DreamGains Financial Services
www.dreamgains.com October 1st 2007, Monday
Company Name: El Forge Limited
BSE Code: 531144
BSE Price: 76.85
Industry: Casting & Forging
EPS: 8.51
Market Cap: 65.55 Crore
Introduction
Incorporated in 1934, El Forge is one of the leading forging manufacturers in South India with over 38 years of experience in metal forming. The company manufactures and markets carbon, alloy and stainless steel forges for the automotive component and process industries. It also has machining capabilities, which have now evolved into a thrust area for the company. ELF supplies both forging and machining components to OEMs (Ashok Leyland) and Tier-I suppliers (MICO, Rane TRW, Sundaram Clayton, Lucas).
It has four manufacturing facilities, one each at Chromepet, Gummudipundi and Thurapakkam in Chennai and one at Hosur in Tamil Nadu. The company currently has an installed capacity of producing 18,200 MT per annum. In a bid to expand its markets in Europe, it recently acquired a majority stake in UK-based Shakespeare Forging, SFL, which registered a turnover of £4.5 million in FY05.
Investment rationales
Excellent business model
ELF has a well diversified client portfolio and a suitably de-risked business model. Its major clients are MICO, Greaves and Ashok Leyland, who cumulatively account for 37% of the revenues. Thus, the company’s client concentration risk is relatively lower than a majority of the auto ancillary companies in India. This lends ELF a competitive edge and shores up its growth prospects going forward.
Domestic growth on the fast track
ELF is likely to sustain its strong domestic growth trajectory considering its impressive client portfolio. In particular, we expect the company to benefit immensely from the buoyant future prospects of its biggest client - MICO, which generates approximately 20% of ELF’s revenue. ELF has been servicing MICO for over 30 years now, forging a strong relationship in the process. In order to build on this relationship and ensure customer satisfaction, the company has set up a machine shop facility at Chromepet division fully dedicated to executing orders received from MICO.
Overall, we expect ELF’s domestic revenues to accelerate at a CAGR of 20.4% over FY06-09E, propelled by the increasing demand from the automobile industry, buoyant growth prospects of its clients and the broad-based product portfolio.
Exports to be the key driver
Exports have been the primary driver of ELF’s growth in the last three years, stepping up at a CAGR of 40% during FY02-05. The company now intends to leverage on the relationships built with major global clients over the years. It has also recently acquired a UK-based forging company, Shakespeare Forging, SFL, and is looking to tap SFL’s existing client base for the export of its products.
Going forward, we expect ELF’s exports to grow at a CAGR of 56.4% over FY05-09E from Rs 181.6 million in FY05 to Rs 695.8 million in FY09E. This amounts to an estimated 38.8% of net sales in FY08E up from 22.5% in FY05.
Scaling up the value chain
ELF is moving up the value chain by shifting its focus to machined components, which offer relatively higher margins (20-22% as against 12-14% for forged products). The company intends to raise the share of machined components to 50% of its revenues in the next three to four years from the current 20%. This will prove highly value accretive for the company and is expected to expand operating profit margins from 12.9% in FY05 to 15.2% in FY08E. Consequent to this, the operating profit is projected to witness a CAGR of 37.3% over FY05-09E as against a net sales growth of 30.3%.
Cost hikes transferable to clients
In the past, ELF has been able to pass on the increased cost of raw materials to clients by virtue of its superior services and sturdy client relationships. Thus, its operating profit margins have remained stable in the last two to three years, despite the high volatility in prices of steel, a key raw material for the company. ELF’s ability to transfer its increased cost burden to clients places it at an advantage to peers, who are forced to absorb the price hikes themselves and thus face margin pressure.
Boosting operational efficiency
ELF is undergoing a major reallocation of its manufacturing facilities, in order to rev up operational performance. The company currently has units spread across four locations in South India. Now, it plans to route its services solely through two main units - a new facility at Sriperumbudur (Chennai) and the existing unit at Hosur (Tamil Nadu), while disposing of the other three units at Chromopet, Thurapakkam and Gummidipoondi.
The new Sriperumbudur unit will be a state-of-the-art facility that will arm the company with superior technology necessary to meet higher-end client requirements. This facility will have six new press lines supported by induction heaters, and is expected to commence operations next month. The other unit at Hosur is also likely to be modernised in order to provide customers with value-added services.
The consolidation of facilities will improve manufacturing efficiencies through better outlay, handling and control. These measures will also improve asset utilisation levels leading to enhanced operational profits.
Focus on quality & process development
ELF is targeting higher productivity by making improvements in products and processes, developing new products, achieving high value addition and enhancing quality. The company has also set up a new team of skilled professionals to improve operational efficiencies. We believe these measures will help ELF meet the targets set by it, both in terms of quantity and quality.
Capacity to increase by 28%
ELF plans to raise its capacity to 23,200 MTPA from the existing 18,200 MTPA by FY07. The capital expenditure for its expansion-cum-modernisation programme is likely to be around Rs 400 million, which will spill over from FY05 to FY07. As a part of the financing process, the company had issued debentures last year which have now been converted into equity shares amounting to Rs 59 million.
ELF will also take a loan of Rs 220 million from banks while the balance Rs 121 million will be funded through internal accruals. We believe that the company will comfortably complete its ongoing expansion cum-modernisation project as per schedule.
Acquisition to create strong synergies
In July 2005 ELF acquired a 74% stake in UK-based forging company Shakespeare Forging, SFL, for a consideration of £3,50,000 (Rs 27 million). This will be paid in two instalments, partly through cash and partly through the issue of equity shares. As per the agreement, ELF will further acquire the balance 24% equity in SFL after three years (by July 2008).
Earnings to grow at 51% CAGR over FY05-09E
Considering all the parameters, we expect ELF’s net profit to post a CAGR of 45.4% over FY05-09E on a standalone basis, with a sustainable ROE of 35%. On a consolidated basis, the revenues are likely to grow at a CAGR of 36% over FY05-09E, while net profit is expected to grow at a CAGR of 51% during the same period. This translates to standalone EPS of Rs 18.4 and consolidated EPS of Rs 20.7 in FY08-09.
Investment concerns
We believe ELF carries a high foreign currency risk considering its strong reliance on export-driven growth.”
ELF manufactures smaller-weight forged components, and is thus exposed to competition from unorganised forging manufacturers. China is also a major threat in the international market, but this is somewhat offset by India’s technical manpower edge.
Automobile OEMs, global as well as domestic, are under increasing pressure to reduce input costs and improve their margins. In such a scenario, auto component vendors have a limited ability to pass on increases in input costs; this exposes them to volatility in raw material prices.
MICO to expand aggressively in India
The Bosch group (MICO’s holding company) has recently announced ambitious business expansion plans for the Indian market. The group proposes to invest Rs 18 billion in India between CY05 and CY08. A significant chunk of this investment is likely to be utilised for the expansion of the company’s automotive activities.
We are therefore positive about MICO’s growth prospects and expect its sales to grow at a 17% CAGR over CY05-07, on the back of an expected surge in demand for diesel cars/utility vehicles, and the requirement for compliance with Euro III norms in India.
About SFL
Shakespeare Forging, UK is primarily engaged in the auto ancillary business as a drop forger, and has an annual turnover of around £4.5 million. It also supplies forged components to mining companies, which is a relatively high margin business as compared to the auto ancillary segment.
A bulk of SFL’s products is manufactured in the UK and the balance is offshore.
Due to the unfavourable business climate for manufacturing in the UK, especially in auto ancillaries (due to high employment cost and overheads), SFL’s turnover has declined and it has been running into losses for the past few years. The rationale behind the acquisition was the shifting of the manufacturing base to India through ELF, with SFL concentrating on the stocking, sales, marketing and manufacture of select high value-add products. We believe this step will benefit both companies.
ELF to be a major beneficiary of MICO’s expansion plans
We expect the company to benefit immensely from the buoyant future prospects of its biggest client —MICO, which generates approximately 20% of ELF’s revenues. ELF manufactures flanges (approximately 28,000 pieces) for MICO and has set up a machine shop facility at its Chromepet division fully dedicated to executing orders from this client.
The Bosch group (MICO’s holding company) has recently announced ambitious business expansion plans for the Indian market. The group proposes to invest Rs 18 billion in India between CY05 and CY08. A significant chunk of this investment is likely to be utilized for the expansion of the company’s automotive activities. This leaves us optimistic about MICO’s growth prospects and we expect its sales to grow at a 17% CAGR over CY05-07, on the back of an expected surge in demand for diesel cars/utility vehicles, and the requirement for compliance with Euro III norms in India.
Exports to be a key driver
We expect ELF to leverage on the relationships built by its acquired company — UK based Shakespeare Forging, SFL — and to tap SFL’s existing client base for the export of its products. We see the share of exports rising to 22% of revenues in FY07 and 35% in FY09.
Moving up the value chain
ELF is moving up the value chain by focusing on machining components, which offer relatively higher margins (20-22% as against 12-14% for forged products). We expect the share of machined components to rise from 23% of revenues in FY06 to 35% by FY09. This will help the company to elevate its operating profit margin.
Focus on quality & process development
ELF is targeting higher productivity by making improvements in products and processes, developing new products, achieving high value addition and enhancing quality. The company has also set up a new team of skilled professionals to improve operational efficiencies. We believe these measures will help the company meet its targets, both in terms of quantity and quality.
Expansion plans on schedule
ELF has made a total investment of Rs 270 million in FY06 for its expansion-cum-modernisation programme. The company plans to invest an additional Rs 130 million in FY08 in order to raise its manufacturing capacity to 23,200 MTPA.
As a part of the financing process, ELF had issued debentures last year which have now been converted into equity shares amounting to Rs 59 million. ELF will also take a loan of Rs 220 million from banks while the balance Rs 121 million will be funded through internal accruals. We believe that the company will comfortably complete its ongoing expansion-cum-modernisation project as per schedule.
Reallocation of manufacturing facilities
ELF is undertaking a major reallocation of its manufacturing facilities in order to rev up operational performance. The company currently has units spread across four locations in South India. It now plans to route its production solely through two units — a new facility at Sriperumbudur (Chennai) and the existing unit at Hosur (Tamil Nadu), while disposing of the other three at Chromopet, Thurapakkam and Gummidipoondi. We expect the new Chennai facility to be operative by the end of September ’06.
Valuation
At the current market price of Rs 77, the stock is discounting its FY07E earnings by 6.0x and FY07E cash earnings by 5.2x on a standalone basis. On the EV/EBIDTA basis, the stock’s enterprise value is discounting its FY08E EBIDTA by 4.4x. On a consolidated basis, the stock is discounting its FY08E earnings by 5.5x. ELF’s valuations are attractive even on a comparative basis. It is trading at a 50-60% discount to peers and to the industry average. We believe this gap is unjustified.
ELF is a small-cap stock with a lot of steam left in it. The company is at the inflexion point and has the potential to grow tremendously. We believe that ELF’s aggressive plans are reasonable and will be achieved on schedule. Further, the acquisition of SFL has given it a strong platform to develop its market in Europe.
And the company’s plan to shift focus to machining components is a welcome step. We therefore initiate coverage on ELF with a Buy recommendation with a target of Rs 171 in a 12-month timeframe.
We Recommend a Strong Buy On El Forge For Medium To Long Term.
Important Disclaimer: Investment in equity shares has its own risks. Sincere efforts have been made to present the right investment perspective. The information contained herein is based on analysis and up on sources that we consider reliable. We, however, do not vouch for the accuracy or the completeness thereof. This material is for personal information and we are not responsible for any loss incurred based upon it & take no responsibility whatsoever for any financial profits or loss which may arise from the recommendations above.
Disclosure: This is just a recommendation, we are not inviting to act or buy or sell any instrument. This is just our research report. You should do your own research and BUY IT. Sources: Brics PCG Group