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Ashok Leyland rated ‘Buy’ by Motilal Oswal

Tax shield on accumulated losses would limit impact on FY17/18 EPS

By: | Published: September 19, 2016 6:07 AM
Ashok leyland shares HFL is a critical vendor for AL, as it sources 80% of its need for cylinder blocks and heads from HFL. (Reuters)

Ashok Leyland’s board has approved the merger of Hinduja Foundries Ltd (HFL), the group company supplying cylinder blocks and heads to AL. The merger would result in 2.8% dilution and increase the promoters stake to 51.3%. The swap ratio implies discount of 38% to HFL’s closing price of R54.5 on 14/Sep/16. Though the materiality of this deal might be low, it deviates from the management’s stated objective of streamlining AL’s balance sheet. While we are yet to factor in for HFL in our AL’s estimates, given the tax shield on accumulated losses we see limited change in FY17/18 EPS. We now value AL at ~8x EV/Ebitda (v/s 9x earlier), to factor in for potential impact of this deal on capital efficiencies.

Contours of the deal

The share swap ratio approved is at 40 shares of AL for every 100 shares of HFL, resulting in dilution of ~2.8% for AL. AL has 2.6% equity stake in HFL and preference share investment of R3.25 bn, which would get canceled on merger.

About Hinduja Foundries

HFL is one of the largest producers of cylinder blocks and heads in India. In FY16 (12m), it had revenues of R5.8 bn (-7% y-o-y), adj Ebitda loss of R312 m (-6% margins) and adj PAT loss of ~R1.7 bn. It has net debt of R4.5 bn as of Mar-16. It has 2 manufacturing plants, with total capacity of 1,32,000 tons.

Rationale for the deal

HFL is a critical vendor for AL, as it sources 80% of its need for cylinder blocks and heads from HFL. Considering weak financials, there was threat on sustenance of HFL’s operation, which would have hit AL’s operations. HFL’s accumulated losses of R10.6 bn would give tax shield of R3.3 bn to AL.

Our view on the deal

While we understand the criticality of HFL’s product for AL’s operations, we believe merger of HFL with AL might not be the most optimum solution from minority shareholders’ perspective. However, the promoters have significantly sweetened the deal for AL’s minority shareholders by offering 38% discount to closing valuation of HFL (as of 14/Sep/16).

Under AL, HFL should attain Ebitda break-even in a short period of time; PAT break-even would be dependent on further rightsizing of operations and/or fund infusion. Based on Q1FY17 performance of HFL, without any improvement AL’s Ebitda would see downgrade of 1.3% and EPS would see cut of ~8.5% (including equity dilution).

Valuation and view

We are yet to factor in for HFL in our AL’s estimates pending regulatory and shareholders’ approval. However, given tax shield of

R3.25 bn on accumulated losses of R10.5 bn, we see limited change in FY17/18 EPS. For long term perspective, we are hopeful of continuance of focused capital allocation and are positive on the strategy of broad basing revenue stream to reduce cyclicality.

graph hfl

Short term volatility in volumes notwithstanding, we believe CV cycle has more legs to it and would grow at 12-15% CAGR over next three years. Management’s focused approach is paying-off in (i) market share gains, (ii) rising ASPs, (iii) controlled cost, (iv) reducing working capital, (v) significant control on capex and (vi) debt reduction. AL’s valuations at 9.6xFY18e EPS and EV/Ebitda of 6.1x are attractive, considering strong EPS growth of ~47% CAGR over FY16-18E. We now value AL at ~8x EV/Ebitda, to factor in for potential impact of this deal on capital efficiencies due to increase in capital employed without commensurate improvement in operating performance. Maintain Buy with target price of ~R105 (~8x FY18 EV/Ebitda).

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