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CRG: Earnings risk
undermines valuation
With significant exposure to troubled overseas economies,
visibility on demand recovery remains low
We believe margins will bottom in 1H, but don’t expect a sharp
recovery thereafter; our FY12-13 EPS estimates, revised down 2-
9%, are 20-21% below consensus
At a 12m forward PE of 14.7x, valuation does not look particularly
attractive; remain Neutral with TP cut to INR170 from INR205
Investment thesis
We believe Crompton remains in a difficult spot
as far as the demand outlook is concerned. We
believe its power business (c65% of group sales)
is likely to witness no growth in orders this year,
due to: disruption in demand for power
equipments in the US and Europe (c25-30% group
sales) and anticipated weakness in domestic
transmission orders this year.
In addition, we believe order intake growth in
industrials business will also moderate this year to
c15% from c39% in FY11, as domestic GDP
growth and industrial capex slows down. The
outlook for the consumer business also remains
bleak and, while we anticipate a pick-up in
demand from the levels of 1Q, we don’t expect
growth to return to the 20-25% range seen in the
past couple of years.
With no other significant levers for growth,
except for its recent acquisitions of Emotron and
QEI, we believe Crompton is likely to record sales
growth of only c9-13% for FY12-13.
The biggest risk, however, pertains to margins,
which are likely to erode significantly in FY12
and remain under pressure going into FY13. We
expect the biggest margin erosion to come in the
power business, where we believe the
international business will most likely remain
loss-making this year and the margins in the
domestic business will fall to c12-13% (from
c18% in FY10-11 in the face of stiff competition.
In addition, we expect margins in the industrial
and consumer businesses to remain under
pressure, due to a lower-margin acquisition in the
case of former and a significant decline in growth
in the latter. Driven by these factors, we currently
forecast the EBITDA margin to decline to c9.1%
in FY12 and c10.0% in FY13 compared to
c13.4% in FY11.
Given a deteriorating international environment,
we have taken a more cautious view on CG’s
international power business going into FY13 and
have revised down our FY13-14 EPS estimates by
c8-9%. Subsequently, we have reduced our target
price on Crompton to INR170 from INR205
earlier. Our target price is driven by our preferred
EVA valuation methodology (please see
Valuation section for details) and implies that 12
months from now the stock should trade at a 12m
forward PE of c13.0x on a 24-month EPS estimate
of INR13.1.
We note that margins and earnings visibility in the
coming quarters are key swing factors for the
stock. Our FY12-13 EPS estimates are c20-21%
below consensus and the only upward risk to our
estimates we see is in a much lower tax rate of
c14-15% (as guided by management) compared to
our current assumption of c26%.
In addition to earnings risk due to macroeconomic
environment, we believe the stock will
likely suffer from the loss of investor confidence
and hence a higher equity risk premium in the
near term. Therefore, at a 14.7x 12m forward PE
(versus an historical average of 18x), valuation
does not look particularly attractive and we expect
it to remain range bound until earnings visibility
improves. Hence, we reiterate our Neutral rating.
The key bull and bear factors related to CRG are
as follows.
Bull factors
Recent acquisitions likely to provide some
impetus to earnings growth
Company has strong presence in all its
business segments and has significantly
improved its product range
Balance sheet remains under-levered and
working capital requirements remain low
Current valuation at c20% discount to
historical average
Bear factors
Demand remains under pressure in all
business segments
Low visibility on potential margin erosion in
the power business
The crisis in 1Q and the subsequent loss of
investor confidence warrants a higher risk
premium, in our opinion
Order book remains weak at c0.7x FY11
group sales or c0.9x FY11 group sales
excluding the consumer business
Valuation
Our target price of INR170 is derived from our
preferred EVA valuation methodology, assuming
a target sales growth of c7%, through-cycle
operating return margin of c8.5% and WACC of
c14.9%. Our target price implies that 12 months
from now the stock should be trading at a 12-
month forward PE of c13.0 on 24-month forward
EPS of INR13.1.
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 INR170
suggests a potential return of c14% (excluding
dividend), which remains within the Neutral
rating band; hence, we reiterate our Neutral rating
on the stock.
Risks
We highlight the key risks related to our
investment case on CRG below:
Upside risks
Significantly lower ‘sustained’ tax rate
Significant pick-up in consumer business
growth
Downside risks
Prolonged economic crisis in the West
Delay/cancellation of domestic transmission
projects
Excessive pricing pressure
Expensive acquisition
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