AL DID NOT panic during the transition phase (post Supreme Court’s March 29, 2017,order banning sale of BS-III vehicles fromApril1,2017)due to a well chalked out strategy to handle BS-III stock. Given the technology adopted by the company, replacing BS-III engines with BS-IV ones was as simple as replacing one battery with another. It envisages cost impact to be minimal.
Cost effective design: AL’s BS-IVdesign is based onExhaust GasRecirculation (EGR) technology, which is better suited to Indian conditions versus peers, who use Selective CatalyticReduction(SCR)basedonEuropean technology, which also entails higher costs. Price hikes of 8-10% included the impact of BS-IV/commodity costs and some margin markup. Peers using SCR technology will have to resort to higher price hikes. Inventory: Total BS-III inventory of 10,664 units, of which only 1,000 units were at the dealers’end.
AL generally operates at very low dealer inventory given its cash and carry model.The company did not offer huge discounts to clear old inventory given low dealer inventory levels and clarity on alternative uses of BS-III engines. Of 9,700 unsold stock, 2K units will be exported.The balance stock will be retrofitted with BS-IV engines and older BS-III engines will be directed towards the replacement market. Outlook and valuations We are enthused by the technological prowess displayed by AL in managing the transition to BS-IV as the least cost manufacturer. This, along with granular focus on widening product basket and distribution reach, will propel current 15-year high market share and industry leading margin/RoE.
We estimate EPS CAGR of 26% over FY16-19 and RoE to improve ~830 bps to 26.4% in FY19 (18% in FY16).We maintain ‘BUY/SO’with `125 target price (10x FY19e EV/Ebitda and assign `6 to the Hinduja Finance stake.At CMP, the stock trades at FY19e PER of 12x. Older BS-III engines to serve replacement market: Over the past 7years, the total number of BS-III engines fleet is ~550K.Of these,5-10% are replaced every year, implying an annual replacement demand of 25-50K units. Overall impact to be `200 mn: Total retrofit cost is minimal around `200 mn, which will be recovered by selling BS-III engines in the replacement market. BS-IVcost increase to be lower for AL than peers: AL has effected a 4% price hike in January to pass on higher commodity costs and a further10% hike to absorb BSIV transition costs as well as additional commodity cost pressures.
Despite the steep hike, AL is confident that it will price its products competitively. AL’s design, based on EGR technology, is better suited to Indian conditions versus peers who use the SCRtechnologybased on European technology, which also entails higher costs. AL is the only domestic OEM.