Ashok Leyland’s (AL) Q2FY17 Ebitda was ~8% ahead of our/ consensus estimates, led by a favourable product mix (higher exports, defence and spare part sales). While management expects the curbs on black money to affect medium and heavy commercial vehicle (MHCV) industry growth in the near term, it expects a strong recovery in Q4FY17 on account of pre-buying (as prices will rise from April 2017 due to BS4 norms) and drive FY17 volumes.
Given the slower run-rates in 1HFY17 (-1% y-o-y), we lower our FY17F industry growth estimate to 10% y-o-y (from 18% y-o-y earlier). However, the strong traction in the exports markets, order-wins in the defence segment and rising spare part sales will partially offset the weak momentum in the CV segment.
For AL, we cut our FY17-19F overall MHCV volume growth estimates to ~10%/5%/5% (18%/ 7%/8% earlier); thus, we cut our FY17F-19F EPS by 1-7%. Hence, we cut our SOTP-based TP to R88. AL operates in a cyclical demand environment and its FY16 market share (33%) and Ebitda margins (12.8%/12.2% for FY17F/18F) are both at the high-end of the historical ranges. As we estimate FY17-19F Ebitda CAGR to be only 9%, we believe the current valuation at ~8.6x FY18F EV/Ebitda factors in the positives. A sharp slowdown in the MHCV cycle is a key risk to our valuation.
We value AL at 8x FY19F Ebitda (discounted back to Nov-18F). We value other investments at R4.9/share.
MHCV industry to face headwinds from FY18-19F
After successive periods of strong MHCV industry growth over FY15-16 (~23% CAGR), 1HFY17 disappointed with industry volumes declining by 1%. This was driven by a sharper-than-anticipated 14% decline in Q2FY17 volumes on an adverse base (on last year’s pre-buying as the braking norms became mandatory from 3QFY16). Volumes in Oct-16 have been better with industry volumes likely up ~16%, we estimate. We expect 2HFY17F to benefit from pre-buying on account of price hikes due to BS-4 emission norms becoming mandatory from April-2017, and a pick-up in the mining/construction segment driving the demand for tippers. However, given the low growth in industrial production, new freight demand growth remains a concern. Thus, we lower our FY17F industry growth estimate to ~10% (vs. our earlier estimate of 20%). We expect industry growth to remain structurally lower over FY18-19F at 5% (8% earlier) on improved efficiency due to the goods and services tax, 5% cost increase on BS-4 emission norms and competition from railways.
DFC can impact truck demand by 7-22% over FY20-21F: Our analysis indicates that the implementation of the Dedicated Freight Corridor (DFC) in railways could lead to the addition of 250 billion ton kms of capacity over FY18-20F. However, only 50% of this is incremental new capacity, and the rest is replacement capacity from the existing rail freight. Assuming a gradual ramp-up in utilisation (25/75/25 bn ton kms commissioned over FY20-22F), we believe this could affect new truck demand by 7%/22% in FY20/21F). Thus, new MHCV truck sales could come under pressure from FY20F.
AL’s MHCV market share remains at peak levels
After a slight decline in 1QFY17, AL’s market share has improved to 33% in 2QFY17, which is at near-peak levels. Management highlighted that the company is refraining from participating in the high discounts prevalent in the industry which can lead to some market share loss going ahead. We maintain our view that it would be difficult for AL to hold on to its market share in the scenario of slowing industry demand and high competition in the segment. Thus, we expect AL’s overall MHCV volume growth at 12%/5% for FY17/18. In FY19, we expect AL’s volumes to grow 5%, in line with the industry.
Industry forecasts indicate utilisation levels unlikely to increase materially: Competition from new players like Bharat Benz (a subsidiary of Daimler, which only reports annual numbers) and Mahindra has increased substantially. Also, peers like Tata Motors and Eicher have introduced products in the trailer segment to capitalise on the strong demand. Thus, we believe AL’s market share is unlikely to inch up materially from FY16 levels. Also, given the subdued industry growth outlook, we expect industry utilisation levels to touch only ~61% by FY19F; hence, discounting levels are unlikely to come off any time soon, limiting margin upside.
Margins at all-time highs
AL’s long-term Ebitda margins in the past upcycles have been at ~10-11%. We build in higher margins in this cycle, supported by: (i) a benign cost environment; (ii) operating leverage benefits; (iii) a higher defence revenue mix, and (iv) 100% excise duty benefits for its plant in Pantnagar. The latter adds ~150 ps to margins, in our view. As we expect a sharp cost increase of ~5% in FY18F after the implementation of the BS4 norms, there is a risk that costs may not be fully passed on if the cycle peaks out.
Lowering FY17-19F earnings
We cut our revenue estimates by 4%/6%/8% for FY17/18/19F. We expect Ebitda margins at 12.8%/12.2%/12.1% in FY17/18/ 19F, which leads to 2%/4%/7% cuts in Ebitda estimates. Thus, our EPS estimates are down 1%/4%/7% to R5.7/6.2/6.7 for FY17/18/19F. Our Ebitda estimates are largely in line with consensus for FY18-19F.
Maintain Neutral; target price of Rs 88
We use a SOTP methodology to derive our new TP of R88 (R93 earlier). We roll forward our valuations to FY19F Ebitda, compared with the average FY18-19F Ebitda earlier and discount it back to Nov-18F. We value the stand-alone business at ~R83/sh based on 8x EV-Ebitda. We value the company’s investments at R4.9/sh.
(i) Weaker-than-expected MHCV industry volumes: We expect industry growth to remain slow at ~5% over FY18-19F. However, if GST gets implemented from April 2017, there could be downside risks to our estimates. (ii) Ability to sustain margins: The company needs to pass on the BS-4 emission norm cost increase of ~5% in FY18F. The inability to pass on the cost increase due to high competition would impact Ebitda margins. (iii) Strong order wins in the defence segment: The company has already won one defence order in Q4FY16 and is vying for more orders. Better execution can lead to upside risk to our estimates.