Discovering Value in the Gears Industry : A stock to look out for which has 38% market share in India
Elecon Engineering Ltd.
- Products: Gears and Material Handling Division
- Revenue Mix: Gears 89% & MHE- 11%
- Gears: 60% Standard & 40% Customised, After sales service – 20-22% of the business
- Market Position: 38% market share in India in gears (Pan India Presence)
- Geographic Presence: 70% India & 30% Outside India
- Caters to diverse sectors: Steel, Cement, Sugar, Marine, Defence etc.
- Plant Location: Anand-Gujarat
- Good Presence: Marine Gearbox for Defence, Vertical Mill Gearboxes in Cement & Power, Rolling Mill Pinion Stands, and Sugar Mill Planetary Drives.
What led us to research the gears/gearbox industry?
We did a top-down analysis at macro level and analyzed that Indian capex cycle can rebound. India’s capex cycle has been muted since last 10 years as private capex was flat. It was only the government capex that had supported infrastructure spending with 13% CAGR over FY10-20. What has changed now?
- Investment cycle has bottomed out. Investment contribution to GDP has reduced to 26.7% in FY21 from peak of 36% in FY07.
- Healthy Balance Sheet and Good Cash Flows of corporates
- Accommodative Monetary Policy: Low cost of funds & Adequate Liquidity
- High Demand from domestic as well as export markets
- Cut in corporate tax rate for new capex (15%)
- Reforms done in the past like RERA, GST etc.
- Government initiatives to boost manufacturing activities like PLI Scheme, import substitution initiatives
- National Infrastructure Pipeline of Rs. 1.1 trillion over FY20-25 which is twice of the total spending done in FY13-19.
- China plus one strategy helping India to boost manufacturing activities
- Indian Renewable/Clean Energy in focusGovernment spending is the first to revive in any capex cycle. This gives confidence to private players to make expansion. Hence, we see an upsurge in capital expenditure. Order Flows for capital goods companies are growing. For instance, Thermax Limited is engaged in the business of manufacture and sale of boilers, heating and cooling equipment, industrial chemicals, and water and waste management equipment. The following table highlights the order book trend.
Why, we prefer investing in this sector at this point in time?
Sticking to our investment style, we have chosen a company whose product is irreplaceable, plays a pivotal role in the capex cycle. Interestingly, the product looks simple and yet the industry is dominated by 2-3 players.
Before, we go further and discuss Elecon in detail, wanted to highlight few things. In the previous two reports on RHI Magnesita and Usha Martin Ltd., we discussed whether the product is investment or a consumable to visualise the scope of growth.
As an investor, you and we at Niveshaay, would prefer consumable products. Repeat orders, short manufacturing cycle helps us to visualise scope of growth. Here, replacement cycle is very long. But as they say, always have a fresh perspective while investing to overcome previous biases. Ruling out a company should have proper reasoning. Visiting gears and grinding expo in Pune, some more dig down into the sector helped us to understand the industry composition and structure in great detail.
What made us consider this industry?
- The industry growth has remained muted since a very long time.
- Initial signs of good order book visibility
- Low-capacity utilisation in the industry prompting no new capex requirements to cater to higher demand.
- Fragmented Market but Elecon Engineering holds 35-38% market share in India and Shanthi Gears attracts limited competition as it is into customised gears.
- The quality of the product plays an important role in functioning of the machinery. These two companies are known for their quality in the industry, got this insight from various other small players exhibited at the expo. This point makes it a sticky business.
Why Elecon Engineering Ltd.?
38 % Market Share in India
The company has strong presence in standard gears. Here, orders are placed from catalogues by customers.
Operating Leverage: Currently, operating at lower capacity utilisation
The company is operating at 60% capacity utilisation and can easily ramp up the capacity. With higher utilisations, margins can also improve. During the last decade, company almost doubled its capacity. As utilisation of asset increases, fixed costs will go down. Hence, it can improve EBITDA margins.
Healthy Order Book for the year
As per the management guidelines, 20-25% is expected in FY23. Current order book stands at Rs. 605 crores in gears business and in MHE orders on hand are of Rs. 127 crores.
Restructuring done in MHE division, positive contribution this year onwards with improved margins Company has done away with their legacy business model (contracting). Here, expected EBITDA margins is around 15-20%.
Here, they’ve changed their strategy. Majority of the business is now, coming from after sales which is revamping or modernizing material handling plants as well as providing services and manufacturing spares and delivering to customers. These are profitable business and have healthy margins. These products have good payment terms unlike the previous model.
Focus on Exports
All the overseas entities have now turned profitable due to re-structuring initiatives. Interestingly, in one of the conference calls, they highlighted how acceptance of their products overseas happen when they use it once, finds out that the product is robust and reliable. This leads to repeat orders. This happened with the company in South America. With local reference, they tend to receive repeat orders. In export market, bargaining power is high. US markets prefer to buy from India and China. Europe markets prefer
local market products. Also, with lower metal prices, export products can command high margins too.
It aims to be net debt free by FY23.
It is a fantastic combination to play on a company when the following happens together:
- Volume Growth
- Margins Growth Probability
- Operating Leverage Play
- Focus on to be net debt free
All these points are expected to play out for Elecon Engineering Ltd.
Elecon Engineering Ltd. Conference Call Q4FY22 excerpts
- Growth guidance in gears division for FY23: 15-20%
- Margins should improve as utilization improves
- They have a o/s orderbook of Rs. 490 crores. Product cycle varies from 3-5 months. This high order-book at the beginning of the year has happened after a very long period of time.
- For, 98-99% of the orders, the company will be able to pass on the higher prices.
- Focus on exports. Overseas subsidiaries have turned profitable now.
In the current scenario, we can classify Elecon Engineering Ltd. under a category where the company doesn’t require further investments to grow for a foreseeable future. Also, with revival in capex cycle expected, restructuring and operating leverage play, the company is expected to perform well in the coming quarters.
Elecon Engineering is a a part of Niveshaay’s Mid & Small Cap focused portfolio which contains companies available at reasonable valuations with strong market hold
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Niveshaay is a SEBI Registered (SEBI Registration No. INA000008552) Investment Advisory Firm. The research and reports express our opinions which we have based upon generally available public information, field research, inferences and deductions through are due diligence and analytical process. To the best our ability and belief, all information contained here is accurate and reliable, and has been obtained from public sources we believe to be accurate and reliable. We make no representation, express or implied, as to the accuracy, timeliness, or completeness of any such information or with regard to the results obtained from its use. This report does not represent an investment advice or a recommendation or a solicitation to buy any securities.