KEC International has agreed to acquire 100% stake in SAE Towers, a US-based transmission tower company for an enterprise value of $95 million. KEC would acquire this stake from a private equity firm, Acon Investments. SAE Towers is a leading steel lattice transmission tower company with an annual production capacity of 100,000 tonnes. It has manufacturing facilities located in Mexico and Brazil and operates in the Brazil, Mexico, and US markets (more than 40% marketshare).

The transaction would provide access to KEC in North and Latin America and would also lead to KEC becoming the largest lattice tower manufacturing company globally. Further, it would also help both companies to draw synergies from each other in terms of technology and processes.

Funding through internal accruals and debt: The management has indicated that the acquisition would be funded through internal accruals and debt. KEC had a closing cash balance of Rs 70 crore at the end of FY10 while debt on the books of SAE is $16 million.

SAE tower acquisition likely to be EPS accretive: The company is expected to report annual turnover of $137 million for CY10 (December 2010), with Ebitda margin of 14% and PAT (profit after tax) margin of 8%. The management has indicated that the capacity utilisation of SAE Towers is expected to increase from 60% to 100% in next three to four years given the strong demand expected in the American markets. Further, the Ebitda (earnings before interest, taxes, depreciation and amortisation) margin is expected to be sustainable at 12-14%, while PAT margin at 7-8%. We estimate the deal to be earnings-accretive as SAE is likely to provide incremental earnings of about 15% during first 12 months post-deal closure.

Valuation: We value KEC international using PE (price-to-earnings) multiple-based valuation. KEC has historically traded in the range of 10x-20x. It traded in the range of 5x-10x for a brief period due to market correction and currently trades in the band of 10-15x. HSBC earnings are 8% lower than consensus for FY12 primarily due to lower sales growth. Given 7% YoY (year-on-year) growth in order book, consensus sales growth estimate of 17% in FY12 looks aggressive. Based on target PE multiple of 13x and forward 4-quarter earnings (March 2012 earnings per share), we arrive at target price of Rs 595.

Under our research model, for stocks with a volatility indicator, the Neutral band is 10 percentage points above and below the hurdle rate for India stocks of 10.5%. For KEC, this translates into a Neutral band of 0.5-20.5% around the current share price. Our target price of Rs 595 for KEC shares implies a potential total return.

Key risks: (i) slowdown in order flow; (ii) higher execution, which may lead to higher revenue booking than in our estimates; (iii) lower/higher cost of raw materials; (iv) higher than expected interest cost; and (v) lower/higher tax due to carry forward losses in RPG Cables post merger.