Institutional Equities - Nirmal Bang Raja Batteries- Initiating Coverage... · Institutional...

Please refer to the disclaimer towards the end of the document.

Institutional Equities

Initi

atin

g C

over

age

Reuters: AMAR.BO; Bloomberg: AMRJ IN

Amara Raja Batteries

Underdog Today, But Market Leader Tomorrow We believe Amara Raja Batteries (ARBL) is structurally best placed to ride the Indian demand for automotive (auto) and industrial batteries. While a significant P/E multiple re-rating has already occurred, there is still a case for a 20% premium to the industry leader, Exide Industries (EIL), on one-year forward earnings (as against 6% currently), given its superior and more predictable growth prospects. Over the past several quarters, ARBL outperformed EIL on top-line growth and also on margins/earnings fronts. Further, ARBL’s big-ticket capex phase would soon be behind it. We expect stable EBITDA margin at 16.9%-17.7% over FY15E-FY16E, and likely double-digit sales/earnings CAGR of 19.9%-23.2% over FY15E-FY16E. ARBL currently trades at 13.7x FY15E EPS and 10.4x FY16E EPS. We have assigned Buy rating to ARBL with a target price of Rs426 (17.4x FY15E EPS). ARBL’s near-term earnings inadequately capture the superior long-term compounded growth potential of this powerful business franchise.

Core holding in auto ancillary space: ARBL deserves a pride of place in any long-term investment portfolio built around Indian auto ancillaries. Many factors go in its favour, viz.

cost-effective world class VRLA (valve regulated lead-acid) battery technology from world leader Johnson Controls, strong brands, growth-hungry management, and a fast expanding distribution network, to name a few. For investors, ARBL offers a very agnostic way of playing the long-term Indian auto demand growth story.

Strong promoters, highly committed JV partner and internally funded growth: ARBL’s promoters, the Galla family, and world renowned partner Johnson Controls, are highly committed to its future growth. While Johnson Controls provides world-class technology, the Galla family brings in high level of entrepreneurial dynamism. Superlative growth over the past decade happened with no recourse to fresh equity. And to top that, even after the recent ~Rs7bn capex, net gearing is at a low 4%. Near total reluctance in diluting equity reflects the promoters’ confidence in ARBL’s business model and future plans.

Sustainable cost structure, stable margin, improving asset turnover and strong FCF: Access to superior VRLA battery technology of Johnson Controls gives ARBL superior cost efficiency. Even under stressed conditions, ARBL can still enjoy cost advantage of 5%-6% of net sales over industry leader EIL. We expect ARBL to report stable EBITDA margin at 16.9%-17.7% over FY15E-FY16E, and asset turnover to rise from 3.2x in FY14E to 4.9x by FY16E. With the big-ticket capex phase mostly behind, we expect total free cash flow (FCF) of Rs7.0bn over FY15E-FY16E, driven by ramp-up of new capacity.

Valuation not cheap, but a solid long-term compounding story: Notwithstanding near-term headwinds in the OEM (original equipment manufacturer) auto battery segment and the UPS (uninterrupted power supply) industrial battery segment, and a significant rise in depreciation charges on account of major addition to gross block (likely to be fully in line by 1QFY15), ARBL should witness positive earnings growth momentum over FY15E-FY16E. All this in an environment where industry leader and rival, EIL is likely to struggle with tepid-to-declining sales and PAT growth. With P/E ratios at 13.7x/10.4x on FY15E/FY16E EPS, respectively, ARBL stock may not be cheap by mid-cap standards but offers a solid long-term compounding potential.

BUY

Sector: Automobile Ancillary

CMP: Rs336

Target Price: Rs426

Upside: 26%

K N Sreenivasan [email protected] +91-22-3926 8110

Key Data

Current Shares O/S (mn) 170.8

Mkt Cap (Rsbn/US$mn) 57.5/918.2

52 Wk H / L (Rs) 367/205

Daily Vol. (3M NSE Avg.) 310,872

Share holding (%) 1QFY14 2QFY14 3QFY14

Promoter 52.1 52.1 52.1

FII 16.6 16.7 19.0

DII 14.2 15.0 12.8

Corporate 3.2 2.9 3.1

General Public 14.0 13.4 13.2

One Year Indexed Stock Performance

60

70

80

90

100

110

120

Feb-13 Apr-13 Jun-13 Aug-13 Oct-13 Dec-13 Feb-14

AMARA RAJA BATT NSE CNX NIFTY INDEX

Price Performance (%)

1 M 6 M 1 Yr

Amara Raja Batteries 2.8 39.2 12.2

Nifty Index (3.4) 5.7 0.2

Source: Bloomberg

Y/E March (Rsmn) FY12 FY13 FY14E FY15E FY16E

Net sales 23,809 29,811 34,603 40,838 49,692 EBITDA 3,561 4,712 5,794 6,891 8,792 Net profit 2,151 2,867 3,648 4,179 5,550 EPS (Rs) 12.6 16.8 21.4 24.5 32.5 EPS growth (%) 45.2 33.3 27.2 14.6 32.8 EBITDA margin (%) 15.0 15.8 16.7 16.9 17.7 PER (x) 26.7 20.0 15.7 13.7 10.4 P/BV (x) 7.8 6.1 4.7 3.7 2.9 EV/sales (x) 2.4 1.8 1.7 1.3 1.0 EV/EBITDA (x) 15.8 11.5 10.0 8.0 5.8 RoCE (%) 37.8 41.2 39.3 34.8 38.6 RoE (%) 29.3 30.4 30.1 27.2 28.5

Source: Company, Nirmal Bang Institutional Equities Research

5 February 2014


Amara Raja Batteries 2

Business Overview/Investment Arguments

Access to Johnson Controls’ world renowned lead-acid battery technology

The US$29bn battery MNC, Johnson Controls, is the world leader in lead-acid auto batteries, producing more than 135mn pieces annually. Lead-acid battery markets will continue to expand globally in the next 10-15 years, and more so in fast -growing emerging markets like China and India where the vehicle population is expected to witness a strong secular growth. As much as 99% of passenger vehicles globally use lead-acid batteries. Johnson Control’s research and development (R&D) is at the cutting edge of VRLA battery technology that can potentially increase the energy density of batteries (same at Ampere-hour or Ah in a lesser battery volume) and potentially deliver more power at lower costs (i.e. same Ah using lesser quantity of lead). Ceteris paribus, what Johnson Controls’ cutting-edge battery technology could potentially deliver financially is higher EBITDA margin, or alternatively gains in market share if technology-driven incremental margins are eschewed. In a nutshell, Johnson Controls’ superior battery technology, we believe, offers certain competitive advantages which makes ARBL a superior growth proxy in the auto and industrial battery segments. Johnson Controls is not only the technology provider for ARBL, but it is an equal strategic/joint venture partner with the Galla family, with both holding a 26% stake each in ARBL. The ARBL stock deserves a technology premium because of the presence of Johnson Controls in the company’s overall scheme of things. Apart from the auto battery space, access to Johnson Controls’ superior VRLA battery technology can only further cement ARBL’s position as one of the leading industrial battery manufacturer as well.

Deeply entrenched market position in auto as well as industrial battery segments

Exhibit 1 below shows how ARBL is deeply entrenched in key auto and industrial battery segments. ARBL’s 28% and 22% market shares (as of FY13-end), respectively, in the four-wheeler OEM and replacement market segments have been hard won, against competition from players like EIL. In the telecommunications (telecom) battery space, ARBL is the acknowledged market leader with a FY13 market share of 46%. It should be noted that the telecom segment is the space which lead-acid battery market leader EIL had entered nearly four-five years ago and vacated the same soon after. EIL vacated the telecom battery space then because it realised that it did not have a cost-effective telecom battery solution to offer. That it took EIL another three-four years before it could develop cost-effective battery solution for the telecom space, says a lot about the technological edge which ARBL enjoys, thanks to the access to Johnson Control’s technology. Incidentally, at the post 3QFY14 results conference-call, EIL’s management stated that it had about a year ago re-entered the telecom battery space (given that after three-four years of R&D, it had cost-effective solutions now) and has a low single-digit market share. Can EIL hope to counter ARBL’s major headstart in the telecom battery segment in a jiffy? Certainly not. In fact, unlike the UPS battery segment which is currently going through quite tough demand conditions, ARBL’s strong market position in the very stable telecom battery space is a source of big comfort as far as its exposure to industrial battery segment is concerned. In the UPS battery segment, we believe ARBL is placed second on a market share of 32% with EIL being the undisputed market leader in this space.

Exhibit 1: Segment-wise market share

0

10

20

30

40

50

Fo

ur-

wh

ee

ler

(OE

M)

Fo

ur-

wh

ee

ler

(Re

pla

cem

en

t)

Tw

o-w

he

ele

r (R

ep

lace

me

nt)

Te

leco

m

UP

S

FY10 FY11 FY12 FY13

(%)




Capacity expansion on track

Our channel checks indicate that ARBL’s capacity addition is mostly as per schedule. Given the strong demand for its products, ARBL is in the midst of Rs7.5bn capex spending over FY14E-FY15E, with a view to ramp up capacity.

1) Given the strong replacement demand for four-wheeler batteries, ARBL has ramped up four-wheeler battery capacity to 6.0mn units as of end-May 2013 (from 5.6mn earlier), which would further go up to 8.2mn units by end-June 2014E.

2) Two-wheeler battery capacity to be raised from 4.8mn to 8.4mn units.

3) ARBL is also converting a part of its existing medium VRLA battery capacity for making four-wheeler batteries in order to meet the rising demand for four-wheeler batteries.

4) Medium VRLA battery capacity enhanced from 1.8mn units to 3.6mn units as of end-October 2013.

5) Large VRLA battery capacity increased from 750mn Ah to 1,000mn Ah as of end-October 2013.

6) Also, there is significant fungibility for these new capacities, in the sense that these capacities can be interchangeably used for making batteries in other segments as well. The fungibility of new capacities should thus be seen as imparting a certain degree of operational flexibility when faced with dynamically changing demand side conditions.

Exhibit 2: New capacities and their timeline

Description Capacity (units) Additional capacity Capex Commissioning

Four-wheeler 5.6mn 0.4mn units (brownfield addition) Rs0.15bn Already commissioned in 2QFY14.

Four-wheeler - 2.25mn (greenfield capacity) Rs3.9bn June 2014 (i.e. commissioning in 1QFY15/2QFY15). Progressing as per original schedule.

Two-wheeler 4.8mn 3.6mn Rs1.0bn Originally envisaged to commence supplies in a phased manner from 3QFY14, but commissioning of this brownfield capacity addition stands delayed to 4QFY14.

Medium VRLA 1.8mn 1.8mn Rs1.9bn October, 2013 (supplies started in 3QFY14)

Large VRLA 750mn Ah 250mn Ah Rs0.5bn October, 2013 (supplies started in 3QFY14)

Total capex - - Rs7.45bn -

Source: Company

New greenfield site at Chitoor means risk diversification as well

ARBL’s new greenfield site at Chitoor in Andhra Pradesh means the company will now be operating through two plants, i.e. existing Karakambadi plant near the temple town of Tirupati and the new Chitoor plant. The Chitoor plant is equidistant from Chennai and Bengaluru. From an industrial relations’ point of view, having two plants at different locations imparts a certain degree of risk diversification as well.

Organic growth entirely funded internally with no recourse to fresh equity

One important aspect of ARBL’s organic growth story is that the company has not tapped the equity market even once during its high-growth phase that started in FY01.The 50% jump in issued equity capital witnessed in FY07 was entirely on account of a 1:2 bonus share issue and involved no fresh raising of equity. Between end-FY03 and end-FY13, ARBL’s gross block went up 4.4x at Rs6,727mn, and its net working capital (NWC) rose 9.8x at Rs6,886mn. The rise in gross block and NWC were the two key drivers of balance sheet expansion (5.8x) between FY03 and FY13. While the gross block and NWC put together rose by Rs11,396mn over FY03-FY13, the total loan funds rose by only Rs775mn. The rise in loan funds was thus just 6.8% of the combined rise in gross block and NWC over FY03-FY13. Obviously, this implies that ~93% of ABRL’s rise in gross block and NWC over FY03-FY13 were funded entirely through internal accruals. The points to note are:

1) ABRL’s growth has been profitable.

2) ABRL management’s reluctance to dilute equity itself is a key signal of its confidence in the underlying profitability of the business model.



Attractive capital efficiency likely on new capex; IRoCE on further expansion at new greenfield locations can be superlative

Exhibit 3 below shows the fresh capex/ gross block addition (to come on line over FY14E-FY15E) can be RoCE-accretive in 30-36 months (most conservative and stretched estimate of the time). We believe the incremental gross block being added can easily deliver EBITDA margin of 16%, which in turn implies RoCE of 27% on incremental gross block. The projected RoCE of 27% is expected to be significantly above the company’s cost of capital. More importantly, the new greenfield location at Chitoor offers ARBL the ability to expand further there, with only incremental capex needed for any addition. What we like to highlight here is that the IRoCE on eventual further capacity addition at Chittoor can be high.

Exhibit 3: Incremental capital output ratios on new capacity

Capacity Capex Peak revenue* Asset

(Rsbn) @ 100% capacity utilisation (Rsbn) turnover (x)*

(A) Indl. batteries

MVRLA 19.0 50.0 2.6

LVRLA 5.0 25.0 5.0

(B) Automotive batteries

Four-wheeler batteries 40.5 75.0 1.9

Two-wheeler batteries 10.0 17.5 1.8

Total 74.5 167.5 2.2

Calculations

Peak revenue potential on new (Rsbn) - 167.5 -

capex @ 100% capacity utilisation.

EBITDA margin (%) - 16.0% -

Peak EBITDA on new assets (Rsbn) - 26.8 -

Depreciation (Rsbn) - 6.7 -

EBIT (Rsbn) - 20.1 -

RoCE (%), [EBIT/ gross block added] - 27.0% -

*Based on company estimates (Annual Report 2012-13)

Source: ARBL Annual Report 2012-13, Nirmal Bang Institutional Equities Research

Distribution channel expansion goes hand-in-hand, expanding geographic footprint

ARBL’s distribution set-up is the second-largest in the battery sector in India. The ’Amaron’ network is made up of 287 franchised distributors, including over 21,000 retailers and over 2,400 service hubs. The ’Powerzone’ network comprises over 1,100 retail outlets having semi-urban and rural presence. Industry leader EIL has ~39,000 retail outlets, and ARBL is fast catching up on the distribution front. ARBL’s capacity expansion and distribution network expansion is expected to go hand-in-hand. In the branded battery market, distribution muscle has a key role in driving revenue growth, and ARBL is fast catching up with EIL. What the expanding production capacities and strengthened distribution muscle means is that ARBL will get stronger in the western and eastern regions of India. These are the areas where ARBL’s presence so far has been traditionally weaker compared to EIL.

Market share of organised players improving

There have been various estimates of the share of the organised battery market players in India. While some observers peg it ~35-40%, there are others who talk of an over 50-60% share. One sub-segment where there is higher presence of the unorganised sector is in the cost-conscious and price-sensitive truck/bus battery (24 volt) segment. Be that as it may, the key point to note is that the share of the organised sector is increasing because of superior battery life and product warranty. The current price differential between branded and unorganised sector batteries is ~15%-20%.

Owners of personal-use vehicles like cars and two-wheelers are now increasingly opting for branded batteries only. Gone are the days when vehicle owners typically opted for batteries made by local/regional players.



As regards the commercial vehicle market, it is a three-tier market where the new vehicles (up to five-year old) ply on the lucrative long distance routes which are mostly inter-state, and truck/ bus operators in the top tier typically go for only branded batteries like Amaron or Exide, while looking for replacement. Once economically the best possible years are behind, these trucks/ buses (over five-year old) then move into Tier-2 markets where they are used for intra-state medium-distance hauls. After remaining in Tier-2 markets for four-five years, these trucks and buses finally end up in Tier-3 markets where they are used only for intra-city short-distance hauls. The prevalence of usage of unorganised sector batteries is high, mainly in Tier-2 and Tier-3 truck/ bus markets. Operators in these less lucrative segments prefer to go for unbranded batteries, as they tend to be cheaper. However, with the awareness of longer life and the benefits of sealed VRLA battery (which requires no frequent top-up with acid electrolytes) increasing, one can expect at least Tier-2 truck/bus operators to increasingly go for branded batteries. Truck/ battery sales volume may be lower than car and two-wheeler battery sales volume. However, truck/ bus batteries are normally 2.5x-3.0x costlier than an average car battery on a per unit basis. Therefore, from a top-line point of view, the increased adoption of branded batteries by truck/ bus operators does matter for branded battery producers.

Investing through the down-phase in new capacity and in better distribution facility

We believe ARBL is doing the right thing by currently expanding production as well as distribution capacities significantly, at a time when the Indian automobile sector as a whole is going through a very rough patch. On hindsight, industry troughs typically turn out to be great times for long-haul players in the auto OEM space as well as auto ancillary space to not only rationalise their cost structure, but also undertake the required capacity expansion to ride the next wave of growth in the industry. We believe the current downcycle will also turn out to be no different, in so far as the above assessment goes.

Why do we think ARBL has a sustainable and structural cost advantage versus industry leader EIL?

There are some interesting and important takeaways that we gleaned after participating in EIL’s 3QFY14 post-results conference call (held on 15 January, 2014), that have significant bearing and relevance from ARBL’s perspective.

EIL’s top management stated that:

1) EIL went for an upward price revision of ~5%-6% in May/June 2013 and another 7.5% in September 2013 for its batteries so, to compensate for the steep rise in raw material costs following the rupee’s sharp depreciation against the US dollar (USD) in June –September 2013. ARBL also went for similar battery price hikes during the said period. Further, in November 2013, EIL cut battery prices by 5%-6%, given the fact that the steep erosion in the rupee got partially reversed. In November 2013, ARBL hiked its prices further by ~2.5%.

2) After all the above price revisions and as it stands currently, EIL’s management stated that ARBL, which currently operates very close to 100% of its capacity (against EIL’s~70%), sells its products at a weighted average price of 14%-15% below EIL, and yet enjoys EBITDA margin of 16%-17%. One thing we wish to specifically state here is that end-customer battery pricing is the effective price paid that also factors in the discount/set-off for surrendering the used/dead battery. To cite an example, a price difference of Rs500 (i.e. ARBL offering a price higher by Rs500 for used/dead battery as against EIL) on a typical 50-55 Ah car battery can actually mean ~10% off on the sticker price of a new battery. In other words, even though the sticker prices of like-to-like batteries from rival producers like EIL or ARBL may be the same, the differential in the price paid for dead/used battery can be the source of effective price differential between two rival producers. Over the past two years, we have been noticing a higher price being quoted by ARBL dealers for dead batteries, and that to some extent matches with what EIL management stated.

3) EIL’s management also stated that ideally it likes to maintain only a 5% product price premium versus ARBL as it believes that a 5% pricing premium is what appropriately captures the superior brand strength of EIL. However, today it is unable to bring down the pricing differential to significantly less than the current 14%-15% gap because while ARBL operates almost 100% of its capacity, EIL’s capacity utilisation is only 70%. And given that EIL’s EBITDA margin in 3QFY14 is just 10.9%, it is amply clear that industry leader just does not have any leeway to cut product prices without denting margins further. Can one totally attribute the price differential between ARBL and EIL solely to the 30% capacity utilisation differential between the two companies, as is what EIL’s management suggests? By saying so, EIL’s management likes the investors to believe that rival ARBL does not have any sustainable structural cost advantage. But does a reverse/ backward calculation support this contention? And is the ideal 5% price premium that EIL likes to keep over ARBL is a demonstration of EIL’s superior brand power or just a convenient camouflage or cover up for its structural cost disadvantage vis-à-vis ARBL?



4) Going by EIL version, whether the 30% higher capacity utilisation. of ARBL (~100% versus EIL’s~ 70%) translates to a 15% price advantage for ARBL? Is it correct? ARBL’s raw material costs account for ~66%-67% of sales. So around one-third or 33% of 30% of sales (30% = difference in capacity utilisation) can be the gross contribution level advantage that ARBL can enjoy against EIL, which is 10% of sales, if one were to assume that other than raw material there are no other variable costs. But normally, other variable costs do exist, and let us assume that 30% of 30% of sales is 9% of sales, which could be a fairly realistic assessment of the price advantage that ARBL enjoys on account of full capacity utilisation (against EIL’s 70%). The above argument means that the balance 5%-6% of net sales of pricing advantage that ARBL enjoys could entirely be because of some structural cost advantage To cite an example, ARBL’s employee costs, as a percentage of net sales for FY12/FY13, have been ~130bps-150bps down against that of EIL.

5) Even if ARBL’s capacity utilisation plunges to the level of 65%-70% after its current mega capacity expansion, ARBL could still enjoy a 5%-6% pricing advantage versus EIL on account of some of the structural cost advantage. While lower employee costs structure could be a factor, we strongly believe Johnson Controls’ VRLA technology is more cost-efficient than EIL’s, although we do not have exact and precise evidence to back the same. Also, industry feedback is that ARBL has a better captive lead recycling facility. But circumstantial evidence of higher prices offered by ARBL dealers for used/dead batteries alludes to the conclusion that ARBL is passing on a meaningful portion of its superior cost efficiency to end-customers. It is likely that a relatively better cost structure could act as a sustainable “competitive advantage” for ARBL, thereby restricting EIL’s ability to regain its market share losses since the past few years.

ARBL - Today’s underdog can easily be tomorrow’s market leader

As of today, ARBL stands ranked second-largest among India’s organised automotive battery players. We think ARBL has more fire in its belly than rivals. The Galla family’s aggression and ambition is not on thin air, it is backed by the powerful battery technology from Johnson Controls. We see a lot of parallels between Apollo Tyres and ARBL. Apollo Tyres was an underdog in the Indian tyre industry during the 80s and 90s, but today it figures in the top echelons of domestic tyre manufacturers.

Not for nothing has ARBL majorly closed its valuation gap versus market leader EIL

ARBL’s profitable journey from a non-entity in 2001 to the number two player by 2013 among India’s lead-acid battery manufacturers has not gone unnoticed. The street has been prescient and it managed to capture and recognise ARBL’s aggressive, profitable and expansionist initiatives by progressively ramping up its valuation multiple over more than a decade. Initial skepticism and doubts about ARBL in the early 2000s have slowly and progressively given way to a more realistic assessment of its capabilities, as the validation of improving performance kept coming in, in the form of successive quarterly results milestones. Exhibit 4 below shows how ARBL’s valuation closed the gap against market leader EIL.

Exhibit 4: Narrowing valuation gap between industry leader EIL and ARBL

-90%

-80%

-70%

-60%

-50%

-40%

-30%

-20%

-10%

0%

10%

20%

31

-Ma

r-0

6

31

-Ju

l-06

30

-No

v-0

6

31

-Ma

r-0

7

31

-Ju

l-07

30

-No

v-0

7

31

-Ma

r-0

8

31

-Ju

l-08

30

-No

v-0

8

31

-Ma

r-0

9

31

-Ju

l-09

30

-No

v-0

9

31

-Ma

r-1

0

31

-Ju

l-10

30

-No

v-1

0

31

-Ma

r-1

1

31

-Ju

l-11

30

-No

v-1

1

31

-Ma

r-1

2

31

-Ju

l-12

30

-No

v-1

2

31

-Ma

r-1

3

31

-Ju

l-13

30

-No

v-1

3

Source: Bloomberg, Nirmal Bang Institutional Equities Research



ARBL possibly deserves a valuation premium to EIL

In ARBL, we are in all likelihood looking at a company that could very well be tomorrow’s market leader in the organised lead-acid battery manufacturing industry in India.

An objective assessment of management initiatives at ARBL over the past 12-13 years reveals:-

1) The management stayed exclusively focused on lead-acid battery business. It never got into any distractive business diversification.

2) ARBL’s joint venture partners, Johnson Controls and Galla family, have over the past more than 12-13 years, demonstrated unity of purpose in their actions, and no discord or lack of understanding emanated from two partners.

3) Johnson Controls is a world leader in VRLA battery business.

4) ARBL is a company whose top management has managed its organic business growth almost entirely through internal accruals, and has not approached the equity market even once for fresh capital over the past 12-13 years. This is a clear sign of the management ‘s confidence in the underlying strength of its business model.

5) The management indicated several times of its desire to make ARBL the numero uno player in the Indian lead-acid battery market, backed by its access to VRLA battery technology from Johnson Controls.

Further, at this juncture, where a higher degree of earnings stability and defensiveness are appreciated by the equity market, ARBL enjoys a superior product portfolio with a higher exposure to the more stable auto replacement market (48% of ARBL’s overall revenue versus 42% in case of EIL) and also a higher exposure to the stable telecom battery segment (50% of ARBL’s industry battery revenue versus 9%-10% of EIL’s industry battery revenue). That industry leader EIL faced capacity constraints in FY10/FY11 is well known, but what is quite important to note is that the company is still finding it very difficult to regain market share that it ceded to ARBL in the automobile replacement segment. Both at the conceptual level and also on the back of ARBL’s past track record of execution, we believe there exists a fairly strong case for arguing that ARBL deserves valuation at a premium to the industry leader. Today, ARBL stock trades at a 5%-6% premium to EIL, on one-year rolling P/E basis. We believe ARBL will most likely offer superior growth prospects over EIL for the next four-five years at least. Given the mega over Rs7bn capex that ARBL plans to successfully put on the ground completely by 1HFY15, and given the management’s continued thrust on distribution expansion, we believe the next few years should see superior growth from ARBL, and accordingly we think a 15%-20% P/E premium for ARBL against industry leader EIL, on one-year rolling forward numbers, can be easily justified. ARBL’s consistent track record of superior performance over the past five-six years, we believe, has significantly improved investor confidence in the company’s capability, and consequently, risk premiums have been progressively easing and one can argue that there is leeway for a further decline.

Also, it is pertinent to note EIL’s significant earnings volatility over the past three-four quarters and particularly in 3QFY14 (EIL’s top-line down 10.9% YoY and PAT down 25.5% YoY in 3QFY14). ARBL, on the contrary, registered a fairly consistent and stable financial performance over the same period. ARBL reported a divergent 3QFY14 performance versus EIL when it posted 13.4% and 17.4% YoY growth in top-line and PAT, respectively, for 3QFY14. We believe ARBL’s divergent and superior performance is on the back of superior revenue mix (viz. stable and higher margin auto segment replacement revenue at 48% of overall revenue for ARBL versus EIL’s 42%), much higher exposure to the more stable telecom segment on the industrial battery side (~20% of overall revenue for ARBL versus just ~3%-4% for EIL), fast expanding retail network (over 21,000 retail outlets in FY13 versus 18,000 in FY11), superior cost efficiency as well as operating margin or OPM profile (15%-17%for ARBL versus EIL’s 13%-14%).

ARBL’s relationship with auto OEMs has stood the test of times

While Johnson Controls, ARBL’s technological and strategic partner, supplies its products to most global automobile OEMs; ARBL, in India, supplies to domestic OEMs like Maruti Suzuki India, Mahindra & Mahindra (M&M), Tata Motors, Hyundai, Honda Cars India, Ford India, and Ashok Leyland. These are four-wheeler OEM relationships that have stood the test of times. ARBL currently enjoys a 30% market share in the four-wheeler OEM market for auto batteries, up from 28% as of end-FY13 and 24% in FY10. We believe ARBL’s above market share in the four-wheeler OEM segment could rise further in the medium to long-term, given the aggressive capacity expansion and marketing exercises that ARBL has been carrying out. Having said that, in the very near term, ARBL is expected to reel under volume growth pressure in the four-wheeler OEM segment, given that both passenger car and commercial vehicle sales are witnessing a decline.



On the two-wheeler OEM side, ARBL has already received approvals from players like Bajaj Auto, Hero MotoCorp (HMCL), Honda Motors and Scooters India (HMSI), and M&M. OEM supply of batteries to HMSI has already begun. Once the next round of two-wheeler battery capacity gets added in 4QFY14, ARBL will then start supplying to HMCL and Bajaj Auto some time in 4QFY14. Lastly, while the OEM segment offers only thin margins compared to the replacement segment, what it gives branded battery producers is high visibility. And typically, buyers of new cars, as and when they go for replacement after two-three years, normally prefer the battery brand that comes with the new vehicle.

Generally, at the moment, OEM sales of battery producers like ARBL and EIL are significantly declining in the CV as well as passenger car segments, while it is only the two-wheeler segment that is showing flat or marginally negative growth. However, given ARBL’s new two-wheeler battery capacity coming in by early February 2014, and with first-time supplies to HMCL and Bajaj Auto expected to kick in soon after, we believe ARBL could witness significant traction in two-wheeler OEM battery supply over the next several quarters.

Replacement market provides stability to revenue and earnings

Unlike some auto ancillary players who operate only in the OEM segment, battery manufacturers like ARBL and EIL are present in the replacement as well as OEM segments of the broader auto market. In fact, it is the replacement segment which caters to the huge and existing bank of vehicles in the system, that is typically far bigger than the OEM segment. What the higher reliance on replacement demand implies is that there is typically more stability and lesser cyclicality in the earnings of auto ancillary players which derive a significantly higher share of revenue from the replacement segment.

The presence of replacement demand tends to have a dampening or a “flywheel” kind of effect on sharp cyclicality and volatility, and imparts a certain degree of defensiveness to these stocks. One could argue for a reduced risk premium (versus auto OEMs or ancillaries catering only to OEMs) for auto ancillary stocks which are heavily replacement market-dependent, and consequently have higher P/E multiples. However, notwithstanding the relative defensiveness, stocks like ARBL tend to display significant earnings growth momentum when automobile demand is on a secular uptrend, i.e. when both the OEM as well as replacement demand fires on all cylinders.

Overall market feedback is that ARBL continues to gain market share in the automobile replacement segment, with ARBL growing faster than EIL. Based on our channel checks and interactions with industry participants, this deviation in growth rate is largely led by favourable change in perception towards Amaron brand and some warranty issues in the case of Exide brand of batteries. While the automobile replacement market in both passenger cars and two-wheelers has been faring reasonably well with growth sustaining, the pressure points are in replacement sales in commercial vehicles or CVs (both medium and heavy commercial vehicles, and light commercial vehicles) as well as the passenger taxi segment. Channel checks indicate that the pressure in replacement sales in CV and passenger taxi segments is felt more by EIL than by ARBL. We believe that while ARBL’s replacement battery sales growth in cars and two-wheelers is currently in low double-digit, that of EIL is in low single-digit as well.

Average automobile battery replacement cycle of three years likely to remain at that level

Typically, an average automotive battery lasts three years. Long-lasting batteries, which function beyond the normal average life, are sold by battery producers with a 48-month or 60-month warranty/guarantee, and there is definitely a significant price premium to be paid by customers for such batteries. In fact, ARBL was a trend-setter, when it introduced batteries with a 48-month or 60-month guarantee. However, most of the replacement battery customers go for batteries that last for about three years, as the general belief is that one gets the best trade-off between battery price and battery life on such batteries. We believe that a average three-year replacement cycle provides the optimal trade-off for battery producers as well in the complex trade-off between revenue and profitability. On the sale of an automobile battery with a five-year life, the battery manufacturer gets higher realisation and higher per unit profit on the same, but the next replacement on that battery may be after five years. On the sale of a battery with just a two-year guarantee , the battery producer gets a lower realisation and lower profit than on a battery with three-year guarantee; but the next replacement on this battery gets reduced to two years. In a nutshell, we like to point out that a battery with a three-year guarantee offers the optimal trade-off for battery producers (and customers as well) between per unit profit and replacement cycle/time which affects revenue visibility.



Major presence in telecom battery segment provides comfort at a time when UPS business faces rough weather

ARBL’s exposure to the industrial battery segment is not as severely impacted as that of industry leader EIL.

Around 40% of ARBL’s FY13 revenue came from industrial battery sales.

The reasons behind this are as follows:

1) Telecom batteries account for ~ 49%-50% of ARBL’s industrial battery sales. Unlike EIL which is just a fringe player in the telecom battery segment, ARBL is the market leader with end-FY13 market share of 46%. Even though telecom tower strength is fairly stagnant at ~400,000 (annual growth of just ~2-3%), the expansion in long-term demand will come from increasing tenancy ratios (can expand from the current average of 1.1-1.2x to over 2.0x over the next three-four years). Particularly in cities, there is increased opposition against setting up new tower sites. With tower strength fairly stagnant and tenancy ratio expansion being more of a long-term driver; in the short to medium-term, 90% of the telecom battery segment demand comes from the replacement market. In our view, telecom replacement sales are holding up well, and on an overall basis, such sales can provide a stable 8%-10% YoY growth, even on a most conservative basis. Large telecom tower players now prefer battery vendors who can provide total solutions package, an area where ARBL scores with its superior quality products, higher reliability, and better cost efficiency. Also, telecom tower companies do not mind paying a slight premium for such products and services from vendors like ARBL. Can ARBL capitalise on these favourable industry dynamics? Certainly yes, and we believe ARBL will not only be able to protect its current 46% market share in the telecom battery space; but also may expand its share to ~55% over the medium term. What was till recently standing in the way of ARBL’s ambition was capacity constraints, but with both substantial medium and large VRLA incremental capacity coming on line recently, ARBL is on track to achieve decent growth in the telecom segment. Nothing illustrates the sharply divergent positions of ARBL and EIL in the telecom battery space than their market shares – 46% of ARBL against low single-digit 6%-7% of EIL. Inability to match the lower cost structure of players like ARBL forced EIL to vacate the telecom battery space about four years ago. After taking more than three years to come up with cost-effective telecom battery solutions, EIL re-entered the segment about a year ago. However, industry feedback is that EIL is still struggling in the telecom battery segment, and it will be quite difficult for it to regain the space it ceded to nimble-footed rivals like ARBL.

2) If one were to go by the takeaways from EIL’s recent 3QFY14 post results con-call, the industrial UPS battery demand is facing huge near-term headwinds from a decline on the OEM side, largely driven by macro-economic weakness. In the case of EIL overall UPS battery unit sales witnessed a37-38% YoY decline in 3QFY14. Key point to note in the case of ARBL is that UPS/inverter battery segment accounted for a much lower 38%-39% of its industrial battery revenue, as compared to ~90% of EIL’s industrial battery revenue. For ARBL, we believe 40% of the UPS battery demand comes from the OEM segment, and the balance 60% from the replacement market. Overall, while ARBL’s UPS battery sales could potentially witness some decline in the next few quarters, we still think it could be muted compared to EIL’s 37%-38% decline likely in unit sales. UPS battery demand, particularly on the OEM side, can pick up only if there is macro-economic recovery; while long-term segmental outlook is likely to remain strong, driven by sustained power-deficit scenario (notwithstanding the new found interconnectivity of northern and southern power grids, and the consequent creation of a national grid) and rising computerisation across industries like information technology or IT, banking, financial services and insurance or BFSI, retail, ATMs, e-governance projects and e-commerce institutions. Net-net, ARBL’s UPS battery segment capacity expansion could take more time than originally anticipated, given the weak macro-economic environment currently. Nevertheless, we draw comfort from the fact that in the case of ARBL, UPS/inverter battery revenue is only ~38% of industrial battery revenue compared to ~90% of industrial battery revenue in case of EIL. Therefore, the impact, if any, of any slowdown in the UPS battery space will be far less pronounced in case of ARBL.

Management confident of speedily utilising new capacity coming on stream by 1HFY15

As already stated, ARBL’s management appears confident of quickly utilising incremental capacity coming up by 1HFY15, i.e. the time-line by when the major impact of the Rs7bn-Rs8bn capex is felt by way of commissioned fresh capacity ARBL is expanding capacity across segments by ~40% by 1HFY15E. Especially, in the telecom battery replacement and two-wheeler segments, where currently it is facing constraints, we believe ARBL can ramp up the utilisation of new capacity coming on line pretty fast. Even in case of four-wheeler battery, it is relatively better placed on replacement demand, than EIL.



In addition, ARBL has started supplying two-wheeler batteries to HMSI and will soon start supplying to HMCL and Bajaj Auto from 4QFY14 onwards, i.e. once the new capacity comes up very soon. The main auto segment, which is quite weak currently, is four-wheeler OEM, which continues to reel under pressure. Nonetheless, here too, ARBL gained market share from ~24% in FY10 to ~30% currently.

Lead prices likely to remain benign and under control

Lead is the principal raw material in battery manufacture, and accounts for ~77%-80% of total raw material costs (raw material costs are typically 66%-69% of net sales). As Exhibit 5 below shows, lead prices on LME are off from their highs of February 2013, and prices have been mostly hovering in the US$2,000-US$2,250 band over the past three quarters. However, in 2QFY14 and 3QFY14, Indian battery producers were negatively impacted, not because of volatility in lead prices (USD) but by the sharp depreciation of the rupee (June-October 2013). Battery producers like EIL and ARBL hiked product prices during the above period to counter the steep rupee depreciation

We believe lead prices are likely to stay benign in the coming quarters, all the more so against the backdrop of further tapering of the quantitative easing-3 programme by the US Federal Reserve in the coming quarters. The key point to note is that going forward, battery manufacturers like ARBL are unlikely to be impacted by any sharp lead price (USD-denominated) volatility, and the rupee also appears to be stable now. Lead prices typically find their way through ARBL’s operating figures with a one-quarter lag. This is because of the fact that battery producers like ARBL typically plan their production schedule and production run a quarter in advance, and then lock-in the prices of critical raw material inputs like lead simultaneously with the one quarter-in-advance planning exercise.

Exhibit 5: LME lead prices

1,800

1,900

2,000

2,100

2,200

2,300

2,400

2,500

Jan

-13

Jan

-13

Fe

b-1

3

Ma

r-1

3

Ma

r-1

3

Ap

r-1

3

Ma

y-1

3

Ma

y-1

3

Jun

-13

Jul-1

3

Jul-1

3

Au

g-1

3

Se

p-1

3

Oct

-13

Oct

-13

No

v-1

3

De

c-1

3

De

c-1

3

(US$)

Source: Bloomberg

There are pressure points relating to near-term growth and they may continue for few more quarters

For battery producers like ARBL, short-run growth pressures in the automotive as well as industrial segments cannot be ignored. The two pressure points faced by ARBL are:

1) The auto OEM side, where both passenger car and commercial vehicle industry sales have been declining because of macro-economic headwinds, and a full bottoming out as well as recovery may still be some quarters away (some time in 2HFY15E).

2) In industrial batteries, the UPS/ inverter battery segment is facing macro-economic weakness, and hence is facing flattish to negative growth. There has been a slowdown in new UPS sales by UPS manufacturers, as the demand from small and medium commercial and industrial establishments is on the wane following macro-economic weakness.

However, as already pointed out in earlier sections, ARBL is relatively in a far more comfortable position EIL. In the automotive battery side, ARBL has a bigger exposure to replacement sales, which are holding quite well. Also, unlike EIL, even in commercial vehicle replacement battery sales, ARBL is doing significantly better than EIL. On the industrial battery front, ~50% of ARBL’s industrial battery sales comes from the stable and steadily growing telecom segment, unlike EIL, which derives just about ~9%-10% of industrial battery revenue from this segment. Again, even in the troubled UPS battery segment, we believe ARBL is facing far less muted decline than EIL’s 37% YoY fall (in 3QFY14).



In short, we like to point out that ARBL’s strong auto replacement market focus and higher reliance on the stable telecom segment within the overall industrial battery space, will see it sailing through the difficult near-term macro business environment, registering likely decent and positive growth in both top-line and bottom-line over the next few quarters. And this should be a significant divergence from the likely decline that industry leader EIL is likely to report in the coming quarters.

Key areas of near-term as well as medium to long-term growth for ARBL

Given below we list the key near-term as also medium to long-term drivers of growth for ARBL. Also, we discuss both existing growth avenues and new growth opportunities.

1) Recovery in auto OEM market: ARBL will be a beneficiary of the eventual demand recovery in all OEM vehicle segments in India, i.e. passenger cars, commercial vehicles and two-wheelers. Overall macro-economic weakness has particularly hurt commercial vehicle sales, where MHCV production/sales declined by ~25%-27% YoY in 9MFY14, and LCV production/sales fell 14%-18% YoY in the same period. Passenger car OEM production/ sales were down ~3-5% in 9MFY14. The only auto sub-segment which registered muted but positive growth in 9MFY14 was two-wheelers, whose production/sales grew ~5%-6% YoY. Auto OEM sales have been negatively impacted by the combined influence of high interest rates as well as fuel (petrol and diesel) prices and persistently high inflation in the economy.

However, given market expectations of a likely stable and decisive government coming to power at the Centre post 2014 Lok Sabha elections, we expect a gradual improvement in the macro-economic environment. We are looking at likely initial signs of a recovery in the auto OEM market in 2HFY15. Notwithstanding the near-term growth hiccups and current weak macro-economic environment, the case for a robust long-term Indian auto demand growth story appears to be intact. We remain optimistic on Indian auto demand growth prospects over the medium to long-term.

2) Growth in auto replacement markets to provide near-term cushion: As stated earlier, auto battery replacement market continues to grow even when auto OEM market slows down. Industry experts point out it takes about three years of consecutive fall in OEM sales to translate into flattish replacement market battery sales. In the near term, we continue to believe that replacement auto battery sales will aid decent top-line growth for ARBL in the coming quarters.

3) Expansion in market share can also drive growth: Growth for ARBL can also occur through the capture of higher market share in the four-wheeler OEM and replacement markets. Further, market share gains in the four-wheeler segment will be closely challenged by EIL. However, given ARBL’s aggression and perseverance, we remain optimistic of its ability to drive future growth through increased market share. Particularly, on the passenger car front, ARBL’s successful penetration of the OEM diesel car segment (Maruti Suzuki’s highly successful Dzire and Swift platforms) is expected to pay rich dividends by way of strong replacement market sales.

4) Foray into two-wheeler OEM space a near-term trigger: ARBL has been a recent entrant in the two-wheeler OEM segment. Its FY13 market share in this segment was in low single-digit, given that it was just a relatively smaller supplier and that too only to Honda’s 100% Indian subsidiary, HMSI (~18% of FY13 Indian two-wheeler production). While individual unit battery price realisation is substantially lower in the two-wheeler segment (Rs500-Rs700 versus over Rs3,500-Rs4,000 for four-wheeler batteries) and margins in the two-wheeler OEM market are thin, the high volume base of the two-wheeler OEM market cannot be ignored (~15mn units in FY13). Beginning early February 2014, ARBL will start supplying to industry leader Hero MotoCorp, and also players like Bajaj Auto and M&M. Thus, beginning early February 2014, the size of the two-wheeler OEM market it will address is set to expand from ~18% of the market to a whopping 68%-70%. We expect secular profit growth from ARBL’s rising exposure to the Indian two-wheeler OEM market, although we concede margins in this space, may be lower than that in the four-wheeler space. ARBL already has approvals in place from Bajaj Auto and Hero MotoCorp.

5) Telecom battery segment to provide stable growth: Based on FY13 numbers, telecom batteries accounted for ~20% of ARBL’s overall revenue (industrial batteries @40% of overall revenue, and telecom segment accounting for ~49-50% of industrial battery sales). While the current telecom tower strength is ~400,000 (annual growth at ~ 2%-3%), most of the towers are three-five years old, and near-term replacement battery sales are almost given. This apart, the medium to long-term growth in telecom batteries will come from rising tenancy ratio (from 1.1x-1.2x currently to over 2.0x over the next few years).



6) Also, industry experts are pointing towards increasingly harsher battery operating environment in the wake of fast rising telecom traffic etc., as a result of which the battery life cycle gradually declined, thereby aiding stronger replacement sales. In the telecom battery space, ARBL has earned excellent name as a trusted and reliable total solutions provider for VRLA batteries. The industry feedback is that telecom tower companies appreciate the deep discharge/ fast recharge capabilities of ARBL’s VRLA offering. Thus the combination of ARBL’s superior product offering coupled with rising tenancy ratio and declining battery lifecycle (following harsh operating conditions) should easily provide a decent growth of 8%-10% per annum in telecom battery revenue for ARBL over the next four-five years. Further, the management apparently is targeting a market share of 54%-55% in telecom batteries within the next few years, while the current share is ~46%. Hence, the likely expansion in market share could also add to some incremental growth for ARBL’s telecom battery business.

Also, as nearly 60% of the existing telecom towers operate on diesel power, and given the recent government initiatives to cut carbon emission, there is a possibility of at least ~50% of urban towers shifting to the hybrid mode (diesel power and solar power), while ~20% of rural towers could shift to this mode. There is industry talk that hybrid towers lead to increased battery requirement in each tower, thereby aiding future growth.

7) New geographies: Geographically speaking, the Indian Ocean rim provides a new growth opportunity. The company’s management believes that China’s weakening competitive advantage in lead-acid battery manufacture because of a combination of reasons - strengthening renminbi, rising Chinese wages and an increased focus on environmental issues provides players like ARBL an attractive entry opportunity in the Indian Ocean rim markets.

8) Non-conventional energy space: ARBL is now establishing a meaningful presence in the solar battery space. Indian solar industry in 2013 accounted for 1,045MW, and is expected to grow 2.5x at 2,500MW over the next two years. The Jawaharlal Nehru National Solar Mission (JNNSM) envisages 20,000MW of grid-tied solar power and 2,000MW of off-grid power by 2020. Every MW of off-grid power is likely to generate 2mn Ah industrial battery potential with a periodic replacement opportunity. This is a huge long-term business opportunity (ARBL’s current large VLRA capacity is only 1,000mn Amp/Hr).

9) Inclusion theme in BFSI sector and ATM network expansion: The recent drive by the Reserve Bank of India (RBI) on inclusive banking requires public sector banks to reach out to the unbanked population in rural India. The government’s plan to issue fresh banking licences to non-banking financial companies or NBFCs should widen the banking network further in semi-urban and rural areas. In short, increased penetration by public sector banks, private sector banks, insurance companies and NBFCs should drive up the demand for industrial/UPS batteries. Most particularly, many Tier-II and Tier-III towns face severe power shortage, and it is a no-brainer that the RBI’s financial inclusion drive is a positive for VRLA battery producers like ARBL. On the ATM side, the current population of just 74 ATMs per 1mn people shows gross under-penetration, and also a new government directive says that every branch of a public sector bank should have an ATM facility by 2014. Big-ticket near-term ATM addition is expected in Tier-II and Tier-III towns in the near term, as existing installations are mostly concentrated in Tier-I cities. Also, the recent RBI nod to NBFCs to set up their own white-label ATMs in semi-urban and rural areas is another growth driver. Net-net, the installed base of ATMs is projected to grow 4x - from 100,000 in 2012 to 400,000 by 2017E.

10) Opportunities in IT/ITES/retail/logistics segments: India’s vibrant IT services sector and the business process outsourcing (BPO) sector should witness export revenue rising 12%-14% in FY14E at ~US$87bn (Source: NASSCOM, NBIE Research). Organised Indian retail is growing at ~15% annually. On the logistics front, businesses are rapidly adopting the hub-and-spoke logistics model as industry keeps spreading on a pan-India basis. There are also increased government initiatives on warehousing and storage facilities. The combination of all the above should lead to significant long-term demand growth in UPS and inverter systems, and hence demand for industrial batteries will follow suit. The near-term business outlook in industrial UPS and inverter space is quite weak.

11) Opportunities in home UPS battery segment: This will be a new area of opportunity for ARBL, which it plans to enter by late-FY15/ early FY16, thereby providing another area of incremental growth. Home UPS is a completely different segment versus the commercial/ industrial and SME (small and medium enterprise) applications of UPS. ARBL is apparently working on some new battery offerings for the home UPS segment, which has a fairly huge addressable market size as per industry experts (upwards of Rs50bn). ARBL could potentially witness superlative growth in this segment.



12) Industrial and commercial side of UPS market to recover eventually: Battery demand from UPS manufacturers supplying new equipment to SMEs, shops and commercial establishments, small offices etc. is presently on the wane because of macro-economic headwinds. However, it is only a question of when and not if, as regards a macro-economic recovery. Given market expectations of a likely stable and decisive government coming to power at the Centre post 2014 elections, we believe that the macro side may slowly start recovering from 2HFY15. A growing India will continue to face serious power shortage. Notwithstanding the euphoria surrounding the recent linking of southern and the northern power grids to form a national power grid, the fact remains that India faces serious power shortage. Even though industry leader EIL’s management stated in the 3QFY14 results con-call that the formation of the national power grid may dampen UPS demand, we think India’s structural power shortage just cannot be wished away, even though the national grid may be able to reduce regional power imbalances by smoothening them out a bit. We stay positive on the medium to long-term demand prospects of commercial/ industrial applications of UPS.

ARBL is an agnostic way to play Indian automobile demand growth story

The value of ARBL’s battery brands and its distribution muscle in domestic market is all contextual and dependent on the secular growth outlook on Indian automobile demand. Pessimists who focus obsessively on today’s demand environment in India are likely to see the ARBL stock as a cup which is half empty. Optimists who believe in the long-term India growth story are likely to see ARBL as a cup which is half full, and we belong to this camp. Notwithstanding the current travails and the difficult business environment in India, there is no escaping the reality that India presents the “last frontier” of mega growth for the global automobile OEMs. Why else would global names like Volkswagen, Audi, Mercedes Benz, Renault, Nissan etc. make significant investments in India, notwithstanding the current sluggish demand environment?

Passenger car demand rose 10x in China during 2001-11. Today, Volkswagen, which made major investments in China a few decades before the demand explosion, is the market leader there. Automobile demand explosion in India is only a question of when, and not if. And, if one is a believer in the above likely secular growth theme, then battery players with powerful brands and distribution muscle can be a highly agnostic way of playing India’s automobile demand growth story.

Key risks/challenges

1) In the branded market, on a pan-India basis, EIL and ARBL are a sort of oligopoly. Till date, neither of them resorted to any predatory/disruptive pricing strategy, as both believe in profitable growth. Even though we believe this situation will continue going forward, the adoption of any form of disruptive pricing could be termed as a risk.

2) Other threats could be the possibility of a player like Tata Auto Comp-Yuasa joint venture (which has presence in automobile battery as well as industrial/ inverter segments getting aggressive, or a regional player with an excellent pedigree like AMCO turning more ambitious. As of now, there are no signs of aggression from any of these players.

3) What if auto OEMs squeeze battery providers on battery pricing? In any case, creamier profits for battery players like ARBL and EIL come from the replacement market only. As much as 80% of ABRL’s auto battery sales come from the replacement demand segment. Our belief is that battery manufacturers like ARBL and EIL extend to OEMs a 35%-40% discount on replacement market prices. What OEM sales give is high brand visibility to branded players like ARBL and EIL. Car owners, as and when they go for battery replacement, typically opt for the same brand of battery that was in the new car that they purchased. The point is that given the already high discount to replacement market prices, OEMs are unlikely to ask for further cuts from branded battery players like ARBL and EIL. The ground reality is that the superior profits from replacement market sales are actually subsidising OEM sales, and this will continue going forward as well. This is simply because of the ‘chicken and egg’ effect, i.e. superior replacement market profit comes only because of the brand visibility gained via sales to auto OEMs.

4) Any kind of a break-down in the relationship between the JV partners can be a risk, but there are absolutely no signs of that at all. As it stands today, there is enough mutuality and congruence in the interests of both the JV partners, as both understand the potential of Indian battery market. Even if there is a very remote possibility of any relationship break-down, the chances and probabilities of Johnson Controls buying out its local partner seems much more likely than the reverse. Johnson Control’s large balance sheet can very easily absorb and digest stake buyout of a local partner, than the other way round.



5) Implicit in our view of some improvement in 2HFY15 in demand outlook for both auto and industrial batteries is the belief that a stable and decisive government will get elected and come to power at the Centre post 2014 general elections. Implicit is the belief that a decisive government that is elected will kick-start many long-delayed projects, thereby leading to an improved overall business environment. Any eventuality in the form of a hung Parliament post 2014 elections can pose a risk to our positive view on ARBL.

6) The auto sector, from which ARBL derives 60% of its revenue, is a rate-sensitive sector. At this juncture, we continue to hope and are cautiously optimistic on a very gradual softening in interest rates. However, the RBI is increasingly leaning and moving closer towards Consumer Price Index (CPI)-based inflation targeting. However, headline CPI has been unrelenting and sticky at over 9% in the past four-five years and if headline CPI does not begin a slow slide, it is possible that RBI’s CPI-based inflation targeting could result in interest rates staying hard for a longer term, in which case any possibility of an interest rate cut-driven demand recovery for automobile OEMs could get delayed by at least a few quarters. The above poses a time-wise risk to our Buy call on ARBL.



Financial highlights Exhibit 6: 3QFY14 performance

YoY QoQ YTD YTD YoY

(Rsmn) 3QFY13 4QFY13 1QFY14 2QFY14 3QFY14 (%) (%) FY13 FY14 (%)

Net sales (net of excise) 7,564 8,011 8,869 8,047 8,600 - - 21,603 25,515 -

Other operational income 42.7 26.9 69.1 24.0 29.8 - - 169.9 122.9 -

Net income from operations 7,607 8,038 8,938 8,071 8,629 13.4 6.9 21,773 25,638 17.8

Raw materials consumption (costs) 4,425 4,685 5,048 5,114 5,348 - - 12,954 15,510 -

Purchase costs of stock-in-trade 537 1,057 1,164 242 342 - - 1,575 1,748 -

Change in inventories 64 (213) (242) (94) (29.3) - - (107.6) (366.0) -

Total raw material costs 5,026 5,529 5,969 5,262 5,660 12.6 7.6 14,421 16,891 17.1

Raw material costs, % net sales 66.1 68.8 66.8 65.2 65.6

66.2 65.9

Employee costs 320 352 385 391 392 22.6 0.2 914 1,169 27.9

Employee expenses as % of net sales 4.2 4.4 4.3 4.8 4.5 - - 4.2 4.6 -

Other expenses 1,043 1,037 1,130 998 1,074 3.0 7.6 2,847 3,201 12.4

Other expenses as % of net sales 13.7 12.9 12.6 12.4 12.4

13.1 12.5

Total expenses 6,389 6,918 7,484 6,651 7,126 11.5 7.1 18,182 21,261 16.9

Depreciation 132 267 145 154 157 18.6 1.7 394 456 15.9

EBITDA 1,218 1,119 1,454 1,420 1,503 23.4 5.9 3,591 4,377 21.9

EBITDA margin (%) 16.0 13.9 16.3 17.6 17.4 - - 16.5 17.1 -

EBIT 1,086 852 1,309 1,266 1,346 24.0 6.4 3,198 3,921 22.6

EBIT margin (%) 14.3 10.6 14.6 15.7 15.6 - - 14.7 15.3 -

Other income 70.7 71.1 96.5 73.7 72.8 3.0 -1.2 199.2 243.0 22.0

PBIDT 1,288 1,190 1,551 1,494 1,576 22.3 5.5 3,790 4,620 21.9

Interest costs 1.0 2.7 0.4 0.5 0.3 -70.0 -40.0 7.3 1.1 -84.9

PBT (before exceptional items) 1,155 920 1,405 1,339 1,419 22.8 6.0 3,390 4,163 22.8

Exceptional items

2.0 - - - - - (93.6) - -

PBT (after exceptional items) 1,155 922 1,405 1,339 1,419 22.8 6.0 3,296 4,163 26.3

Tax 346 326 427 393 469 35.5 19.2 1,025 1,289 25.7

PAT 809 596 978 946 950 17.4 0.5 2,271 2,874 26.5

PAT margin (%) 10.6 7.4 10.9 11.7 11.0 - - 10.4 11.2 -

Paid-up equity 17.1 17.1 17.1 17.1 17.1 0.0 0.0 17.1 17.1 0.0

EPS, Rs. 4.7 3.5 5.7 5.5 5.6 17.4 0.5 13.3 16.8 26.5

Tax rate (%) 30.0 35.4 30.4 29.4 33.0 - - 31.1 31.0 -

Source: Company

● There have been no pricing actions from ARBL in auto replacement batteries since the November 2013 hike of ~2.5-3.0%.

● OEM supplies to two-wheeler player HMSI began for the first time in 2QFY14, when ARBL started supplies to HMSI’s Karnataka plant. Supplies to HMSI continued into 3QFY14.

● Flattish-to-declining trend seen in 1HFY14 in UPS battery volume growth continued in 3QFY14. However, ARBL’s situation here is significantly better than EIL’s 37% YoY decline in UPS volume sales for the same quarter.

● Telecom battery segment, which grew in double-digits, in 2QFY14, continued to grow almost at the same pace in 3QFY14. We believe that ARBL continues to see market share gains in the telecom segment. ARBL is apparently also benefitting from new contracts signed during the previous quarter with most telecom tower operators at improved price realisation.

● USD-denominated lead prices (key raw material) were stable in 3QFY14 compared to 2QFY14. The Indian rupee-denominated lead price changes (following rupee value erosion in September/October 2014) affects the cost base with a one-quarter time lag, and players like ARBL and EIL took swift pricing actions to counter lead price rise. However, the impact of the sharp rupee depreciation on raw material costs is likely to be felt much more only in 4QFY14. The above possible explains why we just had only a benign 40bps sequential increase in 3QFY14 raw material costs.

● ARBL’s 3QFY14 EBITDA margin at 17.4% was up 140bps YoY, but down 20bps QoQ.

● Employee costs and other expenses remained under a tight leash in 3QFY14.



● Notwithstanding higher tax rate of 3QFY14 at 33% (up 300bps YoY), ARBL reported a 17.4% YoY growth in PAT for the quarter against a 13.4% YoY growth in top-line. The 3QFY14 results displayed a sharp divergence from industry leader EIL’s results, which showed a 11% YoY fall in top-line and a 26% YoY decline in PAT.

Likely 19.9%/ 23.2% CAGRs in top-line and PAT/EPS growth over FY15E-FY16E

Exhibit 7 below is self explanatory, and shows the YoY percentage growth in net sales, EBITDA and PAT from FY06 to FY16E. We project CAGRs of 19.9%/23.2% in top-line and EPS growth, respectively, over FY15E-F16E.

Exhibit 7: Growth trend in net sales, EBITDA and PAT

(50)

0

50

100

150

200

FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14E FY15E FY16E

Net sales growth EBITDA growth PAT growth

(%)

Source: ARBL annual reports, Nirmal Bang Institutional Equities Research

Significant rise in free cash flows likely over the next few years

ARBL’s mega capex phase will be over by FY14 (FY14 capex Rs6.74bn). Going forward, we expect a significantly lower capex of Rs1bn each in FY15/FY16. Our view is that early signs of a recovery are likely by 2HFY15E in key automobile OEM segments in India. Consequently, we expect improved revenue growth to kick in from 2HFY15. Thus, while cash flow from operations should witness a decent uptick in FY15/FY16, the capex requirement for both these years is likely to be significantly lower than FY14E’s huge Rs 6.74bn. FCF is likely to increase from negative Rs3.55bn in FY14E to Rs3.92bn in FY16E.

Exhibit 8: Historic and projected free cash flow

(5,000)

(4,000)

(3,000)

(2,000)

(1,000)

0

1,000

2,000

3,000

4,000

5,000

FY09 FY10 FY11 FY12 FY13 FY14E FY15E FY16E

(Rsmn)

Note: FCF = Cash flow from operations net of working capital change and net of capex




Very low to negative balance sheet gearing gives ARBL significant leeway to go for future capex without equity dilution

In the current uncertain and volatile environment, high gearing is considered anathema, while low gearing is considered to be beneficial, although in reality appropriate gearing is very contextual. Thus for a company like ARBL, which enjoys some degree of stability in earnings following its higher exposure to auto replacement market, a low or negative gearing is a rather sub-optimal capital structure. Exhibit 9 below shows how ARBL’s net gearing (net debt to net worth as a percentage), has changed during FY03- FY13, and how it is likely to change over FY13-FY16E.

Exhibit 9: Historic and projected gearing

(40)

(20)

0

20

40

60

80

100 F

Y0

3

FY

04

FY

05

FY

06

FY

07

FY

08

FY

09

FY

10

FY

11

FY

12

FY

13

FY

14

E

FY

15

E

FY

16

E

(%)


Notwithstanding the Rs6.74bn capex in FY14E, ARBL’s net gearing is expected to be only at a very low 3.9% by end-FY14E after staying negative in FY12 and FY13. With no big-ticket capex likely over FY15-FY16, and with fairly strong operational cash flows, net gearing is projected to be negative in FY15E (-15.4%) as well as FY16E (-30.0%).

While a very low or negative gearing can be a sub-optimal capital structure, nevertheless, the fact is that such negative gearing gives the management significant leeway to pursue growth over the next four-five years, without any recourse equity dilution. Any shortfall in internal accruals to fund future growth capex needs can easily be met through higher debt on the balance sheet and in the process, the capital structure could improve to being more optimal/appropriately geared.

Improving asset turnover

As the chart below shows, ARBL’s asset turnover, at 6.5x, peaked out in FY13, with the capacity utilisation rate running close to ~100%, and with the big-ticket capex/CWIP of Rs6.74bn happening only in FY14E. Consequently, we expect asset turnover to register a sharp decline at 3.2x in FY14E. Thereafter, as newly- added capacities get progressively ramped up, we expect asset turnover to gradually rise to 4.9x by FY16E.



Exhibit 10: Asset turnover ratio

0

1

2

3

4

5

6

7

FY

03

FY

04

FY

05

FY

06

FY

07

FY

08

FY

09

FY

10

FY

11

FY

12

FY

13

FY

14

E

FY

15

E

FY

16

E

(x)

Note: Asset turnover (x) defined as net sales divided by year-end net block plus CWIP


Valuation and rating

As already stated, we expect ARBL to post a CAGR of 19.9% in top-line and a 23.2% CAGR in PAT over FY15E-FY16E.

ARBL stock has witnessed a strong re-rating over the past almost two years, driven by consistent and sustained outperformance vis-à-vis peer and market leader EIL. Over the past two years, not only has ARBL been consistently eroding EIL’s market share, it has also been achieving EBITDA margin superior to EIL (~300bps gap at least).

With a conservative ~23.2% CAGR in EPS over FY15E-FY16E, we have valued the stock at a Lynch ratio of 0.75x on two-year earnings CAGRs. This led us to put a 17.4x multiple on FY15E EPS of Rs24.5, thereby arriving at a target price of Rs426 on ARBL. Our FY16E EPS of Rs32.5 is at the top end of street estimates. We have assigned a Buy rating for the stock following a likely 26% appreciation over the next one year.

Exhibit 11: ARBL’s P/E band

0

100

200

300

400

500

600

3/3

1/2

006

7/3

1/2

006

11

/30

/200

6

3/3

1/2

007

7/3

1/2

007

11

/30

/200

7

3/3

1/2

008

7/3

1/2

008

11

/30

/200

8

3/3

1/2

009

7/3

1/2

009

11

/30

/200

9

3/3

1/2

010

7/3

1/2

010

11

/30

/201

0

3/3

1/2

011

7/3

1/2

011

11

/30

/201

1

3/3

1/2

012

7/3

1/2

012

11

/30

/201

2

3/3

1/2

013

7/3

1/2

013

11

/30

/201

3

Last Price 5x 10x 15x 20x

(Rs)




Financials

Exhibit 12: Income statement


Net sales 23,809 29,811 34,603 40,838 49,692

% growth 35.2 25.2 16.1 18.0 21.7

Raw material costs 16,070 19,951 22,871 26,994 33,045

Staff costs 1,003 1,266 1,572 1,886 2,188

Other costs 3,176 3,882 4,367 5,067 5,667

Total expenditure 20,249 25,099 28,810 33,947 40,900

EBITDA 3,561 4,712 5,794 6,891 8,792

% growth 38.3 32.3 23.0 18.9 27.6

EBITDA margin (%) 15.0 15.8 16.7 16.9 17.7

Other income 115 269 243 220 480

Interest costs 24.5 10.0 61.6 59.2 11.3

Gross profit 3,651 4,971 5,975 7,052 9,261

% growth 39.3 36.1 20.2 18.0 31.3

Depreciation 465 661 708 1,248 1,333

Profit before tax 3,186 4,310 5,267 5,804 7,928

% growth 44.6 35.3 22.2 10.2 36.6

Tax 1,036 1,351 1,619 1,625 2,378

Effective tax rate (%) 32.5 31.4 30.7 28.0 30.0

Net profit 2,151 2,959 3,648 4,179 5,550

% growth 45.2 37.6 23.3 14.6 32.8

Extraordinary items - (91.6) - - -

Reported net profit 2,151 2,867 3,648 4,179 5,550

% growth 45.2 33.3 27.2 14.6 32.8

EPS (Rs) 12.59 16.8 21.4 24.5 32.5

% growth 45.2 33.3 27.2 14.6 32.8


Exhibit 14: Balance sheet


Equity 171 171 171 171 171

Reserves 8,064 10,427 13,475 16,955 21,705

Net worth 8,235 10,598 13,646 17,126 21,876

Short-term loans 71 99 99 99 99

Long-term loans 785 773 1,523 773 773

Total Loans 855 872 1,622 872 872

Deferred tax liabilities 220 195 195 195 195

Liabilities 9,310 11,665 15,463 18,193 22,943

Gross block 6,212 6,727 14,177 15,177 16,177

Depreciation 2,667 3,138 3,826 5,073 6,406

Net block 3,546 3,589 10,351 10,104 9,771

Capital work-in-progress 315 1,030 315 315 315

Long-term Investments 161 161 161 161 161

Inventories 2,666 2,929 3,552 4,097 5,266

Debtors 3,198 3,807 4,460 5,296 6,575

Cash 2,292 4,108 1,283 3,710 7,631

Other current assets 1,337 2,082 1,730 2,042 2,485

Total current assets 9,493 12,925 11,025 15,145 21,957

Creditors 889 1,363 1,305 1,844 2,011

Other current liabilities 3,317 4,677 5,083 5,688 7,249

Total current liabilities 4,206 6,040 6,389 7,532 9,261

Net current assets 5,288 6,886 4,636 7,613 12,696

Total assets 9,310 11,665 15,463 18,193 22,943


Exhibit 13: Cash flow


EBIT 3,096 4,051 5,085 5,643 7,459

(Inc.)/dec. in working capital 530 218 (575) (550) (1,162)

Cash flow from operations 3,626 4,269 4,510 5,093 6,298

Other income 115 269 243 220 480

Depreciation 465 661 708 1,248 1,333

Interest paid (-) (24) (10) (62) (59) (11)

Tax paid (-) (1,036) (1,351) (1,619) (1,625) (2,378)

Dividends paid (-) (259) (375) (599) (699) (799)

Net cash from operations 2,886 3,462 3,181 4,177 4,921

Capital expenditure (-) (765) (1,229) (6,735) (1,000) (1,000)

Net cash after capex 2,121 2,233 (3,554) 3,177 3,921

Inc./(dec.) in short-term borrowing (228) 28 - - -

Inc./(dec.) in long-term borrowing 98 (36) 750 (750) -

Inc./(dec.) in borrowings (130) (8) 750 (750) -

Cash from financial activities (130) (8) 750 (750) -

Others (151) (409) (21) - -

Opening cash 451 2,292 4,108 1,283 3,710

Closing cash 2,292 4,108 1,283 3,710 7,631

Change in cash 1,841 1,816 (2,825) 2,427 3,921


Exhibit 15: Key ratios

Y/E March FY12 FY13 FY14E FY15E FY16E

Per share (Rs)

Reported EPS 12.6 16.8 21.4 24.5 32.5

Adjusted EPS 12.6 16.8 21.4 24.5 32.5

DPS 1.9 2.5 3.0 3.5 4.0

BV/share 48.2 62.0 79.9 100.3 128.1

Profitability & return ratios

EBITDA margin (%) 15.0 15.8 16.7 16.9 17.7

EBIT margin (%) 13.0 13.6 14.7 13.8 15.0

Net profit margin (%) 9.0 9.6 10.5 10.2 11.2

RoE (%) [on avg.. book] 29.3 30.4 30.1 27.2 28.5

RoCE (%) [on avg.. CE] 37.8 41.2 39.3 34.8 38.6

Efficiency ratios

Asset turnover (x) 6.2 6.5 3.2 3.9 4.9

Net WC (days) [net of cash] 45.9 34.0 35.4 34.9 37.2

Receivables (days) 49.0 46.6 47.0 47.3 48.3

Inventory (days) 40.9 35.9 37.5 36.6 38.7

Payables (days) 13.6 16.7 13.8 16.5 14.8

Current ratio (x) 2.3 2.1 1.7 2.0 2.4

Quick ratio (x) 1.6 1.7 1.2 1.5 1.8

Valuation ratios

EV/sales (x) 2.4 1.8 1.7 1.3 1.0

EV/EBITDA (x) 15.8 11.5 10.0 8.0 5.8

P/E (x) 26.7 20.0 15.7 13.7 10.4

P/BV (x) 7.8 6.1 4.7 3.7 2.9




Disclaimer

Stock Ratings Absolute Returns

BUY > 15%

HOLD 0-15%

SELL < 0%

This report is published by Nirmal Bang’s Institutional Equities Research desk. Nirmal Bang has other business units with independent research teams separated by Chinese walls, and therefore may, at times, have different or contrary views on stocks and markets. This report is for the personal information of the authorised recipient and is not for public distribution. This should not be reproduced or redistributed to any other person or in any form. This report is for the general information for the clients of Nirmal Bang Equities Pvt. Ltd., a division of Nirmal Bang, and should not be construed as an offer or solicitation of an offer to buy/sell any securities.

We have exercised due diligence in checking the correctness and authenticity of the information contained herein, so far as it relates to current and historical information, but do not guarantee its accuracy or completeness. The opinions expressed are our current opinions as of the date appearing in the material and may be subject to change from time to time without notice.

Nirmal Bang or any persons connected with it do not accept any liability arising from the use of this document or the information contained therein. The recipients of this material should rely on their own judgment and take their own professional advice before acting on this information. Nirmal Bang or any of its connected persons including its directors or subsidiaries or associates or employees or agents shall not be in any way responsible for any loss or damage that may arise to any person/s from any inadvertent error in the information contained, views and opinions expressed in this publication.

‘Access our reports on Bloomberg Type NBIE <GO>’

Team Details:

Name Email Id Direct Line

Rahul Arora CEO [email protected] -

Hemindra Hazari Head of Research [email protected] +91 22 3926 8017 / 18

Dealing

Ravi Jagtiani Dealing Desk [email protected] +91 22 3926 8230, +91 22 6636 8833

Pradeep Kasat Dealing Desk [email protected] +91 22 3926 8100/8101, +91 22 6636 8831

Michael Pillai Dealing Desk [email protected] +91 22 3926 8102/8103, +91 22 6636 8830

Umesh Bharadia Dealing Desk [email protected] +91-22-39268226

Nirmal Bang Equities Pvt. Ltd.

Correspondence Address

B-2, 301/302, Marathon Innova,

Nr. Peninsula Corporate Park

Lower Parel (W), Mumbai-400013.

Board No. : 91 22 3926 8000/1

Fax. : 022 3926 8010

Institutional Equities - Nirmal Bang Raja Batteries- Initiating Coverage... · Institutional...

Documents

Transcript of Institutional Equities - Nirmal Bang Raja Batteries- Initiating Coverage... · Institutional...