Ashok Leyland - "Margins may spur a surprise,Upgrade to BUY" :: LKP

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Q2 results significantly better than expectations despite weakness in its forte

Ashok Leyland (ALL)’s Q2 FY12 performance was significantly above our expectations as volumes grew by 23% qoq while declining just 4% yoy. Net realizations grew by 18% yoy and 1% qoq, thus taking net sales up to Rs.30.9bn, a growth of 14% yoy. Volume growth in the quarter came in a difficult environment where most of the sub segments of ALL faced challenges. The strongholds of ALL, both geographically as well as segment-wise viz South India and tractor trailers & MAVs respectively reported weaknesses. In South India, issues related with elections in TN, mining ban in Karnataka and Telangana issues in AP resulted in drop in performances. Western region, which is the second strong geography of ALL, witnessed a drop in the tractor trailer industry of 20%. Drop in freight rates originating from South and East India led to softened demand in these regions. Management is concerned with the continuation of the same; however, strengthening freight rate movement in north and west may offset the weaknesses in other geographies.

Going forward, with the issues in South India getting resolved and ALL’s aggressive plans to increase its distribution in other geographies, the company may improve its lost market share. Management has projected its market share to move up to 25.6% from 20.2% in the period between Aprils-September 2011 period. Although we believe this is a bit too optimistic, we believe that 22-23% market share is quite achievable.

Seasonality and peaking of interest rates may lead to a volume growth close to 1 lakh for FY 12E

Easing up of South Indian markets, growing distribution strength in other markets, seasonality of strong H2 as compared to H1 and peaking out of interest rate cycle gives us confidence that the company may reach volumes close to 1,00,000 units, a growth of 5.6% yoy in line with management’s expectations. Increased sales of U truck (<2000 sold in H1, expectation of 6000 in H2) will help the cause. Additionally, strong export performance in H1 aided by Latin American and African countries is expected to continue. We expect 30%/24% yoy growth in exports in FY 12/FY13E.

Q2 margin performance may get repeated in the next two quarters

EBITDA margins of 11.2% adjusted for one of item of `150mn in other expenses(7.1% v/s 7.3% yoy and 8.1% qoq)  and declining raw material costs as a % of sales (73.5% v/s 73.7% yoy) led to sharp margin rise in Q2 FY12. Margins of 11.2% were higher by 140 bps qoq and just 10 bps lower yoy. Increased production of 9,000 units from the tax haven plant of Pantnagar also led to cost savings and support to margins. Going forward, with the management expecting to produce 20,000 units from this plant in H2, we expect higher benefits to accrue, thus improving margins. Given the falling raw material prices, improving volume performance and the impact of price hike of ~1% taken on November 1st, we believe that there would be a positive impact on margins going forward. Hence, the EBITDA margin for H1 which were at 10.5% is expected to move up to 10.7% above the management’s estimate of 10.5%. Reducing finished goods inventory (9000 v/s 10,100 at the end of Q1) will allow the company to improve its utilization rate further and reduce inventory bearing costs. Reduction in working capital costs will also have a positive impact on the bottom-line.

Outlook and valuation 

In view of robust Q2 performance and expectations of strong profitability and solid volume growth in H2, we are upgrading the stock to a BUY. At CMP of Rs.28, the stock is trading10x times its FY13E EPS of Rs.2.72. We value the stock at 12x times, which seems quite reasonable viewing the improving growth prospects. We have a target price of Rs.33, an upside of 17%.