Verdict: Value for long term investors

IPO Snapshot:

Varroc Engineering is entering the primary market on Tuesday 26^th June 2018, with an offer for sale (OFS) of up to 2.02 crore equity shares of Re.1 each by promoters (9% of OFS) and PE investor Tata Capital (91% of OFS), in the price band of Rs. 965 to Rs. 967 per share. Representing 15% of the post issue paid-up share capital, total issue size is Rs. 1,955 crore at the upper end of the price band. Issue closes on Thursday 28^th June and listing is likely on 6^th July.

Company Overview:

Varroc Engineering, promoted by Rahul Bajaj’s nephew and Endurance Technologies’ Anurang Jain’s identical twin Tarang Jain, is a tier 1 auto component maker (supplying to original equipment manufacturers). Its business can be geographically broadly divided as under:

1. International business: exterior lighting products for global passenger vehicles, accounting for 64% of FY17 consolidated revenue of Rs. 9,600 crore. Company is world’s 6^th largest auto lighting company with above 4% global market share. Within the electric vehicle (EV) space, it enjoys a strong presence with 20% market share. As per information gathered from our sources, it counts the world’s premier EV company Tesla as one of its key clients, estimated to be having roughly Rs. 900 crore of sales or approximately 8% of consolidated turnover, which is quite substantial and assuring.
2. Domestic business: plastic/polymer, electrical/electronics and precision metallic components for 2 and 3 wheelers in India, accounting for 33% of annual topline. Company’s largest customer Bajaj Auto comprises of 18% of consolidated revenues or 50% of domestic revenues. Besides, it caters to all major domestic 2 wheeler makers such as Honda, Royal Enfield, Yamaha, Suzuki, Hero.

Company has 36 plants across low-cost manufacturing countries such as Mexico, Czech Republic, China (2 plants through 50% JV), India (25 plants), and 4 more are under development in Brazil and Morocco, likely to get operational in FY19. Given its global presence, revenue stream is geographically diversified with 42% coming from Europe, 35% from India and 22% from North America. Last month, company has entered into an agreement to acquire a Turkish external automotive lighting company, which is awaiting local regulatory nod. It also invests well in R&D, which accounted for 4.5% of FY18 revenue, up from 3.8% in FY17.

Objects of Issue and Shareholding Pattern:

Since the issue is 100% OFS, no funds will flow into the company. Tata Capital is making a complete exit on its 4 year investment, at an IRR of 292%, which is extraordinary and unheard of. To put it differently, this investment has returned the PE investor a compounded return of 56% per annum, which is mind-boggling, to say the least! Post IPO, promoter holding will shrink to 85.00%, from current 86.30%.

Financial Performance:

Company’s financial performance has improved steadily, with 5 year revenue CAGR of 20% and EBITDA CAGR of 30%, as EBITDA margins strengthened to 9.6% from 6.3% in FY13. On FY18 consolidated revenue of Rs.10,278 crore (up 11% YoY), EBITDA stood at Rs. 984 crore (up 31% YoY), while net profit was reported at Rs. 451 crore (up 49% YoY), translating into an EPS of Rs. 33.40, on an equity of Rs. 13.48 crore, of face value Re. 1 each. While FY18 RoE was heathy at 16% (up from 14% in FY17), net margins at 4.3% are still low, as significant chunk of operations are undertaken in the overseas markets. As of 31-3-18, net worth stood at Rs. 2,828 crore, while total debt was at Rs. 980 crore. Excluding cash and equivalents of Rs. 331 crore, net debt to equity ratio of 0.23:1 is comfortable.

Valuation:

At Rs. 967 per share, company’s market cap will be Rs. 13,036 crore, with EV of Rs. 13,685 crore, discounting FY18 earnings by PE and EV/EBITDA multiples of 29x and 18x respectively, which are among the lowest in the peer comparison table below:

^Based on closing prices as of 22-6-18 

Although Varroc’s revenues are significantly higher than both Bharat Forge and Endurance Technologies, its margins are much lower, leading to lower valuation multiples for itself, both in terms of PE and EV/EBITDA. Minda Industries, India’s 3^rd largest auto lighting player, with market leading positions in the domestic auto switch and horn segments also has superior margins vis-à-vis Varroc, justifying its higher multiples. Smaller auto lighting maker, DK Jain group company Lumax Industries, with 60% domestic market share and Japan’s Stanley as a JV partner, has much lower topline, but comparable margins of 9% at EBITDA level and 4% at net level, with similar PE of 28x, its FY18 earnings, as Varroc.

Thus, domestic focused auto component makers witnessing higher growth, especially on the passenger and utility vehicle side, are enjoying premium valuations on the bourses currently, a piece which is missing in Varroc’s product basket. Even in the domestic market, its key client is Bajaj Auto, which did not have a good run in FY18, although sales in first 2 months of the current fiscal were encouraging. Varroc’s operations are more inclined towards the mature global markets, where auto sector is expected to clock low single digit growth, as against high single-to-double digit growth in India. However, being future-ready with sizeable market share in the EV space bodes well for Varroc. Sound fundamentals and attractive pricing (PE multiple for of 23x and EV/EBITDA multiple of 11x, based on FY19E earnings) are added positives. Moreover, low floating stock post-listing, due to high promoter holding of 85% may keep valuations rich, as was seen in the case of Endurance Technologies, when listed about 20 months ago, with promoter shareholding of 82.50%.

Conclusion:

Company has demonstrated healthy growth historically, and its fundamentals remain sound. However it still has significant ground to cover in terms of improving margins and making inroads into the high-growth domestic passenger vehicle OEMs. Considering positive view on auto sector coupled with issue not being aggressively priced, one can apply in the IPO, preferably with a medium to long term view.

Disclosure: No interest.