Havells India A Trio of Positives: Dealer Franchise, Brand Strength, and Demand Growth; OW ::Morgan Stanley Research,

Havells India
A Trio of Positives: Dealer
Franchise, Brand Strength,
and Demand Growth; OW
We think Havells is in a sweet spot in the domestic
FMEG market – with its leading dealer franchise,
strong brand, and diversified product lineup.
Sylvania's reduced debt is a tailwind. We think the
stock deserves a premium to its historical P/E, on
consistently high domestic EPS CAGR and ROE.
AlphaWise dealer survey confirms Havells’ dealer
strategy is bearing fruit: Our pan-India survey of 503
dealers in the competitive fast-moving electrical goods
(FMEG) market shows that Havells has a leading
franchise and the highest revenue share at dealers
surveyed, and that dealers expect to increase its share in
their business. However, market fragmentation and lower
penetration in India’s south and west are challenges.
Solid play on rising FMEG demand in India: We
expect strong FMEG growth amid increasing household
numbers, greater access to electricity, and rising income.
Havells is gaining market share across key categories
and generating strong revenue growth.
Gradual recovery at Sylvania; reduced consolidated
debt and lower interest cost gives comfort: We
expect modest revenue momentum in tough macro
conditions, but we like the margin focus. Lower interest
costs on lower consolidated net debt is earnings
positive.
P/E premium warranted: We use a P/E-based sum of the
parts to value the stock. We think the premium to Havells’
15x five-year average P/E in our 19x (consolidated 1-year
forward EPS) target P/E is justified, because of Havells’
strengthening domestic franchise, consistent domestic EPS
delivery, 20-25% domestic ROE, and Sylvania’s improved
balance sheet.
Key risks: Slower-than-expected domestic growth;
weakening margins at Sylvania.

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Investment Summary: Overweight
Why should investors buy Havells’ stock now?
We believe Havells is a secular growth story in an otherwise
cyclical, industrial space, and that the stock should trade at a
premium to its historical average, suggesting further multiple
expansion. The following considerations underpin this view.
• Macro recovery bodes well for the near-term growth:
Morgan Stanley’s India economist, Chetan Ahya, forecasts
India’s GDP growth at 6% for F2014 and 6.9% for F2015
following 5% in F2013. A macro rebound should create a
tailwind for Havells’ earnings performance versus the
headwind of the past two to three years.
• AlphaWise survey establishes that Havells has an
effective strategy and its operating performance is on a
solid footing: Catering to its dealer franchise has been core
to Havells’ growth strategy, and our AlphaWise survey finds
that the company has a leading market position among
dealers. This supports our belief that Havells’ recent robust
growth is sustainable.
• Sylvania’s lower gearing is a positive for earnings: With
lower debt – and lower interest cost – Sylvania’s earnings
should show a near-term uptick, in our view, further boosting
consolidated earnings. Structurally, Sylvania’s lower net debt
and stable core earnings imply reduced risk of funding from
Havells, which had been a key investor concern.
We think Havells stock deserves to trade at a premium to
its historical average P/E
A higher premium relative to history is justified now, in our view,
because in the past few years, Havells has built a leading
position – including a dealer franchise – in an industry where
we see strong fundamentals, strengthened its brand and
launched new product categories. In addition, the share of the
high-margin business of total revenues is increasing. Havells
stock compares well with mid-cap consumer stocks (such as
Marico and Asian Paints) and better relative to industrial peers
(such as Cummins, Larsen & Toubro) on earnings growth and
growth consistency (past 10 years), working capital
requirements and ROE. We value Havells’ domestic business
at 20x 1-year forward earnings, which is a 50% premium to its
long-term average. We value Sylvania at 12x 1-year forward
earnings, which is around a 15% discount to peers such as
Zumtobel, given Havells’ lower exposure to the LED market
and higher gearing relative to peers’. (The Sylvania business is
the European, Latin American and Asian operations of the
lighting company, Sylvania, which Havells acquired in 2007.)
Pan-India AlphaWise survey of 503 dealers in 2012
provides evidence of an industry-leading dealer franchise
at Havells, which would give it a competitive edge
Our survey reveals that Havells has the highest dealer
penetration (73% of dealers surveyed) on a pan-India basis
and ranks in the top 3 (based on share of dealer revenue) for
46% of dealers relative to 39% for the next competitor. From a
regional perspective, Havells is the industry leader in the north
and east of the country and a top 5 player in the south and west,
in terms of dealer penetration. Moreover, the survey shows that
dealers that rank Havells in the top 3 (in revenue share) are
willing to raise Havells’ share in their business further, implying
scope for market share gains with existing channel partners.
This is especially an advantage in an industry in which
competition is intensifying. Based on the survey, we identify
greater fragmentation and lower dealer penetration as key
challenges for Havells in the south and west. However, through
its strong brand and diversified product portfolio, the company
should gain market share in the medium term, we believe.
Focus on customer pull through brand building and new
launches as consumer component grows; complements
strategy of leveraging channel relationships
Over the past 10 years, Havells has launched new products
(such as fans, lighting and consumer durables), growth for
which is relatively more aligned to housing expenditure /
consumption than for its existing categories such as cables and
wire, which are generally linked to industrial capex. This was
consistent with the company’s strategy of launching products
distributed through existing channels, which could boost dealer
relationships and ensure greater mind share / shelf space.
Moreover, these products have higher margins, bolstering
earnings momentum. In an otherwise commoditized industry,
Havells has focused on building a brand. Its advertising
expenditure grew at a 29% CAGR in F06-13, ahead of its 23%
revenue CAGR and faster than growth at competitors. This
gave Havells more visibility with customers and aided growth
through customer pull, a positive for medium-term earnings
performance.

Lower debt and funding costs enhance near-term
earnings for Sylvania; we expect stable margins
Sylvania’s consolidated net debt dropped to €93mn in F2013
from €127mn in F2011 primarily because of a one-time gain on
settling an issue with Osram AG and Osram Sylvania Inc. The
settlement confirmed and clarified jurisdictional ownership of
the Sylvania brand. Further, this entitled both parties to
manufacture and brand products in each other's territories,
provided they are destined for sale in their own territories. The
parties also withdrew all pending litigations. In light of the
allocation of rights, Havells Sylvania received a one-time fee of
US$38mn.
The lower debt levels and cost of funds are reducing interest
payments, down to 20% of EBITDA in F2014, we estimate,
from 44% in F2011, giving a boost to near-term earnings.
However, we expect core EBITDA growth to be modest in view
of subdued revenue momentum in Europe, partly offset by
mid-single digit growth in Latin America. We expect margins
will remain stable.
Rising competition is the key medium-term challenge
Competition has increased in the FMEG industry in recent
years as peers have launched new products and regional firms
have focused on widening their geographical presence. This
could pose a near-term challenge to Havells, particularly given
its industry leading position. In our view, however, its strong
product portfolio and leading dealer franchise position it well to
manage the competition.
Strong standalone balance sheet but key risks in working
capital management and investment at Sylvania
We estimate Havells’ net cash at Rs2.4bn in F2014. The
balance sheet should remain robust based on our assumptions
of limited capital expenditure (Rs1bn in F2014) and strong
operating cash flow (Rs3.6bn in F2014), which is being partly
driven by active working capital management. However, a
sustained rise in working capital could pose some risk to the
strength of the balance sheet. In view of the improvements in
Sylvania’s balance sheet, we think the risk of further
investment by Havells beyond the current plans is low. Havells
has invested around €125mn in Sylvania and plans to invest a
further €26mn in the next three years. The risk remains,
nevertheless.