Tough to justify Havells' valuation

FY18 margins might be checked due to acquisition of Lloyd and competitive pressure

Havells, the electrical equipment major, might be a classic case of a mid-cap stock being re-rated much ahead of an improvement in its fundamentals.

While its stock continued to react positively (up two per cent on Wednesday) to a decent set of March quarter (Q4) results, the 50 per cent year-to-date gain might limit a significant upside from here, as Havells now trades at 40 times its estimated FY18 earnings.

And, sustaining the profitability could be a challenge. Even if recovery after demonetisation gradually plays out, the consolidation of Lloyd's recently acquired consumer business could dilute the earnings margin.

In fact, even the Q4 performance doesn't convincingly demonstrate that the note ban pressures are gone. Schemes introduced by the company during that period to push sales at dealers might be only gradually withdrawn in the coming weeks. Pricing for this, the Street did not have high expectations, too.

Still, net revenue for the quarter (Q4) at Rs 1,710 crore (up 17 per cent year-on-year) managed to comfortably exceed the Bloomberg estimate of Rs 1,643 crore. However, net profit, impacted by certain write-offs, was down 73 per cent over a year, sharply below expectation.

That said, as the March quarter of FY16 was also puffed by a one-off gain of Rs 204 crore, these items have to be excluded. Profit before tax and one-off transactions at Rs 171 crore grew by only four per cent over a year. This is muted compared to revenue growth, as higher selling, general and administrative (SG&A) expenses kept a check on operating profit, up four per cent year-on-year to Rs 230 crore. The latter margin, thus, took a beating from 15.2 per cent a year before to 13.4 per cent in Q4.

As for the segments, beneficial copper prices for most of Q4 helped the cables division to post revenue growth of 12 per cent but the division's margin declined by 180 basis points (bps). Being a commodity-dependent segment, analysts believe the trend should normalise by the June quarter. The switchgear business, which for long posted single-digit growth, showed promise in Q4 with revenue growth of 12 per cent. However, its operating profit margins have declined steadily over recent quarters, from 40 per cent to 38.5 per cent in Q4. The consumer durables business continues to offer cushion (revenue up 28 per cent year-on-year), though the intense competition and the company's inability to pass on increasing raw material costs dragged profit margins for the segment down by nearly 360 bps year-on-year to 24.5 per cent.

A few analysts say Bajaj Electricals' recent revamping of its distribution network could have helped entities, including Havells, to gain some market share, apart from the structural shift from unorganised to organised players.

Lighting seems to be the only segment where Havells could sustain its pricing and competitive pressures, as its margins expanded by 390 bps to 28.5 per cent, though revenue growth remained muted.

Even as margins came under pressure for most segments, this was expected. The recent price hike, implemented in early May, could lift margins, save for the recent acquisition of Lloyd's air conditioning business. Analysts say the acquisition could limit any significant improvement in profitability and estimate the combined operating profit margin at 12-12.5 per cent. For FY17, this was 13.5 per cent.

This is why analysts question the 40 times FY18 earning multiple of the stock. "While revenues might improve, it would be at the cost of profitability, in which case the multiples seem stretched and unjustified," says an analyst with a domestic brokerage. In fact, some believe that Havells' stock is of late being re-rated at par with consumer staples. "That is a big risk, as the difference in return profile for staples and durables is huge," the analyst adds. This is why his tribe is cautious on whether Havells would justify these valuations.