CXO DIARIES

Varroc Engineering
Focus on wallet share and profitability improvement

Varroc Engineering Ltd, in its international automotive lighting business is aiming Varroc Engineering is a global tier-1 automotive
to improve wallet share with large OEM groups such as VW and Renault-Nissan- component group. It has two primary business
Mitsubishi among others. Its new plants in Brazil, Morocco and Poland have won lines, (i) exterior lighting systems for passenger
orders which will translate into higher revenues from the current fiscal. While the cars OEMs worldwide and (ii) a wide range of
components in India, for 2W/3W OEMs. Mr
utilization in the current year will be in the range of 15-20%, profitability of these
Tarang Jain is the promoter and Managing
new plants will improve considerably from FY21 by when the utilization levels are Director at Varroc. He holds a bachelor’s degree
expected to rise to 40-45% and further to 60-65% by FY22. Varroc is aiming a in commerce from University of Bombay and a
significant improvement in EBIDTA margins through 1) raw material cost savings diploma in business administration from
by driving in purchasing efficiencies, 2) substitution of part-purchase of electronics Mr. Tarang Jain – University of Laussane, Switzerland. He has 30
Managing Director years of experience in the automotive industry.
for LEDs with in-house manufacturing under a JV, 3) optimizing employee costs
and 4) controlling launch costs. In the China JV operations, while the industry
continues to be weak, VLS JV has won contracts from the local players in China such CMP (Rs) (As on Jul 03, 2019) 477 Sector: Auto Components
as Geely, SAIC and FAW. These orders are expected to fructify into significant
Market cap (Rs mn) 64,359 Rating BUY
revenues from FY22. US-China trade war truce is critical for the revival of industry
growth in China.
Exhibit 1: Financial Summary
Y/e 31 Mar (Rs mn) FY18 FY19 FY20E FY21E
In India operations, while the industry is expected to grow in the range of 6-7% over
Revenues 102,788 120,365 130,498 142,977
the next couple of years, Varroc is expected to outperform industry growth with 1)
yoy growth (%) 10.5 17.1 8.4 9.6
increasing wallet share with existing customers, 2) scaling up revenues from new
OPM (%) 8.5 9.0 9.4 10.1
customers such as TVS Motors and Hero Motocorp and 3) new products such as
Reported PAT 4,503 4,463 4,912 6,456
electronic fuel injection and catalytic converter contributing meaningfully from next
yoy growth (%) 48.6 (0.9) 10.1 31.4
fiscal under BS VI regime.
EPS (Rs) 33.4 33.1 36.4 47.9
P/E (x) 14.3 14.4 13.1 10.0
Varroc is aiming for a 100bps improvement in EBIDTA margins during FY20 for its
EV/EBITDA (x) 8.1 7.3 6.3 5.0
VLS operations. The company has lined up a capital expenditure plan of Rs8bn for
Debt/Equity (x) 0.3 0.5 0.4 0.3
the current fiscal of which Rs5bn will be spent on VLS and Rs3bn on India
RoE (%) 18.4 15.3 14.5 16.6
operations (considering pruning it to Rs2bn).
RoCE (%) 14.6 14.5 13.9 16.3
Source: Company, YES Sec - Research

July 04, 2019

Research Analyst: Prayesh Jain  prayesh.jain@ysil.in
Head of Research: Amar Ambani  amar.ambani@ysil.in (For important information about YES SECURITIES (INDIA) LTD. and other disclosures, refer to the end of this material.)
Varroc Engineering Ltd
VLS – Europe, US
 VLS derives 60% of lighting revenues are from European region,
where the current industry performance is akin to Q4 FY19.
However, VLS, during FY19, has seen major order wins and re-wins
to the tune of €462mn (€228mn of new business wins and €234mn of
re-wins). VLS has been able to outbid the top three peers globally to
win these orders and better pricing has played a key role. New order
wins are mainly from customers such as VW and Renault-Nissan-
Mitsubishi JV among others.
 Geographically expanded presence (Brazil, Morocco and Poland) is
likely to help VLS win orders from the large OEM groups such as
VW, Ford and Nissan-Renault-Mitsubishi as these customers also
have a wider presence and have global platforms. With new plants,
VLS is now present in all important regions where these customer
groups want them to be in.
 OEM commentary – US – China trade war needs to be resolved for
a fresh trigger but OEMs continue to invest in new products on ICE
and EV platforms. During last fiscal, the weakness was owing to the
fact the OEMs were finding it difficult to homologate with emission
norms (WLTP). However, the same seems to be sorted out for now.
 New plants: VLS expects Rs3.2-3.3bn of revenues from the three new
plants (Brazil, Morocco and Poland) in the current fiscal with 15-20%
capacity utilization leading to losses which will be absorbed in FY20
margins (improvement in core operations). Profitability from these
plants will start flowing from FY21 when the utilization is expected
to increase to 55-60%. In FY22, Poland and Morocco will reach
revenues of at least €150m each and are likely to earn double digit
EBIDTA margins. Brazil, being a much smaller plant, is likely to earn
marginal profits from FY22 and scale up further in FY23.
 Mexico plant volumes have dropped from last fiscal as car sales
have declined primarily from Tesla, which is a major customer for
the plant. Other OEMs have also seen some pressures. Despite lower
volumes, the plant is earning double digit EBIDTA Margins. Going
ahead, recent new order wins will start contributing from FY21 and
will scale to much stronger growth would from FY22.
 Turkey acquisition: The entity accounted €30mn revenues and 20%
EBIDTA margins in FY19. Considering the future growth
opportunities, the company is moving to a new location (within a
short distance from the current plant) for larger capacities.
 New products: VLS continues to work on future products involving
sensors and telematics. However, in the meanwhile, the company
has worked on traceability of production. Any product issue can be
traced back to plant, shift and people within a short time. This will
help identify the issue and resolve it at the earliest. No major
products warranties have been triggered in the past few years for
VLS.
VLS - China JV
 During the current steep fall in volumes in China, local players have
fared relatively better with no major de-growth as compared to the
international players.
 The industry growth in the first two months of the current fiscal
have continued to be weak and outlook remains cautious for the
current fiscal.
 €62mn orders were won in China last year, of which €50mn is from
local players such as Geely (partners of VW), SAIC and FAW. This
provides good revenue visibility for the next couple of years.
 US-China Trade war truce can be a big trigger, not just for China but
also for global demand.
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Varroc Engineering Ltd
India business
 85% of the revenues is contributed by two-wheelers. 17 key products
are being sold to inclusive of the new products viz Electronic Fuel
Injection (EFI) and catalyst converter (CC) - will replace the old
product. Key growth driver has been cross selling of these products
to existing customers.
 The company is budgeting for a 6-7% industry growth in two-
wheelers and 5% in the car segment. Cross selling of two-wheeler
products and light weighting parts for four wheelers will help
Varroc Engineering outperform industry growth.
 TVS Motors is now a customer for Varroc Engineering with
commencement of sales of Magneto from the current year and
scaling up to Rs40mn per month from next fiscal. Also, orders for a
couple of more products are under discussion from TVS Motors.
With Hero Motocorp, discussion is on for additional products of
which revenues for some will start from the next fiscal. Varroc
expects to receive orders from Suzuki, Yamaha and Royal Enfield
for additional products over the medium term.
 New products: BS VI will products (EFI and CC) give higher
revenues. Also, the company will soon start manufacturing of motor
and motor controllers (Rs20,000 per set) for electric two-wheelers
from next fiscal.
EBIDTA margins improvement plan
 During the last couple of years, margins at VLS suffered because of
launch costs and lower utilization levels in Europe operations.
Several measures are being taken to improve the performance led
by 1) substituting part purchase of electronics with in-house
manufacturing of electronics for LEDs, 2) bringing in purchase
efficiencies, 3) optimizing manpower costs, and 4) controlling
launch costs.
 Electronic facility: VLS is setting up a JV in Romania with a 70%
stake to manufacture electronics required in LEDs to replace 35% of
current purchases. The plant is being set up in the city of Timisoara
and is expected to commence operations during the current fiscal.
VLS spends about €150mn on electronic purchases per annum. The
facility in Romania is expected to generate €45-50mn revenues
within a year or so. On this, VLS will save ~€5mn as the JV will sell
electronics 10% cheaper when compared to current purchase cost.
Additionally, the JV will make its own profit, which will be reflected
in the consolidated performance of Varroc Engineering.
 Raw material cost savings – To bring down the RM costs, VLS is
working on several initiatives that includes 1) make v/s buy
decision wherein some in-house manufacturing will be shifted to
buying on specific locations where savings can be done, 2) to bring
in purchasing efficiencies, VLS has hired experts from global
leaders. The key components where costs can be pruned are wiring
harnesses and plastic raw materials. Annual savings are likely to 5%
but considering that most contract with OEMs account for per
annum discounts of 3% the net savings are likely to be 2%.
 Launch costs: During the past few years, VLS has been exceeding its
budgets on launch costs due to 1) significantly higher level of
rejections during trial runs, 2) problem of suppliers with regards to
deliverables leading increase in backlog, 3) use of premium freight
services to offset the impact of backlog and 4) remaking of products
which led to higher consumables. VLS has significantly improved
on these parameters and going ahead launch costs are likely to trend
lower. New launches from the new plants are expected to be much
smoother as the back-end of launch programs have been
strengthened.
 Staff costs: Large portion of fixed costs for Varroc are in salaries. To
reduce the staff costs Varroc has 1) frozen on new hiring except for
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Varroc Engineering Ltd

critical hiring and 2) will also optimize employee strength Strong growth deserves premium valuations
selectively. Considering our expectations of margin expansion and outperformance
 Ultimately Varroc aims to clock a double digit EBIDTA margin in its of revenue growth v/s industry, we estimate earnings CAGR of 20%
VLS operations in the current fiscal. This target is in spite of during FY19-21E. We find the valuations attractive at FY21E P/E of 10x.
factoring in lower utilization of the new plants. Global automotive lighting majors such as Koito, Stanley, Valeo and
Hella trade at FY21E P/E of 10-12x. Given its stronger revenue and
Other highlights earnings growth profile, we believe VLS deserves a premium. In the
domestic market, FY21E P/E for auto ancillary companies ranges
 Capex: For the current fiscal Varroc has budgeted for Rs8bn – Rs5bn
between 12-22x. In our reckoning, VEL’s domestic business deserve
in VLS and Rs3bn in India. The company is aiming to prune capex
multiples towards the higher end of this range. Overall, we assign 16x
in India to Rs2bn considering the current slowdown. Over the next
P/E on FY21E estimated earnings to arrive at a fair value of Rs766.
few years, capex is not likely to Rs8bn per annum. For VLS, the
Retain our BUY rating.
company will not require additional sites for the next four years at
least.
 Shareholding pattern: Promoter holding in Varroc is at 85%, which
needs to be reduced to 75% over the next two years. Currently, the
issue is not a top of the mind concern for promoters considering the
timeline. While all options remain open, promoter preference seems
to be towards a secondary sale rather than inorganic route or
primary sale.

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