Margin expansion key to support high valuation at Escorts
There seems to be a bright rainbow over Escorts Ltd, after the rains. From June, when it was certain the monsoon was on track, until now, the agri-machinery manufacturer’s stock skyrocketed 123% in just three months.
Many factors came together to fuel investor confidence, which continues in the company’s favour. At the forefront is the strong recovery in tractor sales on the back of a normal monsoon after two successive failed years. From April to August, tractor sales jumped by 17.5% year-on-year, with August sales alone soaring 55%.
And this momentum is likely to remain through this fiscal year as the company expands its presence in the southern markets, which have steadily bucked the slowdown and outperformed growth rates. Meanwhile, Escorts continues to grow in its stronghold markets in the northern and central belts.
The sudden turnaround in tractor sales after several quarters of contraction is a reason for re-rating the company’s stock. In fiscal year 2016, Escorts’s net revenue had contracted on the back of declining tractor sales. Its valuation had so far tailed that of other farm equipment manufacturers like VST Tillers Tractors Ltd, as other divisions dragged overall performance.
However, at current levels, the stock’s one-year forward price-to-earnings multiple has doubled to around 16 in a span of six months.
Another fillip to valuation comes from the management’s decision to sell the loss-making auto products division— which was bleeding and a drain on profitability for several years—which has signalled its intent to focus on the company’s core business.
But then, profit expansion is important to sustain the current valuation. Yes, besides farm equipment, Escorts is focusing on revving up revenue growth in other divisions like construction machinery and railways too. A slew of new products have been planned across these segments to improve utilization and improve profitability. However, this may take some time to start contributing to profits in a big way.
A key hurdle is that the company is saddled with high costs—a function of low output and high fixed expenses too. Forecasts by the management to trim raw material costs and employee costs through a voluntary retirement scheme are likely to give a leg-up to profitability. Analysts have pencilled an operating margin of about 9% by FY18—twice that of FY16.
The caveat, however, is that with nearly 85% of its revenue dependent on the vagaries of the monsoon, the stock’s earning trajectory will be cyclical and unpredictable. Unless Escorts is able to stabilize profit margins over a longer term, the stock’s valuations may see wide fluctuations.