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VLS profitability challenges persist

Varroc Engineering’s (VEL) Q2FY22 operating performance was in line with consensus estimates as EBITDA margin came in at -0.2% (down 925bps YoY) and VEL reported a PAT loss of ~Rs3bn. Global lighting business (VLS) sales fell 13% QoQ to EUR198.2mn as margins further shrank 210bps to -7.2% (impacted by weaker mix and negative operating leverage). Profitability at the greenfield plant continues to be a challenge as volume ramp-up gets delayed impacted by production issues and higher sourcing costs (e.g. electronics). India business has witnessed sequential recovery as domestic market opens up and OEMs undertook festive production. However, slower margin improvement, continued capex and working capital needs are likely to keep debt levels elevated (FY23E: ~Rs30bn). Maintain HOLD.

* Key highlights of the quarter: Top line at Rs30.4bn was up 3.5% YoY as India business revenue rose ~36% YoY to ~Rs12.7bn as OEMs ramped up production for festive season, and VLS sales were down 13% YoY (due to semi-conductor issues) at EUR198.2mn. EBITDA margin at -0.2% was 925bps lower largely due to lower production volumes and higher employee expenses (up 20.6% / 213bps YoY). VLS margins lagged (-7.3%) due to drop in Czech and Morocco production (~21%/15% QoQ, respectively) while China JV reported 5.9% margin (vs 4.6% in Q1).

* Key highlights of earnings call: Management indicated: a) Project RACE to target price increases, OEM underutilisation and obsolescence charge, design to cost changes and line optimisation to optimise fixed costs at VLS; b) VLS targets EUR90- 95mn in revenue/month along with project RACE benefits to drive profitability targets of 7% EBIT and 12% EBITDA margin by Q4FY23; c) VEL has 60% share of business in motor and controllers supply for Bajaj Chetak and is a supplier for motors, motor controllers, telematics, on-board chargers and vehicle control units; d) gross debt increased to Rs30bn due to higher capex and WC needs and is expected to be at elevated levels for FY22; FY22/FY23E capex is expected at EUR45mn for VLS entity and Rs1.5-2.0bn for India business; and e) VEL has the potential to achieve content per vehicle of ~Rs38k in 2W and ~Rs46k in 3W for EVs.

* Maintain HOLD: VLS remains an attractive play on higher content per vehicle theme as electrification progresses. However, execution challenges coupled with weak balance sheet continue to keep us cautious. We cut our EPS estimates by ~39% for FY23; we value the business on SoTP basis. We introduce FY24E and rollover to Sep’23E and trim our VLS multiple to 3x (earlier: 4x) EV/EBITDA on the back of delayed execution and maintain India business multiple to 8x EV/EBITDA and China JV PE multiple at 6x. We maintain our HOLD rating with SoTP-based target price of Rs289 (earlier: Rs310).

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