With many growth engines, Varroc Engineering has opportunities to scale up

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Given its presence in key growth areas, a low-cost manufacturing base and focus on driving up margins, the prospects for Varroc Engineering, one of India’s largest auto component companies, appear robust. The company, which ended FY18 with revenues of over Rs 100 billion, gets over 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 is valuations.

Large global opportunity

While the auto lighting market is large, the company has a lot of catching up to do as it is the sixth largest player with a four per cent share in a global market worth about $28 billion. Given the significant demand for electronic and digital technologies and design differentiation, offerings such as light emitting diode (LED), 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 as well as geographies. 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 auto lighting market) as the company’s market share at 20 per cent is just behind the global leader Magnetti Marelli’s 21 per cent. Given rising share of electric vehicles, higher growth rates would translate into revenue gains for the company.

Margin gains ahead

What will help Varroc win new orders is also the competitive edge of having manufacturing and research and development units in low-cost countries. In addition to India, the company has global manufacturing centres in Mexico, China, Turkey and Czech Republic, while another two in Brazil and Morocco are expected to open this fiscal. The company is focussing on margin improvement by enhancing operating efficiencies and has been consolidating its operations in FY18 which included the sale of non-core assets in Mexico. While the segment gets margins to the tune 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 revenues come from Indian operations, which supplies polymer, electrical and metallic parts to all segments of the auto sector, though a majority goes into two- and three-wheelers. While half its India revenues comes from just one player, Bajaj Auto, the share has come down from 61 per cent in FY15. This should come down further on incremental volumes from Hero MotoCorp, Honda, Royal Enfield and Yamaha. However, it will be a gradual process given that Bajaj Auto too is expected to grow at a fast clip with revival in exports and recovery in domestic market after sluggish volume growth over the last 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 bikes as two-wheeler makers look to pass on the increase in input costs. 

Valuations

At the upper band of the issue, the company is asking for a valuation of 29 times its FY18 earnings per share. While there are no exact peers, Motherson Sumi, which has operations both in India and outside, trades at 36 times its FY18 estimates. The premium for a peer like Motherson is justified given higher return ratios and competitive strengths. While there is a scope for growth and return ratios improving, valuation comfort is missing. Investors with a longer term horizon can look at the issue.

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