Research Report - Greaves Cotton Ltd

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Greaves Cotton Ltd
Buy (Target Price: Rs 90)

 

Market Data Price on reco. date (Rs) 63 (BSE) Mkt. Price BSE / NSE (Rs) 64 / 64 Change since reco.  1.0% 52-week High/Low (Rs) 87 / 60 NSE Symbol GREAVESCOT BSE Code 501455 No. of shares 244.2 m Free float 48.4% Market cap (Rs m) 15,385   Rs 100 invested is now worth   Stock price performance GCL Index* 6-Mths -7.3% -5.5% 1-Yrs -24.6% -3.7% 3-Yrs 2.6% -3.2% Returns over 1 yr are compounded annual averages * BSE Midcap index Shareholding (Dec-12) Category (%) Promoters 51.6 FIIs 8.4 DIIs 27.2 Others 12.8 Total 100.0

Investment Rationale An uncharacteristic moat for an ancillary play: Moat, in simple words, is the ability of the business to maintain a competitive edge over its competitors. It is all the more difficult to create a moat around businesses where its fortunes itself are dependent upon another industry. Greaves Cotton, our Midcap Select for this fortnight, is one such company which has managed to achieve this feat. Basically, Greaves Cotton manufactures auto engines. As such, its fortunes are dependent upon the auto industry. A slowdown in the latter can have impact on the business of the company. Also, the company lacks necessary pricing power. That's because it deals with larger original equipment manufacturers (OEMs). Further, it should be noted that most auto companies have their own captive engine manufacturing capabilities. Hence, the business case for Greaves Cotton arises only when an auto company decides to outsource its engine requirements. All these factors add a large deal of uncertainty factor to the business. But yet the company has managed to create a moat around itself. Let us see how. The company enters into a long term supply agreement of about 8-10 years with the OEMs. And there are basically two reasons that enable the company to do that. The first reason is the technological skill sets that the company possesses. This enables it to manufacture fuel efficient and pollution compliant engines. Secondly, it may be noted that outsourcing becomes a necessity for OEMs especially during boom times. That's because OEMs can't afford to focus only on in house engine manufacturing during such periods. If they do, then competition may erode the market share by cutting down the cycle time through outsourcing. Also, it may be noted that outsourcing is not just a boom time phenomena. Let's say that an auto company wants to focus only on assembling and marketing which are its core strengths. In that case, outsourcing becomes a requirement. Thus, the case for outsourcing reduces the uncertainty factor associated with the business. Further, long term supply agreements add the necessary stability. In short, Greaves Cotton is a perfect recipe of a business with strong economic moat. The valuations are also attractive with the stock trading at 9.4 times our FY15E EPS estimates. As such, we advise investors to buy the stock with a target of Rs 90 from an FY15 perspective. This provides a point to point return of 44% and CAGR of 20%. However, investors should ensure that no stock forms more than 5% of their portfolio. They are also advised to have a look at the asset allocation guide appended at the end. Strong balance sheet and shareholder friendly: Greaves Cotton has an excellent historical track record. It has been relatively debt free, and over the last 10 years, its RoE has averaged in the region of 26%. Its operating cash flows have also been positive over the same period. It has also been paying dividends since the last 18 quarters in a row now. This shows management's intention of rewarding shareholders. Also, it may be noted that in FY12, the company paid a special dividend of Rs 0.80 per share on gain arising from sale of land. Now, this is quite uncharacteristic of a company operating in a tight liquid environment. There are many companies that would prefer to hoard cash on their balance sheets in such a scenario. However, management's willingness to release cash for the want of right deployment opportunity speaks volumes about its capital allocation skills. Diversified portfolio with rich clientele: Greaves Cotton has a well diversified engine portfolio with a rich clientele. Overall, auto engines contribute 50-55% of total sales. Within the auto space, the company majorly focuses on the light commercial vehicle (LCV) segment. It has presence in both 3 and 4 wheeler LCV space. While in the 4 wheeler space it is still a small operator with only one major client namely Tata Motors the market share of the company in this space has increased from less than 3% in FY11 to about 9% in FY12. In the 3 wheeler space, the company has 80% market share. Apart from auto engines, Greaves Cotton also manufactures engines which are used in the agro equipments and auxiliary power industry. The company also manufactures industrial engines which are used in marine, material handling and mining & construction applications as well. Thus, even if the auto segment within the engines division is concentrated towards LCV, the overall portfolio is well diversified Apart from a diversified portfolio the company also has a rich clientele base. In the auto space, the company has contracts with leading vehicle manufacturers like Piaggio, Tata Motors, M&M and Atul Auto etc. And these are long term supply contracts which provide sustainability and stability to the business model. Non-auto engines business offers lucrative opportunity: Although within the engine division, auto has the larger revenue pie, the company's non-auto businesses offer lucrative opportunity over the longer term. The agro equipment division offers huge opportunities due to the capability to produce multi fuel engines and pump sets. Apart from this, the company also has a strong nationwide distribution network which is of prime importance. Further the company also manufactures generation sets which are used in retail outlets, hotels, hospitals and commercial complexes. With organised retail gaining momentum in India, the auxiliary power segment has huge opportunities going forward. In addition, the company also plans to strengthen its presence in the marine segment which has eroded over time due to lack of focus. Thus, we believe the non-auto engine business holds potential in the near future. Infrastructure equipment division shows signs of revival: The construction equipment division of the company has been a laggard especially on the profitability front. The segment incurred losses in FY12 and was also in the red as of 9MFY13. However, the road equipment business has shown signs of revival. Even though the concrete segment is still suffering the company introduced a few new products in this segment and strengthened the distribution network. As a result, the market share from the concrete segment improved. Also, the management feels that breakeven for this segment is likely to be achieved in 4QFY13 (not for the full year but only for the particular quarter). As such, we feel that the infrastructure equipment business is at the cusp of revival and going forward the performance is likely to improve. Cost reduction initiatives to support margins: It may be noted that the company has undertaken various material cost reduction initiatives over the last two quarters in order to improve margins. And its fruits are already visible. For instance, in 3QFY13, the operating margins of the company improved to 13.9% from 12.4% in 3QFY12. And the trend is likely to continue in the future as well. Although the margins of the company are vulnerable to movement in the material & manufacturing expenses it may be noted that raw material cost have remained in the region of 70% over the last 5 years (FY09 was an exception). Thus, material expenses do not show much volatility and if steps are taken to reduce the same it can have positive impact on the operating margins.

 

Investment Concerns Fortunes dependent upon auto industry: Engines basically play an ancillary role to the broader auto industry in general. Thus, fortunes of the engine industry are closely linked to the cyclicality in the auto space. Hence, a slowdown in the auto industry is likely to have a direct impact on Greaves Cotton. Nonetheless, it may be noted that auto engines consists of about 50-55% of the company's total sales. Over time the company has diversified itself into industrial, power and other segments. Thus, its reliance on the auto industry has lowered over time. Apart from this it is interesting to note that Greaves Cotton enters into long term supply contracts with the auto companies, thereby providing long term visibility to the business. Lacks pricing power: Being an ancillary play, the company lacks bargaining power. Not surprisingly, the engine realizations over the last few years have been in declining trend. And we do not expect the trend to reverse in the near future either. Thus, if the raw material prices which account for 70% of the total cost, increase due to general volatility in commodity market, margins can come under pressure. However, it may be noted that the company does take calibrated increase in prices depending upon the market situation. For instance, in 3QFY13, it increased the realizations with one particular customer by 5%. However, it may be noted that while the company does increase prices depending upon the market situation and raw material volatility it can't dictate terms. Also, with increasing competition the ability to increase prices is limited. Background Established in 1859, Greaves Cotton Ltd is one of the leading and well diversified engineering companies in India. The company's business is basically divided into three segments viz; Engines, Infrastructure Equipments and Others. Greaves Cotton manufactures engines which are used in the auto and agro equipment industry. Apart from this, the company also manufactures industrial engines used for marine, material handling, and mining & construction applications. It is also involved in manufacture of generation sets used in retail outlets, commercial complexes, hotels and hospitals. The infrastructure equipment division manufactures products like concrete mixers, batching plants, concrete pumps used in the construction industry. It also manufactures vibratory rollers for asphalt and soil compaction. The company also has presence in the earth moving segment which opens up opportunities in the road building and irrigation. The others segment consists of stores of spares which are used for refurbishment of engines and construction equipment.   Industry Prospects The fortunes of the engine industry are closely linked to the prospects of the auto industry as a whole. The Indian auto sector reported a near flat growth in FY12. However, the small commercial vehicle segment where Greaves Cotton has presence grew by 27% YoY. Further, within that the 3 wheeler diesel vehicles grew by 5% YoY compared to 18% YoY growth witnessed in the previous year. So, overall FY12 was a tough year for the auto industry. However, with interest rates cooling down one may see revival in volumes going forward. Also, the power deficit that prevails in the country will augment the demand for generation sets over the next few years. Further, increasing thrust on urban and rural infrastructure will be the critical growth catalyst for the construction equipment division. Entry into the earth moving segment will also broaden the overall portfolio. So, overall the prospects for both auto and non-auto business appear to be bright.   Key Management Personnel Mr Karan Thapar serves as a chairman of Cotton Greaves Ltd. He is a qualified Chartered Accountant and has directorship with different Thapar Group companies including English Indian Clays Ltd, Bharat Projects Pvt Ltd, Bharat Starch Products Ltd etc. Mr Sunil Pahilajani is the managing director and CEO of the company. He is a mechanical engineer from Indian Institute of Technology, Roorkee. Overall he has more than 27 years of experience with various companies namely Maruti Udyog Ltd, Mahindra Navistar engines, Caparo India etc. Risk Analysis Sector: Engines typically play an ancillary role to the broader auto industry. And the auto industry itself has witnessed a slowdown off late. Also, delay in capex by corporates is hurting the volumes in infrastructure and equipments division. As a result, we assign a 'medium' risk rating to the stock on this parameter. Company standing: Greaves Cotton is one of the leading player and a well diversified engineering company with an 80% market share in single cylinder engines market. The company also has a strong presence in the non-auto engine market thus providing a cushion in case of a slowdown in the auto industry. It also has a strong portfolio of infrastructure equipments. We thus assign a 'strong' rating to the company on this parameter. Sales: Greaves Cotton has generated average revenues to the tune of nearly Rs 16.2 bn over the last three years. It may be noted that 9MFY11 figures have been annualized to arrive at the past 3 year average. Further, the company is expected to generate average revenues to the tune of Rs 19.5 bn over the next three years. We thus assign a low risk rating of 10 to the stock on this parameter. Operating margin: Operating margin is a measurement of what proportion of a company's revenue is left over after paying for variable costs of production such as raw materials, wages, and sales and marketing costs. A healthy operating margin is required for a company to be able to pay for its fixed costs, such as interest on debt. The higher the margin, the better it is for the company as it indicates its operating efficiency. Greaves Cotton's average operating margins for the past three years has been 14.5%, and we expect it to marginally decline to 13.6% during the next three years. As such, we assign a medium risk rating of 4 to the stock on this parameter. Long term EPS growth: We expect the company's adjusted net profit to grow at a CAGR of 7.2 % between FY12 and FY15 (CAGR of 45.1% during FY09-FY12).As such, the rating assigned to the stock on this factor is 2. Return on capital invested (ROIC): ROIC is an important tool to assess a company's potential to be a quality investment by determining how well the management is able to allocate capital into its operations for future growth. A ROIC of above 15% is considered decent for companies that are in an expansionary phase. Considering Greaves Cotton's last three years' average ROIC of 25.7%, we have assigned a medium-risk rating of 6 to the stock on this parameter. Dividend payout: Greaves Cotton had an average dividend payout of 40% over the last 3 years. Going forward we expect the payout ratio to stabilize at 30%. The rating assigned on this parameter is 9. Promoter holding: A larger share of promoter holding indicates the confidence of people who run the company. We believe that a greater than 40% promoter holding indicates safety for retail investors. At the end of December 2012, the promoter holding in Greaves Cotton stood at 51.5%. We have thus assigned a medium-risk rating of 5 to the stock. FII holding: We believe that FII holding of greater than 25% can lead to high volatility in the stock price. FII holding in the company stood at 8.4% at the end of December 2012. Therefore, the rating assigned is 8. Liquidity: The past 52-week's average daily volume of the stock on both BSE and NSE is in the range of 112,000 shares, which indicates that the stock has high liquidity. The rating assigned is thus 7. Current ratio: The average current ratio of the company during the last three years stood at 1.5 times, indicating the company's ability to pay up short-term obligations. A ratio under 1 suggests that the company is unable, at that point, to pay off its obligations if they came due. Based on these factors, we assign a medium-risk rating of 6 to the stock. Debt to equity ratio: A highly leveraged business is the first to get hit during times of economic downturn, as companies have to consistently pay interest costs, despite lower profitability. We believe that a debt to equity ratio of greater than 1 is a high-risk proposition. The company has been relatively debt free over the last 3 years. We have thus assigned it a risk rating of 10. Interest coverage ratio: This ratio is used to determine how comfortably a company is placed in terms of payment of interest on outstanding debt. The interest coverage ratio is calculated by dividing a company's earnings before interest and taxes (EBIT) by its interest expense for a given period. The lower the ratio, the greater are the risks. As the company is relatively debt free the rating assigned to the stock on this parameter is 10. P/E Ratio: The P/E ratio (price-to-earnings ratio) of a stock is a measure of the price paid for a share relative to per share income or profit earned by the company. This is one of the important metrics to judge the attractiveness of a stock, and thus gets the highest weightage in our risk matrix. The company's standalone P/E on its earnings of the past four quarters currently stands at 8.6 times. As such, we have assigned a risk rating of 8 to the stock on this parameter. Considering the above analysis, the total ranking assigned to the company is 84 that, on a weighted basis, stands at 6.9. This makes the stock a medium-risk investment from a long-term perspective.   Valuations Greaves Cotton is an independent engine manufacturer with 80% market share in single cylinder diesel engines market. In addition, the company also has a strong foothold in the non-auto engine business as well, thereby diversifying the overall portfolio. Furthermore, it has a strong balance sheet, high returns on capital and healthy cash flows. Over the last five years, the company has traded at an average multiple of 15x TTM earnings. However, considering the recent slowdown in the auto sector as well as poor performance from the infrastructure equipment division we apply a 10% discount to the past 5 year TTM average multiple. As such, we assign a multiple of 13.5x on FY15 EPS which yields a target of Rs 90. This offers a CAGR of 20% over a two year period. As such, we recommend a buy on the stock. However, investors should ensure that no stock forms more than 5% of his/her portfolio. It should be noted that we had last recommended this stock in March 2011 with a target price of Rs 125 per share. But with the end user industry of the company's products entering a slowdown, the earlier target looks difficult to achieve over the next couple of years. Having said that, some potential for outperformance from our new target price of Rs 90 does exist if there is a revival in the end user industries. But we have preferred to be conservative with both our earnings estimates and also the PE multiple that we have given to the stock. Valuations   Consolidated (Rs m) FY12 FY13E FY14E FY15E Revenue (Rs m) 17,893 18,767 19,656 20,354 Adjusted PAT (Rs m) 1,315 1,549 1,558 1,623 EPS (Rs) 5.4 6.3 6.4 6.6 Price to earnings (x) 11.6 9.9 9.8 9.4 EV/EBITDA (x) 6.3 6.0 5.6 5.3 EV/Sales (x) 0.9 0.8 0.8 0.7 Adjusted RoE (%) 20.8% 21.5% 18.7% 17.2% RoCE (%) 19.6% 18.7% 17.2% 15.8%   Risk Matrix Rating accorded Rating Weightage* (A) Rating# (B) Weighted (A*B) Sector risk - Medium NA Company's standing - Strong NA Performance parameters Sales 5.0% 10 0.5 Operating margins 5.0% 4 0.2 Long term EPS growth 10.0% 2 0.2 Return on invested capital 10.0% 5 0.5 Technical parameters Dividend payout 5.0% 9 0.5 Promoter holding 10.0% 5 0.5 FII holding 5.0% 8 0.4 Liquidity 10.0% 7 0.7 Safety parameters Current ratio 5.0% 6 0.3 Debt to equity ratio 10.0% 10 1.0 Interest coverage ratio 5.0% 10 0.5 P/E ratio 20.0% 8 1.6 Final Rating** 84 6.9 # Rating has been assigned on the basis of the company's performance over the past five years and expected performance over the next 3 to 5 years. Rating is on a scale of 1 to 10, with 1 indicating highest risk and 10 indicating lowest risk. * 'Weightage' indicates the relative importance in percentage terms of the parameter. For instance, for an investor, given all the performance metrics, return ratios (say ROE) should be the foremost criteria for buying/not buying stocks. ** The final rating has been arrived at by multiplying the rating/points given on each parameter with the respective weightage Financials at a glance   Consolidated (Rs m) FY12 FY13E FY14E FY15E Total income 17,893 18,767 19,656 20,354 Sales growth (%) 39.7% 4.9% 4.7% 3.6% Operating profit 2,367 2,496 2,673 2,809 Operating profit margin (%) 13.2% 13.3% 13.6% 13.8% Adjusted Net profit 1,315 1,549 1,558 1,623 Adjusted Net profit margin (%) 7.3% 8.3% 7.9% 8.0%   Balance Sheet Current assets 6,972 7,934 8,545 9,617 Fixed assets 3,510 3,567 4,089 4,257 Others 437 465 477 486 Total Assets 10,919 11,967 13,110 14,359   Current liabilities 3,739 3,770 3,743 3,762 Net worth 6,310 7,218 8,308 9,444 Loan Funds 330 363 417 474 Others 540 616 642 679 Total liabilities 10,919 11,967 13,110 14,359