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Recovery in the US business drives operating performance

Earnings above our estimate

* Avalon Technologies (AVALON) reported a strong quarter, with revenue growing 37% YoY in 2QFY25, led by a healthy recovery in US operations (up 57% YoY) and consistent performance in the Indian business (up 16% YoY). Operating profitability improved (up 470bp) led by a shift in ~45- 50% of the US manufacturing operations to India and favorable operating leverage.

* With the beginning of restocking by US customers, incremental order flows from new customers, and the growing Indian business, we expect AVALON to deliver a strong 2HFY25 performance coupled with margin expansion (operating leverage play).

* Factoring in the strong 2Q performance and positive growth outlook, we raise our EPS estimates for FY25/FY26 by 36%/10%. Reiterate BUY with a TP of INR920 (premised on 35x FY27E EPS).

Traction within railways drives the domestic business

* Consolidated revenue grew 37% YoY to INR2.75b, driven by growth in both domestic (up 16% YoY due to traction in the mobility segment driven by the Indian railway) and US (up 57% YoY due to recovery in the market and the shift from destocking to restocking) operations.

*  Consolidated EBITDA jumped 2.4x YoY to INR301m. Consolidated EBITDA margin expanded 470bp to 11% (+880bp QoQ) despite the contraction of gross margin by 40bp YoY to 36.8%. Operating leverage played its role with employee expense as % of sales decreasing 570bp YoY to ~17% in 2QFY25, while other expenses as a % of sales increased 60bp YoY to ~9% in 2QFY25. The company reported an Adj. PAT of INR175m, up 2.4x YoY.

* The total orderbook stood at 25.85b with short-term order book (executable within 14 months) at INR14.85b (up 19%/2% YoY/QoQ) and longer executable orderbook (from 14 months up to three years) at INR11b (up 10% YoY).

* Gross debt as of Sep’24 stood at INR1.5b vs. INR1.6b as of Mar’24. Net working capital days decreased to 134 from 161 in Mar’24, primarily led by lower receivable days (down 25 days) and higher payable (up 2 days).

* In 1HFY25, Revenue/EBITDA/Adj. PAT increased 9%/20%/6% YoY at INR4.7b/INR345m/152m. For 2HFY25, implied Revenue/EBITDA/Adj. PAT growth is 41%/2.1x/3.3x YoY, led by strong growth across all verticals, coupled with margin expansion.

Highlights from the management commentary

* Guidance: AVALON has maintained its FY25 revenue growth guidance to 16-20% with gross margins ranging from 33% to 35%. It expects healthy growth to continue in 2HFY25. The US manufacturing mix is expected to come down to ~15% by the end of FY25, resulting in cost benefits and margin expansion.

* Clean Energy: AVALON is primarily involved in the clean energy storage EMS business in the US, an industry experiencing a robust growth rate of 60-70%. The management is not expecting any major impact with the new US administration’s measures to curb clean energy projects (e.g. slashing IRA incentives)

* Demand Growth: US customers are restocking and returning to normalcy, and with the US rate cut cycle underway, demand growth is increasing. In India, the company is experiencing growth in the Mobility (Rail and Air), Communication, and Industrial segments.

Valuation and view

* With US operations now witnessing a healthy recovery and the Indian business experiencing growth, we expect AVALON’s revenue and profitability to experience healthy improvement from 2HFY25 onwards. We also believe the company’s long-term revenue trajectory will continue to be strong, backed by: 1) the addition of new customers in the US and Indian markets and 2) order inflows from high-growth/high-margin industries, such as Clean Energy, Mobility, and Industrials.

* We estimate AVALON to post a CAGR of 31%/57%/83% in revenue/EBITDA/adj. PAT over FY24-FY27 on account of strong growth and healthy order inflows. Reiterate BUY with a TP of INR920 (premised on 35x FY27E EPS).

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