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Sharp commodity inflation leads to margin miss

Solar Industries’ (SOIL) earnings disappointed on margins. The company was not able to pass on sharp increase in input commodity prices, resulting in standalone gross margins correcting 200bps QoQ. Q2FY22 being a seasonally weak quarter (volumes were down 21% QoQ), operating leverage led to a sharper EBITDA margin correction. Standalone EBITDA margin declined 600bps QoQ and 700bps YoY. Management highlighted that the company has started to pass through higher RM prices. What was disappointing was a QoQ decline in realisation/te in such an inflationary RM environment. Increase in RM prices also led to higher working capital and consequently higher net debt. Management expects working capital days (currently at 108 days) to come down by Mar’22 (to ~ 100 days). The uncertainty on margin environment leads us to downgrade SOIL from ADD to HOLD with an increased target price of Rs2,365/share.

* Guidance relatively strong, despite a weak Q2FY22 print. Management believes that the increase in RM prices will be gradually passed on to consumers and will not lead to demand destruction. Based on the outlook, revenue growth guidance [for FY22?] has been raised to 40%, volume growth guidance has been maintained at 15-20% (implies decline in H2FY22 given ~31% YoY growth in volumes in H1FY22), EBITDA margins have been guided at 20% and PAT margins have been guided at 11%. Also, management believes working capital days will be brought down to ~100 days by FY22E end, which will also help net debt profile. What disappoints us from Q2FY22 print is 1% QoQ decline in realisations /te as RM/te increased ~6% QoQ. Hopefully, mix played a role in the drop in realisations (Q2 witnesses lowest contribution from housing and infra seasonally) which will be reversed going forward.

* International and exports revenues increased 15% QoQ and 34%YoY. Management highlighted that its business is as usual in Turkey; there can be some impact going forward on account of forex fluctuations. Management expects commercial production in Tanzania to start from Nov'21. Project construction is running behind schedule in Australia and expected to be complete in FY22. South African operations have been impacted by steep increase in RM inflation, forex fluctuations and supply chain bottlenecks. The same is expected to normalise in FY23E.

* Defence revenues expected to reach Rs 2.75bn in FY22. Current defence order book is Rs5.76bn, mainly comprising of multimode hand grenade order. Management is waiting for RFP of Pinaka (rocket) order, Acceptance of Necessity by DAC has been approved recently as per management. Defence revenues were largely flat QoQ at Rs570mn.

* Downgrade to HOLD with an increased target price of Rs2,365/share. We value SOIL at 30x FY24E P/E (rolled over from FY23E). Steep increase in share price (up 104% in past 6 months) and clear earnings headwinds lead to our downgrade.

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