ATD: Upside to margin unlikely to materialize  HSBC Research,

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ATD: Upside to margin

unlikely to materialize

 With a weak order book and significant pricing pressure from
competition, the anticipated margin recovery is likely to be muted
 We lower our CY11-12 EPS estimates by 8-14%, c15-18% behind
consensus; this brings down our TP to INR235 from INR270
 We expect the stock to remain range bound unless there is more
clarity on the demerger; downgrade to Neutral from OW


Investment thesis
Areva T&D is largely a domestic T&D play. But
given its weak order intake last year (-c1%) and
anticipated weakness in domestic transmission
orders this year, we believe revenue growth will
likely remain muted this year at c4% and improve
modestly to c12% the year after.
More importantly, we are now turning increasingly
cautious on the anticipated margin recovery at
Areva T&D given that both Siemens and Crompton
have reported significant margin erosion in face of
competition. In such an environment, we believe it
will be difficult for Areva to report any substantial
improvement in margins. We also note Areva
reported a margin decline of c60bp q-o-q and
c140bp y-o-y in 2Q of CY11.
Consequently, we have reduced our margin
expectations, with our forecast of the EBITDA
margin cut from c12.2% to c10.4% for CY11 and
from c12.5% to c11.0% for CY12. As a result, we
have lowered our EPS estimates by c14% for
CY11 and c8% for CY12. This places our EPS
estimates c15-18% below consensus, with
disappointment on margins potentially acting as
the driver of downgrades. On the flip side, betterthan-
expected profitability in the coming quarters
remains a key upside risk to our estimates.
Based on our new estimates, the stock is currently
trading at 29.0x CY11e PE and c21.9x CY12e PE
compared to its historical average 12m forward
PE of c33x for the last 5 years. We think this
discount to the historical average is justified as:
market conditions have deteriorated significantly
and the possibility of the parent company further
increasing its stake has diminished considerably.
Given our earnings downgrade, we have reduced
our target price for Areva T&D to INR235 from
INR270 earlier. Our target price is derived from
our preferred EVA valuation methodology and
implies that 12 months from now the stock should
be trading at a 12-month forward PE multiple of
c19.7x on 24-month forward EPS of INR11.9.


We note that the demerger of the transmission and
distribution business at Areva will take place over
the next 6 months and until more clarity emerges
on this process and the valuation, the stock will
most likely remain range-bound. Hence, we
downgrade the stock to Neutral from OW.
We highlight the key bull and bear factors below.
Bull factors
 Key beneficiary of domestic transmission
growth as the company has strong presence
on the power grid
 Margins should be supported by increasing
localization and the company’s restructuring
 The announced demerger of the distribution
business is likely to lead to de-leveraging of
the balance sheet
 The company is likely to benefit from
Alstom’s transmission equipment sourcing
requirement
Bear factors
 Low exposure to other EPC growth areas,
either domestically or internationally
 Increasing competition in the 765kV
substation space could impair margin recovery
 Valuation not attractive


Little clarity on the demerger process or the
proceeds it will generate
Valuation
Our target price of INR235 is derived from our
preferred EVA valuation methodology, assuming
a target sales growth of c9%, through-cycle
operating return margin of c9.5% and WACC of
c12.1%. Our target price implies that 12 months
from now, the stock should be trading at a 12-
month forward PE of c19.7x on 24-month forward
EPS of INR11.9.
Under HSBC’s research model, for stocks without
a volatility indicator, the Neutral rating band is
5ppt above and below the hurdle rate for India
stocks of 11%. This translates into a Neutral
rating band of 6% to 16% around the current share
price. Our 12-month target price of INR235
suggests a potential return of c7% (excluding
dividends), which is within the Neutral rating
band; hence, we downgrade our rating on the
stock to Neutral from OW.
Risks
We highlight the key risks related to our
investment case on ATD below:
Upside risks
 Significant pick-up in execution
 Better-than-expected improvement in margins
 Early conclusion of the ongoing demerger
Downside risks
 Delay/cancellation of domestic transmission
projects
 Excessive pricing pressure

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