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Escorts Limited
Favourable Tailwinds!
Investment rationale
Selling Investments - focusing on business!
Escorts has restructured its entire business by divesting its stake in all its loss
making businesses (telecom, healthcare, etc.) and using the proceeds to repay
the huge debt accumulated for the same. Subsequently, it has now enhanced
its focus on its core businesses (agri-machinery, railway equipment, auto
components and construction equipment). In our opinion this could not have
come at a better time as all its core businesses are at an inflection point with
favourable tailwinds and Escorts is well-positioned to benefit from the same.
Tractor business on strong footing
Escorts, with 13% market share in tractors, has successfully maintained its
number three position despite major consolidation in the tractor industry
(M&M~PTL, TAFE~Eicher). Now, as utilisation levels ramp-up from the current
61% to 70% in FY11e and 78% in FY12e, Escorts is expected to benefit from
operating leverage, which will enable it to show a sharp improvement in
profitability. The minimal capex will also ensure a sharp uptick in cash
generation and return ratios.
Other businesses - small contribution, huge potential!
While tractors will remain the mainstay for the company, the outlook for its
other businesses is positive. The underlying buoyancy in the infrastructure
segment provides huge scope for the construction equipment subsidiary (ECEL).
With its already well-established service and distribution network along with
a strong brand recall, Escorts is well-placed to benefit from the same.
Valuation and outlook
At the CMP of INR170, the stock trades at 9.8x and 7.2x our FY11e and
FY12e consolidated earnings estimates. In our view, the current valuations do
not capture the sharp turnaround and potential earnings growth (FY10-12e
EPS CAGR of 40%). We recommend a BUY with a target price of INR236 (10x
FY12e EPS), which provides an upside potential of 39% from the current levels.
Investment rationale
Selling investments - focusing on business!
The company has managed to clean up its balance sheet after previously diversifying
into too many businesses, most of which were totally diverse from its core agri-equipment
and engineering division. Some of these like hospitals and telecom were extremely
capital intensive, which put strain on the company's balance sheet and also diluted
the management's bandwidth (and financial resources) from the company's core
businesses.
However, Escorts has now restructured its entire business by divesting its stake in all its
loss making investments. It hived off its telecom business (Escotel and Cellnext) for a
total consideration of INR2.2bn and hospitality business (Escorts Heart and Research
Institute) for a total consideration of INR5.85bn. It used proceeds to repay the huge
debt accumulated for the same. As a result, its consolidated debt has reduced from
INR15bn in FY03 to INR8.8bn in FY05 to INR4bn in FY10 (year ending September).
Consequently, leverage has reduced from 2x to 0.2x.
Subsequently, it has now enhanced its focus (managerial and financial) on its core
businesses, i.e., agri-machinery, railway equipment, auto components and construction
equipment. Now, without the drain of loss-making businesses and burden of the huge
debt, Escorts is well-positioned to capitalise on the growth potential offered by the core
businesses. This could not have come at a better time as all its core businesses are at an
inflection point with favourable tailwinds. With utilisation levels on an uptrend, it will
benefit from the operating leverage. Furthermore, with capacities in place, the capex
will be minimal, which will ensure a sharp uptick in cash generation and return ratios.
Tractor business on strong footing
The tractor industry witnessed a growth of 14% during FY03-10, led by increase in
disposable incomes on the back of rising MSPs and enhanced focus on increasing
farm credit. Farm mechanisation is on the rise attributable to a low availability of
labour and sharp increase in labour costs ~ a function of various policy measures
including the increase in allocation for NREGA (National Rural Employment Guarantee
Act), which has made rural labor scarce and expensive. NREGA gives every rural
household the right to a minimum 100 days of guaranteed employment with a minimum
wage of INR100/day paid within 15 days.
With buoyancy in construction activities, work has been aplenty and labour costs
have risen significantly. This has diverted rural labour (mainly unskilled) from agriculture
related activities to more rewarding and secure NREGA led construction/infrastructure
based activities. This is solely responsible for a high proportion of farm mechanisation,
which has led to the recent buoyancy in tractor demand.
Escorts is the third largest player in the tractor segment after M&M and TAFE, with a
current market share of 13%. It has successfully maintained its No. 3 position in the
largest (and probably the most competitive) tractor market, despite major consolidation
in the tractor industry (M&M~PTL, TAFE~Eicher) which is testimony to the strong brand
equity it enjoys amongst the farmers.
The company has a wide product range, but its forte is the more powerful higher hp
tractors. As a result, it is particularly strong in the 41-50hp range, which accounts for
51% of its volumes (as against 23% of industry volumes). The company is a market
leader in that segment along with M&M, with a market share of 29% each. To cement
its position in the 41-50hp range, it has launched a 45hp tractor with a four-cylinder
engine for the northern market as well as exports. In the longer term, it also plans to
launch a new product in the 15hp tractor range in future to compete with the Mahindra
Yuvraj, which targets smaller farmers to upgrade from bullocks. Penetration levels in
these smaller farms are extremely low (at 1 per 1,000 hectares).
Enhanced focus on relatively untapped avenues, i.e. the smaller-medium hp tractor range,
will help the company outperform the industry. Smaller tractors are apt for soft soil
conditions, as conducting agricultural operations on the same require lower-powered
tractors. Typically, northern states have relatively soft soil, and hence, the demand for
small tractors is higher in these regions, whereas in the southern and western regions, the
soil is relatively hard, and hence, the demand for medium and large tractors are higher.
With a strong ramp-up in volumes, led by aggressive product launches, coupled with
cost cutting initiatives and better working capital management, the company is in a
strong position to improve profitability as well. With annual capacity of 98,940 units,
the utilisation rates are still low at 60%, as against 84% for M&M, 105% for TAFE.
The lower utilisation levels has a visible effect on the margins of the company's tractor
division vis-à-vis that of Mahindra & Mahindra's.
Now, with utilisation levels on an uptrend, the company is expected to benefit from
the operating leverage, enabling it to show a sharp improvement in profitability. In
addition to leveraging of fixed costs, Escorts is undergoing a series of cost-cutting
initiatives like increasing employee productivity, replacing diesel with gas for fuel (as
per the management, this is estimated to reduce their power bill by ~10%) etc.
Other businesses - small contribution, big potential!
While the tractor business will be the mainstay for the company, its other businesses
are also on a favorable footing. The company's earth moving and construction
equipments division is under its 100% subsidiary - Escorts Construction Equipment
Limited (ECEL) which contributes 16% to the company's consolidated revenues and
10% to consolidated EBIT. The outlook for the construction equipment division is
extremely positive given the underlying buoyancy in the industry. We expect the
buoyancy in the sector to continue as infrastructure is still a high focus point for the
government considering its contribution to overall economic development. Investment
in infrastructure (as a % of GDP) is expected to increase from the 7-8% range currently
to almost 11% by FY17. With its already well-established service and distribution
network, coupled with its strong brand recall, there is a lot of scope for Escorts to
ramp-up its presence in the segment.
The company previously had a 40:60 JV with JCB through which it sold backhoe
loaders by the brand of "JCB Escorts". This JV ended in 2003 when JCB bought out
Escorts' 60% stake, post which Escorts had a non-compete clause with JCB till January
2008. Consequent to the expiry of this non-compete agreement, the company has
recently launched a backhoe loader under its own brand name. The backhoe segment
accounts for 26% of the total earth moving segment and is dominated by players like
JCB (70% market share) and L&T. With its already well established service and
distribution network, coupled with its strong brand recall, there is a lot of scope for
Escorts to ramp-up its presence in the same and the company is confident of garnering
~10% market share in this segment by FY11. It currently has capacity in place to
produce 8 backhoe loaders per day (on a three-shift basis).
This division currently has margins of only 3%, but has a lot of potential to scale up as
this business has strong operating leverage. We expect margins to veer towards 8-
10%, over the next two years, once size and scale gets utilised properly and product
mix improves.
Valuation and outlook
At the CMP of INR170, the stock trades at 9.8x and 7.2x our FY11e and FY12e
consolidated earnings estimates. In our view, the current valuations do not capture the
sharp turnaround and potential earnings growth (FY10-FY12e EPS CAGR of 40%).
We recommend a BUY with a target price of INR236 (10x FY12e EPS), which provides
an upside potential of 39% from the current levels.
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