Focus on expanding and creating new profit/revenue pools
Over FY18-21, we expect domestic M&HCV volumes CAGR of ~8% (base case), driven by economic recovery, proliferation of hub & spoke model, and overload restrictions. The growth rate could be even higher (~18% CAGR) if the proposed scrappage policy (for vehicles over 20 years old) is implemented in FY21. The competitive environment is benign, as reflected in the consistent price increases taken by OEMs and the stability in gross margins. After gaining market share profitably over FY15-18, Ashok Leyland (AL) is now shifting its focus toward expanding and creating new revenue/profit pools. This should likely drive revenue/EBITDA/PAT CAGR of 12%/15%/16% over FY18-22. A sharp improvement in the key performance indicators would be key driver of further re-rating.
Unlike last three years, macros/regulations are now supportive
* Domestic M&HCV volumes increased at ~13% CAGR (FY15-18) from the downcycle of FY13/14, despite mixed macro trends, led by the recovery in infra and agri activity, and the strict implementation of the overload ban.
* We expect domestic M&HCV volumes CAGR of ~8% (under our base-case scenario) over FY18-21, driven by an economic recovery, proliferation of the hub & spoke model for the transport of goods, and increased demand for truck makers due to overload restrictions. The growth rate could be even higher (~18% CAGR) if the scrappage policy is implemented in FY21.
* Despite several headwinds (easing of the overloading ban in UP, an increase in rated load and a significant rise in diesel cost), momentum in CV demand remains healthy (growth of ~55% in FY19YTD, though off a low base – 1QFY18 had a pre-buy impact), indicating strength in the underlying demand drivers.
Low risk of substantial volume decline in FY21; competitive intensity remains benign
* We believe that M&HCV demand would be influenced by several factors in FY21. These include (a) the underlying economic environment, (b) the impact of pre-buy (in FY20 ahead of BS6 from April 2020), (c) operationalization of dedicated freight corridors (DFCs) and (d) the potential benefits from the implementation of the proposed scrappage policy.
* Contrary to the general perception, there is no historical evidence of a decline in volumes in a year of transition to new emission norms. In fact, on all three previous occasions of transition, CV volumes have grown, suggesting that demand drivers (IIP, agri, capex/investment, etc.) play a more important role.
* We expect a limited impact on new CV demand from higher rated load, as only select segments will benefit from it. Considering the benefit only to trucks under 8 years of age, the impact should be at ~23% of FY18 volumes.
* Despite higher discounts, competitive intensity is benign, as reflected in the consistent price increases taken by OEMs and the stability in gross margins. In FY20, the combined utilization of AL and Tata Motors (TTMT) is expected to touch 90% (~84% for the industry), implying more pricing power.
AL v2.0: Focus on creating and expanding profit/revenue pools
* AL's transformation journey (v1.0) from FY14 led to a profitable market share gain to 34.2% in FY18 (from 26.4% in FY13) and an improvement in the EBITDA margin (+340bp over FY13 to ~10.4% in FY18). Importantly, AL has now turned into a net cash company (~INR31b in FY18 from net debt of ~INR43b in FY13).
* Under AL v2.0, the company has shifted its focus toward expanding and creating new revenue and profit pools. De-risking of the M&HCV business, along with expansion of nascent business like spares (5% of sales), exports (9% of sales) and defence (3% of sales), is the key focus area. Also, it is stepping up its presence in relatively weak segments like LCVs, ICVs and school buses.
* AL has set up a new business vertical – Customer Solution – to target a higher share of the customer wallet across lifecycle in areas like finance, spares and fuel. A trucker who buys ~INR2m truck would also be spending ~INR35m over a 10-year period in operating and maintaining the truck.
Expect ~15% EBITDA CAGR over FY18-22
* AL's focus on expanding and creating new profit/revenue pools is likely to drive revenue/EBITDA/PAT CAGR of 12%/15%/16% over FY18-22.
* The strategy to de-risk business is expected to yield results, with the share domestic trucks in revenue likely to shrink to 60% by FY22 (v/s 66% in FY18).
* EBITDA margin is expected to expand from 10.4% in FY18 to 11.5% in FY22 (11.6% in FY20 and 10.3% in FY21), led by the mix shift toward nascent businesses with higher margins and operating leverage benefits.
* The merger of LCV subsidiaries from 2HFY19 is expected to be EBITDA and PAT accretive. We expect ~30bp accretion to standalone EBITDA margin upon the merger.
Valuations – further scope of re-rating
* Structural changes in balance sheet and de-risking of the business model are expected to result in free cash flow of INR58b over FY19-21, with RoE/RoCE of 20.8%/19.2% by FY21 (v/s 23.7%/20.7% in FY18 and 28.4%/26.1% in FY20).
* Despite re-rating since FY14, current valuations still do not fully reflect the sharp improvement in its key performance indicators.
* We have revised our estimates upward to factor in no material impact on volumes from an increase in rated load. We are upgrading our EPS estimates for FY19/20 by ~5%/2%.
* The stock trades at 9.1x/6.8x FY19/20 EV/EBITDA. It is trading below 10 year average EV/EBITDA of ~8.2x and near 1 standard deviation below mean. Based on reverse DCF calculation, implied terminal growth at current price is 0.4%.
* We roll forward AL's target price to FY21 to capture the negative impact of the potential decline in volumes. On downcycle earnings (10% EBITDA decline in FY21E), we value AL at 9x EV/EBITDA (v/s ten-year average multiple of 8.2x). We assign INR13 to NBFC post 20% hold-co to arrive at a revised target price of INR148 (Mar-21).
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