Balkrishna Industries (BALIND) direct.com. Initiating Coverage. Increasing grip on high-growth path OUTPERFORMER

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1 January 7, 2008 Tyres Initiating Coverage Balkrishna Industries (BALIND) Increasing grip on high-growth path Balkrishna Industries Ltd (BIL), part of the Siyaram Poddar group, is a leading producer and exporter of OHT (off-highway truck) tyres. The company has divested its paper and textile businesses into separate subsidiaries to focus on the high-growth, high-margin tyre segment. Its presence in the niche OHT segment, coupled with capacity expansion would result in a substantial growth in top line. Further, the improvement in key operational ratios like material, power and fuel costs would boost EBIDTA margins. The company s low cost of production (compared to global players) and enhanced capacity would help it cash in on increasing demand for OHT tyres worldwide. We initiate coverage on the stock with an OUTPERFORMER rating. Presence in niche OHT tyre segment BIL has a presence in the niche OHT tyre segment. The size of the OHT tyre market worldwide is estimated at US$7.5 billion. BIL has a 3% market share globally. The company operates about 1,700 SKUs (stock keeping units) that cater to demand from varied industries, mainly exports. The increasing demand for OHT tyres overseas, and BIL s competitive pricing (25-30% lower than global peers) would enable it grow at a faster pace and enhance its market share in the coming years. Excellent EBITDA margins, likely to improve further The company enjoys EBITDA margins of around 20.2% currently, which are much higher than global peers (3.5%-5%). We believe the margins would improve further to 26% in FY10 due to the company's focus on its core tyre business and divestment of non-core low profit making paper and textile processing business. Valuations At the current price of Rs 739, the stock is trading at an attractive valuation of 8.9x FY09E and 7.7x FY10E EPS of Rs 83.2 and Rs 95.7 respectively. We expect a re-rating on the stock on account of the company s continued high earnings growth and the recent de-merger of its non-tyre businesses. We rate the stock an OUTPERFORMER with a 12-month price target of Rs 957 based on 10x FY10E EPS. This represents an upside of 29.7% from current levels. Current price Target price Rs 739 Potential upside 13% Rs 957 Potential upside Time Frame 29.7% Time frame 12 months 12 months Analyst s Name Supriya Khedkar supriya.khedkar@icicidirect.com Sanjay Manyal Sanjay.manyal@icicidirect.com hini.singh@icici Sales & EPS trend 1,600 direct.com Rs crore 1,300 1, OUTPERFORMER FY06 FY07 FY08EFY09E FY10E Net Sales EPS (Rs) Rs Stock metrics Promoters holdings (%) 54.1 Market cap (Rs crore) 1, week H/L 719/450 BSE Sensex 20,211 Average volume 4,956 Comparative return metrics (%) Stock return 3 M 6M 12M Balkrishna Industries JK Tyres Apollo Tyres Exhibit 1: Key Financials Net Profit (Rs crore) Equity Shares (Crore) EPS (Rs) EPS Growth (%) EBITDA margin (%) PER (x) P/BV (x) Price/sales (x) EV/EBITDA (x) ROCE (%) ROE (%) Price Trend 1, Mar-06 May-06 Jul-06 Sep-06 Nov-06 Jan-07 Mar-07 Target price Absolute buy May-07 Jul-07 Sep-07 Nov-07 ICICIdirect Equity Research 1 P age

2 Company Background Balkrishna Industries (BIL) is the flagship of the Rs 1,800 crore Siyaram Poddar Group. It is one of the leading tyre manufacturers India focused on the OHT (off-highway truck) tyre segment. In FY07, its total installed capacity was 100,000 tpa (tonnes per annum). It has three manufacturing facilities located at Bhiwadi and Chopanki in Rajasthan, and Waluj in Maharashtra. The company has established its presence in this segment with over 1,700 SKU, for Agricultural, Industrial and Construction and Earthmoving applications. The tyre segment contributes around 85% of total sales. The company exports almost 90% of its total tyre production. The company had paper and paperboard division manufacturing coated duplex/ triplex boards with installed capacity of 54,000 tpa that contributed around Rs 118 crore in FY07. It also had a small textile processing division, which used to undertake job work from Siyaram Silk Mills (a group company) with a capacity of 24 million metres per annum with modest turnover of Rs 28.5 crore in FY07. To focus on its core business of tyres, the company divested these two units into separate subsidiaries, Balkrishna Paper Mills and Balkrishna Synthetics, with effect from March 31, Shareholding pattern (30/09/2007) Shareholder % Holdings Promoters 54.1 Institutional Investors 36.5 Other Investors 1.3 General public 8.1 Promoter & Institutional holding trend /12/ /03/ /06/ /09/2007 Total of Promoter Non Promoter (Institution) Exhibit 2: Product mix by segment Agricultural Forklift truck Others Steering wheel (Tractor) Skid Steer High-speed Trailer Implement and Trailer Excavator Lawn and Garden Flotation Radial Compactor Gold cart Tractor Bias Backhoe loader Tractor Radial Earth mover Source: Company Exhibit 3: Segment wise sales (FY07: Rs 878 crore) Segments % to sales Agricultural 65 Industrial and construction 25 Others 10 Source: Company 2 P age

3 INVESTMENT RATIONALE Presence in niche segment BIL has a presence in the niche OHT tyre segment. Globally, OHT tyres accounts for 10% of the total tyre sales. The global size of the OHT tyre market is estimated at ~ US$ 7.5 billion. There is a very high degree of concentration in the segment, with the top 3 players (Bridgestone, Goodyear and Michelin) having a 50-55% market share. OHT tyres are used for agricultural, industrial, and construction and earthmoving purposes. The OHT segment focuses on highly customised requirements, unlike automobile tyres. BIL s major strength lies in its R&D (research and development). Over the years, it has developed over 1,700 SKU, which offer a wide range of offerings. It rolls out around 150 new products every year to cater to the requirements of varied industries. Its SKUs and product development act as a entry barrier in the industry. The company exports around 90% of its sales. The balance 10% is sold to OEMs (original equipment manufacturers) in India. It has a 3% market share in the global OHT tyre segment. Out of total sales, around 70-75% comes from the replacement market. The balance production is mainly for companies who outsource production to BIL. Exhibit 4: Global market share of major players 28% 21% 18.2% 17.7% 17.3% 14% 6.5% 7% 0% Bridgestone Michelin Goodyear Continental 4.6% 3.6% 2.9% 3.0% Pirelli Sumitomo Yokohama Balkrishna Others 26.2% 1,700 SKU, worldwide dealership and cost competitiveness enabled company to have 3% market share globally, which will continue to expand in coming years. Source: Michelin investor presentation Since BIL s revenues are primarily derived from the replacement demand, the company has established a robust distribution network in Europe, the US and Middle East. It currently has 200 dealers worldwide. Collectively, these factors have helped the company position itself in the segment. 3 P age

4 Excellent EBITDA margins BIL s EBITDA margins are a hefty 20.2%, against 5%-6% of its global peers. This is mainly due to the low labour costs in India, and also lower power and fuel costs. In India, employee cost is around 5%-6% of net sales, whereas in overseas countries it accounts for 12%-15%, pressurising EBITDA margins. US-based Titan International operates on 3.8% EBITDA margins (CY06), while French tyre maker, Michelin, operates on 4.5% margins. Its low cost of production also enables BIL sell its products at around 25%-30% cheaper compared to global rivals. The company currently has a 3% market share. Going forward, we believe its lower pricing strategy would enable it to garner a higher market share in the coming years. Divestment of non-core businesses to boost margins further The company divested its stake from non-core paper and paperboard and textileprocessing businesses into separate subsidiaries. The paper business was operating on 7%-8% EBITDA margins. The textile processing business (mainly job work for group companies) was suffering due to negative margins. BIL s focus on the core tyre business combined with an improving costs-to-sales ratio would aid margin expansion. We expect EBITDA margins to expand from 20% in FY07 to 26% in FY10. Exit from non core business to aid margin expansion Exhibit 5: EBIDTA margins to expand Improving EBITDA to bring substantial improvement in EBITDA margins 18 Source: Company In our assumptions, the likely movement of raw material prices is presented in following chart. Exhibit 6: Raw material prices movement 115,000 95,000 Raw material prices to rise steadily 75,000 55,000 35,000 15,000 Natural Rubber Synthetic Rubber Carbon Black Source: Company 4 P age

5 Capacity expansion to result in volume growth BIL is expanding its capacity by 29%. The capacity at the Bhiwadi plant is being increased by 4,500 tpa and Chopanki plant by 13,000 tpa. The company is also putting up OTR (off-the road) tyre facility at Chopanki with initial capacity of 11,500 tpa. OTR tyres are mainly used by earthmovers. Post capacity expansion, the capacity would be 129,000 tpa. The capex plans also includes a warehouse facility of 160,000 square metres to store inventory. The warehousing facility is essential as the company plans to stock a sizeable inventory whenever rubber prices decline. The move would help the company benefit from low prices controlling costs. The total capex is around Rs 150 crore. The company is also considering a fourth tyre manufacturing plant with capacity of 75,000 80,000 tpa, and a captive power plant at a total capex of Rs crore. After the expansion, its total capacity would be 209,000 tpa. Exhibit 7: Capacity ramp-up schedule (in tpa) Plant location FY07 FY08E FY09E FY10E Bhiwadi 48,000 52,500 52, ,500 Chopanki ,000 43,000 43,000 43,000 Chopanki -2-11,500 11,500 11,500 Walunj 22,000 22,000 22,000 22,000 Total 100, , , ,000 Will demand support the capacity expansion? OTR plant Doubling capacity Incremental capacity to support volume growth BIL s major sales (around 60-65%) are from agricultural-related equipment tyres. Further, most of the exports are to EU (European Union) countries. These countries are now focused on increasing productivity. The large size of farms in these countries, coupled with declining farmer population, is boosting demand for tractors and other agriculture related applications. The soaring demand, complemented with an effective pricing strategy of selling 25-30% cheaper than competitors is expected to help the company garner higher market share increasing volume sales. Appreciation of rupee is not a concern Exports accounts for around 90% of sales. Further, about 65% of sales are to the EU countries, meaning a major part of the company's earnings are in Euros. Among total sales, 52-53% of the revenues are in Euros, while 45% are in US dollars. While the dollar has depreciated by around 13% against the rupee in the past few months, the appreciation in rupee against the Euro is only 5%. This has mitigated the risk of currency depreciation, protecting sales growth. Further, the import content of raw material is around 42%, which is mostly dollardenominated. This has also mitigated the negative impact on dollar-denominated exports. 5 P age

6 Exhibit 8: Mitigation of impact of rupee appreciation Revenues: By region Revenues: By currency Raw material content Europ e 65% ROW 20% USA 15% Re 3% Euro 52% Dollar 45% Re 3% Euro 52% Dollar 45% 6 P age

7 RISKS & CONCERNS Currency risk The appreciation of the rupee against the US dollar and euro could impact revenue growth. Regional risk Around 65% of the company's revenues are from Europe. This regional concentration could become a risk for the company going forward. Raw material prices Rubber is a key raw material. A rise in rubber prices beyond our projection could impact EBITDA margins and net profit estimates. 7 P age

8 INDUSTRY OUTLOOK The global off highway tyre market accounts for 10% of world sales and estimated to be around USD 7.5 billion (Rs 30,000 crore). This segment is highly concentrated by top 3 players, which includes Bridgestone, Goodyear and Michelin, having around 50% -55% market shares. These tyres require higher degree of customization depending on the applications as against the highway tyres. This is the main reason for tyre companies manufacturing OHT to have larger number of SKUs, which can meet the demand from varied industries. OHT demand is mainly from the following industries where the each industry has different applications. Agricultural Construction Earthmoving Mining Quarrying These industries are closely related to the growth of the economy. These industries are expected to grow at 8% -10% per annum, as we all know that the spend on infrastructure development and capacity expansion by various industries are robust in almost every country. Agriculture is the main focus area of almost every country. Most of the BIL s exports are to EU (European Union) countries and these courtiers are now focused on increasing productivity. The large size of farms in these countries, coupled with declining farmer populations, is boosting demand for tractors and other agriculture related applications. As per data released by Michelin in its presentation for 2006, the tractors demand is increasing at good pace especially in Europe and North America. Exhibit 9: Region wise tractor fleets upgraded Middle East and India North America Europe Japan and Korea South America Australia and New Zealand Europe and North America are the two main markets; BIL s exports are mainly to these regions. Source: Michelin fact book P age

9 Globally, though OEMs takes the major pie of the total tyre demand, the demand from replacement market is in the region of 32% - 40%. BIL s region wise sales contribution Exhibit 10: World agricultural tyre market 38% 41% 41% 62% 59% 59% 31% 69% Replacement market accounts for 70% - 75% of BIL s revenues USA 15% ROW 20% Europe 65% North America Europe South America Rest of the worl OE RT Source: Michelin fact book P age

10 FINANCIALS BIL reported a robust 41.6% growth in net sales to Rs crore in FY07 from Rs 620 crore in FY06. Higher operational costs, mainly due to a rise in raw material, and power and fuel expenses, restricted EBITDA growth to 26.8% at Rs crore. This resulted in a 140 bps decline in EBITDA margins to 20.2%. The company had a presence in the paper and paperboard, and textile processing segments. In order to focus on higher margin tyre segment, BIL recently divested the paper and textile processing businesses into separate companies. 21% CAGR in net sales over FY07-10E BIL has decided to focus on its tyre business with a thrust on increasing its presence in the export market. Backed by capacity expansions, net sales are expected to witness a 21% CAGR to Rs 1,556.3 over FY07-10E. On a year-to-year basis, it would be 29.1%. The growth contributors would be: 1. Volume expansion by 29%; 2. The company s exit from the low-margin paper and textile businesses; and 3. A marginal rise in sales realisations, ranging from 2.5% to 4% y-o-y. Exhibit 11: Capacity expansion and utilisation FY07 FY08E FY09E FY10E Total capacity (tpa) 100, , , ,000 Capacity utilization (%) Production (tpa) 55,841 77,400 90, ,750 Gross sales (Rs crore) Tyres , , ,578.5 Others Net sales (Rs crore) , , ,556.3 Increased capacity will be employed partially Exhibit 12: Margins from various business segments EBITDA margins (%) FY07 FY08E FY09E FY10E Tyres Paper and paper boards Textile processing - VE EBITDA margins to expand Rubber prices declined last year. With improving raw material, and power and fuel per unit costs, we expect the EBIDTA margins to improve from 20.2% in FY07 to 26% in FY10E. With the company now focusing on the tyre business, raw material-to-sales ratio is expected to improve from 54.8% in FY07 to 50.2% in FY10. Power and fuel per unit cost would decline from 6.3% to about %. These improvements would aid an expansion in EBITDA margin from 21.2% to 26% in FY10E, bringing a substantial improvement in bottom line. 10 P age

11 Exhibit 13: EBIDTA margins to expand High margins from tyre business, resulting a sudden spurt Exit from low EBITDA margin businesses % CAGR in net profit The improvement in EBITDA margins and low debt-equity ratio, keeping interest costs intact, would lead to a 28.3% CAGR in net profit over FY07-10E to Rs crore from Rs 87.6 crore in FY07. This would translate into an EPS of Rs 95.7 in FY10E from Rs 45.3 in FY07, making the stock attractive at current valuations. Debt-equity ratio to decline despite capex We believe the company would maintain its debt-equity ratio of around 1, despite the Rs 150 crore capex over the next 2 years, and Rs 400 crore in FY10 to increase capacity. The improvement in cash from operation and profitability would help company to maintain its debt equity ratio at around1. Exhibit 14: Debt-equity ratio P age

12 VALUATION At the current price of Rs 739, the stock is trading at an attractive valuation of 8.9x FY09E and 7.7x FY10E EPS of Rs 83.2 and Rs 95.7 respectively. We expect a rerating on the stock on account of the company s continued high earnings growth and the recent de-merger of its non-tyre businesses. We rate the stock an OUTPERFORMER with a 12-month price target of Rs 957 based on 10x FY10E EPS. This represents an upside of 29.7% from current levels. Exhibit 15: P/E chart Mar-06 May-06 Jul-06 Sep-06 Nov-06 Jan-07 Mar-07 May-07 Jul-07 Sep-07 Nov-07 Jan-08 BIL is a cheapest stock available on the bourses on P/E basis. It also enjoys highest return ratios as against its competitors. The consistently growing revenues, improving EBITDA margins and its efforts to increase its presence in global market make its growth prospects promising. Exhibit 16: Comparative matrix (FY09E basis) Net sales (Rs crore) NP (Rs Crore) EPS (Rs) P/E (x) EV/EBITD A (x) RoE(%) RoCE (%) Mcap (Rs crore) Apollo Tyres 4, ,464.4 JK Tyre & Inds * 3, Balkrishna Ind ,426.7 Source: ICICdirect Research, * JK Tyre consensus 12 P age

13 FINANCIAL SUMMARY Profit & Loss Account (Rs crore) 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) % growth Balance Sheet (Rs crore) Equity Reserves Net worth Short-term Loans Long-term Loans Total Loans Deferred tax liability Total liabilities Gross Block Depreciation Net Block Capital work-in-progress Long-term Investments Inventories Debtors Cash Other Current assets Total Current assets Total current liabilities Net current assets Total assets % CAGR over FY07-10E EBITDA to grow at a 31.6% CAGR over FY07-10E, focus on core tyre business to bring substantial improvement in EBITDA margins 28.3% CAGR in net profit 13 P age

14 Cash Flow Statement (Rs crore) Year end March 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 short-term borrowing Inc./(dec.) in long-term borrowing Inc./(dec.) in borrowings Inc./(Dec.) in Investments Inc./(Dec.) in Preference Capital Equity issue/(buyback) Cash from Financial Activities Others Opening cash Closing cash Change in Cash Ratios EBITDA margin (%) PER (x) P/BV (x) Price/sales (x) EV/EBITDA (x) Debt-equity (x) Dividend Yield (%) ROCE (%) ROE (%) Despite capex, ratios will remain impressive 14 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, Mafatlal House, Ground Floor, 163, H T Parekh Marg, Churchgate, 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 t prior written consent of ICICI Securities Ltd (I-Sec). The author of the report does not hold any investment t 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