Rebounding CV sales provides a springboard to Jamna

Company Brief

Jamna Auto Industries Ltd. (JAI), a INR 11.75 billion (USD 174 million) automotive parts company is an Indian multinational which manufactures and supplies auto suspension products -parabolic/ tapered leaf spring, lift axle & air suspension - mainly for OEMs in the CV segment. JAI is India's largest and amongst the world's top three players in Multileaf Springs. The company is headquartered in New Delhi, India. The company has its manufacturing unit in Yamuna Nagar, Malanpur (near Gwalior), Chennai and Jamshedpur and its products are sold in over 25 countries.

Industry Overview

Commercial Vehicle: The Commercial Vehicle (CV) segment in India which started  experiencing a down-cycle in FY13, started a recovery phase in FY15 with improving economic outlook and consumer sentiments under the new Government. Indian CV sales (including exports), managed to cut the decline to 1.3% in FY15, after a steep fall of 18.7% in FY14, with signs of recovery in the domestic CV segment and strong growth in CV exports as according to Society of Indian Automobile (SIAM). Domestic CV sales narrowed down it’s de-growth to 2.8% in the year after falling down 20.2% in FY14. Amongst CV sub-segments Medium & Heavy Commercial Vehicle (M&HCV) showed robust growth while the Light Commercial Vehicle (LCV) continued to experience slowdown. CV exports rebounded back to positive growth territory reporting a 11.3% growth in FY15. The CV exports have grown at 5-year CAGR of 13.8% generating a healthy 12.2% share of CV production in FY15. Consistent growth in the auto component exports is an indication of growing credibility of ‘India made’ components. The Medium & Heavy Commercial Vehicle (M&HCV) sub-segment, including export sales, bounced back to robust growth of 17.4% YoY in FY15 after two years of decline. In addition, with the presence of MNC players, as the industry places increased importance on technologically advanced and value added products, the component makers remain in a sweet spot. Also, the aftermarket will be an important growth and profitability driver for the industry with customers’ preference for quality branded products.

Auto Components: According to Automotive Component Manufacturers Association of India (ACMA), Auto component sector is estimated to cross $110bn in turnover by 2020 driven by rising domestic demand in the OEM market, expanding replacement market and plans of major global OEMs to make India a component sourcing hub for their global operations. ACMA estimates the auto component sector to grow a minimum of 8-10% in FY16.

Investment Positives

Commanding position in the market: Jamna Auto Industries (JAI) is well positioned in the leaf spring and air suspension space given its dominant presence in parabolic leaf spring market. Jamna corners 90% of the country’s parabolic leaf spring market share. JAI caters to commercial vehicle manufacturers and has a strong customer base (TATA, Mahindra, VW, Isuzu, Volvo etc), in addition to being a pioneer in the leaf spring space. Company generates 80% of revenue from India. The domestic CV sector is estimated to grow in double-digits – 10-13% by SIAM with M&HCV segment on sustainable up cycle. The on-going recovery in automotive sector augurs well for JAI. ICRA research estimates M&HCV segment to grow 12-14% in FY16 driven by replacement demand, stronger growth in infrastructure, mining, and industrial sectors, and move to BS-IV emission norms from October 2015 onwards leading to new demand. We believe the new reforms and initiatives by current government’s ‘Make in India’ campaign is expected to make India an automobile manufacturing hub. JAI is well-positioned to maximize growth and returns as it develops new growth drivers in higher margin replacement market, new value added products aided by strong cash accruals and strengthened balance-sheet.

JAI has emerged as a pioneer in adoption of new technologies buoyed by its extensive in-house research & development programmes. Company’s focus on R&D innovations has always been a priority. JAI also enters into partners with global leaders like Ridewell Corporation, USA, with whom it has collaborated for design and manufacturing of Air Suspension and Lift Axles. Over time, the company is witnessing an increase in the value of its products per vehicle. With increased adoption of portfolio of new generation products in India, we see this growing further.

Consistently strong financial performance

The company has reported strong financial numbers for FY15-16. JAI reported a top line growth of 15.2% in FY15-16 with an EBITDA margin of 12.7%, up approx. 385 bps YoY. The increase in the margins was primarily due to lower Brent crude and commodity prices. The company intends to maintain an EBITDA margin of 12.5% in the coming years and also intends to become a zero debt company by 1Q16-17. 

Catalyst

“Make in India” and “Smart City” projects push in the right direction to make India 3rd largest market for automobiles:

Indian Automotive Sector is a significant contributor to nation’s progress. As per SIAM’s Automotive Mission Plan 2006- 2016, the Indian automobile industry accounted for 7.1% of India’s GDP, 27% of India’s Industrial GDP and 4.3% of overall exports, second only to textile and handicrafts in FY14. The Government is committed to make India the third largest market for automobiles by 2016, behind only China and the US, making the sector a top priority under its ‘Make in India’ program. In order to push local manufacturing, in the Budget 2015-16, the Government increased the effective tariff rate on imported commercial vehicles from 10% to 20%, making the import of completely built units expensive. Other initiatives like reduced corporate tax rate, infrastructure focus and GST implementation will indirectly benefit the sector.

Margin expansion to drive earning growth

Given the high cyclicality in JAI’s revenue trends, EBITDA margins have also been quite volatile. The company’s average margins over the past 10 years have been at 9-10%. Now, on a medium to long term basis, JAI is hopeful that its products and market de-risking strategy will improve margin trends. An increase in the share of the aftermarket/exports, along with thrust on ramping up value-added products (parabolic springs, lift axles, etc.) will drive a structural improvement in JAI’s margins.

Key Risks

The cyclical nature of CV industry has led to significant volatility in JAI’s margins and earnings trajectory on historical basis. The company is attempting to partially mitigate the risk in two ways: (1) Growing revenue mix from non-cyclical segments and expanding its revenues from high value-added products and (2) lowering its break-even utilizations to protect significant margin erosion in down-cycle years.

JAI has a high concentration which is a key risk to the company. Tata Motors and Ashok Leyland together account for almost 65% of the company’s revenue. The long-standing consolidated nature of the Indian CV market has been an inhibiting factor for the company to de-risk its business. Nevertheless, traction in aftermarkets/ exports will provide diversification avenues for the company.

Valuation

Jamna Auto currently trades at a P/E of 17.4x (on CMP of INR 146.7), which is above the industry P/E of 16.4x. We believe the company deserves to trade at a premium to its peers (and historical valuation), given its strong earnings outlook, steady diversification of revenue base with increasing share of non-cyclical segments, lesser volatility in margins due to lowering break-even utilization and top quartile return ratios among auto component companies.Rebounding CV sales provides a springboard to Jamna.

We continue to love EROS

Eros stock witnessed a significant decline from all time high levels of INR 635 in mid-July 2015 to about INR 173 currently and is trading below its October, 2010 IPO price of INR 175 per share. The sharp correction was due to concerns raised by a short seller over accounting practices followed by the parent company (Eros International PLC). The major issues were 1) the stark increase in receivables owing to increased business exposure to UAE, 2) validation of the Eros Now user base and 3) the future cash flow viability. The parent has provided a point-to-point rebuttal to the concerns followed by Eros International’s announcement of a completion on March 21, 2016, of an internal audit review with the assistance of Skadden Arps Slate Meagher & Flom LLP. The review covered analysis of company's financial reporting areas which includes its UAE sales and revenue, amortization policy of intangibles, related party transaction with Eros International Media. Eros International got a clean chit in an independent internal review, thereby reinforcing confidence in the company's accounting policy, practices and disclosures (stock was up merely 5% on this announcement on the day of the announcement).

Eros International’s results are scheduled to be out on May 27. The company has remained confident of not having done anything wrong in this entire saga and has taken all the necessary steps to address the concerns raised by bears. While Eros currently trades at a very low one year forward PE ratio of 5.8x (vs 9.0x for its peers), we believe the concrete triggers for the company’s re-rating are- the improvement in receivables, a clear transfer pricing deal with the parent coupled with other steps such as announcing dividend payment and a possible share buyback- that would revive confidence levels in the stock. 

VA Tech Wabag - A potential multi-bagger in a niche and strategically important industry!

Company Overview

VA Tech Wabag (Wabag), a INR 32 billion (USD 480 million) pure-play water treatment company is an Indian multinational player operating in the business of water and waste water treatment solutions both in India and other emerging markets (Asia, Africa, Middle East and Central & Eastern European countries). The company provides a complete range of water and waste water treatment solutions, with product offerings spread across municipal drinking water, municipal sewage, industrial water, industrial effluents, desalination and recycle. It is a technology driven company with more than 100 patents with R&D centers located in India, Austria and Switzerland. It has a strong track record having executed more than 2300 projects executed over the last three decades.

Industry Context

Water Treatment: In the Indian context, the treatment of water has a strong business potential. A rapidly growing population demanding more water per capita (140 liters per capita per day) along with inadequate conservation & rain water harvesting has resulted in severe water shortage; a major cause for concern for the government and local municipalities across the country. Water being a scarce resource, conservation and preservation has been an area of focus for public and private sector enterprises across the globe. Governments across regions are also laying special emphasis in this direction and hence business traction is expected to improve further in the years ahead.

Sewage Treatment: Sewage treatment is currently has not been handled efficiently, however it’s now one of the top priorities for the Government in pursuit of its ‘Swacch Bharat campaign’. India is likely to spending large sums on sewage treatment, irrigation and water recycling in the forthcoming years. Central Pollution Control Board (CPCB) has reassessed sewage generation and treatment capacity for Urban Population of India for the year 2015. As per CPCB, Sewage generation is estimated to be ~62000 MLD and sewage treatment capacity developed so far is only 23277 MLD (approx 38% of demand) from 816 STPs. Cities and towns do not have adequate system for sewage collection and treatment; thus the entire waste water either falls into rivers/ lakes or remains inundated on land, causing potential risk of ground water contamination.

Furthermore, additional opportunity is expected to come under way by way of AMRUT project (earlier known as JNNURM) from various municipal corporations and state governments, Smart cities program and Namami Ganga project (It’s a hybrid-annuity based PPP model  with a INR 250 billion allocation to be committed in next 2-3 years).

These factors ensure a strong business opportunity for the VA Tech Wabag. VA Tech Wabag competes against global payers such as SIIC Environment Holdings Ltd, China Everbright Water Ltd., ELL Environmental Holdings Ltd, Sino Thai Engineering and Construction PCL and Politeknik Metal Sanayi Ve Ticaret AS in its target market and against Indian companies such as Eco Recycling Ltd, Ion Exchange India Ltd.

  

Investment Positives

1. Improved Order book position: With an improved order book position of INR79.5 billion (USD 1.2 billion), Wabag provides investors with revenue visibility for the next 2-3 years (INR 24.4 billion in FY15). Despite a challenging environment, Wabag has won orders of INR50 billion in FY16 (a beat versus company’s earlier guidance of INR35-37 billion). The beat was primarily driven by two large orders worth INR13 billion announced in March 2016 - the INR6 billion ((USD90 million) order for a water reclamation plant at Chennai and an INR7.3 billion (USD108 million) integrated water supply scheme for Polgahawela, Sri Lanka. The order book has been growing at a faster pace, although the company is now focusing on high value orders coupled with higher margin profile.

2. Asset light model: Wabag is a technology driven company and has an asset light business model, as it outsources bulk of its non-core activities such as capital intensive construction business, to external vendors. The company is currently reaping the benefits of amounts spent on in-house R&D activities and patents developed by the overseas subsidiary over the years.

3. Geographic and Customer diversity: VA Tech Wabag’s products and services are offered to a wide range of customers spread across different industries and geographies. This cushions the company against any long term adverse impact on its business performance as revenue is diversified across customers and geographies. On the flip side, presence in multiple countries exposes the company to operational and Government risks. VA Tech Wabag has taken many steps towards consolidation of sites and to mitigate the risks. The company has created a team specifically to ensure project closure and collections (with delineated closure-related incentives). Moreover, the company has set minimum contract size standards for various segments (for instance, INR500 million for Indian municipal contracts and half the amount for international projects).

Reasons for the recent stock underperformance

Wabag has declined 55% from INR943 on 18^th March 2015 to an intermediate low of INR421 on 1^st March 2016. The reasons for this fall are lower margins, euro depreciation versus INR (11% decline in FY16) and excess cash which depressed the company’s return ratios.

· The company's FY16 margins were impacted by low margin overseas projects (low-margin Turkey STP O&M contract for INR3 billion (6% revenue contribution in 9M FY16)) and higher provisioning (INR300 million provisions for Al Gubrah’s projects).

· Wabag has a significant amount of cash, almost INR2.1 billion (as of Sept. 2016) of cash. The company hasn’t been able to put this cash in use for acquisitions and hence this has depressed the return ratios.

Catalysts

Strong inflow growth along with steady project execution to result in robust revenue growth trajectory

Wabag’s order inflow is likely to be driven by domestic orders in FY17, with projects like Namami Gange, Atal Mission for Rejuvenation and Urban Transformation (AMRUT) and finalization of large municipal water and desalination projects across Mumbai and Chennai. This along with order wins in FY16 should result in an acceleration in topline growth in FY17 and FY18. Growth will be led by execution of large orders such as Petronas project, AMAS, Bahrain, Istanbul O&M and Dangote etc. Notwithstanding benign crude oil prices, projects in which Wabag operates have not been impacted.

Margin expansion on cards, cash conversion to improve

Wabag has traditionally struggled with margins in a few large projects (Turkey STP O&M, APGENCO contracts). Going forward, margins would steadily improve due to better EBITDA mix projects, higher revenue recognition of key projects, rising revenue share from O&M along with focused efforts on site closures and collections. In the last few years, profits growth has lagged revenue growth. This is likely to reverse with expected margin expansion, operating leverage from normalized depreciation, which should result in higher PAT growth.  Margin  and  cash  conversion  will  be  boosted  by  growing  share of Petronas project revenues and focused efforts on site closures and collections.

Key Risks

FX risks

VA Tech Wabag operates in international markets and hence is exposed to currency movements, however is naturally hedged to some extent as most of the costs are also incurred in local currency of the respective foreign country. Based on its target markets, it is faces FX risk from euro depreciation

Geopolitical risks – Ability to execute projects in tough geographies

VA Tech Wabag operates in different countries and hence any geopolitical instability in a country of operation (e.g. Nigeria, Turkey etc) or surrounding countries might impact its business and repatriation of funds could be a challenge.

Valuations can re-rate

Wabag has traded in the P/E band of 20-30x and P/B of 2-3x till FY14. However, in FY15, stock rerated on account of the Indian government’s thrust on water conservation and initiatives undertaken to improve the quality of water, and reached P/E of 50x. However due to global pressures and volatility in financial markets coupled with some delays in the execution of few projects, the stock has corrected substantially in FY16. We believe that this correction should be used to accumulate the stock as it provides substantial upside from current levels over a 2-3 years time frame. At current CMP of INR570 as on 23^rd May, the stock trades at 25.2x 2017 consensus EPS/18.9x 2018 consensus EPS. The valuations are much below as compared to its historical valuations. Moreover WABAG deserves a premium valuation due to scarcity of listed large cap pure-play water treatment comps. We believe improving margins and cash conversion metrics, would lead to a potential re-rating of the stock.

Disclaimer

Investment ideas issued by Maxim Research Pvt. Ltd, does not constitute a recommendation for any investor to purchase or sell any particular security. Any investor should determine whether a particular security is suitable based on the investor’s objectives, financial situation needs, and tax status. The investors should take note of the fact that stocks in Emerging markets like India tend to be more volatile and impact costs tend to be higher as compared to the developed markets. Maxim Research Pvt Ltd., its employees and affiliates may maintain positions and buy and sell the securities or options of the issuers mentioned herein (Safe to assume vested interest - long position on the stock). This is not a complete Research Document. All materials are subject to change without notice. Information is obtained from sources believed to be reliable, but its accuracy and completeness are not guaranteed.

All Standard Disclaimers apply

Implications of Mauritius tax treaty changes for markets

On May 10^th 2016, The Government of India amended the three-decade old treaty with Mauritius. Under an amended tax treaty, India would tax capital gains on investments channeled through Mauritius. This change will be implemented in three phases:

1. No change for investments made before April 2017: The investments made before 1 April 2017 will not be liable to be taxed in India. This means that even if investors who have brought shares in Indian companies before 1 April 2017 decide to sell these shares after this date, the accrued capital gains will not be taxed in India. This provides an incentive to buy Indian stocks (if that was on your radar) prior to this timeline!.

2. From April 2017 to April 2019, the tax applied will be 50% of the Indian domestic tax rate: From April 1, 2017 to March 31, 2019, firms based in Mauritius will have to pay capital gains tax at 50% of domestic tax rate (i.e. at 7.5%). Under the amended treaty, only those Mauritius-based companies that have a total expenditure of more than INR 2.7 million in the preceding twelve months will be able to benefit from the tax treaty.

3. After April 2019, the Indian domestic rate will be applied in full: The full tax rate (currently at 15%) is applicable on the capital gains on sale/transfer of Indian shares by Mauritius based firms.

But in this world nothing can be said to be certain, except death and taxes…Benjamin Franklin

As Benjamin Franklin quote summarizes, nothing can be certain, except death and taxes. Of course investors do not like to be taxed; however it is not a big deal as it is made to be! The Indian stock market also reacted negatively with a knee jerk reaction; however it recovered within hours as markets took a more balance view about this tax treaty. Here is our take on this:

No retrospective taxation and advance notice prior to implementation: What will come as a relief to foreign institutional investments (FIIs) is that there won't be any retrospective taxation on the capital gains made on shares of Indian companies. All shares purchased till March 31, 2017 will not be subject to short-term capital gains tax. India anyway does not have any capital gains tax on investment held for one year or more. Hence long term investors do not pay taxes anyway! Yes, this could affect ‘hot money’ flows, which is in fact will reduce unnecessary volatility in Indian equity markets. This move will result in a more stable and transparent regime and is a positive for long term investors. India is likely to see durable foreign investments from FIIs in the long-term as round-tripping of funds would be reduced.

Level-playing field for DIIs and FIIs: This move of the government was a long-awaited wish of the mutual fund industry in India as it is seen providing a level playing field to domestic and international mutual funds. Till now, short-term investment by FIIs were not taxable while those by mutual funds were.

Investors give more importance to the fundamentals of the market, rather than tax benefits: Participatory notes (P-notes) are the instruments issued by brokers to overseas investors, who invest in the Indian stock market without registering themselves. More than two-thirds of investments through P-notes or offshore derivative instruments (ODIs) come via Mauritius (30%) and Singapore (36.5%), which will now get taxed for short-term capital gains, starting 1 April 2017. The fund flows through P-notes will be impacted, however prior notice before implementation would mean that the impact will be negligible as these investors who accessed Indian markets through P-notes, can register directly with the capital markets regulator - Securities and Exchange Board of India (SEBI). Yes, this move will make P-notes less attractive as it is costlier than registering as an FPI. Yes, it could impact a few brokers who depend on this flow but it is not too bad for Indian markets in general. At the end of the day, Investors would base their investment decision in the Indian markets based on the FX adjusted net returns and not whether tax freebies are available or not. 

Changes applicable only for equity investments: Investors in mutual funds, derivatives and debt will not fall under ambit of the proposed tax changes as these instruments aren't mentioned in the reworked double taxation avoidance agreement. The provisions of the General Anti-Avoidance Rule (GAAR), which take effect from April 1, 2017, will override the tax treaty provisions in case the agreement is abused.

Reworking of Singaporean tax treaty on cards: The capital gains tax clause in the Indo-Mauritius treaty, becomes applicable to the Indo-Singapore tax treaty as well. This is because the agreement for avoidance of double taxation with Singapore ("India-Singapore DTAA") under the India-Singapore DTAA is co-terminus with the benefits available under erstwhile provisions on capital gains contained in the treaty with Mauritius. That means not only short-term capital gains tax will be imposed on FIIs purchases from Mauritius but from Singapore too. We expect the Government to move with this tax amendment in the next few days.

To conclude….As Indian markets, rightly so, have not reacted negatively to the Mauritius tax treaty changes. We opine that Investors do not need to be pampered and lured to invest in India; however prospects of stable FX adjusted sustainable long term returns will certainly draw investors to Indian markets.