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Escorts Limited
Sound business, attractive valuation; a new Buy
Initiate with Buy, PO of Rs166 (40% potential upside)
Escorts Ltd, one of India’s leading agri-machinery companies, is our new Buy with
a SOTP-based PO of Rs166. Our investment opinion is driven by structural
demand for tractor biz (85% of company’s sales). We also expect non-agri
operations (railway equipments, auto parts) to be less of a drag, and construction
equipment biz to unlock value in the long term. As a result, we forecast 21% EPS
CAGR over 2010-13E. On our sum-of-the-parts based methodology, we value the
tractor biz at 10x Mar’12E EPS (20% discount to industry leader M&M’s target
multiple) and construction equipment biz at Rs.16 (7x Mar’12E EV/EBITDA).
Tractor business to sustain strong demand
We believe Escorts, which ranks 3rd in market share, is in the middle of a
structural growth due to increasing mechanization, growing affordability and rising
labor shortage in rural India. We expect Escorts to achieve higher-than-industry
tractor sales CAGR of 15% over the next two years, on (1) new launches such as
inverter-tractor, etc. and (2) marketing initiatives in South India, where it lags
compared to other regions.
Construction equipment business to show sharp recovery
Escorts Construction Equipment (ECEL), the company’s wholly owned subsidiary,
has built its leadership in the niche segment of Pick ‘n’ carry cranes. ECEL is now
focusing on front/backend loaders and with recent launch of newer products, we
expect it to achieve significant scale, via 16% revenue CAGR in 2010-13E, and
double EBITDA margin to 6%.
Compelling valuations
We expect Escorts to be free cash flow positive this fiscal, turn debt-free next year
& improve RoE over forecast period. Based on superior prospects, we expect the
company’s stock valuations to improve from P/E of 7x & P/B of 0.6x (on Mar’12E).
Initiate at Buy, PO of Rs166
We initiate coverage on Escorts, a mid-sized Indian tractor company with a
significant presence in North India, with a Buy rating and PO of Rs166, implying
40% potential upside. Over the past two years, Escorts has witnessed a
turnaround, mainly due to its core tractor biz (accounts for ~85% of standalone
sales), even as its marginal operations - railway equipment and auto parts -
continue to restrict overall growth. The company also operates a construction
equipment business through a fully owned subsidiary, which in our view will also
register turnaround through better scale and efficiencies.
Tractor demand is structural
We forecast 12% CAGR over FY10-12E for domestic tractor volumes. This will be
on the back of (a) increasing mechanization, (b) growing affordability, (c) rising
labor shortage in rural India, and (d) increasing labor cost. We expect Escorts to
achieve higher-than-industry growth, at 15% volume CAGR for tractors, and gain
market share over the next two years, led by:
Innovative product launches: Escorts is bringing innovative products, such
as inverter tractor, to satisfy the different needs of the customers.
Improving presence in South India: Escorts, traditionally weak in South
India, is expected to gain market share in the region on the back of (a)
offering South India-specific products and (b) bolstering dealer network.
Reinforcing the sales force: In order to penetrate the market, Escorts is rejigging
its operations and ramping up its sales force.
Construction business to achieve scale
Indian construction equipment industry is expected to show ~20% volume CAGR
over the next five years. ECEL has built leadership in the niche segment of Pick
‘n’ carry cranes. We expect it to achieve significant scale, by posting 16%
revenue CAGR over FY10-13E. We expect a reversal of EBITDA margin
contraction from FY11 and doubling of EBITDA margin to 6% by FY13. This is on
account of cost-reduction initiatives, development of new products which enjoy
higher margins, and an already improving product mix.
Revenue growth strong; margins & EPS growth
to follow
We expect strong revenue momentum across all key verticals. We forecast 14%
CAGR in standalone revenues over FY10-13E, driven by the Agri Machinery Group
which is likely to post revenue CAGR of 15%. However, a surge in commodity price
and increased marketing costs for its South India operations would push margin
recovery & EPS growth from FY12 onwards. We expect back-ended 24% CAGR over
FY10-13E in standalone profit, driven by (a) 14% revenue CAGR, (b) 120bp EBIT
margin gains due to operating leverage and (c) lower interest cost.
Attractive base valuations
At 7x Mar’12E consolidated EPS, Escorts trades at a huge discount to industry
leader M&M and most of the auto companies under our coverage. On account of
its strong growth, Escorts’ tractor business should re-rate to 10x Mar’12E EPS
(valued at Rs150/sh), which represents a 20% discount to our target multiple for
M&M. We value ECEL at an early-cycle multiple of 7x Mar’12E EV/EBITDA
(Rs16/sh).
Risks & concerns
Fall in tractor demand
Poor agricultural growth could impact tractor demand. Escorts derives about 70%
of its consolidated revenues from its tractor business. A fall in demand could
severely impact its top-line as well as utilization, which would push the company
into making losses once again.
Surge in input price
Raw materials, steel and aluminum are the key, accounting for 70% of the total
costs. Any sharp increase in their prices would impact Escorts’ profitability.
Delay in turnaround in non-agri business
The non-agri business has been a drag on Escorts’ profitability. We expect the
construction equipment business to expand its margins on account of better
product mix and higher utilization. Any delay in achieving this would lead to a
stress on the firm’s overall profitability.
Tractors: Demand is structural
The tractor industry in India currently has structural demand drivers in place,
especially with the government focus on rural India through steps such as raising
minimum support price (MSP), interest subvention schemes, setting up of
agricultural export zones, NREGA scheme, loan waivers – all of which boost the
financial health of farmers. These factors, along with lower degree of agricultural
mechanization, will keep the demand for tractors strong in the near to medium
term.
We forecast 12% volume CAGR
Led by the strong demand, we forecast tractor volumes to achieve a 12% CAGR
over FY10-12E. Despite a drought year, FY10 witnessed a 30% surge in
domestic tractor volumes. We continue to expect a strong run-rate over the next
two years.
Agriculture: Key area of government focus
The first leg of India’s growth story had been urban driven, when services took
the lead in terms of growth. However, with government’s increased emphasis on
equitable growth, the agriculture sector is the next focus area as it employs twothirds
of India’s working population. To improve productivity and yields, the Indian
agriculture sector would take steps to increase mechanization, moving away from
its present labor-intensive nature.
Mechanization the only way forward
Farm growth can be achieved by a variety of steps (as shown in table 2).
However, the other vectors of farm growth may not be implementable in the short
term and so more focus would be on mechanization as an enabler of improved
productivity and yields.
Increasing affordability
Rural income, a key factor influencing tractor demand, has been growing at a
steady rate over the past few years, largely led by (a) rise in MSP for most crops,
and (b) good Rabi crop followed by a good Kharif crop. Another key positive is the
increased access to credit for the farmers.
Rise in MSP helping farmers
In order to incentivize the farm sector, the government has been raising the MSP
for most crops substantially over the past few years. This has greatly improved
the profitability of most crops and enriched farmers who are a key driver for
tractor demand.
Access to credit at low cost
Agricultural credit along with other rural spend has been going up steadily over
the past five years. This, coupled with the loan waiver scheme, has greatly
enhanced the affordability of the farmers, thus increasing their discretionary
spends. Banks have significantly increased their lending to the agricultural sector.
NREGA & other Govt schemes leading to labor shortages
The National Rural Employment Guarantee Act (NREGA) has enabled rural
laborers to get a job with a minimum wage of Rs100 per day. Other government
initiatives such as PMGSY (Pradhan Mantri Gram Sadak Yojna) and Bharat
Nirman have also generated significant employment for landless laborers who
were earlier employed by land-owning farmers for unskilled farm work. The
indirect impact of such government initiatives is two-fold:
1. Lower availability of farm labor, and
2. Increase in cost of labor
This appears to have encouraged the land-owning farmers to opt for increased
farm mechanization and buying more tractors.
New products & alternate usage augmenting traditional
sales growth
Smaller-HP tractors and other multi-purpose innovative tractors have caught the
attention of farmers with small land holding who earlier relied only on farm labor.
Another area of demand for sub-40 HP tractors is from:
Rural transport: The govt’s thrust on rural connectivity by way of PMGSY,
etc has led to the construction of paved roads. Tractors have successfully
replaced bullock carts as the preferred mode of haulage and transport of
agricultural produce.
Usage in other areas: Tractors have recently found usage in the
construction sector as well. They are often used to transport waste, soil/sand
etc. They are also used by airlines/ hotels for hauling luggage.
Escorts: On road to recovery
We expect Escorts to be one of the key beneficiaries of the improved industry
dynamics in its core business of tractors. Other smaller businesses of the firm are
also going to benefit from the modernization drive of the Indian Railways and the
construction boom.
Making amends
Escorts diversified into many unrelated businesses during the past two decades.
This had a negative impact on its core tractor franchise, due to (a) lack of
management focus, and (b) deterioration of balance sheet because of high
gearing. Over the past few years, Escorts had been hiving off its non-core
businesses and has been successful in bringing down the gearing. The new
corporate structure is much simpler with a lot of focus on the core tractor
business.
Tractors should be the main growth driver
With increased focus on the tractors vertical post the business restructuring, we
expect Escorts to grow ahead of the industry and gain market share. We expect
tractors to remain the dominant business of Escorts, with 70% share in
consolidated revenues and a 14% CAGR over FY10-13E.
New products and branding
Historically, Escorts has dominated the market for high-end tractors (41-50HP). It
has the highest market share in this category, at 16-20%. On the other hand,
Escorts has only one tractor model in the sub-30 HP category, which has limited
its growth. The company, therefore, plans to gain market share in the lower-HP
market with the launch of new products. It also plans to launch 8-10 new variants
in different categories which would help sustain growth.
Differentiated product portfolio in the pipeline
Escorts is trying to introduce innovative products which would be able to
differentiate themselves from competition and satisfy the different needs of the
customer. For example, it recently launched inverter tractor, rice puddlers, etc.
which cater to the other needs of the customer apart from the core need.
Focus on South Indian market
While Escorts is very strong in the North Indian market (21% share), it has very little
presence in South India. The company’s South Indian market share is at 4.8% as of
1HFY11, after having lost around 350bp of market share in the past five years. To
improve its standing in South India, Escorts has started taking steps such as:
Launching products specific to South India’s needs: Escorts has
launched South India-specific products such as rice-puddlers which can work
in deep water as well. This is expected to enhance its market share in the
region.
Bolstering the dealer network: Traditionally, Escorts has had a very poor
dealer network in South India, which it is in the process of rectifying. Increase
in dealer network will help the company push sales into the region.
Sales-force re-jig: Escorts is re-jigging its sales force by placing some of its
successful sales managers in South India, to help implement its new
strategy.
Expect market share gains
We expect Escorts to gain market share over the next two years led by (a)
innovative product launches, (b) improving presence in South India, and (c)
reinforcing its sales force.
Focus on exports
In order to boost sales, Escorts has increased its focus on overseas markets,
especially Africa. The firm had won a Tanzanian Govt. order for 1,430 tractors in
FY10. It is planning two offices in Africa to widen its reach in the African market.
We expect exports to become significant after 3-4 years.
Railway equipment business- Steady state
Escorts is one of the major manufacturers of railway components in India. It has
partnered Indian Railways for a long time and has a very broad product portfolio
of brakes, couplers, shock absorbers etc. Although the current railways business
is small (7% of total sales), it is expected to benefit from the railways
modernization which India would have to implement eventually. We forecast
railways business revenues to grow at a steady 10% CAGR over FY10-13E and
maintain EBIT margin of ~10%.
Indian Railways: Upcoming modernization & expansion
Indian Railways is expected to increase its capacity by adding more lines as well
as doubling existing lines in the next 10 years. It plans to lay 2500 km of new
lines and double or multiple ~30000 km of rail route by 2020. Escorts has been
involved with Indian Railways for the past 3-4 decades and has forged strong
relationships. This modernization and expansion drive would enable Escorts to
get continuous orders.
Auto component business- still to recover
Escorts is one of the major manufacturers of auto suspension products including
shock absorbers and automotive products including die casting components,
brake shoes and clutch plates. This is a small business (~4% of revenue) with
very few clients. It has currently very low utilization leading to EBITDA-level
losses. We expect Escorts to continue making small losses in this segment over
the next few years due to no significant change in strategy.
Construction equipment- riding the boom
ECEL is a wholly owned subsidiary of Escorts Ltd and is engaged in
manufacturing and selling construction equipments like cranes, forklifts and
loaders. It also has collaborations with various global players whose products are
marketed by Escorts in India.
Construction equipment demand strong on high infra spend
The sharp spurt in infrastructure spend over the 11th and 12th 5-year plan is
expected to keep the construction equipment demand strong. Total infrastructure
spend for India is forecast to go up from ~5% (~$200bn) of GDP in the 10th 5-year
plan to around 9% (~$1tn) of GDP in the 12th 5-year plan.
Financial Analysis
Over the near term, we expect Escorts to reap the benefits of the restructuring of
its businesses over the past few years. We expect a 22% CAGR over FY10-13E
in standalone profit driven by (a) 14% revenue CAGR, (b) 100bp EBIT margin
gains due to operating leverage and (c) lower interest cost.
Revenue momentum across segments
We expect a 14% CAGR in standalone revenues over FY10-13E driven primarily
by the Agri Machinery Group, which will likely achieve a revenue CAGR of 15%.
Railway equipment business and auto ancillary product group are expected to
clock 12% and 10% CAGR, respectively, over FY10-13E.
Agri Machinery Group, the key driving unit
Agri Machinery Group (AMG) which manufactures farm equipments is the key
unit contributing about 88% of standalone revenues and 99% of standalone EBIT
in FY10. AMG showed a strong 30% growth in sales in FY10 and is expected to
record a 15% revenue CAGR over FY10-13E. Improving utilization would add
130bp to its EBIT margin over FY10-13E.
Railways & auto parts biz to show only small improvements
While both railways and auto parts business are expected to show modest topline
growth over FY10-13, margins for these divisions would remain under
pressure on account of (a) lower margin products in railways and (b) lower
utilization in the auto parts business.
Margins to expand 120bp…
We forecast 120bp standalone EBIT margin expansion over FY10-13E. This is
driven by 150bp improvement in AMG EBIT margins over FY10-13E on account
of improvement in utilization in its tractor business from 61% in 2010 to 87% in
2013E.
…but mostly from FY12E
We expect margins to decline by 100bps in FY11E on account of (a) a sharp rise
in commodity prices (16% YoY increase in steel price & 10% YoY increase in
aluminum price) and (b) increased marketing spend to improve market position in
South India. We expect the benefit of operating leverage to kick in with a lag
reflected in margin expansion from FY12E.
EPS growth back-ended; to pick-up from FY12
We expect benefits of rising utilization and better volumes to translate into strong
EPS growth from FY12E. We forecast about 24% standalone PAT CAGR over
FY10-13E, largely driven by:
Sales growth of ~14% on the back of ~15% increase in tractor sales over
FY10-13E.
EBIT margin gain of ~130bp over FY10-13E on the back of improving
utilization.
Lower interest cost as the company becomes net cash surplus in FY12.
Construction business to show recovery
ECEL accounts for around 16% of the consolidated revenues. We expect a 16%
CAGR in ECEL revenues over FY10-13E. We also expect a reversal of EBITDA
margin contraction from FY11 onwards on account of cost-reduction initiatives,
development of new products which enjoy higher margins, and an already
improving product mix. The company can potentially surprise on the margin front
if it delivers on all these aspects.
Balance sheet no longer a concern
Escorts has cut its debt over the past few years by (a) monetizing its non-core
businesses and (b) conversion of FCCBs. We expect Escorts to become net cash
positive in FY12E.
RoE set to improve
Escorts is expected to improve its RoE to 12.2% from -1.4% over FY08-13E. This
is on account of:
Improving utilization from sub-40% to around 88% over the same period.
Improving EBITDA margins from 5.2% to 8.7% over FY08-13E.
Low capex requirement
The utilization for most of Escorts’ businesses is currently low with the tractor
business utilization at around 61%. We do not foresee any significant capex
spend over the next 2-3 years. The company has guided for a very small capex
plan of Rs1.45bn over FY11-13E to upgrade its existing facility.
FCF to turn positive in FY11
We expect free cash flow (FCF) to turn positive for Escorts from FY11 on account
of (a) increasing profits, (b) lower capex requirements, and (c) working capital
discipline.
Valuations- Buy for 40% upside
We believe Escorts should be valued on sum-of-the-parts basis as its
construction equipment business and core tractor business are in different stages
of recovery. While the tractor business has already returned to profitability, its
construction business is expected to turn around only in FY11. Our PO of Rs166
is based on sum-of-the-parts of Escorts’ core tractor business and its construction
equipment subsidiary. We value Escorts’ core tractor business at 10x Mar’12E
EPS (value Rs150/share) which is at a 20% discount to our industry leader
M&M’s target multiple. Construction equipment business (ECEL) is valued at 7x
Mar’12E EV/EBITDA (Rs16/share).
Trades at a discount to other auto companies
Escorts trades at a discount to most of the auto companies under our coverage
and especially vs M&M, another tractor major. Escorts is currently trading at 8x
FY11E consolidated EPS, which represents ~40% discount to M&M on FY11E
EPS. However, as the company’s tractor business has recovered and is expected
to show strong 20% EPS CAGR over FY10-13E, we believe this discount should
narrow.
ECEL gives a value of Rs16 per share
We value ECEL separately as we believe it is at a different stage of recovery vs
the parent. At 7x FY11E EV/EBITDA, the valuation comes to Rs26 per share. The
higher multiple is justified as ECEL is still in the early stage of recovery.
Table 10: Value of ECEL
ECEL Rs. Mn
2011E EBITDA 276
2012E EBITDA 396
Mar'12E EBITDA 336
7X FY11E EBITDA 2,353
EV of ECEL 2,353
Debt of ECEL 820
Equity Value 1,533
Per share equity value (Rs) 16
Source: BofA-ML Global Research
Price objective basis & risk
Escorts Limited (XSOCF)
Our PO of Rs166 is based on sum of parts of the constituent businesses. We
value (1) standalone business at 10x Mar'12E EPS (Rs150/share), a 20%
discount to the target mulitple for our industry leader M&M, and (2) Escorts
Construction Equipment Ltd (ECEL) at a multiple of 7x Mar'12E EV/EBITDA
(Rs16/share). Downside risks: Slowdown in the economy and increasing
competition that would adversely affect volume growth, and rising input costs.
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Escorts Limited
Sound business, attractive valuation; a new Buy
Initiate with Buy, PO of Rs166 (40% potential upside)
Escorts Ltd, one of India’s leading agri-machinery companies, is our new Buy with
a SOTP-based PO of Rs166. Our investment opinion is driven by structural
demand for tractor biz (85% of company’s sales). We also expect non-agri
operations (railway equipments, auto parts) to be less of a drag, and construction
equipment biz to unlock value in the long term. As a result, we forecast 21% EPS
CAGR over 2010-13E. On our sum-of-the-parts based methodology, we value the
tractor biz at 10x Mar’12E EPS (20% discount to industry leader M&M’s target
multiple) and construction equipment biz at Rs.16 (7x Mar’12E EV/EBITDA).
Tractor business to sustain strong demand
We believe Escorts, which ranks 3rd in market share, is in the middle of a
structural growth due to increasing mechanization, growing affordability and rising
labor shortage in rural India. We expect Escorts to achieve higher-than-industry
tractor sales CAGR of 15% over the next two years, on (1) new launches such as
inverter-tractor, etc. and (2) marketing initiatives in South India, where it lags
compared to other regions.
Construction equipment business to show sharp recovery
Escorts Construction Equipment (ECEL), the company’s wholly owned subsidiary,
has built its leadership in the niche segment of Pick ‘n’ carry cranes. ECEL is now
focusing on front/backend loaders and with recent launch of newer products, we
expect it to achieve significant scale, via 16% revenue CAGR in 2010-13E, and
double EBITDA margin to 6%.
Compelling valuations
We expect Escorts to be free cash flow positive this fiscal, turn debt-free next year
& improve RoE over forecast period. Based on superior prospects, we expect the
company’s stock valuations to improve from P/E of 7x & P/B of 0.6x (on Mar’12E).
Initiate at Buy, PO of Rs166
We initiate coverage on Escorts, a mid-sized Indian tractor company with a
significant presence in North India, with a Buy rating and PO of Rs166, implying
40% potential upside. Over the past two years, Escorts has witnessed a
turnaround, mainly due to its core tractor biz (accounts for ~85% of standalone
sales), even as its marginal operations - railway equipment and auto parts -
continue to restrict overall growth. The company also operates a construction
equipment business through a fully owned subsidiary, which in our view will also
register turnaround through better scale and efficiencies.
Tractor demand is structural
We forecast 12% CAGR over FY10-12E for domestic tractor volumes. This will be
on the back of (a) increasing mechanization, (b) growing affordability, (c) rising
labor shortage in rural India, and (d) increasing labor cost. We expect Escorts to
achieve higher-than-industry growth, at 15% volume CAGR for tractors, and gain
market share over the next two years, led by:
Innovative product launches: Escorts is bringing innovative products, such
as inverter tractor, to satisfy the different needs of the customers.
Improving presence in South India: Escorts, traditionally weak in South
India, is expected to gain market share in the region on the back of (a)
offering South India-specific products and (b) bolstering dealer network.
Reinforcing the sales force: In order to penetrate the market, Escorts is rejigging
its operations and ramping up its sales force.
Construction business to achieve scale
Indian construction equipment industry is expected to show ~20% volume CAGR
over the next five years. ECEL has built leadership in the niche segment of Pick
‘n’ carry cranes. We expect it to achieve significant scale, by posting 16%
revenue CAGR over FY10-13E. We expect a reversal of EBITDA margin
contraction from FY11 and doubling of EBITDA margin to 6% by FY13. This is on
account of cost-reduction initiatives, development of new products which enjoy
higher margins, and an already improving product mix.
Revenue growth strong; margins & EPS growth
to follow
We expect strong revenue momentum across all key verticals. We forecast 14%
CAGR in standalone revenues over FY10-13E, driven by the Agri Machinery Group
which is likely to post revenue CAGR of 15%. However, a surge in commodity price
and increased marketing costs for its South India operations would push margin
recovery & EPS growth from FY12 onwards. We expect back-ended 24% CAGR over
FY10-13E in standalone profit, driven by (a) 14% revenue CAGR, (b) 120bp EBIT
margin gains due to operating leverage and (c) lower interest cost.
Attractive base valuations
At 7x Mar’12E consolidated EPS, Escorts trades at a huge discount to industry
leader M&M and most of the auto companies under our coverage. On account of
its strong growth, Escorts’ tractor business should re-rate to 10x Mar’12E EPS
(valued at Rs150/sh), which represents a 20% discount to our target multiple for
M&M. We value ECEL at an early-cycle multiple of 7x Mar’12E EV/EBITDA
(Rs16/sh).
Risks & concerns
Fall in tractor demand
Poor agricultural growth could impact tractor demand. Escorts derives about 70%
of its consolidated revenues from its tractor business. A fall in demand could
severely impact its top-line as well as utilization, which would push the company
into making losses once again.
Surge in input price
Raw materials, steel and aluminum are the key, accounting for 70% of the total
costs. Any sharp increase in their prices would impact Escorts’ profitability.
Delay in turnaround in non-agri business
The non-agri business has been a drag on Escorts’ profitability. We expect the
construction equipment business to expand its margins on account of better
product mix and higher utilization. Any delay in achieving this would lead to a
stress on the firm’s overall profitability.
Tractors: Demand is structural
The tractor industry in India currently has structural demand drivers in place,
especially with the government focus on rural India through steps such as raising
minimum support price (MSP), interest subvention schemes, setting up of
agricultural export zones, NREGA scheme, loan waivers – all of which boost the
financial health of farmers. These factors, along with lower degree of agricultural
mechanization, will keep the demand for tractors strong in the near to medium
term.
We forecast 12% volume CAGR
Led by the strong demand, we forecast tractor volumes to achieve a 12% CAGR
over FY10-12E. Despite a drought year, FY10 witnessed a 30% surge in
domestic tractor volumes. We continue to expect a strong run-rate over the next
two years.
Agriculture: Key area of government focus
The first leg of India’s growth story had been urban driven, when services took
the lead in terms of growth. However, with government’s increased emphasis on
equitable growth, the agriculture sector is the next focus area as it employs twothirds
of India’s working population. To improve productivity and yields, the Indian
agriculture sector would take steps to increase mechanization, moving away from
its present labor-intensive nature.
Mechanization the only way forward
Farm growth can be achieved by a variety of steps (as shown in table 2).
However, the other vectors of farm growth may not be implementable in the short
term and so more focus would be on mechanization as an enabler of improved
productivity and yields.
Increasing affordability
Rural income, a key factor influencing tractor demand, has been growing at a
steady rate over the past few years, largely led by (a) rise in MSP for most crops,
and (b) good Rabi crop followed by a good Kharif crop. Another key positive is the
increased access to credit for the farmers.
Rise in MSP helping farmers
In order to incentivize the farm sector, the government has been raising the MSP
for most crops substantially over the past few years. This has greatly improved
the profitability of most crops and enriched farmers who are a key driver for
tractor demand.
Access to credit at low cost
Agricultural credit along with other rural spend has been going up steadily over
the past five years. This, coupled with the loan waiver scheme, has greatly
enhanced the affordability of the farmers, thus increasing their discretionary
spends. Banks have significantly increased their lending to the agricultural sector.
NREGA & other Govt schemes leading to labor shortages
The National Rural Employment Guarantee Act (NREGA) has enabled rural
laborers to get a job with a minimum wage of Rs100 per day. Other government
initiatives such as PMGSY (Pradhan Mantri Gram Sadak Yojna) and Bharat
Nirman have also generated significant employment for landless laborers who
were earlier employed by land-owning farmers for unskilled farm work. The
indirect impact of such government initiatives is two-fold:
1. Lower availability of farm labor, and
2. Increase in cost of labor
This appears to have encouraged the land-owning farmers to opt for increased
farm mechanization and buying more tractors.
New products & alternate usage augmenting traditional
sales growth
Smaller-HP tractors and other multi-purpose innovative tractors have caught the
attention of farmers with small land holding who earlier relied only on farm labor.
Another area of demand for sub-40 HP tractors is from:
Rural transport: The govt’s thrust on rural connectivity by way of PMGSY,
etc has led to the construction of paved roads. Tractors have successfully
replaced bullock carts as the preferred mode of haulage and transport of
agricultural produce.
Usage in other areas: Tractors have recently found usage in the
construction sector as well. They are often used to transport waste, soil/sand
etc. They are also used by airlines/ hotels for hauling luggage.
Escorts: On road to recovery
We expect Escorts to be one of the key beneficiaries of the improved industry
dynamics in its core business of tractors. Other smaller businesses of the firm are
also going to benefit from the modernization drive of the Indian Railways and the
construction boom.
Making amends
Escorts diversified into many unrelated businesses during the past two decades.
This had a negative impact on its core tractor franchise, due to (a) lack of
management focus, and (b) deterioration of balance sheet because of high
gearing. Over the past few years, Escorts had been hiving off its non-core
businesses and has been successful in bringing down the gearing. The new
corporate structure is much simpler with a lot of focus on the core tractor
business.
Tractors should be the main growth driver
With increased focus on the tractors vertical post the business restructuring, we
expect Escorts to grow ahead of the industry and gain market share. We expect
tractors to remain the dominant business of Escorts, with 70% share in
consolidated revenues and a 14% CAGR over FY10-13E.
New products and branding
Historically, Escorts has dominated the market for high-end tractors (41-50HP). It
has the highest market share in this category, at 16-20%. On the other hand,
Escorts has only one tractor model in the sub-30 HP category, which has limited
its growth. The company, therefore, plans to gain market share in the lower-HP
market with the launch of new products. It also plans to launch 8-10 new variants
in different categories which would help sustain growth.
Differentiated product portfolio in the pipeline
Escorts is trying to introduce innovative products which would be able to
differentiate themselves from competition and satisfy the different needs of the
customer. For example, it recently launched inverter tractor, rice puddlers, etc.
which cater to the other needs of the customer apart from the core need.
Focus on South Indian market
While Escorts is very strong in the North Indian market (21% share), it has very little
presence in South India. The company’s South Indian market share is at 4.8% as of
1HFY11, after having lost around 350bp of market share in the past five years. To
improve its standing in South India, Escorts has started taking steps such as:
Launching products specific to South India’s needs: Escorts has
launched South India-specific products such as rice-puddlers which can work
in deep water as well. This is expected to enhance its market share in the
region.
Bolstering the dealer network: Traditionally, Escorts has had a very poor
dealer network in South India, which it is in the process of rectifying. Increase
in dealer network will help the company push sales into the region.
Sales-force re-jig: Escorts is re-jigging its sales force by placing some of its
successful sales managers in South India, to help implement its new
strategy.
Expect market share gains
We expect Escorts to gain market share over the next two years led by (a)
innovative product launches, (b) improving presence in South India, and (c)
reinforcing its sales force.
Focus on exports
In order to boost sales, Escorts has increased its focus on overseas markets,
especially Africa. The firm had won a Tanzanian Govt. order for 1,430 tractors in
FY10. It is planning two offices in Africa to widen its reach in the African market.
We expect exports to become significant after 3-4 years.
Railway equipment business- Steady state
Escorts is one of the major manufacturers of railway components in India. It has
partnered Indian Railways for a long time and has a very broad product portfolio
of brakes, couplers, shock absorbers etc. Although the current railways business
is small (7% of total sales), it is expected to benefit from the railways
modernization which India would have to implement eventually. We forecast
railways business revenues to grow at a steady 10% CAGR over FY10-13E and
maintain EBIT margin of ~10%.
Indian Railways: Upcoming modernization & expansion
Indian Railways is expected to increase its capacity by adding more lines as well
as doubling existing lines in the next 10 years. It plans to lay 2500 km of new
lines and double or multiple ~30000 km of rail route by 2020. Escorts has been
involved with Indian Railways for the past 3-4 decades and has forged strong
relationships. This modernization and expansion drive would enable Escorts to
get continuous orders.
Auto component business- still to recover
Escorts is one of the major manufacturers of auto suspension products including
shock absorbers and automotive products including die casting components,
brake shoes and clutch plates. This is a small business (~4% of revenue) with
very few clients. It has currently very low utilization leading to EBITDA-level
losses. We expect Escorts to continue making small losses in this segment over
the next few years due to no significant change in strategy.
Construction equipment- riding the boom
ECEL is a wholly owned subsidiary of Escorts Ltd and is engaged in
manufacturing and selling construction equipments like cranes, forklifts and
loaders. It also has collaborations with various global players whose products are
marketed by Escorts in India.
Construction equipment demand strong on high infra spend
The sharp spurt in infrastructure spend over the 11th and 12th 5-year plan is
expected to keep the construction equipment demand strong. Total infrastructure
spend for India is forecast to go up from ~5% (~$200bn) of GDP in the 10th 5-year
plan to around 9% (~$1tn) of GDP in the 12th 5-year plan.
Financial Analysis
Over the near term, we expect Escorts to reap the benefits of the restructuring of
its businesses over the past few years. We expect a 22% CAGR over FY10-13E
in standalone profit driven by (a) 14% revenue CAGR, (b) 100bp EBIT margin
gains due to operating leverage and (c) lower interest cost.
Revenue momentum across segments
We expect a 14% CAGR in standalone revenues over FY10-13E driven primarily
by the Agri Machinery Group, which will likely achieve a revenue CAGR of 15%.
Railway equipment business and auto ancillary product group are expected to
clock 12% and 10% CAGR, respectively, over FY10-13E.
Agri Machinery Group, the key driving unit
Agri Machinery Group (AMG) which manufactures farm equipments is the key
unit contributing about 88% of standalone revenues and 99% of standalone EBIT
in FY10. AMG showed a strong 30% growth in sales in FY10 and is expected to
record a 15% revenue CAGR over FY10-13E. Improving utilization would add
130bp to its EBIT margin over FY10-13E.
Railways & auto parts biz to show only small improvements
While both railways and auto parts business are expected to show modest topline
growth over FY10-13, margins for these divisions would remain under
pressure on account of (a) lower margin products in railways and (b) lower
utilization in the auto parts business.
Margins to expand 120bp…
We forecast 120bp standalone EBIT margin expansion over FY10-13E. This is
driven by 150bp improvement in AMG EBIT margins over FY10-13E on account
of improvement in utilization in its tractor business from 61% in 2010 to 87% in
2013E.
…but mostly from FY12E
We expect margins to decline by 100bps in FY11E on account of (a) a sharp rise
in commodity prices (16% YoY increase in steel price & 10% YoY increase in
aluminum price) and (b) increased marketing spend to improve market position in
South India. We expect the benefit of operating leverage to kick in with a lag
reflected in margin expansion from FY12E.
EPS growth back-ended; to pick-up from FY12
We expect benefits of rising utilization and better volumes to translate into strong
EPS growth from FY12E. We forecast about 24% standalone PAT CAGR over
FY10-13E, largely driven by:
Sales growth of ~14% on the back of ~15% increase in tractor sales over
FY10-13E.
EBIT margin gain of ~130bp over FY10-13E on the back of improving
utilization.
Lower interest cost as the company becomes net cash surplus in FY12.
Construction business to show recovery
ECEL accounts for around 16% of the consolidated revenues. We expect a 16%
CAGR in ECEL revenues over FY10-13E. We also expect a reversal of EBITDA
margin contraction from FY11 onwards on account of cost-reduction initiatives,
development of new products which enjoy higher margins, and an already
improving product mix. The company can potentially surprise on the margin front
if it delivers on all these aspects.
Balance sheet no longer a concern
Escorts has cut its debt over the past few years by (a) monetizing its non-core
businesses and (b) conversion of FCCBs. We expect Escorts to become net cash
positive in FY12E.
RoE set to improve
Escorts is expected to improve its RoE to 12.2% from -1.4% over FY08-13E. This
is on account of:
Improving utilization from sub-40% to around 88% over the same period.
Improving EBITDA margins from 5.2% to 8.7% over FY08-13E.
Low capex requirement
The utilization for most of Escorts’ businesses is currently low with the tractor
business utilization at around 61%. We do not foresee any significant capex
spend over the next 2-3 years. The company has guided for a very small capex
plan of Rs1.45bn over FY11-13E to upgrade its existing facility.
FCF to turn positive in FY11
We expect free cash flow (FCF) to turn positive for Escorts from FY11 on account
of (a) increasing profits, (b) lower capex requirements, and (c) working capital
discipline.
Valuations- Buy for 40% upside
We believe Escorts should be valued on sum-of-the-parts basis as its
construction equipment business and core tractor business are in different stages
of recovery. While the tractor business has already returned to profitability, its
construction business is expected to turn around only in FY11. Our PO of Rs166
is based on sum-of-the-parts of Escorts’ core tractor business and its construction
equipment subsidiary. We value Escorts’ core tractor business at 10x Mar’12E
EPS (value Rs150/share) which is at a 20% discount to our industry leader
M&M’s target multiple. Construction equipment business (ECEL) is valued at 7x
Mar’12E EV/EBITDA (Rs16/share).
Trades at a discount to other auto companies
Escorts trades at a discount to most of the auto companies under our coverage
and especially vs M&M, another tractor major. Escorts is currently trading at 8x
FY11E consolidated EPS, which represents ~40% discount to M&M on FY11E
EPS. However, as the company’s tractor business has recovered and is expected
to show strong 20% EPS CAGR over FY10-13E, we believe this discount should
narrow.
ECEL gives a value of Rs16 per share
We value ECEL separately as we believe it is at a different stage of recovery vs
the parent. At 7x FY11E EV/EBITDA, the valuation comes to Rs26 per share. The
higher multiple is justified as ECEL is still in the early stage of recovery.
Table 10: Value of ECEL
ECEL Rs. Mn
2011E EBITDA 276
2012E EBITDA 396
Mar'12E EBITDA 336
7X FY11E EBITDA 2,353
EV of ECEL 2,353
Debt of ECEL 820
Equity Value 1,533
Per share equity value (Rs) 16
Source: BofA-ML Global Research
Price objective basis & risk
Escorts Limited (XSOCF)
Our PO of Rs166 is based on sum of parts of the constituent businesses. We
value (1) standalone business at 10x Mar'12E EPS (Rs150/share), a 20%
discount to the target mulitple for our industry leader M&M, and (2) Escorts
Construction Equipment Ltd (ECEL) at a multiple of 7x Mar'12E EV/EBITDA
(Rs16/share). Downside risks: Slowdown in the economy and increasing
competition that would adversely affect volume growth, and rising input costs.
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