Early Cyclical Reversal on the Card; Upgrade to BUY
Escorts (ESC) has delivered largely an in-line performance in 2QFY20. While its margin improved in construction equipment segment, the Company witnessed contraction in tractor margin. Its revenue and EBIDTA fell by 5% YoY (-7% QoQ) and 20% YoY (-11% QoQ) to Rs13.2bn and Rs1.3bn vs. our estimate of Rs13.3bn and Rs1.2bn respectively. However, due to tax credit, its adjusted PAT grew by 11% YoY (+30% QoQ) to Rs1.1bn vs our estimates of Rs865mn. Its EBIDTA margin fell by 169bps YoY and 44bps QoQ to 9.6% (vs. our estimate of 9%) mainly due to lower operating leverage and inferior product-mix in tractor segment. Better margins at construction segment benefitted overall margins. Its tractor volume fell by 6% YoY, while construction equipment volume plunged by 29% YoY. Notably, its railway segment’s revenue rose by a strong 20% YoY. Its EBIT margin stood at 10.3% and 19.1% for Agri business and Railway business, respectively. In view of likely early cyclical reversal, better margin across all three business segments coupled with strong positive cash flow and attractive valuation at 9.5x FY22E, we upgrade our recommendation on the stock to BUY from REDUCE.
Following a significant volume decline over the last 10 months, the domestic tractor industry started witnessing better traction since the beginning of festive season, which we expect to continue. Based on changing dynamics of the industry and fundamentally favourable triggers like strong monsoons, likely government’s subsidies in 2HFY20 and increasing non-agri usage, we expect tractor industry to recover in FY21E as against our earlier estimate of downcycle in FY21E. Moreover, likely pick-up in construction activities, higher water level at reservoirs and low YoY base are the key positive factors. Improving cost structure in construction equipment business, better traction in high-margin railway segment with its rising order book would further expand its margin going forward. Notably, non-agri usage of tractors would compensate the expected fall in agri-driven demand to greater extent. The Management expects margin to expand in 2HFY20 on the back of lower commodity cost, better product-mix and production rationalisation. At the same time, our channel check also indicates positive sentiment in rural markets post favourable monsoon.
Outlook & Valuation
We expect ESC’s tractor volume to fall by 8% in FY20E, and likely to remain flat in FY21E. We reduce our construction equipment volume estimate by 12%/15% for FY20E/FY21E, respectively. We lower our revenue and EBIDTA estimates by 1% and 5% for FY20E, while factoring higher tractor volume and better margin, we increase our FY21E revenue and EBIDTA estimates by 4% and 14%. Factoring in new tax rate, we raise our EPS estimates by 11% and 34% for FY20E and FY21E respectively. Further, in light of earlier-than-expected reversal of tractor cycle, ESC’s stronger margin performance particularly in construction equipment segment and better return ratio in FY22, we increase our P/E valuation from 10.5x to 13.5x. In view of likely early cyclical reversal and better margin across all three business segments coupled with strong positive cash flow, and rolling over our estimates to FY22E, we upgrade our recommendation on the stock to BUY from REDUCE with a revised Target Price of Rs925 (from Rs435 earlier), valuing it at 13.5x FY22E EPS. Moreover, improving visibility on tractor industry’s volume over the next 2-3 quarters further strengthens the case for valuation upgrade.
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