Primary Offer. Varroc Engineering: Bright prospects

The demonetisation and GST hiccups turned out to be only temporary blips for auto and auto component stocks, which have had a relatively smooth run in the last few years. As a result, the valuation multiples of many of these stocks, especially in the mid-cap space, have shot up. The good growth prospects for the domestic industry have added to the merry.

Varroc Engineering, an auto component player is coming out with its IPO at a time when the industry is in a sweet spot. But thankfully, the offer is not forbiddingly expensive.

At the price band of ₹965-967, the PE (price-to-earnings) ratio for the issue works out to about 29 times the company’s consolidated earnings for the year-ended March 2018.

This valuation multiple is much lower than that of mid-cap peers such as Endurance Technologies (which now trades at 46 times).

Investors with a high-risk appetite can subscribe to this IPO. A diversified product, client and geography mix, reasonable valuation, and scope for improving profitability make the offer attractive.

There are no immediate or short-term triggers for those looking to make a quick buck and, hence, only investors with a two to three-year perspective must consider taking exposure.

The entire issue is an offer for sale from the promoter and private equity investors, amounting to ₹1,951-1,955 crore.

The business

Varroc Engineering is a tier-1 supplier of exterior lighting systems, plastic/polymer, electrical, electronic and precision metallic components to the car, two-wheeler and three-wheeler industry in India and abroad. Its global business is predominantly in the lighting space, obtained through the acquisition of Visteon in 2012 (now renamed Varroc Lighting Systems).

The company derives 60-65 per cent of its consolidated revenues from this segment and counts Jaguar Land Rover, Renault, Volkswagen, Daimler , Ford and PSA among its clients. About 30-35 per cent of the consolidated business comes from the supply of polymer, metallic and electric components to customers in India.

This list includes two/three-wheeler makers such as Bajaj Auto, Royal Enfield, Piaggio, Honda, Hero and Harley Davidson. Much like its peers mentioned above, the company follows an inorganic growth strategy. It has recently executed an agreement to acquire another four-wheeler lighting business in Turkey.

Prospects

The global passenger vehicle market is expected to grow at a compounded rate of 2 per cent over 2016-21, influenced predominantly by the slower growth in mature markets such as Europe, North America and Japan.

However, the global automotive exterior lighting market is expected to grow at 4.3 per cent during the same period, thanks to increasing lighting content in vehicles.

Far from having only a functional use, lighting today is a design and aesthetic feature and plays a critical role in ensuring safety and energy efficiency.

Trends such as connectivity between cars and autonomous driving, which are catching on globally, also call for higher lighting content per vehicle.

Varroc is the sixth largest player in the global automotive lighting business and with marquee clients under its belt, will benefit from these trends.

It has a comprehensive product portfolio across lighting technologies such as halogen, xenon and LED.

While this business brings high single-digit margins currently, the company expects it to move to 12-13 per cent in three to five years’ time.

According to the management, increased content per vehicle, scale from any future acquisitions, higher penetration of the more profitable LED lights as well as vertical integration through in-house supply of lighting electronics will help improve the margins.

Prospects appear sunny for the Indian business too. Cash crunch from demonetisation and hiccups due to the BS-IV/GST transition took the wind out of two-wheeler sales in 2016-17.

But the segment regained momentum in 2017-18, posting a 15 per cent volume growth.

This trend has continued into the first two months of this fiscal as well. Rising affordability of the urban consumer and traction in rural demand are positives for two-wheeler sales.

Besides, with Royal Enfield and Harley Davidson among its clients, Varroc will also be a beneficiary of the increasing preference for premium bikes among Indians.

For three-wheelers, opening of auto rickshaw permits from time to time as well as the catching on of the hub and spoke model — where small commercial vehicles are used for last mile connectivity — will keep sales volumes going.

Financials

The company’s revenues have grown at a compounded growth rate (2015-2018) of 14.3 per cent to ₹10,379 crore for the year-ended March 31, 2018. For the year ended March 2018, the company recorded a net profit of ₹451 crore.

The growth in net profit over 2015-18 is not meaningful as it has been impacted by revaluation of debt portion of the convertible preference shares in fiscals 2015, 2016 and 2017 (shown as finance costs).

Hence, the operating profit growth paints a more realistic picture. Since fiscal 2015, its operating profit has shown a 12.5 per cent growth to ₹877. 5 crore.

Consolidated operating margins since fiscal 2015 have hovered around 6-8.8 per cent. However, with the global margins expected to better, this number may improve in the coming years.

The convertible preference shares have since been converted to equity.

Considering its global exposure, the dent in profits from time to time due to currency fluctuations is a risk.

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