Stock re-rating hinges on progress in recovery plan

Still awaiting improvement in earnings: Crompton?s Q4 earnings again missed expectations significantly. Crompton finally clocked in an EPS (earnings per share) of R5.8 vs. initial guidance (Q1) of R13+. The ferocity of the earnings miss and subsequent downgrades in the last four quarters have now made it difficult to give ?full? credibility to the recovery plan, which the management presented at the Q4 analyst meet. In addition, the volatile macro environment and the plethora of external issues (pricing pressure, currency etc) don?t help. Hence, at this stage, we believe it is only prudent to wait for some improvement before turning bullish on the outlook.

The big-delta in the international margins likely to be back-end loaded: While there are clearly many moving parts at Crompton, we believe a large part of margin recovery has to be driven by the international business which turned loss making in FY12 (-1.5% of sales) after delivering high single-digit margins for last three-four years. A potential turnaround is likely to be driven by: i) operational restructuring; ii) completion of low-margin or loss making orders; and iii) pricing stabilisation.

Pricing pressure remains widespread and unabated. We believe it is still early to turn too bullish on the quantum of improvement in international margins in FY13. We currently forecast a positive margin swing of 250 bps (basis points) in the international business, driving FY13e consolidated Ebitda (earnings before interest, taxes, depreciation, and amortisation) margin to 7.9%, up 80 bps y-o-y.

Upgrade to N(V): While we have largely kept our sales estimates unchanged and are in line with consensus, we have lowered our Ebitda margin estimate to 7.9%, driving an FY13/14e EPS cut of 27-28% to R7.5/10.2. We are currently 20-25% below consensus. On our new estimates, the stock doesn?t look expensive, trading at 14x (times) FY13e and 10.3x FY14e PE (price-to-earnings ratio). Hence, while we lower our TP (target price) to R115 to reflect the earnings cut, we upgrade our rating on the stock to Neutral (V) from Underweight (V) as we see marginal scope for the share price to rise. We believe the stock will re-rate materially only when the company starts delivering on its recovery plan and when macro volatility starts receding. Our TP is derived from our preferred EVA (economic value added) valuation methodology and implies a 12m forward target PE of 11.1x on FY14e EPS of R10.2.

Key takeaways from the analyst meet

FY12 Performance:

* Management has improved the product portfolio in the last 12 months; it indigenised the 1200kV AC transformer, exported energy efficient motors and has launched a premium range of fans.

* Streamlined manufacturing footprint and increased low-cost sourcing. Consequently, increased exports from India and established a sourcing facility in Shanghai

* Order inflow in Q4 was driven by all regions, with India contributing 50%, EMEA (Europe, Middle East & Africa) 26%, Americas 15% and Asia-Pacific the rest. Except for Americas, order inflow in Q4 was weaker than in Q3 across all geographies

* In Q4, exports increased by 14% in the Power business and by 24% in the Industrials business; market share in Fans increased to 24%

Recovery Action plan (benefits spread over three years)

* Enhance product offering: by moving to high value-added offerings (UHV transformers, energy efficient motors, etc) and new geographies (ME and Brazil) which, according to Crompton, will add 15 0bps in Ebitda margin.

* Sourcing initiatives: shifting the majority of sourcing to low-cost countries; this to add 150 bps to Ebitda margin.

* Manufacturing footprint: consolidating European platforms and adding additional capacity of 50,000MVA in India .

* Productivity improvement: implementing six sigma and rolling out sustainability program in each unit; likely to add 50bps to operating margin.

Outlook & guidance

* Guiding for growth of 15% in order inflows, 12-14% in sales and an Ebitda margin of 8-9% in FY13; management expects a 450bps margin improvement over the next three years

* Investment in new products in all three business segments; management has guided for capex of $300m over the next three years

* In India, Crompton expects growth in PGCIL and renewable orders to remain robust.

* In the international markets, Crompton expects moderate growth in Asia and Americas and strong growth in the European renewable wind offshore market.