The year that was: Bharat Forge (BFL) made a strong start to 2015 with solid revenue growth coming from strong Class 8 truck orders and a robust order book from the oil and gas business. However, 2015 ended with weak new orders, slowing build rates and much lower income from the oil and gas business. This resulted in the share price being lower than it was at the beginning of 2015.
2015—A year of ups and downs
Share price performance at the start of 2015 was strong as US Class 8 trucks reported robust order intake and build rates. Also, BFL appeared to be unaffected by the fall in oil prices. By mid-2015, US Class 8 trucks orders started tapering and by Q4 15, shale producers ran out of hedges which led to a sharp reduction in capex, and investors started to factor in a sustained period of low oil prices. We believe these factors led to a sharp decline in BFL’s share price. We see further impact of these factors on reported earnings in the coming quarters.
2016—The year to come: In the current fiscal year, given the commercial vehicle (CV) and oil and gas business revenue drivers are missing, we expect y-o-y growth will be negligible. With FY16e earnings setting a low base for FY17e, and newer product lines set to go into production, we expect BFL to return to its growth trajectory despite weak markets. We expect new order announcements for railways, defence and import substituting products to support stock performance.
H2 2016 could prove favourable with positive announcements and improving earnings. We expect FY17e to see some positive momentum as it benefits from the low base set in FY16e and as new initiatives start to contribute meaningfully to earnings. We expect revenues will start to increase as the contribution from railways and aerospace starts to replace the loss of revenue from the oil and gas business. Similarly, weaker revenues from exports in the CV segment are likely to be made up by stronger sales in the Indian CV market as customers increase buying ahead of new emission norms in April 2017.
But don’t expect a stellar 2016 yet
Recent data on preliminary net orders for US Class 8 trucks was up 68% m-o-m for December. While the preliminary net orders for US Class 8 trucks were better than expected, they were down 36% y-o-y. The key data point we look at is build rates; for December build rates appear to have weakened significantly. We expect that OEMs are likely to announce further production cuts.
Q3 FY16e earnings preview: We expect BFL to report a c13% y-o-y revenue decline which will result in a decline in earnings of 14% y-o-y and a 4% q-o-q.
2016—The year of downs and ups
We expect Q3 FY16e and Q4 FY16e to be weak as the standalone company is likely to show y-o-y earnings decline after eight quarters. We believe this is likely to result in the company reporting almost negligible earnings growth for FY16.
Valuation and risks: We cut our estimates for FY16e/17e/18e by 5-9% as we expect CV build rates will fall, order cancellations are likely to be higher than expected and its customers could report further cuts in capex. However, we believe the company has successfully transitioned to a business model based on product quality and innovation, not just cost competitiveness. We believe there is significant flexible capacity that can be used to manufacture products in various segments. We now expect earnings growth of 16% over FY16e-18e with RoE (return on equity) reaching 21% by FY17e and long-term growth potential of c10%. We estimate that BFL will be net cash by FY18e. We continue to value the business at a 26x GGM-based one-year forward P/E (price to earnings ratio), as we believe it is close to trough earnings and near-term earnings do not completely capture the full potential of the business. We roll forward our valuation to December 2017e from September 2017e EPS (earnings per share) and discount it back by a year to arrive at our current fair value target price of R1,030 (from R1,080).