Varroc Engineering - Order book execution critical for earnings growth - ICICI Securities

Varroc Engineering's (VEL) Q2FY21 operating performance was ahead of consensus estimates as EBITDA margin came in at 9.1% (up 53bps YoY). Sales grew ~21% YoY on the back of ramp-up in greenfield plants, though margins were flat YoY. FCF generation (~Rs4bn in Q2) aided debt reduction of Rs3.5bn. Key takeaways from investor call: a) VLS two greenfield plants are likely to turn EBITDA positive in FY22 as revenues surpass >EUR 150mn revenues; b) VLS order book tilt is heavily to LED (high content) which is likely to drive aid margins in future, c) tight control on capex to continue as management objective remains to improve cash flows and reduce net debt (target: Rs26bn). Stock remains attractive at ~21% FY22E FCF yield. Maintain BUY.

Key takeaways from the call:

- EBITDA margin for India business in Q2 was higher due to salary reductions implemented in Mar'20 up to Sep'20. EBITDA margins are likely going to come off by 100bps in H2 to ~12.5%. Consolidated margins impacted due to higher revenue mix of loss making greenfield plants which are likely to improve in H2/FY22.

- The new greenfield plants started ramping up in Oct'20; Morocco plant has commenced new projects and is expected to reach revenues of EUR5.5mn. Poland plant is likely to reach EUR4mn in Nov'20 (EUR5mn-6mn in Jan'21). The new plants need revenues of ~EUR100mn per year to report healthy EBITDA.

- Capex for FY21 is EUR45mn and that for FY22 is EUR50mn (totaling ~Rs6bn). VLS order bidding on new/existing projects is set with IRR target of 18-20%. Company expects ~ EUR200mn-225mn worth of orderbook by Q4FY21.

- VLS has a very strong EV portfolio with ~20% market share. It is present in: 1) Tesla Model Y globally; 2) front lamps and DRLs for VW ID3.0/4.0 in Europe, North America and China; 3) Ford Mustang Mach-e (rear lamp) supplied from Mexico; and 4) Renault Zoe supplied from Czech facility.

- VLS is trying to substitute halogen offerings with low-cost LEDs for entry level models across mass market products to aid product adoption.

- China JV business is witnessing steady improvement mainly due to its biggest customer Changan performing well. Nov-Dec being the strongest months for auto sector in China are likely to see further improvement in performance.

- Tax rates were higher as loss absorption w.r.t. greenfield plants, which did not have provision for deferred tax accumulation, and would continue to be elevated in FY21.

- Catalytic converter production in India was constrained due to supply-side issues and has touched monthly run-rate of Rs100mn-120mn. It is expected to cross Rs150mn in Dec'20 and reach Rs200mn-250mn per month from FY22 onwards.

Valuation and recommendation

VLS remains an attractive play on the move towards higher LED penetration among global OEMs and cost reduction from the ramp-up of greenfield facilities. We expect VEL's revenue growth at ~16% CAGR over FY21-FY23E. We lower our FY22E EPS estimates by ~4% on account of higher interest, depreciation costs. Due to the mixing of global and domestic automotive exposures, we value the business on SoTP basis. We rollover to Sep'22E and value VLS and its China JV at 4x EV/EBITDA and 7x P/E Sep'22E, respectively, and India business at unchanged multiple of 8x EV/EBITDA Sep'22E to arrive at an unchanged SoTP-based target price of Rs491. Maintain BUY.

Shares of Varroc Engineering Ltd was last trading in BSE at Rs.300.7 as compared to the previous close of Rs. 297. The total number of shares traded during the day was 19423 in over 1502 trades.

The stock hit an intraday high of Rs. 306.2 and intraday low of 296. The net turnover during the day was Rs. 5864883.

Source : Equity Bulls

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