Sunday, November 2, 2014

>CROMPTON GREAVES: Lower-than-expected EBITDA; board approves demerger

Consolidated 2QFY15 EBITDA at Rs1.7bn (up 4% YoY) was 12% below our estimates, as revenue at Rs34.3bn (up 7% YoY) and gross margin at 31.8% (up 30bps YoY) came 7% and 70bps below our estimate respectively. EBITDA margin at 4.9% (down 10bps YoY) was 30bps below our expectation. Higher tax rate at 46% (vs our estimate of 30%) led to PAT of Rs570mn, 28% below our estimate. We do not change our estimates for FY15, as we expect strong growth in the consumer business in 2HFY15 (led by strong festival demand) and pick-up in execution of high margin order backlog in the power business. The board approved the demerger of the consumer business, with Crompton
holding 25% in the proposed consumer company; balance by the existing shareholders. Whilst the demerger will unlock value, we believe the CMP already factors in this; our TP of Rs185/share values the consumer business at Rs102/share, implied FY16 P/E of 21.4x (6% discount to Havells). We remain concerned around the rising share of MNCs in domestic power, rising competitive intensity in fans, and a fragile recovery in Europe.

Results overview: Consolidated revenues at Rs34.3bn increased 7% YoY led by 13% YoY growth in consumer products. EBITDA increased by only 4% YoY due to a 21% YoY increase in other expenses. Consequently, EBITDA margin declined 10bps YoY to 4.9%. However, PBT increased by 16% YoY to Rs1.3bn due to a 39% YoY increase in other income. The higher share of profits in associates led to PAT increasing by 20% YoY to Rs696mn.

Within the segments, on a consolidated basis, the major revenue driver was the consumer products business which reported a YoY revenue growth of 13% led by strong growth of fans (up 13% YoY) given the extended summer. Pumps and Lighting grew by 7% YoY and 5% YoY. The Power and industrial segment’s revenue grew 5% YoY. A margin improvement was seen on a consolidated basis across segments. Whilst consumer business’ EBIT margin improved 30bps YoY to 12.0% led by
operating leverage, power and industrial systems’ margin improved 20bps YoY and 160bps Yoy to 2.2% and 9.2% led by improvement in the margin of the international power (up 80bps YoY) and industrial (up 690bps YoY) businesses.

On a standalone basis, revenues registered a meagre growth of 8% at Rs19bn led by a 13% YoY increase in the consumer durables business; revenues of power systems increased 6% YoY and industrial system increased 7% YoY. EBITDA increased by only 5% YoY to Rs1.7bn due to a 13% YoY increase in employee expenses. Consequently, EBITDA margin declined 20bps YoY to 8.7%. However, PBT declined by 1% YoY to Rs1.8bn due to a 10% increase in depreciation. Increase in tax rate from 24% in 2QFY14 to 28% led to a 7% decline in PAT to Rs1.3bn.

Demerger approved by board: CRG’s board approved the demerger of the consumer business to Crompton Consumer Products Ltd (CCPL) with effect from 1 April 2015. Upon the completion of the demerger process, CRG would hold a 25% stake in the proposed CCPL and the balance would be held by the existing shareholders of CRG. The shareholders of CRG would be allotted 3 shares of CCPL for every 4 shares held in CRG. CCPL would be listed on the BSE and NSE. Note that there is no change in the shareholding of the minority holders in the demerged entity, as no strategic shareholder has been brought in.

Where do we go from here? Despite revenue and EBITDA being 7% and 12% below our estimate, we are not changing our estimates for FY15, as we expect strong growth in the consumer business in 2HFY15 (on the back of strong festive demand) coupled with pick-up in execution of high margin order backlog in the power business. Note that CRG has bagged recent orders at higher margins, part of which are likely to be booked in 2HFY15 and this should help in margin improvement. For the full year, we model in revenue growth of 14% YoY (vs 8% YoY in 1HFY15) and EBITDA margin
expansion of 150bps YoY in FY15 (vs 20bps in 1HFY15).

However, we remain concerned about the following factors:

■ Europe recovery likely to be fragile: The GDP growth outlook for Europe has been deteriorating with the IMF doubling the probability of the Eurozone re-entering into a recession to 38% in October 2014 from 19% in April 2014. If Europe continues to disappoint, the turnaround of international subsidiaries may get delayed further and the international franchise’s losses may widen. Note that the European region contributed to ~35% of consolidated revenues in FY14.

■ Competition increasing in the consumer business: Within the domestic consumer segment in India, Crompton has a strong presence in the fans segment, which contributed to ~40% of consumer products’ revenues in FY14. However, competition intensified in FY14 with the entry of five new players (Polycab, Schneider, Luminous, Surya and RR Kabel). Competition has increased due to: (1) attractive margins (more than 13% in the premium decorative segment), (2) healthy 24% volume CAGR over FY09-12, (3) rising share of premium and decorative fans (now accounts for 50% of
the market as compared to a fifth five years ago), and (4) shortening replacement cycle (now five years as compared to 7-8 years five years back, as RPMs have increased to 380 from 200 earlier and share of pedestal, wall and table fans which have to be replaced after 2-3 years has increased to 40% as compared to 30% three years back). Given Crompton’s market leadership in this segment, any disruptive strategy adopted by these new players (like cutting prices) could hurt its fan margins.

■ Rising competition in Indian power business from foreign players: Rising competition from foreign players that are competing for Power Grid (PGCIL) tenders and the dismal balance sheets of SEBs have hurt CRG’s power franchise. Its EBITDA margins declined to 11% over FY12-14 vs 14% in FY06-10 and revenue CAGR slowed down to 3% in FY12-14 vs 10% over FY08-12. With foreign players now setting up manufacturing base in India (TBEA and Toshiba), competition should further intensify and this would hurt CRG.

■ Feeder separation, a negative catalyst for the power franchise
The Rs430bn and Rs326bn Union allocation for feeder separation and strengthening of the grid should help in restructuring the balance sheet of SEBs. However, this may not be a positive catalyst for Crompton as any improvement in the balance sheet of SEBs will invite competition from the foreign players. Thus, whilst we assume a pickup in revenue CAGR for Crompton to 16% over FY14-16 (vs 3% in FY12-14) as the balance sheet of the SEBs improve, we assume a margin improvement of only 40bps to 9.1% over FY14-17 vs FY12-14. This is far lower compared to the 13.3% margins reported during FY09-11 when Crompton did not face any competition.

■ Punchy valuations; impact of demerger already priced in: At CMP of Rs191/share, CRG is trading at 15.9x FY16 P/E, a 3% premium to its five-year oneyear forward P/E. Our SOTP value of Rs185/share implies an FY16 P/E of 15.4x. We value the consumer business at Rs102/share (implied FY16 P/E of 21.4x), the standalone power business at Rs31/share (implied FY16 P/E of 17.3x), the standalone industrial business at 20/share (implied FY16 P/E of 11.3x) and international subsidiaries at Rs18/share (15.7x FY16 P/E).

Our implied multiple for the consumer business is at a 6% discount to Havells. We believe the discount is justified given Havells strong consumer franchise, superior range of products with higher revenue CAGR of 18% (vs CRG’s 12%) over FY11-14, and higher average EBIT margin (adjusted for unallocable expenses) at 11.4% (vs CRG’s 9.7%) over FY11-14. We value the standalone power business at a 56% discount based on FY16 P/E to its capital goods peers such as BHEL, Siemens, ABB and Alstom T&D and the standalone industrial business at a 45% discount to capital goods peers such as Cummins, Kirloskar Oil Engines and KSB Pumps. We believe such a steep discount is justified given CRG’s weak power franchise and inferior management quality. Also, we believe CRG’s standalone industrial should trade at a discount to peers given the commoditised nature of CRG’s portfolio.