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Ashok Leyland: Is there enough gas?

Jan 25, 2005

Performance summary
Ashok Leyland announced its 3QFY05 results today. While the company has posted a 40% and 21% growth in net profit in 3QFY05 and 9mFY05 respectively, much of the rise is because of better product mix and higher other income. The company has managed to control raw material expenses, which has consequently cushioned operating margins. However, if one were to exclude forex credit from expenses, operating margins have actually declined during the quarter.

(Rs m) 3QFY04 3QFY05 Change 9mFY04 9mFY05 Change
Net sales 8,535 9,871 15.7% 22,724 27,231 19.8%
Expenditure 7,693 8,772 14.0% 20,309 24,713 21.7%
Operating profit (EBDITA) 842 1,100 30.6% 2,416 2,518 4.2%
EBDITA margin (%) 9.9% 11.1%   10.6% 9.2%  
Other income 18 62 244.1% 129 211 63.2%
Interest (net) 45 18 -59.4% 226 39 -82.7%
Depreciation 233 255 9.6% 713 753 5.6%
Profit before tax 582 888 52.6% 1,606 1,937 20.6%
Extraordinary income/(expense) (18) (24) 33.9% (41) (71) 71.7%
Tax 184 248 34.5% 502 579 15.3%
Profit after tax/(loss) 380 617 62.3% 1,063 1,286 21.1%
Net profit margin (%) 4.5% 6.2%   4.7% 4.7%  
No. of shares (m) 1,189.3 1,189.3   1,189.3 1,189.3  
Diluted earnings per share (Rs)* 1.3 2.1   1.2 1.4  
Price to earnings ratio (x)         15.6  
(* annualised)            

What is the company's business?
Ashok Leyland (ASOK) is the second largest manufacturer of medium and heavy commercial vehicles (M/HCV) in India. It has a 28% market share in the domestic CV segment and a marginal presence of 1% in LCV's (light commercial vehicles). Apart from CVs, ASOK is also a key player in the passenger bus segment with almost 50%-55% market share. CVs and passenger vehicles contributed to 91% of revenues in FY04 while engines, sale of CKD units, castings and spare parts contributed the balance. Land Rover Leyland Investment Holdings (LRLIH) owns 51% of ASOK.

What has driven performance in 3QFY05?
Strike impacts volume growth:  As is evident from the table below, total volumes in 3QFY05 have increased only by 3%. While medium and heavy commercial vehicle sales have increased by 6% during the quarter, light commercial vehicle sales (LCVs) have tumbled owing to strike at one of the company's manufacturing facilities. Lower exports and subdued demand from domestic state transport undertakings are the key reasons behind the decline in passenger vehicle sales. To put things in perspective, export of buses declined by 29% during the quarter. But akin to the last two years, the shift in demand to tractor trailers and increased contribution from tippers (in light of the increased road construction activities) has translated into better realisation per unit. The company, in its conference call, has stated its plans to increase production and sales (including exports of 1,200 units to Iraq).

Volume break-up
(Rs m) 3QFY04 3QFY05 Change 9mFY04 9mFY05 Change
Passenger vehicles 3,152 3,028 -3.9% 8,757 8,639 -1.3%
M/HCVs 9,164 9,713 6.0% 23,597 27,522 16.6%
LCVs 157 90 -42.7% 484 250 -48.3%
Total 12,473 12,831 2.9% 32,838 36,411 10.9%

Cost reduction saves the day:  As mentioned by the management in the earlier quarter, Ashok Leyland has been successful in arresting the dramatic rise in raw material costs, which is down 20 basis points YoY in 3QFY05. The decline in other expenses as a percentage of sales during the quarter was on account of value engineering initiatives and forex credit. Also, power expenses have been brought under control, thus resulting in margin improvement. However, if one were to exclude the forex credit to the tune of Rs 80 m to Rs 90 m (source: conference call), operating margins have actually declined in 3QFY05. As far as the margin outlook is concerned, the management hopes to maintain it at current levels, if not increase. In our view, given the fact that input costs have again strengthened (albeit marginally), the near-term margin outlook remains an area of concern.

Cost break-up
(Rs m) 3QFY04 3QFY05 Change 9mFY04 9mFY05 Change
Raw materials 6,295 7,263 15.4% 16,306 20,135 23.5%
% sales 73.8% 73.6%   71.8% 73.9%  
Staff cost 761 845 11.1% 2,317 2,593 11.9%
% sales 8.9% 8.6%   10.2% 9.5%  
Other expenses 985 880 -10.7% 2,607 2,916 11.9%
% sales 11.5% 8.9%   11.5% 10.7%  

Over the last few quarters:  As is evident from the graph on the left side below, it has been a volatile show in the last nine quarters. This has been a key concern affecting our comfort factor with the company. While factors like steel price increase are cyclical in nature (that has a bearing on profitability), when compared with the market leader in the commercial vehicle segment i.e. Tata Motors, Ashok Leyland continues to lag behind.

What to expect?
The stock currently trades at Rs 23 implying a price to earnings multiple of 15.6 times annualised 9mFY05 earnings. We have to upgrade our earnings estimate for the company in light of continued rise in demand for CVs. The company hopes to increase exports in the next fiscal year by almost 25% on the back of new export possibilities to Sri Lanka and Bangladesh (basically, CNG vehicles), which is a positive. It also hopes to increase production capacity to 75,000 units in the second half of FY06, which will provide economies of scale in operations. This combined with any softening of steel prices will act as a profit driver. However, given the fact that the CV industry has been clocking significantly higher growth rates in the last three years (including FY05), we have apprehensions over the sustainability of the same. With more players expected to enter the Indian markets in the higher end of the CV chain, market will be fragmented, which will impact regional players like Ashok Leyland. Given these factors, the risk-reward equation is equally poised and to that extent, investors have to exercise caution.

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