Bharat Forge Q3 runs into a speed breaker, valuations lofty

- Valuation at elevated levels

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Bharat Forge (BFL) (CMP: Rs 499, Mcap: Rs 23,252 crore), a leading auto ancillary metal forging company, yet again disappointed with a very weak set of numbers for the December quarter. The subdued show came amid a tough operating environment in global as well as domestic automobile industries.  A significant decline in volume led to a sharp fall in net revenue. Further, operating profit margin contracted due to negative operating leverage.

Demand weakness marked both domestic and international markets and is expected to linger in April-June of 2019-20. Valuation remains at an elevated level. Hence, we advise investors to avoid it until we see signs of demand improvement.

Quarter result snapshot

Revenue declined a significant 36.4 percent year-on-year (YoY), pulled down by 29.6 percent drop in volume. This was further attributable to a substantial fall in domestic commercial vehicles (CV) (revenue down 58.6 percent) and the industrial segment in international markets where revenue took a hit of 52.3 percent. Overall realisation came off by 9.6 percent.

Domestic business was a big drag, which witnessed a YoY decline of 39 percent. The lacklustre show was a result of a patchy performance of the CV segment, which was dealt a blow by the economic slowdown and muted demand from original equipment manufacturers (OEMs). The industrial segment and passenger vehicles (PV) too lost their way, down 28.3 percent and 1 percent, respectively.

A fall in exports revenue by 34.9 percent (YoY) also kept the financials of the company under strain. The CV segment contracted 26.8 percent on lower demand for trucks, along with depressed freight demand and slowdown in business outlook. The industrial segment fell 52.3 percent due to as customers stayed away.

In terms of operating profitability, it was a big blow. Earnings before interest, tax, depreciation and amortisation (EBITDA) margin plunged as much as 654 bps on a YoY basis, chiefly because of negative operating leverage.

Outlook

The domestic market has been facing challenges in the form of a weakening macro environment, leading to subdued sentiment for the automobile sector, including CVs and PVs.  Other factors such as diminishing liquidity, financing issues, rising interest rates, and slowdown in economic activities are also at play. The going got tougher with the impact of new axle load norms pertaining to CVs. The management expects demand to be weak in the near term before picking up in FY21.

It also pointed to significant cost reduction for India business, the positive impact of which should show up in FY21. This will help in maintaining margins amid weakness.

Upcoming BS VI emission norms remain the near term driver for the company. This is expected to lead to pre-buying as new BS VI compliant vehicles would be expensive than the current ones. Additionally, the government’s scrappage policy would potentially lead to replacement of 200,000-300,000 trucks which are over 20 years old. That should also augur well for the automotive player.

Moreover, we believe that the long-term growth outlook remains promising on the back of a stable government with a focus on economic activities and focus on rising rural income, infrastructure and construction.

There has been a significant slowdown in class 8 truck demand in North America over the past few months, which means a moderation in orders. The management had predicted the second half of the current fiscal to be weaker than the first half, primarily due to lower freight demand and an overall slowdown in economies. This is visible in Q3 FY20 results as well.

However, the management is hopeful that higher content per vehicle and increase in share of wallet of customers is expected to pay off and help the auto component maker in these challenging times.

In terms of PV market, the management expects that this segment will post a strong growth in FY21 as the company has been expanding its presence through a wider product portfolio, customer addition and a growth in value chain.

The industrial segment revenue is expected to stay soft owing to slowdown in the oil and gas industry.

Valuations remain at higher levels for BFL. The stock is trading at 25.3 times FY21 projected consolidated earnings.

Risks

Prolonged demand weakness both in India and international markets could hurt the company. Additionally, any adverse commodity price movement would increase raw material cost and could impact operating profitability.

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