IT S ALL ABOUT MONEY, HONEY!

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1 Harig Crankshafts Ltd Unexplored gains Analyst Amar Ambani February 2005 Dealing Sandeepa Arora Biren Patel IT S ALL ABOUT MONEY, HONEY!

2 Recommendation BUY CMP Rs36 Target price Rs76 52 Week H/L Rs39/3 Market Cap Rs1,125mn Face Value Rs10 Avg. volumes 80,642 Shareholding pattern Share Price Chart (Since Jan2005) Share Holders % holding Promoters 28.5 Institutional Investors 15.1 Indian Public 3.4 Others 53.0 We are initiating coverage on Harig Crankshafts Ltd (HCL), which is set for a turnaround in Q1 FY06 post restructuring. We expect this to result in a topline growth of 336% yoy for HCL during FY06, based on segmental valuation. A change in business mix by concentration on value-added products leading to higher margins coupled with lower financial charges to boost bottomline. Post restructuring in FY05, the company will have zero debt on its balance sheet through equity substitution by way of preferential allotment of equity and warrants to foreign institutional investors (FII) and corporate bodies. Improved financial situation would enable it to avail off adequate working capital funds for optimum capacity utilization. HCL supplies forgings and crankshafts to heavy vehicles and is expanding capacities to meet future demand. It has pending orders from companies like Tata Motors and Ashok Leyland. Refurbishments to the plant are expected to double crankshaft production from Q1 FY06 onwards. A new line for machining subaxle and a machining crankshaft to commence production in Q1 FY06. Addition of a 4,000ton and a 2,500ton forging press line to enable cater to the passenger vehicles segment. The company is expected to operate at 100% of its capacity in forgings from the current level of 25% by Q4 FY06. The company is looking at acquiring a forging and crankshaft plant to gain a locational advantage of being close to its customers. It has a presence in the north and is looking for acquisitions in the west. It is in talks with a few companies and if an acquisition materializes it will give HCL the critical mass it needs to boost topline. NSE code N.L BSE code Reuters code HRIC.BO Bloomberg code HCS@IN Trading at a P/E of 4.6x FY07E earnings on the expanded equity base, a 4.6x FY07E EV/EBITDA and with a P/BV of 1.4x for the same period, the market is yet to discover HCL s true value. Trading volumes have been rising on the counter and we recommend investors to place their bets at the current market price of Rs36. Our 12-month target price of Rs76 for the stock represents an appreciation of 111% from current levels. Table: Financial snapshot FY03 FY04 FY05E FY06E FY07E Net Sales (Rs mn) ,180 1,782 Net profit (Rs mn) (739) (551) (10) Equity (Rs mn) Loan Funds (Rs mn) 2,295 2, EPS (Rs) (40.3) (30.0) (0.3) BV per share (Rs) (96.9) (126.9) P/E (x) P/BV (x) OPM (%) ROCE (%) RONW (%) Source: India Infoline estimates February 09,

3 Company background Harig India and Pradeshiya Industrial Corporation of Uttar Pradesh jointly promoted HCL in 1983 in foreign collaboration with Wilhelumus Import and Export Establishment of Germany. HCL manufactures crankshafts and performs forging applications for various companies in the automobile sector, particularly for tractors and commercial vehicles through its plant located in Noida. Its competitors include Amforge, Ahmednagar Forgings among others. However, unlike Amforge, Ahmednagar Forgings that are purely into forgings, HCL manufactures crankshafts for the automobile industry as well. HCL s clientele includes players like Tata Motors, Ashok Leyland, HMT Tractors, Escorts, Sonalika, Mahindra Gujarat among others. It also meets the requirements of the replacement market, where the company has a significant presence. The company mostly caters to the domestic market. During FY04, HCL exported Rs0.8mn goods through the indirect exports route to UK. However, this is set to change as it is looking to make the most of the outsourcing opportunities that come its way. It is in talks with Krupps of Germany, the largest manufacturer of crankshafts in the world to cater to their crankshaft forging demands. Talks with other companies are on as well, which will increase the proportion of revenues from exports. February 09,

4 Investment rationale Back in business with reorganization... HCL had plans to build a plant on a large scale and benefit from presence in the crankshafts business, which is a supply driven business in India. However, the company went sick before it could commission its plant. HCL posted losses for many years due to the high interest burden that it had to service. However, post financial restructuring -currently in progress- it will be back on track....debt restructuring to perk up balance sheet position HCL registered itself under BIFR and entered into a one-time-settlement with financial institutions to restructure the debt in its balance sheet. As on March 31, 2004, the company had Rs2.8bn debt on its balance sheet comprising principal, interest accrued and penalty. After discussions with ICICI, IDBI and IFCI, the institutions that it owed money, a settlement was reached where all of the interest and penalty was waived off and the company was required to repay the principal in three installments. Accordingly, Rs220mn approximately was required to be paid in three installments during Q2 FY05, Q3 FY05 and Q4 FY05 with the balance amount being waived off. Rs220mn consisted of principal of around Rs200mn and the balance Rs20mn was on account of interest, charged for the installment period. The company has paid around Rs120mn to the institutions and the balance will be repaid during Q4 FY05. In line with this scheme, HCL wrote-back interest liability in its books, which resulted in the networth of the company turning positive....preferential issue of equity and warrants to replace debt HCL had to generate cash to repay the Rs220mn it owed to institutions as per the arrangement between the parties involved. HCL therefore, decided to substitute its outstanding debt with equity by end of FY05 in order to generate the required cash. Accordingly, the company issued 11mn fresh equity of face value Rs10 each on a preferential basis at a premium of Rs4.25 per share to foreign institutional investors (FII), other institutional investors and corporate bodies. Another preferential issue of 9mn warrants of face value Rs10 each at a premium of Rs4.25 per warrant was made to the above mentioned parties. These warrants are convertible into equity of HCL within 18 months from date of allotment. During Q2 FY05, the company s equity increased by Rs34mn to Rs217mn and by Rs93mn in Q3 FY05 to Rs310mn. It issued the balance shares and warrants in January The company has hiked its FII limit to 50% of its paid up equity capital and increased its authorized share capital to Rs420mn from Rs350mn. February 09,

5 The company will receive Rs285mn through issue of preferential equity shares and warrants, including Rs85mn on account of share premium. HCL will use this money to pay off its liabilities by March 2005 and become a debt free company. Considering HCL s current market price of Rs36, we expect all warrant holders to convert their holdings into equity of HCL by March 31, This is because private placement was done at a price of Rs14.25 per share. This will increase the equity of the company to Rs384mn at the end of FY05 from Rs184mn in FY04 and the same has been factored into our estimates. Table: HCL s likely shareholding before and after preferential issue (%) Pre-issue equity Equity holding Equity holding post holding as on Aug post preferential conversion of 23, 2004 equity issue warrants Promoters Institutional Investors Others (including public) Partly paid shares are assumed to be fully paid and included for calculations Source: Company...Utilization rates to rise significantly Due to a negative networth and inability to service interest obligations on account of huge debt, the company could not get access to adequate funds to operate efficiently. The company constantly faced working capital problems and therefore, its plant could not operate at full utilization levels. In its forgings business, the company operated at 20-25% of its actual capacity (not installed capacity). In the high margin and supply driven crankshafts business too, the company could not de-bottleneck and operated at 45% of its installed capacity of 80,000 units pa. Post restructuring, the company s finances will be in better shape. The bankers have now agreed to provide the necessary amount of money as per HCL s requirements time-to-time for its working capital requirements. This will result in increase in utilization rates at its plant leading to lower fixed cost per unit and higher revenues. The company has begun availing of the funds available to increase production. We expect HCL s forging unit to operate at 45%, 75% and 100% capacity utilization by Q1 FY06, Q2 FY06 and Q4 FY06 respectively. We expect 100% capacity utilization in its crankshaft business throughout FY06. Table: HCL s plant capacity Capacities Licensed Installed Actual* Crankshafts (units) 80,000 80,000 80,000 Forgings (MT) 17,000 17,000 12,000 * Production level achievable Source: Company, Annual report February 09,

6 ...Turnaround in Q1 FY06 With restructuring of business in progress, we expect HCL to post a loss of Rs10mn during FY05. With higher capacity utilization during FY06 in both, cranskshafts as well as in forgings, we expect HCL to post a topline of Rs157mn in Q1 FY06. The higher utilization will be on account of greater access to funds for working capital needs. Lower interest expense, marginally higher operating margins due to lower fixed cost per unit and decline in staff cost as a percentage of sales are expected to result in a net profit during the quarter. While we expect the company to turnaround in Q1 FY06, the jump in topline growth will come from the Q2 FY06 and more so from Q3 FY06 onwards. Business model to undergo change......focus on high value crankshaft business HCL is in the business of forgings and manufacturing crankshafts for the auto sector. Crankshafts, especially the machined ones, are a high margin business generating around 25% margins. This is because it has a higher value addition and a supply driven market. On the other hand, forgings are a low margin business with around 10% operating margins. The company plans to shift focus from its forgings business and towards its crankshaft business. Currently, 65-70% of HCL s revenues come from its forgings business and the balance from the crankshaft business. The company is working on a model where, in the long run, forgings will be used for internal requirements only for production of value-added products. In line with this, it is focusing on increasing its machining capacity to meet growing demand. Eventually, it intends to have a capacity large enough for 100% usage of forgings for internal purposes. HCL primarily caters to the demand of the domestic market. It has a marginal presence in exports and that too, through the indirect route. In future, the company is planning to supply abroad by cashing in on any outsourcing opportunity that comes its way. It is in talks with Krupps of Germany, which is the world s largest manufacturer of crankshafts, for catering to its forgings requirements. In the domestic business too, it is looking to shift its focus from the replacement market to the OEM market. It will cater to different segments within the auto sector to broaden customer base. It is in talk with M&M for providing forgings for their engines. From the current 50:50 revenue mix from tractors and commercial vehicles, tractor supplies will gradually fall as a proportion of total revenues. February 09,

7 ...Capacity expansion in progress The company, in the past, was forced to put its growth plans on the back burner because of high debt. Now, with a healthier balance sheet, it has tuned back to focus on its operations. The company is planning to add to its capacities by incurring a capex of Rs500mn during FY06. For this reason, the company plans to raise debt of the same amount during the year through issue of term loans or debentures. HCL has a 6,000ton press line for forgings, which produces 250tons per month. With de-bottlenecking, the company will be able to produce 750tons per month by June We expect the company to produce 1,000tons forgings per month by Q4 FY06, which is 100% of its achievable capacity of 12,000tons pa. HCL is presently into large forgings, meeting the requirements of large vehicles and not those of passenger vehicles. It is therefore adding a 4,000ton press line and a 2,500ton press line to its forging capacity. This will become operational from September 2005 and HCL will be able to supply forgings to passenger vehicles as well. HCL has an installed capacity of 80,000 crankshafts pa. However, as the plant needed refurbishment, the company was able to produce only 3,000 crankshafts per month earlier. The refurbishing exercise is in progress and expected to be completed by March 31, 2005 at a cost of Rs40-50mn. Refurbishing added with balancing equipment will enable the company to produce 100% of its installed capacity in FY06. Further, the company is adding one machine line for sub-axles and another machine line for crankshafts. Both the lines will be installed by Q1 FY06 and ready for production. The machine line for sub-axles will entail a cost of Rs30mn and the one for crankshafts will cost Rs120mn. HCL has already received an order for supply of 10,000 sub-axles every month from Tata Motors. Table: HCL s expansion schedule Exercise Completion of task by 6,000ton press line for forgings De-bottleneck June 30, ,000ton press line for forgings New set-up September 30, ,500ton press line for forgings New set-up September 30, ,000 crankshafts De-bottleneck March 31, machined line for sub-axles New set-up March 31, machined line for crankshafts New set-up March 31, 2005 Source: Company February 09,

8 ...Inorganic growth will add value One of the important factors for achieving success in auto components business is to have locational advantage. It means that the supplier has to be close to its customers. HCL has a good presence in north India as it has its plant at Noida. It is now looking to establish itself in the west as well. For this reason, it is on the look out for acquisition targets to ramp up critical mass. It is presently in talks with various companies for the same. It is looking for a forgings company with around Rs200mn topline and a machining plant with a topline of Rs100mn approximately. The most important criteria being that these companies should be located close to the customers HCL supplies to. This will cost the company Rs mn, which will be used from the Rs500mn debt raised. Acquisition of two of such plants will result in Rs300mn addition to its topline, partly factored into our estimates....topline expected to grow by 336% in FY06 With adequate funds available for its working capital requirements and additions to capacities and its business portfolio, we expect a 336% yoy jump in topline in FY06 to Rs1,180mn. In our estimates, we have assumed HCL s 6,000ton press forgings line to operate at 45% utilization level during Q1 FY05, 75% from June 2005 onwards and 100% from Q4 FY06 onwards. Post refurbishing and addition of balancing equipment, we expect 100% utilization of the installed capacity of crankshafts throughout the year. The company has recently started supplying to the Tata 407. It has also bagged an order for supply of 10,000 sub-axles per month to Tata Motors from Q1 FY06 onwards. It is in talks with Mahindra & Mahindra for their forging requirements in their auto-ancillary business. Pending orders from Tata Motors and Ashok Leyland will ensure full production at its plant. The 4,000ton and 2,500ton press line will add to topline from September 2005 onwards. If talks of takeover of other companies close to HCL s customers materialize, they will contribute around Rs300mn to topline. Chart: HCL s expected quarterly topline in FY06 (Rs mn) Q1 FY06E Q2 FY06E Q3 FY06E Q4 FY06E Source: India Infoline estimates February 09,

9 Operating margins to improve in FY06 HCL is gradually shifting its focus towards the crankshaft business. Within this segment, it is looking at value-added machined crankshafts to generate higher margins. The crankshaft business generates operating margins of around 25%. On the other hand, forgings are a low margin business with around 10% operating margins. There is a shortage in supply and with no capacity additions coming in by other players, the company is confident of 100% utilization at its plant. Higher realizations from supply of value-added products will add to topline. Increased capacity will ensure lower fixed cost per unit. In addition, we expect the company to save heavily on staff cost which is expected to fall to 5.1% of net sales in FY06 as against expected 11.3% of net sales in FY05. We therefore expect a significant rise in operating margins by 785bps yoy during FY06 from estimated margins of 14.7% in FY05. Chart: HCL s operating margin trend (%) FY02 FY03 FY04 FY05E FY06E FY07E Source: Company data, India Infoline estimates Bottomline set to shoot up, improvement in ratios Significant increase in expected topline during FY06 and FY07, higher operating margins and lower financial charges on account of restructuring is expected to result in healthy bottomline growth for the company. With the company expected to be a zero tax paying one for the next 2-3 years and profits up to Rs500mn approximately, will further boost bottomline. We expect HCL to post a net profit of Rs173mn during FY06 compared to an expected loss of Rs10mn during FY05. Table: Improved ratios FY02 FY03 FY04 FY05E FY06E FY07E EPS (Rs) (22.2) (40.3) (30.0) (0.3) BV per share (Rs) (87.8) (96.9) (126.9) EV/PBIDT (x) OPM (%) ROCE (%) RONW (%) (1.9) Source: India Infoline estimates February 09,

10 Attractive valuations HCL is a turnaround story, which is yet to be unveiled by the market. The company has regrouped and has significant growth potential in the next few years. With strong clientele and pending orders, healthier balance sheet post restructuring, additions to capacities and segments, HCL is a low priced stock at current levels. The stock is trading at P/E of 4.6x FY07E earnings on its increased equity base. RONW and ROCE ratios are expected to improve significantly during FY06 and FY07. Based on expected RONW ratio in future and a low P/BV of 1.4x FY07E earnings, we recommend a BUY at the CMP of Rs35 with a 12-month target price of Rs76. Table: Peer comparisons Sales Net profit OPM (%) Equity FV (Rs) CMP (Rs) P/E (x) (Rs mn) (Rs mn) (Rs mn) Bharat Forge 14,739 2, , Amforge 2, Amhednagar Forgings 2, HCL 1, Sales, net profit and P/E are based on FY06 estimates. Peers may not be comparable on one or more parameters due to different business mix. Source: India Infoline estimates Latest Financials Period to 12/04 12/03 Growth 12/04 12/03 Growth (Rs mn) (3) (3) (%) (9) (9) (%) Sales Expenditure (71) (41) 71.7 (167) (121) 38.2 Operating profit Other income Interest 1 (143) - (15) (375) (95.9) Depreciation (8) (8) 0.2 (23) (23) 0.5 PBT (0.1) (144) - (11) (374) (96.9) PAT (0.1) (144) - (11) (374) (96.9) OPM (%) Equity HCL wrote-back provision on term loans for the previous quarter during Q2 FY05 to the tune of Rs80.7mn. This was done after releasing the first installment of the onetime-settlement amount as agreed by all the financial institutions. Operating margins were down during Q3 FY05 to 8.2%. This was lower due to rise in raw material cost as a percentage of net sales. The company had not increased prices for its forging supplies to OEM s during the quarter. However, it will be passing on these price increases to its customers during Q4 FY05 and the operating margin in the last quarter will be significantly higher than Q3 FY05. February 09,

11 Concerns Delay in implementation The key risk to our recommendation is a possible delay in implementation of the company s expansion plans. If this were to occur, it would significantly hamper our topline estimates for FY06. Input cost concerns Steel is a major input cost for HCL. Shortage of steel and high prices threatens to dampen margins of the company. However, this may not be a serious threat as the company is planning to focus on the high margin crankshaft business. Further, the industry expects steel prices to soften in the long-term. Chart: HCL s input cost break-up 1% 17% Steel 4% Source: Company data 78% High tension bolts Semi-finished goods Stores and spares Slowdown in user industries The demand scenario in user industries holds the key for growth of forgings or crankshafts. Automobiles account for the significant portion of revenues for the company s forgings and crankshaft business. Automobiles sector is a cyclical one and any slowdown in the cycle would directly affect revenues of HCL. February 09,

12 Industry scenario With growing demand from the domestic market and huge outsourcing potential due to cheap and skilled labor, the auto-ancillary sector has gained importance over the last few years. Automobiles, consumer durables and construction sector are major forgings user sector. With growth in the economy and the automobiles segment particularly, forgings and crankshafts have witnessed rising demand. There has been an improvement in business confidence and investor confidence in India. This coupled with an upbeat global economy has driven demand. Today, OEM s are focusing on designing and marketing and outsourcing 75-80% of their requirements to vendors. With players like General Motors, Krupps and Ford looking to outsource their requirements to Indian companies through joint ventures and collaborations, opportunities are immense. This is where companies offering value-added products stand to gain. Crankshaft business is a high margin one and the market is supply driven. With no new capacity additions and the product already in shortage, the outlook for suppliers of crankshafts is positive. Rising income levels, easy financing options, low per capita penetration and better infrastructure will drive growth for automobiles in India and consequently demand for forgings and crankshafts. Management profile Like mentioned earlier, HCL was promoted by Harig India and Pradeshiya Industrial Corporation of Uttar Pradesh in collaboration with Wilhelumus Import and Export Establishment of Germany. Mr. Deshbir Singh is the managing director of HCL and the Chairman of the Harig Group of companies. His qualifications include B.Tech (Hons) Mech. IIT, Kharagpur and MS (Mech. and Aerospace), IIT, Chicago. He is 63 years of age and has over 40 years experience in engineering automotive industry in India and USA. He is a member of various government and non-government bodies like Confederation of Indian Industry (CII). Table: HCL s board members Name Designation Mr. Deshbir Singh Managing Director Mr. J.W. Tetteroo Director Mr. Anil Sharma Director Mr. N.S. Parulekar Director Mr. Devender Singh Director Mr. Vasudev Bablani Nominee IDBI Mr. N. Sinha Director Mr. S.M. Bathe Nominee BIFR Source: Company annual report February 09,

13 Income statement Period to FY03 FY04 FY05E FY06E FY07E (Rs in mn) (12) (12) (12) (12) (12) Net Sales ,180 1,782 Operating expenses (153) (168) (231) (914) (1,376) Operating profit Other income PBIDT Interest (443) (555) (20) (45) (41) Depreciation (30) (31) (31) (47) (55) Profit before tax (PBT) (453) (551) (10) Profit after tax (PAT) (453) (551) (10) Extraordinary / prior period items (287) Adjusted profit after tax (APAT) (739) (551) (10) Balance Sheet Period to FY03 FY04 FY05E FY06E FY07E (Rs mn) (12) (12) (12) (12) (12) Sources Share Capital Reserves (1,961) (2,512) Net Worth (1,777) (2,329) ,054 Loan Funds 2,295 2, Total ,243 1,507 Uses Gross Block ,192 1,323 Accd Depreciation (275) (305) (336) (383) (438) Net Block Capital WIP Total Fixed Assets Total Current Assets ,347 Total Current Liabilities (79) (85) (99) (482) (726) Net Working Capital Total ,243 1,507 February 09,

14 Cash flow statement Year to (Rs mn) FY04 FY05E FY06E FY07E Net profit before tax and extraordinary items (551) (10) Depreciation Interest expense Operating profit before working capital changes Add: changes in working capital (Inc)/Dec in (Inc)/dec in sundry debtors (8) (16) (200) (135) (Inc)/dec in inventories (3) (40) (473) (292) Inc/(dec) in sundry creditors Net change in working capital (5) (42) (290) (182) Cash from operating activities 29 (1) (23) 225 Net cash from operating activities 29 (1) (23) 225 Cash Profit 29 (1) (23) 225 Cash flows from investing activities (Inc)/Dec in fixed assets (2) (12) (491) (131) Net cash from investing activities (2) (12) (491) (131) Cash flows from financing activities Inc/(Dec) in debt 530 (2,825) 501 (48) Inc/(Dec) in equity/premium Direct add/(red) to reserves 0 2, Interest expense (555) (20) (45) (41) (inc)/dec in loans & advances 1 (14) 26 (3) Net cash used in financing activities (24) (91) Net increase in cash and cash equivalents 3 8 (7) 3 Cash at start of the year Cash at end of the year February 09,

15 Ratios FY03 FY04 FY05E FY06E FY07E (12) (12) (12) (12) (12) Per share ratios EPS (Rs) (40.3) (30.0) (0.3) Div per share Book value per share (96.9) (126.9) Valuation ratios P/E P/BV EV/sales EV/ PBIT (235.7) EV/PBIDT Profitability ratios OPM (%) PAT (%) (429.4) (275.7) (3.8) ROCE (%) RONW (%) - - (1.9) Liquidity ratios Current ratio Debtors days Inventory days Creditors days Leverage ratios Debt / Total equity Component ratios Raw material Staff cost Other expenditure Notes We expect the company to be exempt from taxes up to a net profit of around Rs500mn for the next 2-3 years. Partly paid equity shares are assumed to be converted into fully paid shares in FY06. If this were not the case, the EPS for FY06E and FY07E earnings would have been Rs4.5 and Rs8.1 respectively. It is assumed that no dividends will be paid during the next two years. February 09,

16 Our Recent Publications IndusInd Bank Ltd Investment Update - February 03, 2005 ICICI Bank - E(I)nsuring growth - February 01, 2005 Mangalam Cement Ltd - Right mix for moving northward - February 01, 2005 Kirloskar Oil Engines Ltd - Investment Update - January 12, 2005 Indo Asian Fusegear Ltd - Investment Update - December 29, 2004 Toll Free info@5pmail.com 5paisa.com is the trade name of India Infoline Securities Pvt Ltd (IISPL), a wholly owned subsidiary of India Infoline Ltd. Our research reports are available on First Call Research Direct/ Thomson Financial and Bloomberg (code: IILL). IISPL is a member of the National Stock Exchange of India (NSE) and The Stock Exchange, Mumbai (BSE). IISPL is also a Depository Participant with NSDL. Published in February All rights reserved. India Infoline Ltd Reference No: IIL/CR01/03/02 This report is for information purposes only and does not construe to be any investment, legal or taxation advice. It is not intended as an offer or solicitation for the purchase and sale of any financial instrument. Any action taken by you on the basis of the information contained herein is your responsibility alone and India Infoline Ltd (hereinafter referred as IIL) and its subsidiaries or its employees or directors, associates will not be liable in any manner for the consequences of such action taken by you. We have exercised due diligence in checking the correctness and authenticity of the information contained herein, but do not represent that it is accurate or complete. IIL or any of its subsidiaries or associates or employees shall not be in any way responsible for any loss or damage that may arise to any person from any inadvertent error in the information contained in this publication. The recipients of this report should rely on their own investigations. IIL and/or its subsidiaries and/or directors, employees or associates may have interests or positions, financial or otherwise in the securities mentioned in this report. India Infoline Ltd, 24 Nirlon Complex, Off Western Exp. Highway, Goregaon(E). Mumbai -63. Tel Fax it s all about money, honey!