>SWARAJ ENIGINES: M&M acquisition has clearly been value accretive to Swaraj Engines

■ Fortunes linked to Indian agriculture
SWE manufactures internal combustion engines for tractors manufactured by the ‘Swaraj Tractors’ division of Mahindra & Mahindra. These tractors are largely used for agricultural purposes, although the share of non-agricultural demand has been increasing of late. The key drivers of tractor demand in India include i) Gap in productivity levels (measured in terms of yield per hectare) in India despite having the second largest arable land in the world – resulting in need for higher farm mechanization; ii) Higher Minimum Support Prices (MSP) of farmers resulting in higher ‘income effect’; iii) Policy initiatives such as NREGA scheme, agriculture being classified as priority sector lending, subsidy on interest repayment, diesel subsidies etc. The domestic tractor industry has witnessed a sales CAGR of 16% in the last three years, much higher than long-term average of 8.5% mainly led by the above factors.


■ Access to the world’s largest tractor manufacturer
SWE enjoys access to the world’s largest tractor manufacturer i.e. Mahindra & Mahindra (M&M) by virtue of the latter holding 33% in SWE. SWE caters to nearly 80% of the demand of ‘Swaraj Tractors’ division of M&M, with the balance 20% being met from its second promoter – Kirloskar Oil Engines. Going forward, SWE expects to meet upto 85-90% requirement of ‘Swaraj Tractors’. SWE believes in its own in-house technological capabilities to cope up with the upcoming challenges in terms of technology changes and believes that its technology is at par with that of global players. The company invests in research and development on a continuous basis.


■ Presence in high HP segment, right geographies augurs well
SWE historically has been present across segments in terms of HP i.e. 20-30HP, 31-40HP, 41-50HP and >50HP. However, going forward it believes that incremental demand for tractors are more likely in the >40HP segment. This is mainly driven by i) Increase in use of tractors for non-agri purposes such as transport, construction/ infrastructure activities etc; ii) Shift in demand from the Northern to western/ southern region where the soil is hard and requires high power tractors; iii) replacement of tractors, where typically farmers replace older tractors with new higher HP tractors. SWE is not looking at entering the <20 HP segment unlike its competitors as it feels that it is a low margin segment with much lesser growth rates. Also, while the traditional markets of north are fairly penetrated in terms of tractor demand, other regions such as Bihar, Western region and Southern region are witnessing higher demand traction due to low penetration levels there. In both these regions, not only does M&M enjoy a significant market share (44-50%), it has also experienced significant growth in market shares over the last ten years.


■ Industry growth rates to moderate in the near-term; Long-term fundamentals intact
Historically, the tractor industry has grown at a long-term average of 8.5%. However, the previous 3-year average has been significantly higher at 16% mainly boosted by policy initiatives and diesel subsidies. SWE expects the growth rates to moderate somewhat over the next 1-2 years i.e. 14-15% in FY12E (mainly due to subdued demand in Jan-Mar 2012 period) and 8-10% in FY13E. However, the growth rate is expected to be still higher than the long-term average of 8.5%. Besides, SWE is likely to exhibit higher growth rate of 18% in FY13E driven by higher share of Swaraj Tractor’s requirement. Long-term prospects still remain attractive driven by i) Huge demand potential for tractors in India – potential demand for 6mn tractors v/s an estimated 4mn tractors currently; ii) Low penetration levels in regions such as Bihar, South and West; iii) growing use of tractors for non-agricultural applications; iv) Farmers’ requirement to dig deeper into the soil to make it more fertile; and v) Strong replacement demand – life of a tractor 10-15 years.


■ Excellent track record, experienced management provides comfort
SWE has an excellent past track record in terms of higher than industry average growth rates – SWE volumes grew @ 42% CAGR, fastest in the industry, in the last 3 years v/s industry average of 16%. Besides, post the acquisition of PTL by M&M, the capacity utilization rates have improved manifold. Further, efficient working capital/ balance sheet management (negative working capital, NIL borrowed funds) gives a significant lever to withstand adverse business cycles. Backing of an experienced management (most senior management employees have been with SWE for over 20 years since Punjab Tractor days) with sound knowledge of the industry/ business offering significant comfort to minority investors


■ Earnings to grow @ 17% CAGR over FY12E-14E; DCF based TP of `925/share; Buy
SWE has been able to optimally utilize its capacities in the past three years mainly due to robust domestic demand and efficient management. SWE is expanding its capacities by ~79% to 75,000 engines by end CY 2012. Although, SWE believes it has the wherewhital to increase its installed capacity to 100,000 engines, we believe there wouldnt be any need for additional capex atleast for the next 2 years. We believe SWE would be able to efficiently sweat its capacity of 75,000 engines over FY14E-15E to achieve the modelled volume growth of 10% in the same time frame. We have modelled the next phase of capacity expansion to begin in end FY15E that would culminate in a total capacity of 90,000 engines in FY16E.


Based on the above factors, we model revenue CAGR of 19% over FY12E-14E. We expect EBITDA margins in FY12E-14E to be lower than the trend seen in FY10-11 (16.2%-16.4% v/s 17.5-19% seen in FY10-11) mainly due to a slowdown in industry growth rates. However, higher than average industry growth rates would support earnings CAGR of 17% over FY12E-14E period. We expect SWE to report EPS of `45/share in FY12E, `52/share in FY13E and `61/share in FY14E. Our long-term DCF based target price of `925/share implies an upside of 141% from current levels. We initiate coverage with a ‘Buy’ rating on the company.


■ Risks
Key risks include i) Dependence on single customer i.e. M&M; ii) Less allocation for rural development may temper growth rates going forward; iii) Decline in availability of agricultural credit due to macro-economic circumstances could affect growth rates, adversely; iv) Natural calamities e.g. drought, flood, etc.; v) Fall in Minimum Support Prices (MSP) of foodgrains could impact farmers’ disposable income.


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