Varroc Engg has several growth engines but valuations a worry

Prospects look robust due to low-cost manufacturing base and focus on driving up margins

Given its presence in key growth areas, a lowcost manufacturing base and focus on driving up margins, the prospects for Varroc Engineering, one of India’s largest automobile component companies, appear robust.

The company, which ended FY18 with revenue over ~100 billion, gets about 60 per cent of it by supplying lighting solutions to global car makers. The global automotive lighting segment is growing at twice the passenger vehicle growth rate, offering players such as Varroc a significant opportunity to scale up business. The only near-term hitch are valuations.

While the auto lighting market is large, the company has a lot of catching up to do, being the sixth largest player with a four per cent share in a market worth about $28 billion. Given the significant demand for electronic and digital technologies and design differentiation, offerings such as light emitting diode, 3D lighting and laser lighting systems, among others, are replacing traditional halogen assemblies. With costs coming down, the preference for these will increase as auto lighting content per vehicle is expected to increase from $250 in 2015 to over $300 in FY20.

Given the significantly larger competitive players, Varroc is looking at increasing the share of overall volumes in this segment through an acquisition, which will give it access to new clients and regions. One sub-segment of the auto lighting segment which should help Varroc is lighting solutions for electric vehicles (currently less than three per cent of the auto lighting market), where its market share is 20 per cent, just behind global leader Magnetti Marelli’s 21 per cent. Given the rising share of electric vehicles, higher growth rates would translate into revenue gains for the company.

Margin gains

What will help Varroc win new orders is also the competitive edge of having manufacturing and research and development units in lowcost countries. In addition to India, the company has global manufacturing centres in Mexico, China, Turkey and the Czech Republic, with one each in Brazil and Morocco expected to open this financial year. The company is focusing on margin improvement by enhancing of operating efficiencies and has been consolidating its operations in FY18, which included the sale of non-core assets in Mexico. While the lighting segment gets a margin of 8.5 per cent, lower than competition, it is looking at crossing the double- digit mark by achieving higher scale and keeping costs under control.

India business

About 32 per cent of its revenue

come from the Indian operation, which supplies polymer, electrical and metallic parts to all segments of the auto sector, a majority going to two-wheelers and threewheelers. While half its India revenues comes from just one player, Bajaj Auto, this share has come down from 61 per cent in FY15. It should reduce further on incremental volumes from Hero MotoCorp, Honda, Royal Enfield and Yamaha. However, it will be a gradual process, as Bajaj Auto is expected to grow at a fast clip with revival in export and recovery in the domestic market after sluggish volume growth over the past few years.

While the new emission norms from FY20 are an opportunity, given the need for higher value components, the risk is the ability of the market to absorb higher prices of motorcycle as twowheeler makers look to pass on the increase in input costs.

Valuation

At the upper band of the stock issue, the company is asking for a valuation of 29 times its FY18 earnings per share. While there are no exact peers, Motherson Sumi with operations both in India and outside trades at 36 times its FY18 estimate. This premium is justified, given Motherson’s higher return ratios (25 per cent versus 14-15 per cent for Varroc), competitive strengths and much larger size. While there is scope for growth and return ratios improving for Varroc, valuation comfort is missing. Investors with a longer-term horizon could consider the issue.