For more than four years now, the country has been struggling with six major macro issues: weak growth, high inflation, burgeoning current account deficit, uncomfortably high fiscal deficit, a weak rupee and policy paralysis. Barring the current account deficit, other issues remain; we don’t expect a macro turn as yet, but things seem to have bottomed out and the extended nature of any recovery provides interesting opportunities for the quality-focused investor, especially towards the second half of 2014.
A global recovery might finally be on the cards after five years, providing a much-needed boost to Indian exports and the external business prospects of Indian firms. While we expect US bond purchases to taper off in the year, sharply changed macro fundamentals limit the potential downside. Closer home, weak growth will translate into a respite from chronic inflation after the next two quarters. We do not expect the investment outlook in the country to improve sharply, given the macro overhang, but prospects are decisively changing for the better, and could see some sentiment boost after the elections.
We choose Voltas, one of the India’s premier engineering companies, as our top pick for 2014 as it will be one of the biggest beneficiaries of such a recovery, with investment turning around after a five-year deceleration. Even if the macro scenario does not play out as projected, and is protracted, this Tata Group company’s strong resilient business model and robust, asset-light balance sheet limit the potential downside.
So, what would drive performance for Voltas? A combination of factors: a turnaround in its electro-mechanical projects and services (EMPS) business; order inflows picking up; and international business finally seeing signs of a revival, with the domestic cooling business steadily holding on. In addition, if the management’s guidance on margin and order-flow recovery pans out, there is scope for positive surprises on current earnings estimates, which would drive valuation multiple further. Let’s examine these arguments in some detail.
Voltas focused on restructuring its EMPS business over the past two years, accelerating execution of low-margin orders to facilitate taking on higher-margin projects. So, while revenues and profitability suffered, completion of the project pipeline improved visibility for revenue traction and profitability in FY14/15. Order inflows declined for the sixth consecutive time in Q1FY14, but showed signs of a pick-up in the second, as the implied order inflow for Q2FY14 was around ₹1,200 crore (against an average run-rate of ₹600 crore for the past six quarters). The expansion of the order book for the EMPS business provides a strong signal for a future turnaround in this segment of the business.
The construction environment in West Asia is gradually recovering, with high-value projects being awarded for the first time since 2008. Voltas is also witnessing encouraging enquiry levels in Qatar, Oman and Saudi Arabia where robust infrastructure spending is being planned, even as major events such as the Dubai Expo 2020 and Qatar 2022 FIFA World Cup are expected to boost the region’s business environment. Owing to its comfortable order backlog position, thanks to the restructuring strategy employed over the past two years, Voltas is now bidding selectively and booking projects with comfortable site margins of 5%-plus. Its three decade-plus track record of delivering quality projects, strong relations with contractors, Tata Group antecedents and, importantly, a relatively low-leverage balance sheet helps its cause in being at pole position in the still-nascent turnaround. Moreover, with risks on the rupee largely mitigated, input cost volatility for Voltas should come down meaningfully. All this will likely translate into a margin improvement of 200 basis points over FY13-15, no mean achievement in a weak macro environment.
Among other segments, the UCP (Unitary Cooling Products) business of the company has held up very well, aided by its enhanced product offerings, robust distribution network, strong brand positioning and aggressive advertising campaigns. The segment has helped the company generate strong revenue growth (around 19% in FY13), stable margins (9-10%) and healthy cash flows. Being only an assembler, Voltas’ asset-light business model strategy facilitates generation of higher return ratios and cash flows. Voltas had ₹350 crore cash in its balance sheet as of end-FY13, equivalent to ₹23 a share, translating to around 14% of the market capitalisation at the time, which is expected to go up to ₹500 crore in FY14, with a total debt of ₹260 crore. Sustained cash generation will also help the company gradually pay off its debt as the cycle turns.
Excluding other income, the stock trades at around 15 times estimated FY15 earnings, which appears reasonable given the company’s strong business model, healthy balance sheet and improved growth outlook. If Voltas continues to deliver on margins and order inflows, we could likely see the stock getting re-rated despite a weak macro. We expect the stock to record around 20-25% return over the next 12 months.
Religare has a buy call on the stock, but the writer in his personal capacity does not own the stock