ESCORTS -Higher raw material costs dents the margin:: Edelweiss

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ESCORTS
Higher raw material costs dents the margin


􀂄 Disappointing quarter; PAT well below estimate
Escorts’ Q1FY11 adjusted PAT, at INR 249 mn (up 6% Y-o-Y, 120% Q-o-Q), was
well below our INR 416 mn estimate. EBITDA margin disappointed on account of
higher-than-expected raw material costs which jumped 48% Y-o-Y and 33% Q-o-Q.

􀂄 EBITDA margin declines ~340bps Y-o-Y on higher raw material costs
Net sales, at INR 8.3 bn (in line with estimate), jumped 24% Q-o-Q led by 17%
Q-o-Q rise in volume and 6% Q-o-Q increase in realisation per vehicle. Realisation
improvement can be attributed to two factors—30% came from change in mix
towards higher-powered tractors and balance 70% was due to price hikes effected
to combat rising input pressures. Steep increase in raw material costs (up 470bps
Q-o-Q) can be attributed to higher costs on account of compliance with new
emission norms and rising commodity prices. Other expenses also soared over
46% Y-o-Y partly on freight and forwarding expenses related to the Tanzanian
export order.
􀂄 ECEL’s performance improves
Margins of the construction equipment business (Escorts Construction Equipment)
improved sequentially by 50bps to 4%. The company sold 155 back hoe loaders
during the quarter.
􀂄 Guidance maintained: 70,000 units and 8.5% EBITDA margin for FY11;
Management sounded confident with respect to tractor growth and further to
mitigate rising raw material costs it stated the company will take another price
hike of ~4% shortly (Note: M&M is not going to take any price hikes). For FY11,
Escorts has maintained volume guidance of over 70,000 units and EBITDA margin
of 8.5%.
􀂄 Outlook and valuations: Rough quarter; downgrade to ‘HOLD’
The stock is currently trading at 9.7x and 8.0x on revised FY11E and FY12E
earnings, respectively. We value the stock at INR 117, at 9x one-year forward
EPS.
While maintaining our net revenue estimate, post disappointing results on back of
steep rise in raw material costs we have revised EBITDA margin down to 7.0%
both for FY11E and FY12E to consider the impact, leading to downwards revision
in earnings by 22% and 24% for FY11E and FY12E, respectively. Hence, we are
downgrading our recommendation on the stock to ‘HOLD’ from ‘BUY’.


􀂄 Company Description
The Escorts Group consists of three major divisions—tractors/farm equipment,
engineering, and construction. While the construction space is listed through a separate
subsidiary, the other two divisions are a part of the standalone business. Tractors
comprise 72% of the total business, railways 7%, and construction 15%.
􀂄 Investment Theme
Escorts business remains on track, while instead of reaping the benefit of operating
leverage, company’s margin in past two quarters have been dented by unexpected steep
increase in raw material costs and higher fixed operating costs leading to margin erosion.
Outlook on tractor remains positive but concerns on cost matrix persist.
􀂄 Key Risks
Execution will be key
Management intends to scale up businesses such as railways and construction over the
next few years. While the opportunities are strong and Escorts seems to have a certain
edge in these businesses, execution will be particularly important.
Higher-than-expected input cost
A substantial rise in commodity costs, largely steel and aluminium, could lead to
significant margin pressure for the company. Further, we note that the company has one
of the weakest EBITDA margins in the industry. Hence, the impact on profitability in the
event of a marginal change in input costs could be substantially higher.