Top Small Cap Stocks Driving Growth in India's Railway Sector

In recent weeks, the railway sector was jolted by a concerning incident in Kanpur. A potentially disastrous event unfolded when a cylinder was placed on the railway tracks. Fortunately, quick action was taken, and the emergency brakes were applied in time, bringing the train to a screeching halt, preventing a major accident.

This, however, is not an isolated incident. Alongside the cylinder, authorities also discovered other suspicious materials at the scene, including a petrol bottle, matchboxes, and what appeared to be a substance resembling gunpowder. These discoveries are deeply troubling, especially when we consider that this incident is one of over a dozen similar cases this year, where hazardous items were found on railway tracks across the country.

Post-pandemic, there has been an increased financial investment in India’s railway sector, leading to growth and positive returns for investors in this industry. However, the possibility of accidents looms large, and any significant mishap could halt the progress seen thus far. It is evident that while budget allocations have been directed toward infrastructure, the safety of the railway network requires equal, if not more, attention. Safety measures must go beyond constructing new tracks and launching new trains; they must include comprehensive upgrades to the railway safety systems. This is a matter not only of capital but of human lives.

Ensuring the safety of the railway network demands a multi-layered approach. Systems need to be put in place to enhance the vigilance of train drivers, minimize human error, secure level crossing gates, monitor track occupancy through complete track circuiting, and improve visibility in adverse weather conditions. Furthermore, the tracks themselves must be of high strength, with mechanisms for efficient track-laying, signaling infrastructure, and regular inspections and maintenance of both tracks and bridges. The technical aspects involved are numerous and complex.

Despite these challenges, it is worth noting that significant progress has been made over the years. In 2001, India witnessed 473 train accidents. By 2023, that number had dropped to 48. While this is commendable, the goal should be to achieve zero accidents, which will require continued and increased investment in railway safety systems.

The government has recognized the importance of safety, and between 2017 and 2018, Rs 1 trillion was allocated to railway safety. By 2022, Rs 1.08 trillion had been utilized. Despite these investments, it’s clear that human control has its limitations. An accident-free railway system requires automation, and India’s own train protection system, ‘Kavach,’ could be the key to this goal.

Kavach is an indigenously developed, automated train protection system that has already been tested on high-speed Vande Bharat trains. It is designed to stop trains traveling at speeds of over 150 kmph within 10 meters of a danger signal by automatically applying the brakes. Not only is Kavach effective, but it is also the most cost-efficient system of its kind globally.

Initially launched as a pilot project in 2016, Kavach was officially adopted as a national system in 2020. As of now, work on installing Kavach has been expedited across 3,000 route kilometers (Rkm). This is just the beginning, with the goal of covering over 35,000 kilometers in the next five years.

As Kavach continues to roll out, several companies stand to benefit, particularly those specializing in railway safety systems. One such company is HBL Power Systems. Known for addressing niche yet scalable markets, HBL Power Systems focuses on sectors like oil and gas, electric vehicles, defense, energy storage systems, and data centers, in addition to railways. The company has made a name for itself by avoiding capital-intensive industries and prioritizing engineering prowess, supported by in-house research and development.

HBL Power Systems has been involved in train safety systems since 2007, and with Kavach now a commercial business, the company expects significant growth. The company’s financials reflect strong performance, with a return on capital employed of 34% and a solid operating profit margin of 20%. While its price-to-earnings (PE) ratio may seem high at 52x, its profits have grown 137% in the past year, resulting in a low price-to-earnings growth (PEG) ratio of 0.4x. Despite some risks, such as order execution challenges and potential issues with its stretched operating cycle, HBL Power Systems remains a strong candidate for investors interested in the railway safety sector.

Another company worth mentioning is Kernex Microsystems (India) Ltd. Although its financial performance has been less than stellar in recent years, with losses, negative return ratios, and a prolonged working capital cycle, recent developments have made it a stock worth watching. Insider buying in August 2024 and a turnaround in its financials during the June quarter have caught investors’ attention. Kernex is involved in railway safety systems, telecom, defense, and IoT products. The company expects its Kavach-related business to grow tenfold by FY27.

While time will tell if Kernex can sustain this momentum, it is another stock to consider for those monitoring the Kavach theme.

A third company to watch is Concord Control Systems Ltd, a small and medium enterprise (SME) with a market capitalization of Rs 11 billion. Concord specializes in traction and coaching products, including battery chargers, lights, fans, and control panels. The company is also making strides in advanced communication products used in locomotive operations. It has invested in research-based companies, integrating them into its railway ecosystem. Notably, Concord has a 26% stake in Progota India, a company involved in Kavach projects. With a robust order book and strong financials, including a return on equity of 28%, Concord is aiming for a 40-50% compound annual growth rate (CAGR) in revenue over the next few years.

Other companies to keep an eye on include Railtel and KEC International, both of which are positioned to benefit from the growing focus on railway safety.

It is Important to note that while these companies show promise, they also come with risks. Execution challenges, order delays, and market fluctuations could impact their performance. Investors must conduct thorough research before making any investment decisions. Nevertheless, the opportunities presented by Kavach are substantial, making these stocks worthy of consideration for those interested in the railway safety sector.

As India’s railway sector continues to modernize and expand, safety will remain a top priority. The progress made so far is encouraging, but there is still much work to be done to ensure the safety of passengers and the efficiency of the system.