Forging its future

POUND WISE

In spite of margin pressure, Bharat Forge remains a good long-term investment.

The largest auto component manufacturer in the country hasn"t had a great run at the stock markets this year.

Bharat Forge, the flagship company of the Kalyani group with a core focus on forged and machined auto components has under-performed both the Sensex as also the Business Standard Auto Ancillary index in 2006.

While the Sensex and the ancillary index returned 47 per cent and 22 per cent respectively over the year, Bharat Forge is down over 7 per cent per cent over the year.

The reason is not difficult to fathom""its consolidated financial performance has been mixed. Though top line growth seems to be firing on all cylinders, its profit margins are under pressure.

In the half year ended September 2006, the company recorded a consolidated net sales growth of a whopping 41 per cent over the same period last year.

But consolidated operating profit margin has declined from19.3 per cent in the first half of FY06 to less than 17 per cent in the April-September period this year. Overall, while many analysts recommend a "hold" on the stock right now, long term prospects appear positive.

Global scale, local advantage
It is the international operations which are proving a drag on margins as standalone operating margins have remained strong at around 25 per cent in the first half of FY07.

But it is also the global operations, which will provide the biggest upside for Bharat Forge. With its manufacturing facilities across six countries, Bharat Forge is already the second largest international forgings player with a capacity nearing 6,00,000 tonnes a year.

Moreover, the strategic presence in the four major automobile markets of Europe, North America, China and India gives the company a significant cushion from cyclical fluctuations in the domestic market.

"The various acquisitions and strategic tie-ups in the past few years have meant better technology and client access," says an analyst adding, "this remains a sure foundation for future growth."

In fact, this probably also underlines the company"s confidence in projecting a 20 per cent growth target in operating profits over the next two years. 
 

FINANCIALS
CRs crore	2005-06	2006-07E	2007-08E
Sales	2258.50	3210.60	3765.70
Operating profit	505.30	643.70	796.20
EPS (Rs)	11.60	14.60	18.40
P/E	31.20	24.80	19.70
Source: Bloomberg

One concern is however the expected slowdown in the US commercial vehicle demand in 2007 which could affect revenues. But the share of heavy duty chassis has come down from 85 per cent H1 FY06 to 58 per cent in H1 FY07 of US revenues. This trend could lessen the impact of a demand slowdown.

Integration blues
Bharat Forge"s acquisitions and tie-ups in the international arena have included the likes of Carl Dan Peddinghaus, Germany in 2004, Federal Forge, USA and Imatra Kilsta, Sweden in 2005 and the joint venture with First Automotive Works, China in March 2006.

Today, with six subsidiaries spread across Germany, Sweden, Scotland, the US and China, Bharat Forge is increasingly focusing on integrating these facilities into a synchronised dual-shore manufacturing model.

However, the overseas subsidiaries which contributed 54 per cent of the consolidated revenue in the quarter ending September 2006 have faced an erosion in margins this year.

Operating profit margins for global subsidiaries had fallen from 10.1 per cent in March to about 8 per cent by September. The key challenge for the company will be to improve its international margins from current levels.

Going forward, the Chinese foray could present significant challenges in the next two years. The larger sectoral climate could also play spoil-sport. "Given the commercial vehicle overhang in the Chinese market, top line growth in 2007 would remain a key challenge for the joint venture," says Mahantesh Sabarad, senior research analyst, Prabhudas Lilladher.

Partnering growth
In recent years, Bharat Forge has concentrated on transforming itself from a supplier to a development partner to OEM's.

As a first step in the process, promising trends in value addition have been seen. For example, the share of machined forgings in total forgings has been increasing from 40 per cent in FY05 to 45 per cent at present and is expected to rise over 50 per cent by FY08.

The company has also been focusing on increasing capacity utilisation in domestic plants. Capacity utilisation which showed a quarter on quarter increase of 12 per cent to 67 per cent in September 2006 is expected to reach around 75 per cent by March 2007. Enhancing capacity utilisation could bring about significant increases in operational efficiencies at plants.

The company is also expanding its capacity by 40,000 tonne to 2.4 lakh tonne a year at its Mundwa plant.This would be on stream by March 2007. The company is also negotiating with four marquee customers for big ticket contracts of $50 million each. These big deals could fructify by early 2007, which should result in a major scaling up of revenues from the second half of FY08.

On the flipside, the prospects of increased competition in the domestic commercial vehicle segment could affect suppliers like Bharat Forge in the near future.

"A pressure on margins of some of its bigger customers like Tata Motors due to increasing competition may affect the profitability of Bharat Forge in FY08", says Ambrish Mishra, senior research analyst, HDFC Securities.

Non-automotive forays
Bharat Forge's aggressive expansion in its non-automotive business involves an investment of nearly Rs 350 crore over the next two years. The focus would be on the energy, aerospace and hydrocarbons segment.

"Increasing focus on the non-automotive segment is an effective de-risking strategy whose effects would be evident from FY09," concurs a senior research analyst.

The revenue share from this segment, which at present stands at around 17 per cent, is thus slowly but steadily inching towards the company target of 20-25 per cent.

The final word
Mishra says, "Today there is a wider choice for investors in the auto-ancillary space, and my recommendation is to accumulate Bharat Forge with a look-out for other good quality ancillary stocks."

As a long term investment, however the stock is a good bet. The advantages of scale, increasing value addition and the forays into the non-automotive space would increasingly have itself felt within the next two-three years.