Merger might shift Leyland investors into lower gear

Stock dips 3.5% on worry that union with Hinduja Foundries would be a negative

The Ashok Leyland stock dipped 3.5 per cent on investor worry that the merger of loss-making Hinduja Foundries (HFL) with it would be a negative for the commercial vehicle (CV) maker. Both companies are part of the Hinduja Group.

The Street's reaction was severer on HFL, whose stock fell 20 per cent, hitting the permitted lower circuit in trading. However, the Leyland management is optimistic and says HFL would add to its profits in two to three years.

HFL is a castings maker and gets about a third of revenue from Leyland. The rest comes from other automobile segments, such as tractors. Leyland sees significant synergy once HFL comes under its roof, and says there is an opportunity to improve the latter's financials, expand the customer base and look at exports more aggressively.

HFL has been making money at the operating profit level over the past couple of months. Leyland says despite the current losses at the net level, the gross margins are sufficient to achieve a turnaround. The management highlighted synergies, improvement in operational areas, tax benefits and the belief that HFL will be earnings-accretive in two to three years as reasons why both boards approved the merger.

Leyland had invested ~320 crore of preferential capital in HFL, without getting a dividend. It would, it said, get 30-35 per cent tax benefit from HFL’s accumulated loss of ~1,100 crore when the merger happenned. Lower interest costs and backing of the bigger corporate entity will help stabilise HFL’s business and financials, according to the company.

However, HFL also has debt of ~512 crore, to now come into Leyland's books; this needs to be serviced.

About 85 per cent of HFL's customers are not direct competitors of Leyland. The management indicated the difficult decision of shutting down HFL’s Ductron castings unit in Hyderabad and a voluntary retirement offer to employees there had already been done.

The challenge is operations and overheads, which needs to be fixed, said Leyland’s finance head, Gopal Mahadevan. He said Leyland itself had been turned around in the past three years and this could be replicated in HFL.

HFL investors will get 0.4 shares of Leyland for every share they hold. This will mean a 2.76 per cent dilution for Leyland on an expanded equity base, and lead to the promoters’ holding increasing to 51.3 per cent, from 50.4 per cent currently. Leyland currently has 7.5 per cent stake in HFL.

Religare’s analysts say while Leyland is confident that HFL’s operational performance will improve, based on the June quarter's net loss of ~120 crore (annualised), the merger implies earnings dilution of about eight per cent for the heavy CV maker in FY17.

The company hopes that the entire merger process would be completed by April, subject to regulatory and shareholder approval. While HFL will be a division in Leyland, it will have its own management and governance board. HFL has appointed D M Reddy as managing director; after the merger, he will head the division.

Meanwhile, though Leyland had a turnaround in performance, reporting strong numbers for FY16 (sales grew 39 per cent and operating profit doubled on the back of a 34 per cent growth in volumes), the near term could see some pressure. Apart from the merger's impact, investors are worried over the state of the medium & heavy CV cycle, which is slowing.

Prior to May, Leyland was reporting a 30 per cent growth in CV volumes, largely on replacement demand and a low base, which came down to single digits in May. Since then, this is on a declining trend. In August, it reported an eight per cent fall in volumes due to weak freight and moderating replacement demand, while year-to-date sales growth is at a muted three per cent. Analysts at Quant Capital say, historically, tapering growth has led to a de-rating in valuations. In such a scenario, Leyland is going for the merger with lossmaking HFL.