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Business tailwinds getting ready to drive the much awaited debt reduction

Varroc Engineering’s (VAR) EBITDA margin for Q4FY23 came in at 9.2%, 139bps higher QoQ, and higher than our estimate of 7%, mainly due to business mix, recoveries and operating leverage other than specific benefits of retrospective cost pass through in Q4. Revenue reduced 2% QoQ to Rs16.9bn due to lower 2W volumes (which contribute ~70% of revenue), as domestic 2W volume got impacted by lower consumption in rural areas and exports got impacted by geopolitical issues. VAR is currently at ~60-62% capacity utilisation, giving scope to improve asset sweating and operating leverage ahead, with recovery in 2W demand. Capex in FY24 is expected at ~Rs2-2.5bn, focused on passenger cars parts, polymer parts and lighting business. During FY23, lifetime revenue from new order wins was Rs52bn, with split of 56%/44% in 4W/2W segments, respectively, and more than a third of its orderbook is from EVs. We have factored 14% revenue CAGR for FY23-FY25E as VAR would be a beneficiary in terms of growth and operating leverage with India 2W market recovering gradually. Maintain BUY with DCF-based target price of Rs366, implying ~18x FY25E EPS.

Q4FY23 conference call takeaways and our views:

* As per the management, Q4 revenue saw YoY decline as 2Ws, which contribute ~70% of revenue, underperformed due to subdued exports by key OEMs impacted by geopolitical issues and domestic demand getting impacted by lower 2W demand in rural markets. Other segments improved on easing of semiconductor supply situation and better economic activity. Revenue mix by business in Q4: polymer at ~33%, electronic at ~22%, lighting at ~21%, metallic at ~12% and aftermarket at ~9%. Bajaj Auto contributed ~38% of overall revenue. During FY23, lifetime revenue from new order wins came in at Rs52bn (Rs18bn from 7 EV customers). Car lighting business in India is witnessing good recovery, following domestic PV trend, though global 2W lighting continued to remain subdued under adverse market conditions. New products in polymer and metallic segments, 2W industry revival and rising mix of EV products (~1% currently) would drive revenue growth over industry growth in FY24-25E, we believe.

* VAR is confident of delivering ~10% EBITDAM in FY24, driven by improving mix, scale and tight control on fixed costs vs current adjusted levels of ~8.5%. Overall capacity utilisation stands at ~60-62% as 2W demand remained subdued in the past 4 years, and thus, any recovery in 2W industry would bode well for utilisation improvement and subsequent benefit in terms of operating leverage. VAR is looking at ~10% EBITDAM primarily driven by domestic legacy business margin improvement along with car lighting and Romania electronic component business improving profitability. VAR is targeting capex of Rs2-2.5bn in FY24 and we are building capex + investment at Rs3.5bn, assuming potential acquisitions in areas related to EV parts and electronics. We expect VAR to become net debt free by FY27E, unless China JV business stake sale or IMES Italy stake sale happen in the near term.

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