabag provides water treatment solutions to municipalities and industrial users, on an EPC basis. Its design and engineering capabilities span drinking water treatment, industrial and process water treatment, desalination and wastewater treatment. With a presence in over 30 countries, the company boasts of more than 100 registered patents and over 2,250 projects over the past three decades. The domestic business (including exports to west Asia and other regions on the continent) and international business account for 50% of revenue each. While the municipalities vertical contributes 68% to revenue, the industrial vertical accounts for the rest. Over the past seven years, VA Tech has clocked impressive revenue CAGR of 21% and PAT CAGR of 42%.

Humongous potential

India has several cities where households do not even have a basic water and sewage connection. The decline in per capita water availability to below 1,700 cubic meters has given India an unfortunate status of a ‘water-stressed’ nation. Unprecedented growth and burgeoning population have created immense pressure on water supply and sewage disposal systems. 

The Indian water supply and wastewater treatment segment will require ₹13.5 trillion of investments — including capex and O&M — over the next 20 years. While many might think this is a staggering number, here is simple math to put these numbers in perspective. I pored over the annual report of Singapore’s water supply utility, which spent $12.3 billion on capex and O&M, cumulatively, over the past 10 years, to cater to its population of approximately 5 million. With a population 250x that of Singapore (and a higher density), I would argue that a future estimate equivalent to 20x what Singapore already spent, in twice the time period, is the least India should do. 

The moot question, however, is not if we need to spend, but if we have the resources to do so. Currently, government, local bodies and multilateral agencies fund water supply projects in India. In other infrastructure sectors, public utilities are overcoming user resistance to pay, which is why toll roads, higher electricity tariffs and voluntary relinquishment of domestic subsidies are becoming more common. Water supply in India is highly subsidised and under-invested, as 80% of the 164 million litre of daily water production is not paid for and utilities recover only 35% of their O&M cost. This calls for levying reasonable consumption-based user charges for water, too, in order to conserve resources and create a sustainable funding mechanism for drinking water supply. 

 Competitive advantage

The water treatment industry is highly competitive. While L&T, Thermax, VA Tech, Praj Industries and Ion Exchange are significant players, VA Tech is the only pure play water company among these.

With patented technologies, an impressive track record and client list, VA Tech is in a great position for the opportunities thrown up in the space due to big government initiatives. The order-book of ₹7,100 crore, including ₹5,600 EPC contracts and the balance O&M contracts, provides the company visibility for 15% revenue CAGR for the next two years. Abating cost pressure could pave the way for a 20% profit CAGR. 

Conventionally, most EPC companies attempt to capture the complete value chain, making it imperative to invest in capital assets and take on debt. VA Tech, however, focuses more on design and technology and outsources the capex-heavy civil portion to large contractors. This has enabled the company to maintain a relatively asset-light balance sheet, with net cash. Working capital requirement is high at around 115 days of sales, but a clean balance sheet helps the company easily fund its current assets. To address the growing demand for BOT investments, VA Tech has a tie-up with Sumitomo Corp of Japan, where the former’s investment is limited to a minority equity stake and the latter brings in cheaper funds. The company has also adopted the collaborative route for O&M and desalination contracts in west Asia. 

Trading at an estimated multiple of 28x and a price-to-book multiple of 3.8x, VA Tech is not a cheap stock. Its valuation reflects the premium accorded to the company’s leadership position in a multi-year high-growth vertical and a strategy to achieve this growth while maintaining a clean balance sheet. 

 Water theme

The global energy and commodity meltdown has severely damaged private investment sentiment. While the market sentiment towards government initiatives has oscillated between exuberance and disappointment over the past two years, I think 2016 will be the year for investment plays in select sectors. Thus, VA Tech will benefit. 

Over the past few quarters, VA Tech’s performance has fallen a bit shy of expectations, as the international business has faced headwinds owing to Euro depreciation, project delays, cost over-runs and liquidated damages (a means of compensation for breach of contract). For VA Tech, a pick-up in the domestic business will be an important stock price driver, as this business is more profitable (12-13% margin) compared with international business (4-5% margin). The domestic business is also predictable in terms of project costs and risks. It is not surprising, therefore, that EPC players with higher domestic revenues tend to command higher valuation multiples. I see 2016 as a year where the fundamental drivers are in place for stronger domestic revenue, which can set the tone for higher growth and re-rating of the stock.  

The views expressed in this article are the author’s own and she does not own the stock