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Headlamps dimmed, but path visible
We initiate coverage on Varroc Engineering (VEL) with a BUY rating and a target price of Rs555, valuing the company on SoTP basis. Our analysis of VEL’s business indicates: (a) lighting business (VLS) remains well dominated by global peers with capability (capital being one of the factor for success); (b) FY21 and FY22 are likely to be inflexion points for VEL as new customers’ programs ramp up (global/BS-VI) while operating costs stabilise; c) incremental LED penetration opportunity is highest amongst US OEMs; and d) BS-VI opportunity has potential to boost revenues by ~4-5%. VEL’s profitability is expected to improve (at ~7% CAGR FY19-FY22E) driven by normalisation of VLS profitability as its new plants stabilise. However, we believe VLS would require sustained investments in R&D and capacity if it strives to gain market share, which could inhibit peak RoCE. Nevertheless, we find the current FCF yield attractive at ~5% on FY21E.
* Global VLS market share gains call for sustained capital deployment: The global lighting business has high concentration (~75-80% market share) amongst the top-5 players. Market shares are well entrenched across the common regional OEMs. VLS’s larger global peers spend significant capital annually on R&D/capex: European peers spend ~9-11% / ~7% of sales while the Asian peers spend ~4-5% / ~7-8% on R&D / capex respectively. VEL increased its investments across R&D/Capex to ~4.5%/9.2% in FY19; we believe sustainable FCF generation along with continued investment intensity is the key business challenge for VEL.
* LED opportunity – Not all customers are equal: We deep-dived into the incremental penetration potential of LED adoption across 110 car models covering eight global OEMs (many of which are existing customers of VLS). The analysis suggests incremental LED penetration opportunity amongst VLS’s key customers remains highest in FCA (only ~20% LED penetration) while customers like Tesla are already at 100% penetration. Other new customers, e.g. Renault Nissan and PSA, are at ~50% and 90% penetration respectively.
* BS-VI ramp-up in India and new plant stabilisation in VLS are key triggers: VEL’s India business is likely to witness revenue boost post BS-VI adoption with incremental addition of ~Rs0.5bn in FY21E. This is likely to improve asset utilisations and margins. New facility investments for VLS are likely to increase revenues by ~EUR130mn/280mn in FY22E/FY23E respectively. Currently, these facilities are in the red owing to low utilisations and full burden of fixed costs.
* Initiate with BUY: We like VEL’s business model and current valuations. Due to material global and domestic automotive exposures, we feel its valuation should be on SoTP basis. We find the current FCF yield attractive at ~5%/11% FY21/22E respectively. We value VLS and its China JV at 5.0x EV/EBITDA / 9x P/E FY22E (discount to global peers) and India business at 7.5x EV/EBITDA FY22E (premium to domestic peers) to arrive at a target price of Rs555. Initiate with a BUY rating.
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