Bharat Forge - Expectation hurdle remains steep - ICICI Securities

We are admirers of Bharat Forge (BHFC) for its focus on quality and innovation, yet the truth is its key business segments (CV, PV, Oil & Gas) are cyclical, which are currently in differing demand rebound cycles. Management is trying to pivot and create a larger pie of revenues from stable segments like defence, aerospace etc. Aerospace segment outlook remains uncertain due to Covid-19 pandemic; however, recent defence procurement policy shift has raised investor confidence in BHFC's potential to win artillery guns' orders. We deep-dived into the artillery segment opportunity, analysed global peers (e.g. Rheinmetall) and our base case incremental DCF value is ~Rs41/share. Key risk: If Kalyani group chooses to bid for defence orders via Kalyani Strategic Systems BHFC benefits drops by 50%. We roll forward earnings into Sep'20, upgrade our rating to REDUCE from SELL.

- Trying to decode the defence (artillery) opportunity: As per media reports, Indian army might procure ~2,700 artillery guns for varied requirements. Currently, the key systems being tested/ procured are from: 1) Global suppliers - e.g. BAE M777, Hanwha K9-Vajra (license-built by M&M, L&T respectively), 2) domestic suppliers - e.g. ATAGS (BHFC, Tata Power), Dhanush (OFB). As per our estimates, the cumulative order value relevant for BHFC could be ~Rs243bn (Refer Table: 2). Our base case assumes: ATAGS wins 60% of towed artillery guns' requirement (~1600 guns), BHFC wins ~30% of orders (~500 guns) along with key input supplies (e.g. gun barrel) for another ~30% of orders (non-OFB suppliers). Key risks to ATAGS ordering remains a) budgetary constraints, b)alternate options like Pinaka (Phase2)

- Global suppliers could be a template for defence profitability: We looked at two global suppliers, Rheinmetall, Elbit Systems as case studies to evaluate defence business financial opportunity for BHFC. Both these companies have grown defence revenues, EBIT at ~6%/5% CAGR in FY10-19, respectively. However, nature of business (higher government procurement) leads to higher net-working capital (ex-cash) requirements (~6-7% of revenue). Rheinmetall (closer proxy to BHFC) with similar revenue mix of automotive (~45% in FY19), non-automotive (~55%) has delivered ~12% RoE/ ~6% EBIT margin over FY10-19. We estimate BHFC's defence business to clock superior EBIT margins (>25%) factoring in significant labour cost advantage, higher asset efficiency.

- Overseas subsidiaries performance likely to remain a drag: The lack of material financial improvement in FY20 remains worrying (Refer Tables 7-8); FY21 is likely to slip further. The fact remains European M&HCV revival is likely a CY21/22 story while cost base surprisingly still remains elevated (employee headcount/cost rose 1%, 2% in FY20, respectively). We estimate consolidated RoCEs rebound in FY22/23 to remain below previous cycle (FY18/19).

- Upgrade to REDUCE: The class-8 truck demand (exports) is likely to scale back >300k units by CY22; however, domestic truck market is unlikely to reach FY18 peak volumes before FY24/25. We cut our multiple to 25x (earlier:27x) Sep'22E EPS (roll forward), add Rs41/share fair value (DCF basis) to arrive at fair value of Rs412.

Shares of BHARAT FORGE LTD. was last trading in BSE at Rs.446.6 as compared to the previous close of Rs. 453.5. The total number of shares traded during the day was 70523 in over 2279 trades.

The stock hit an intraday high of Rs. 455.95 and intraday low of 443.5. The net turnover during the day was Rs. 31675996.

Source : Equity Bulls

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