J K Industries (JKIND)

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1 February 18, 2008 Tyres Initiating coverage J K Industries (JKIND) Spreading growth J K Industries (JKT), the third largest tyre manufacturer in India, is boosting capacities to capitalize on volume expansion in the industry. Increasing demand for passenger vehicles (PVs) and commercial vehicles (CVs), and capacity expansions by auto manufacturers have resulted in soaring demand for tyres. The divestment of its investment business into a separate company and focus on the core tyre business is expected to bring a substantial improvement in the company s financial performance, which are already visible in the results of the last two quarters. Increasing demand to drive growth Soaring demand from OEMs (original equipment manufacturers) as well as replacement market, offers a great opportunity to leading player like JK Industries. We expect the company to clock a 38% CAGR in sales volumes and 13% CAGR in sales over FY07-10E. Capacity expansion to support demand growth The company is expanding capacity by ~ 40% during FY07-11 to 12 million tyres at a total capital expenditure of Rs 1,180 crore in two phases. The enhanced capacities would give it leverage to meet increased demand. Improving financials, EBITDA margins to expand JK Industries quadrupled its net profit to Rs 66.7 crore in FY07, with EBITDA margins improving to 9%. Going forward, we expect a 23.1% CAGR in net profit to Rs crore over FY07-10E on the back of improving product mix and increased focus on high-value, high-margin radial tyres. EBITDA margins are expected to rise to 10.6% during the same period. Valuations The share is currently trading at 5.7x and 5.3x its FY08E and FY09E EPS. On an EV/EBITDA basis, it is trading at 5.2x and 4.5x FY08E and FY09E. Given the strong growth outlook and improving return ratios, we feel the stock deserves a higher valuation. We have underplayed the threat of a slowdown in CV sales (major contribution to sales) as well as price fluctuations in key raw materials. We have valued the company on a conservative basis at 5.5x its FY09 EV/ EBITDA to arrive price of Rs 183 for its core business (on postdiluted equity by around 33%). The recently divested Netflier Finco is listed on bourses, and discounting it by 20% to the current price, we value it at Rs 11 per share. A SOTP valuation gives us a target price of Rs 194. Current price Rs 134 Potential upside 44.8% OUTPERFORMER Analysts Names Supriya Khedkar supriya.khedkar@icicidirect.com Sanjay Manyal sanjay.manyal@icicidirect.com Sales & EPS trend Net Sales Rs c r 4,400 3,800 3,200 2,600 2,000 Target price Rs 194 Time Frame months FY06 FY07 FY08E FY09E FY10E Stock metrics Promoters Holding 47.0 Market Cap Week H/L 205 / 100 Sensex 18,101 Average Volume Comparative return metrics Stock return 3 M 6M 12M Apollo Tyre Ceat JK Tyre NA EPS Rs. Exhibit 1: Key Financials Year ending September FY06 FY07 FY08E FY09E FY10E Net Profit (Rs crore) Equity shares (crore) EBITDA margin (%) EPS (Rs) PER (x) P/BV (x) Price/sales (x) EV/EBITDA (x) ROCE (%) ROE (%) Price Trend Mar-07 Apr-07 May-07 Absolute Sell Target Price Absolute Buy Jun-07 Jul-07 Aug-07 Sep-07 Oct-07 Nov-07 1 P age Dec-07 Jan-08

2 Company Background JK Industries, a Hari Shankar Singhania Group company, is the third largest tyre manufacturer in India, with an overall 17.6% market share. The company has four plants, two in Karnataka, and one each in Rajasthan and Madhya Pradesh. By the end of 2007, the company had total manufacturing capacity of around 8.6 million tyres. It now plans to raise the same to 12 million tyres in two phases at total capital outlay of Rs 1,180 crore. JK Industries hold major share in M&HCV (medium and heavy vehicles) tyres (22.7%) and passenger car tyres (18.4%) segments. It has significant share of export revenue in its gross sales with exports contributing around 14% of gross sales Share holding pattern Shareholders % Holding Promoters 47.0 Institutional investor 16.1 Other Investors 19.7 General public 17.3 Promoter & Institutional holding trend (%) /12/ /03/ /06/ /09/ /12/2007 Exhibit 2: Revenue break-up Total of Promoter Non Promoter (Institution) Exports 14% OEMs State 7% transport 6% Government 7% % to Revenues Replacement market 66% CVs 77% Segment contribution (%) PVs 22% Others 1% Source: Company, ICICIdirect Research ICICIdirect Equity Research 2 P age

3 INVESTMENT RATIONALE Increasing demand to drive growth JK Industries is the leading tyre manufacturer and has presence in both the CV and PV segments, with a market share of 22.7% and 18.4% respectively. It has also emerged as the largest exporter of India for FY07 with exports at Rs crore. Though FY08 started with subdued growth in M&HCV sales, LCV and PV sales were rising continuously. We believe that LCV to rise at a CAGR of 10%, M&HCV at 8% and PVs at 11.3% over FY07-12E on the back of the following factors. 1. Good economic growth supported by rising GDP and industrial production, a key demand driver for commercial vehicles 2. Capacity expansion programs of almost all Indian automobile companies 3. Softening of interest rates Exhibit 3: Volume expansion in automobile sector (Lakh nos) Category FY06 FY07 FY08 FY09 FY10 FY11 FY12 CAGR (07-12E) Passenger Cars % Utility Vehicles % MPVs % Total passenger Vehicels % M&HCVs % LCVs % Total Commercial Vehicles % Three Wheelers % Scooters % Motorcycles % Mopeds % Electrict Two Wheelers % Total Two Wheelers % Grand Total % 3 P age

4 Blue-chip clientele to help garner larger share of incremental demand JK Industries is a major supplier to almost all Indian OEMs, which include Maruti Suzuki, Mahindra & Mahindra, Tata Motors, Force Motors and Volvo. The company is the exclusive supplier to Mahindra s Logan and Maruti s Sx4, Swift, Estilo. For Maruti s other variants, it is the leading supplier. Sales of these vehicles are growing at a rapid space and would support direct demand for tyres at present as well as in replacement market in the coming period. The company is strong in research and development efforts (R&D) and has developed a new tyre for Tata Motor s Nano, which can meet the latter s cost-cutting criteria. We believe, JK Industries would meet around 25% of Nano s requirements in the initial phases. The company supplies to all the major OEMs in India and has good market share in replacement segment. The company has well positioned itself to garner higher share of the incremental demand going forward. Exhibit 4: JK Industries market share in various segments Market share in M & HCV segment Apollo Tyres 29% Others 1% MRF Ltd 20% Its leading position would enable JK Industries grab higher market share from incremental demand Birla Tyres 9% Source: Crisil Research Ceat Ltd. 15% JK Tyre 23% Goodyear India 3% Market share in PV segment MRF Ltd Others 22% 27% Apollo Tyres 16% Ceat Ltd. 5% JK Tyre 18% Goodyear India 12% Source: Crisil Research 4 P age

5 Replacement market: A major growth segment JK Industries derives around 66% of its revenue from the replacement market and 14% from exports. Following chart depicts revenue contribution from various segments. Exhibit 5: Revenue contribution Exports 14% Replacement market 66% OEMs 7% State transport 6% Government 7% The replacement market is a major growth segment for any tyre player as volumes and realizations are comparatively higher here as compared with OEMs. Replacement period vary from vehicle to vehicle and the replacement cycle for various vehicles is as tabulated below. Exhibit 6: Replacement cycle for tyres Vehicle type Tyres per vehicle Replacement (tyres pa) Truck and Bus Tractor Front Trctor Rear Tractor trailor LCV Car Jeep Motorcycles and 3 Wheelers Moped We have considered CVs and PVs in our calculations and not accounted the likely demand from tractors, trailers and OTR due to 5 P age

6 lack of data. We have also ignored demand from 2- and 3 wheelers, as JK Industries does not cater to this segment. Exhibit 7: Demand growth from CV and PV segments (Lakh nos.) FY05 FY06 FY07 FY08E FY09E FY10E CAGR (FY07-10E) OEM Growth (%) Replacement Growth (%) JK Industries is well positioned to garner a higher market share from OEM as well as replacement market Total Growth (%) Capacity expansion to garner higher share of incremental demand To benefit from the rising demand, J K Industries is expanding capacities. In FY07, it increased capacity from 7.6 million tyres to around 8.5 million at capital expenditure of Rs 224 crore. The company would spend another Rs 360 crore to hike its capacity to 10 million tyres by FY09 and Rs 120 crore to increase its OTR capacity for BEML. The company is also considering to increase its total capacity to 12 million tyres by FY11 and is likely to spend around Rs 700 crore for the same. Thus, total capacity would increase by around 40.5% over FY07-11E. Radial tyres provide additional mileage as well as savings in fuel. The company has major presence in PV radials and now with increasing radialisation levels in truck and bus segment, it has undertaken capacity expansion in truck and bus radials. It is also increasing PV radial capacity. The radial tyres are comparatively costlier than bias tyres, and increasing contribution from radial tyres would help the company expand its top line as well as margins. Exhibit 8: Radialisation levels (%) Segment FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY010E Passenger cars LCV Truck & Buses Source: CRISIL Research Exhibit 9: Capacity expansion (Lakh nos.) Type FY07 FY08E FY09E FY10E FY11E Truck bias Truck radials PV bias PV radials Speciality tyres OTR Total Source: Company 6 P age

7 Arrangement with BEML JK Industries have entered through a tri-party arrangement with BEML (Bharat Earth Movers Ltd) and Apollo Tyres to manufacture OTR (off the road) tyres, according to which both JKT and Apollo Tyres would have a separate facility for manufacturing OTR for BEML. The OTR segment yields high margins on account of higher level of customizations required. The OTR project will require an investment of Rs 120 crore, of which Rs 100 crore would be infused by BEML as trade advance. The capacity would be exclusively for BEML. The benefits of these arrangements are given below. Assured sale committed from BEML, and therefore no risk of lower off-take. Likely to have better realizations as compared to automotive tyres. OTR segment is growing at a rapid pace with capacity expansion from user industry like construction equipment, earth moving equipment, etc. The success of the project will also result into capacity enhancement increasing JK Industries's share in the segment. OTR plant with limited capital investments However, the concern is that BEML would have pricing power rather than JK Industries. The project delay would defer volume growth impacting sales and profitability. Financing of projects The total capex outlay of the project other than OTR project for BEML is Rs 360 crore and would be financed by debt equity ratio of 1:1. The company is planning a right issue of equity shares in the ratio of 1:3. Though the company has not finalised the price for the right issue, we, on the basis of funds requirements as well as recent private issue to group company at Rs 105, have assumed the price of Rs 120 per share. Thus we expect company to garner around Rs 123 crore and balance from internal accrual. Post-right issue, the equity capital of the company would be diluted to Rs 41.1 crore from Rs 30.8 crore. Restructuring to focus on core tyre business In the recent restructuring, the company divested its investment portfolio to Netfiler Technologies (the name changed to Netflier Finco Ltd), worth Rs 188 crore out of Rs 250 crore at an equity-swap ratio of 1:4, with equity capital of Rs 10.3 crore. Netflier Finco is listed on bourse at Rs 40. The investment value as on December was Rs 225 crore, translating into Rs 73 per share. However, discounting current market price by 20%, the value per share for JK Industries shareholders comes to Rs 11. (Refer valuation paragraph). 7 P age

8 KEY CONCERNS Slowdown in the user industry A slowdown in CV and PVs may adversely impact the volume growth of the company as the company enjoys the number 3 position in the industry. Higher raw material costs Rise in rubber, the key raw material as well as other raw material like fabric, carbon black and chemicals beyond our expectation poses threat to our EBITDA margin expansion. 8 P age

9 FINANCIALS Consistently on growth path JK Industries has shown consistent top line performance for past few years. Sales increased at a 13.9% CAGR from Rs 1,673.3 crore to Rs 2,816.2 crore over FY Bottom line saw a robust 33.6% CAGR over the same period from Rs 20.9 crore to Rs Rs 66.7 crore. The year FY07 was remarkable year for the company as it managed to improve its EBITDA margins to 9%, after having consistent EBITDA margins of 5%- 7% in past few years. The fall in rubber prices and increasing contribution of radial tyres (high-price, high-margin) helped company report EBITDA margins of 9%, translating into EBITDA of Rs crore. The company is in investment phase, resulting into higher interest outgo and depreciation provisions. The deferred tax provision of Rs 31.2 crore has also been accounted in FY07. Despite these higher costs/provisions, the company has well managed to quadruple the net profit to Rs 66.7 crore from Rs 17 crore in FY06 (Rs 22.1 crore in FY03). Steady growth in sales Going forward, we expect a steady growth in sales due the following factors. 1. Rising demand from automobile segment backed by new launches, capacity expansion as well as rising replacement market 2. Increased volumes from capacity expansion; capacity to increase by 31%, while production to rise by 34.3%, resulting into rise in volume sales of 25.4% 3. Improved product mix Exhibit 10: Production and sales growth (Lakh nos.) FY07E FY08E FY09E FY10E Growth (%) Inst. Cap Production Sales Qty We expect a 13% CAGR in net sales over FY07-10E to Rs 4,065 crore. Improving product mix and the company s efforts on cost savings would result EBITDA margins expanding from 9% to 10.7% in FY08 and to be maintained at this levels. Exhibit 11: Steady rise in sales (Rs crore) Changing product mix with increasing volume to bring 13% CAGR in net sales FY06 FY07 FY08E FY09E FY10E 9 P age

10 EBITDA margins to improve to 10.7% in FY08 and we expect the same to maintained going forward. Exhibit 12: EBITDA margins (%) movement FY06 FY07 FY08E FY09E FY10E Exhibit 13: Net profit (Rs crore) FY06 FY07 FY08E FY09E FY10E The company is planning its current and projected capex with debt equity ratio of 1:1 that would result into higher borrowing as well as expanding gross block. These would result into higher interest and depreciation costs/ provisions pressurizing bottom line growth. We expect a 23.1% CAGR in net profit to Rs crore in FY10 from Rs 66.7 crore in FY07. Q1 performance JK Industries reported a 9.9% y-o-y growth in net sales to Rs crore for Q1FY08. Net profit surged to Rs 21.7 crore from Rs 8.2 crore in the corresponding quarter the previous year. EBITDA margins improved 270 bps to 10.3%. 10 P age

11 Right issue announced The company has announced capex of Rs 360 crore for capacity expansion, which would be financed by debt equity ratio of 1:1. To finance this project, the company has announced the right issue in the ratio of 1:3. We have assumed the price of Rs 120, considering its one-year pricing history as well as financing need to be met from internal accruals. With this right issue, the company would garner around Rs crore, increasing equity from Rs 30.8 crore to Rs 41.1 crore. Loan funds continues to be higher Ongoing capex to require higher debts however improving profits would keep company s leverage ratio in the range of x. Exhibit 14 : Debt-equity ratio (x) FY06 FY07 FY08E FY09E FY10E Return ratios to be maintained Despite higher leveraging, the improving profits would help company to maintain its return ratios at 12-13% in coming years. Exhibit 15: RoCE and RoE movement (%) FY06 FY07 FY08E FY09E FY10E 11 P age

12 VALUATIONS The share is currently trading at 5.7x and 5.3x its FY08E and FY09E EPS. On an EV/EBITDA basis, it is trading at 5.2x and 4.5x FY08E and FY09E. Given the strong growth outlook and improving return ratios, we feel the stock deserves a higher valuation. We have underplayed the threat of a slowdown in CV sales (major contribution to sales) as well as price fluctuations in key raw materials. We have valued the company on a conservative basis at 5.5x its FY09 EV/ EBITDA to arrive price of Rs 183 for its core business (on post-diluted equity by around 33%). The recently divested Netflier Finco is listed on bourses, and discounting it by 20% to the current price of Rs 40, we value the same at Rs 11 per share. A SOTP valuation gives us a target price of Rs 194. Exhibit 16 : Peer comparison FY09E basis Mar-06 May-06 Jul-06 Sep-06 Nov-06 Jan-07 Mar-07 May-07 Jul-07 Sep-07 Nov-07 Jan-08 Mar-08 May-08 Jul-08 Exhibit 17: Peer Comparison (FY09E basis) Net sales NP EBITDA Margins (%) PE RoCE(%) RoE(%) EV/EBITDA (X) Apollo Tyres 4, JK Industries 3, Ceat * 2, * CEAT on consensus basis 12 P age

13 FINANCIAL SUMMARY Profit and Loss Year ending Sept FY06 FY07E FY08E FY09E FY10E Net Sales % growth Raw material Staff Op. Exp Selling & admin Total expenditure EBITDA % growth EBITDA margin (%) Other income Interest Gross Profit % growth Depreciation Profit before tax % growth Tax Effective tax rate (%) Net Profit % growth EPS (Rs) Volume expansion and changing product mix to result in 13% CAGR in net sales EBITDA margins to sustain Higher EBITDA margins to expand bottom line at a 23.1% CAGR Balance Sheet Year ending Sept FY06 FY07E FY08E FY09E FY10E Equity Reserves Net worth Short-term Loans Long-term Loans Total Loans Deferred tax liability Total liabilities 1, , , , ,674.5 Gross Block 2, , , , ,338.2 Depreciation , , ,233.0 Net Block 1, , , , ,105.3 CWIP Investments Inventories Debtors Cash Other Current assets Total Current assets 1, , , , ,365.3 Total current liab Net current assets Total assets 1, , , , , P age

14 Cash Flow Yr end Sept FY06 FY07E FY08E FY09E FY10E EBIT (Inc.)/Dec in working capital Cash flow from operations Other income Depreciation Interest paid (-) Tax paid (-) Dividends paid (-) Net cash from operations Capital Expenditure (-) Net cash after capex Inc./(dec.) in borrowings Inc./(Dec.) in Investments Equity issue/(buyback) Cash from Financial Activities Others Opening cash Closing cash Change in Cash Ratio Analysis Year ending September FY06 FY07E FY08E FY09E FY10E Per share ratios EPS (Rs) DPS (Rs) Sales per share (Rs) BV (Rs) Profitability ratios EBITDA Margins (%) NPM (%) RoCE (%) RoE (%) Valuation ratios P/E (x) P/Bv (x) P/ Sales (x) EV/EBITDA (x) Debt/ Equity (x) Other ratios Interest Coverage (x) Div. yield (%) Asset Turnover (x) Dupont Analysis PAT/PBT PBT/PBIT PBIT/Sales Sales/ Assets Assets/Net Worth P age

15 RATING RATIONALE ICICIDirect endeavours to provide objective opinions and recommendations. ICICIdirect assigns ratings to its stocks according to their notional target price vs current market price and then categorises them as Outperformer, Performer, Hold, and Underperformer. The performance horizon is 2 years unless specified and the notional target price is defined as the analysts' valuation for a stock. Outperformer: 20% or more; Performer: Between 10% and 20%; Hold: +10% return; Underperformer: -10% or more. Harendra Kumar Head - Research & Advisory harendra.kumar@icicidirect.com ICICIdirect Research Desk, ICICI Securities Limited, Gr Floor, Mafatlal House, H. T. Parekh Marg, Back Bay Reclamation Mumbai research@icicidirect.com Disclaimer The report and information contained herein is strictly confidential and meant solely for the selected recipient and may not be altered in any way, transmitted to, copied or distributed, in part or in whole, to any other person or to the media or reproduced in any form, without prior written consent of ICICI Securities Ltd (I-Sec). The author of the report does not hold any investment in any of the companies mentioned in this report. I-Sec may be holding a small number of shares/position in the above-referred companies as on date of release of this report. This report is based on information obtained from public sources and sources believed to be reliable, but no independent verification has been made nor is its accuracy or completeness guaranteed. This report and information herein is solely for informational purpose and may not be used or considered as an offer document or solicitation of offer to buy or sell or subscribe for securities or other financial instruments. Nothing in this report constitutes investment, legal, accounting and tax advice or a representation that any investment or strategy is suitable or appropriate to your specific circumstances. The securities discussed and opinions expressed in this report may not be suitable for all investors, who must make their own investment decisions, based on their own investment objectives, financial positions and needs of specific recipient. This report may not be taken in substitution for the exercise of independent judgement by any recipient. The recipient should independently evaluate the investment risks. I-Sec and affiliates accept no liabilities for any loss or damage of any kind arising out of the use of this report. Past performance is not necessarily a guide to future performance. Actual results may differ materially from those set forth in projections. I-Sec may have issued other reports that are inconsistent with and reach different conclusion from the information presented in this report. This report is not directed or intended for distribution to, or use by, any person or entity who is a citizen or resident of or located in any locality, state, country or other jurisdiction, where such distribution, publication, availability or use would be contrary to law, regulation or which would subject I-Sec and affiliates to any registration or licensing requirement within such jurisdiction. The securities described herein may or may not be eligible for sale in all jurisdictions or to certain category of investors. Persons in whose possession this document may come are required to inform themselves of and to observe such restriction. 15 P age