finolex cables (buy) -err grp- play on industrial capex recovery

8/11/2019 Finolex Cables (BUY) -ERr Grp- Play on Industrial Capex Recovery

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Play on industrial capex recovery

Finolex is levered to a demand recovery in the B2B sector. IIP growthrecovered after each of the past three Union Elections, which is alsocorroborated by our dealer checks. Hence, we expect a recovery afterthe ongoing Union Elections. We upgrade our revenue estimates by 4%for FY15 and 9% for FY15 and EBITDA estimates by 6% for FY15 and 12%for FY16. We now value the investment book at 41 (95% upgrade), aswe now value investment in Finolex Industries at a 50% discount to itsmarket value (earlier book value). Our SOTP-based TP is revised up by33% to 159. Valuation at 1.4x FY16 P/B is attractive given FY16 RoEs of23% and FY14-16 EPS CAGR of 31%. At CMP, the stock is trading at a55% discount to its peers FY16 P/E, despite its FY16 RoE of 23% andFY14-16 EPS CAGR of 31% (vs peers 22%). BUY.

Bet on a recovery in industrial capex

Almost 85% of Finolexs revenues come from B2B businesses (auto, industries,state electricity boards and housing). Empirical evidence suggests a strongcorrelation between IIP growth (represents B2B businesses) and Finolexsrevenue growth. Further Finolexs revenues have also recovered sharply post thelast three Union elections. This was also corroborated in our recent dealerchecks at Bhagirath palace which is Asias largest electrical market.

EBITDA margin to improve with positive impact of operating leverage

Finolexs EBITDA margins in the past have expanded in line with a high revenuegrowth led by a favourable impact of operating leverage. Given our expectationof revenue growth of 25% in FY16 and 16% in FY17, we expect EBITDA margins

to improve 60bps in FY16 and 100bps in FY17 over 10% in FY14. Even in FY15,we expect a margin improvement of 50bps YoY but not led by operatingleverage given 50% YoY increase in ad spends.

Success in switchgears not completely factored in our estimates

We estimate switchgear revenue of `1bn in FY15, which is 50% lower than themanagements guidance. Also, in FY18, we model revenue of `2.9bn whichimplies a meagre 4% market share although 70% of the market share iscontrolled by Havells, Legrand and Schneider and ~35% of the market is insouth India where Finolexs brand is very strong. If we assume 8% market sharein FY18 then our DCF-based target prices increases to `180/share.

Valuations: Crying for a re-rating; steep discount to peers unjustified

Finolex is trading at 1.4x FY16 P/B despite its FY16 RoE of 23% and FY14-16EPS CAGR of 31%. Compared with its peers, it is trading at a steep discount of55% on FY16 EPS despite its higher FY14-16 EPS CAGR of 31% (vs peers 22%)and FY16 RoE of 23% (similar to peers). Also, compared with its cross-cycleaverage one-year forward P/B over FY04-09 (as FY09-13 is not comparable dueto derivative loss), the stock is trading at a 36% discount despite its FY04-08 RoEof 9.6% and EPS CAGR of 32%.

Finolex CablesBUY

COMPANY INSIGHT FNXC IN EQUITY May 08, 2014

Key financials

Year to March ( mn) FY12 FY13 FY14E FY15E FY16ERevenue 20,640 22,707 23,550 28,885 36,169EBITDA margin (%) 8.5 10.1 10.0 10.5 10.9

EPS (`) 8.8 11.0 11.5 15.0 19.6

Reported RoE (%) 12.9 16.8 17.8 20.1 22.9Core RoE (%)* 19.0 24.8 18.6 21.1 23.8P/E (x) 14.2 11.4 10.9 8.4 6.4

P/B (x) 2.4 2.1 1.8 1.6 1.4

Source: Company, Ambit Capital research, Note: * adjusted for derivative loss and other income oninvestments

Light Electricals

RecommendationMcap (bn): `19/US$0.36M ADV (mn): `93/US$1.5

CMP: `127

TP (12 mths): `159

Upside (%): 25%

Flags

Accounting: GREEN

Predictability: REDEarnings Momentum: GREEN

Catalyst

Increase in infra spend by Telcos

Success in switchgears

Performance (%)

Source: Bloomberg, Ambit Capital research

Analyst Details

Bhargav Buddhadev+91 22 3043 3252

[email protected]

Deepesh Agarwal+91 22 3043 3275

[email protected]

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FNXC NIFTY


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Finolex Cables

08 May, 2014 Ambit CapitalPvt. Ltd. Page 2

Recovery in project demand benefitsFinolexFinolexs revenue growth strongly correlated to IIP recovery

Almost 85% of Finolexs revenues come from project-based businesses (like auto and

other industries), state electricity boards (SEBs), new housing, and the constructionsector (see Exhibit 2 below). Due to the weak IIP print in FY14 (declined by 1.1% YoYtill February 2014), Finolexs revenue growth so far in 9MFY14 has been weak at 4%YoY. Empirical evidence suggests a strong correlation between IIP growth (whichrepresents project demand) and Finolexs revenue growth (see Exhibit 1 below).Consequently, a recovery in project demand augurs well for Finolex.

Exhibit 1:

Finolexs revenue growth has a strongcorrelation with the IIP print

Source: Source: MOSPI, Company, Ambit Capital research

Exhibit 2:

Almost 85% of Finolexs revenue is linked toproject demand

Customer typeFinolex Cables - revenue share

(%)

Auto 15%

Industry 15%

Power 15%

Construction Institutional 15%

Construction Retail 25%

Total Project demand 85%

Agriculture 15%

Total demand 100%

Source: Source: Industry, Ambit Capital research

Empirical evidence suggests a recovery in project demand post the UnionElections

Empirical evidence suggests sluggish growth in IIP six months preceding the UnionElections followed by a strong recovery in the six months post the elections. This wasalso corroborated in our recent dealer meetings at the Bhagirath market in Delhi,Asias largest electrical market. Whilst IIP growth in the six months preceding theUnion Elections in September 1999, May 2004 and May 2009 was sluggish at 6%,9% and 1% respectively, IIP growth recovered to 7%, 12% and 9% six months aftereach Union Election (see Exhibit 3 below). Consequently, Finolexs full-year revenue

growth also recovered from 2% in FY99, 4% in FY04 and -6% in FY09 to 24% inFY00, 26% in FY05 and 15% in FY10. Consequently, we are assuming higherrevenue growth of 21% in FY15 and 25% in FY16 as compared to a weak revenuegrowth of 4% in FY14. Note that the higher revenue growth in FY15 and FY16 willalso be led by switchgears, which is a new product launch. We model switchgearsrevenues of `1bn in FY15 and `1.6bn in FY16, which is equivalent to 3.5% and 4.5%of FY15 and FY16 revenues respectively.

-10%

0%

10%

20%

30%

40%

0%

3%

6%

9%

12%

15%

18%

FY08

FY09

FY10

FY11

FY12

FY13

IIP (LHS) Finolex 's revenue growth (%)


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Exhibit 3:

Empirical evidence shows strong recovery in IIPpost elections (representing IIP growth YoY in %)

Source: MOSPI, Ambit Capital research

Exhibit 4:

Historically, Finolexs revenue growth has beenhigher post-election

Source: MOSPI, Company, Ambit Capital research, Note pre-election yearrepresent FY99, FY04, FY09 and FY14 and post-election year represent

FY00, FY05, FY10 and FY15E.

0%

3%

6%

9%

12%

15%

Sep-99 May-04 May-09

Six months preceeding election

Six months following election

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

Sep-99 May-04 May-09 May-14

Pre-election year Post election year


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Finolex Cables


High revenue growth boosts margin givenfavourable impact of operating leverageFinolexs EBITDA margin has recovered in periods of strong revenue growth

Historically, Finolexs EBITDA margins have expanded in years where revenue growth

has recovered. This recovery has primarily been led by a favourable impact ofoperating leverage, as shown in Exhibit 5 below. We assess the impact of operatingleverage by calculating the change in EBITDA margin on a YoY basis and thendeducting the change in gross margins from this. Given our expectation of higherrevenue growth of 21% in FY15 and 25% in FY16, we expect an EBITDA marginimprovement of 60bps YoY and 40bps YoY. As mentioned earlier, the higher revenuegrowth in FY15 and FY16 is also led by the launch of switchgears in FY15.

Exhibit 5:

Higher revenue growth led to favourable operating leverage for Finolex

Source: Company, Ambit Capital research; Note: we calculate operating leverage as YoY change in EBITDA

margin minus YoY change in gross margin.

Impact of operating leverage more in FY16 and FY17 given higher ad spendsin FY15

After Deepak Chhabria, the nephew of Prahlad Chhabria, became the MD in July2013, Finolex has become aggressive in adding dealers in north India (dealer countdoubled in the last three years) and in incurring ad spends (up ~50% YoY so far inFY14). Consequently we expect the favourable impact of operating leverage to beoffset by an increase in advertisement spend in FY15. However, we expect the EBITDAmargins improvement of 30bps YoY in FY16 and 20bps YoY in FY17 to becontributed by the favourable impact of operating leverage. This would be primarily

led by a 30bps and 10bps decrease in employee expense as a percentage ofrevenues in FY16 and FY17, respectively.

-300

-200

-100

0

100

200

300

400

500

-25%

-15%

-5%

5%

15%

25%

35%

45%

FY02

FY03

FY04

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

Revenue growth (%) Operatiiong leverage (bps) on RHS


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Exhibit 6:

Impact of operating leverage more in FY16 and FY17 given higher ad spends in FY15

(in mn unless specified) FY12 FY13 FY14E FY15E FY16E FY17E

Revenues 20,385 22,438 23,310 28,592 35,804 41,617

Raw Material costs 15,694 16,621 17,250 20,876 26,027 30,162

YoY growth -0.6% 5.9% 3.8% 21.0% 24.7% 15.9%

as % of sales 77.0% 74.1% 74.0% 73.0% 72.7% 72.5%

Gross Margin 4,691 5,818 6,061 7,715 9,777 11,455

YoY growth 9.1% 24.0% 4.2% 27.3% 26.7% 17.2%

Gross margin (%) 23.0% 25.9% 26.0% 27.0% 27.3% 27.5%

Gross margin expansion/ (contraction) 160bps 290bps 10bps 100bps 30bps 20bps

Employee expenses 695 846 915 1,016 1,189 1,324

YoY growth 7.3% 21.7% 8.2% 11.1% 16.9% 11.4%

as % of sales 3.4% 3.8% 3.9% 3.6% 3.3% 3.2%

Manufacturing related 322 402 466 572 716 832

YoY growth -2.2% 24.5% 16.1% 22.7% 25.2% 16.2%

as % of sales 1.6% 1.8% 2.0% 2.0% 2.0% 2.0%

Advertising/marketing 1,791 2,042 2,094 2,859 3,580 4,162

YoY growth 16.5% 14.0% 2.5% 36.6% 25.2% 16.2%

as % of sales 8.8% 9.1% 9.0% 10.0% 10.0% 10.0%

Others 389 500 466 572 716 832

YoY growth 19.0% 28.5% -6.8% 22.7% 25.2% 16.2%

as % of sales 1.9% 2.2% 2.0% 2.0% 2.0% 2.0%

EBITDA 1,748 2,297 2,360 2,989 3,941 4,728

YoY growth 0.9% 31.4% 2.8% 26.7% 31.8% 20.0%

EBITDA margin 8.6% 10.2% 10.1% 10.5% 11.0% 11.4%

EBITDA margin expansion/ (contraction) -10bps 170bps -10bps 30bps 60bps 40bps

Operating leverage -160bps -130bps -20bps -70bps 30bps 20bpsSource: Company, Ambit Capital research


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Success in Switchgear business notcompletely factored in our estimatesOur switchgear revenue estimate is conservative

Our switchgear revenue estimates for FY15 is lower than the managements

guidance. The management is guiding for switchgear revenues of`

2bn in FY15,which implies a market share of ~4% in the first year of launch. Our estimate is lowerat `1bn, as the management is guiding for a launch of switchgears in 1QFY15, butwe expect a launch after 2QFY15, as the product has not been showcased to thedealer community yet. Consequently, we have modelled in a conservative revenueestimate of `1bn in FY15 and `1.6bn in FY16. We estimate 4% market share only inFY18 vs the managements target of achieving this market share in FY15.

If Finolex makes a successful debut in launching switchgears then there istremendous opportunity for the company to capture a large market share, given that70% of the market is controlled by three players: Havells, Schneider and Legrand(acquired Indo Asian Fusegear in FY11).

Exhibit 7:

Sensitivity analysis of Finolexs switchgear business

High case Base case Low case

Switchgear revenues

Assumed FY15 revenue of`1.5bn andrevenue growth of 70% in FY16 and 60%in FY17. Consequently, revenue CAGRover FY15-20 comes to 42% andFinolex's market share in FY20 comes to4%.

Assumed FY15 revenue of`1.0bnand revenue growth of 60% in FY16and 40% in FY17. Consequentlyassumed revenue CAGR over FY15-20 is at 34% and Finolex's marketshare in FY20 comes to 1.8%.

Assumed FY15 revenue of`0.5bn andrevenue growth of 15% in FY16 and10% in FY17. Consequently revenueCAGR over FY15-20 comes to 16% andFinolex's market share in FY20 comesto 0.4%.

Switchgear EBIT margin (%)

Assumed Finolex will continue itspremium pricing policy in switchgearsand consequently EBIT margin would be20% in FY15 and 25% in FY16 and FY17.

Assumed Finolex will earn marginlower than established playersinitially and improve its marginsequentially. We assume EBIT marginof 10% in FY15, 15% in FY16 and18% in FY17.

Assumed Finolex will struggle to break-even in switchgear in FY15 with EBITmargin of -10%. Further we assume nilEBIT margin in FY16 and 10% in FY17.

Gross block turnover

Consequent to increase in revenue fromswitchgears, assumed improvement inFinolex's gross block turnover ratio from2.4x in FY14 to 2.8x in FY15 to 3.2x inFY16 and 3.4x in FY17.

Consequent to our base-case

assumption of modest revenuegrowth in switchgears, we haveassumed Finolex's gross blockturnover ratio to improve from 2.4x inFY14 to 2.8x in FY15, to 3.1x in FY16and 3.2x in FY17.

Consequent to low revenues of

switchgears, we assume only marginalimprovement in Finolex's gross blockturnover ratio from 2.4x in FY14 to 2.7xin FY15, to 3.0x in FY16 and 3.1x inFY17.

Fair value ( /share) 180 159 148

Source: Ambit Capital research

Can Finolex capture a large market share in switchgears?

Large opportunity with limited entry barriers:The market share in switchgears ishighly concentrated, with the top-3 players accounting for a market share of ~70% in

the US$2.9bn switchgear industry. This leaves a lot of scope for new entrants likeFinolex to take away market share from the incumbents. Whilst 6-7 years ago, all theIndian companies imported switchgears (Havells imported from a Germanmanufacturer), now with virtually all players manufacturing switchgears in India, thetechnology is no longer an entry barrier. Havells, Schneider and Legrand still hold alarge market share primarily because the per annum market size for this product issmall at ~`50bn for large players like ABB, Siemens or L&T to aggressively tap thismarket. Also, their brand perception amidst consumers is very strong.

Finolexs brand perception as a safety brand is strong: Our discussions withthe dealer community suggest that the perception of Finolexs brand in the mind of aconsumer as a safety brand is very high. Hence, if Finolex launches any newproduct, its product quality by default would be superior and will be accepted for any

application where safety is of prime importance. Consequently, if Finolex is able tore-create the brand perception of its electrical wires then it can challenge the industryleader by capturing a large market share.


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Finolex Cables


Leverage on the existing distribution network; ~50% is replacement market:The replacement market formsalmost 50% of the market, as the life of the product is2-3 years and the buying decision is driven by the dealer who sells the product to thefinal consumer. The remaining 50% of the market is driven by architects/consultantswho certify vendors based on the product quality and pricing. Given that Finolexalready has a strong relationship with these architects/consultants, due to itsreputation as a successful cables and wires company, the gestation period to start

selling in the retail market is minimal. We believe Finolex will first launch the productin south and west India (~50% of Indias overall electrical market), given Finolexsstrong brand recall in these geographies.

Sensitivity analysis relating to the switchgear business - Target priceincreases to 180/share based on management guidance, which is our high-case scenario

If we factor in managements revenue guidance of `1.5bn in FY15 and assume this tonearly triple to `4bn by FY17, EBIT margin of 20% in FY15 and 25% in FY16 andFY17, and an improvement in the gross block turnover from 2.4x in FY14 to 2.8x inFY15 and 3.2x in FY16, our target price increases to `180/share vs the current target

price of `159/share, implying 45% upside.

However, in the low-case scenario we assume: (a) revenue of `0.5bn in FY15 andrevenue growth of 15% in FY16 and 10% in FY17, (b)loss of `50mn in FY15, break-even in FY16 and EBIT margin of 10% in FY17, and (c) marginal improvement ingross block turnover ratio from 2.4x in FY14 to 2.7x in FY15 to 3x in FY16. Thus, ourtarget price declines to `148/share vs `159/share. However, compared with thecurrent market price of `127, it still implies an upside of 16%.


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Key assumptionsWe expect Finolex to report 22% revenue CAGR and 29% PAT CAGR over FY14-16led by the detailed assumptions given in the exhibit below.

Exhibit 8:

Finolex Key assumptions

Particulars FY12 FY13 FY14 FY15E FY16E Comments

Key assumptions (in mn unless otherwise specified)

Electrical cables We expect 22% revenue CAGR over FY14-16 which is higher ascompared to the last five-year industry growth of ~11%. The highergrowth is on account of: (a) rising share of north and east India giventhe brown-field expansion at Roorkee and (b) recovery in industrialcapex in 2HFY15.

Net Revenues 17,705 20,859 21,901 26,282 32,852

% YoY growth 34% 18% 5% 20% 25%

Communication cables We expect 20% revenue CAGR over FY14-16 driven by Reliance Jiosexpansion of the optical fibre footprint. Reliance Jio is expanding itsbackhaul fibre infrastructure for the launch of services on the2,300MHz spectrum band by September 2014. Wireless coverageusing the 2,300MHz band needs more cell sites, the thumb rule being3.2x the cell sites under 900MHz and 1.6x the cell sites under1,800MHz.

Net Revenues 1,420 1,991 2,190 2,628 3,153

% YoY growth -24% 40% 10% 20% 20%

Copper rodWe expect external sales to decline, as it is likely to be used for captiveconsumption given the brownfield expansion at Roorkee.Net Revenues 2,051 836 418 209 167

% YoY growth -21% -59% -50% -50% -20%

Switches, lamps and others We expect revenue growth of 45% in FY14 given the already strongperformance in 9MFY14. For FY15 and FY16, we expect lower growthof 15% given that the market is now shifting towards premiumproducts, which is a gap in Finolexs portfolio.

Net Revenues 394 282 409 470 541

% YoY growth 9% -28% 45% 15% 15%

Switchgears The management has indicated that Finolex would add industrialswitchgears to its product-line in FY15, with targeted revenue of `2bnin FY15. However, we are assuming only 50% of the guidance, asFinolex is a new entrant and `2bn implies a market share of ~4%which may be difficult to achieve in the first year of operation. In FY18,we model revenue of `2.9bn which implies a market share of ~4%.

Net Revenues - - - 1,000 1,600

% YoY growth NA NA NA NA 60%

Key estimates (all figures in mn unless otherwise specified)

Net revenues 20,640 22,707 23,550 28,885 36,169 Based on the above assumptions, we expect the company to reportrevenue CAGR of 24% over FY14-16.% YoY growth 1% 10% 4% 23% 25%

EBITDA 1,748 2,297 2,360 3,028 3,944

We expect EBITDA margin to decline marginally by 10bps in FY14 andthen expand by 50bps in FY15 and 40bps in FY16 on the back of anincrease in the revenue share of switchgears from 0% in FY14 to ~3%in FY15 and ~4% in FY16. We have modelled EBIT margin of 10% forswitchgears in FY15 and 15% in FY16 as compared to ~13.2% incables for FY15. Established players like Havells make more than~30% margins in switchgears.

EBITDA margin (%) 8.5% 10.1% 10.0% 10.5% 10.9%Consequently, we expect EBITDA margins to improve by 50bps YoY inFY15 and 40bps YoY in FY16.

EBITDA (YoY growth) (%) 1% 31% 3% 28% 30%

Interest expense 261 134 138 138 138We model flat YoY growth in interest expense in FY15 and FY16 giventhat Finolex has a debt of `1.5bn on the balance sheet.

PBT 1,093 1,708 2,257 2,934 3,852

Tax rate (%) 10% 15% 22% 22% 22%

We assume a higher tax rate of 22% as compared to 15% in FY13because the MAT credit, which was available in FY12 and FY13, hasbeen set off. However, our average tax rate continues to be lower thanthe marginal tax rate given that the Roorkee plant enjoys a taxexemption.

Adj. PAT 982 1,453 1,761 2,288 3,004 Adjusted for derivative losses.

PAT (YoY growth) (%) -14% 48% 21% 30% 31%

Cash flow from operations (CFO) 2,064 1,572 2,015 2,633 3,345

We expect cash conversion to improve to 40 days in FY15 and 36 daysin FY16 as compared to 44 days in FY14 as share of revenues fromnorth India increase. Consequently, we expect CFO CAGR of 28% overFY14-16.

Capex 461 498 705 774 1,634We expect the company to incur higher capex in FY16, as it plans tobuild a manufacturing facility for switchgears.

Free cash flow 2,525 2,071 2,719 3,407 4,978 Finolex will continue to generate free cash flow.EPS 8.6 10.8 11.5 15.0 19.6 Consequently, we expect EPS CAGR of 31% over FY14-16.

Source: Company, Ambit Capital research


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Exhibit 9:

Change in estimates

In mnNew Old Change (%)

CommentsFY15 FY16 FY15 FY16 FY15 FY16

Recommendation BUY BUY

Target Price 159 120 32%Due to upgrade in revenue and EBITDA margin, improvement in cashconversion in FY15 and FY16 and upgrade to valuation assigned to theinvestment book

Electrical Cables 26,282 32,852 25,274 30,329 4% 8%Given the likelihood of recovery in industrial capex in 2HFY15, weupgrade our revenue estimate for electrical wires by 4% for FY15 and8% for FY16.

Communication cables 2,628 3,153 2,518 3,022 4% 4% Marginal upgrade.

Copper rods 209 167 209 167 0% 0%

Switches, lamps and others 470 541 470 541 0% 0%

Switchgears 1,000 1,600 800 1,120 25% 43%We upgrade our revenue estimates given the improving confidence onthe switchgear market for Finolex from our primary checks.

Net Revenues (excl. excise) 28,592 35,804 27,369 32,888 4% 9% Consequent increase in revenue estimates.

Gross Profit (`mn) 8,065 10,208 7,725 9,380 4% 9% Consequent to increase in revenues.

Gross Margin (%) 28.2% 28.5% 28.2% 28.5%

No change.

EBITDA (`mn) 3,028 3,944 2,858 3,524 6% 12% Consequent to increase in revenue and EBITDA margin expansion.

EBITDA Margin (%) 10.6% 11.0% 10.4% 10.7% 20bps 30bps Favourable operating leverage will result in EBITDA margin expansion.

EBIT (`mn) 2,497 3,343 2,328 2,924 7% 14% Consequent to increase in EBIT.

EBIT Margin (%) 8.7% 9.3% 8.5% 8.9%

PBT (`mn) 2,934 3,852 2,764 3,398 6% 13%Consequent to increase in PBT and PAT.

PAT (`mn) 2,288 3,004 2,156 2,651 6% 13%

Change in WC (`mn)-

323-

398-

714- 981 -55% -59%

Higher revenue growth will result in improvement in cashconversion cycle. We have assumed working capital daysof 40 days in FY15 and 36 days in FY16 (vs 44 days in FY14).

CFO (`mn) 2,633 3,345 2,110 2,408 25% 39%Consequent to increase in PBT and reduction in workingcapital.

FCF (`mn) 1,859 1,711 1,336 774 39% 121% Consequent to increase in CFO.

Capex (`mn) (774) (1,634) (774) (1,634) 0% 0% No change.


Ambit vs consensusOur revenue estimates are ahead of consensus by 5% for FY15 and 13% for FY16due to our recent dealer checks in Bhagirath Palace (Asias largest electrical market),Karol Bagh and Lohar Chawl where dealers expect a pick-up in the project businessfrom 2HFY15 onwards (refer to page 2 for more details). Consequently, our EBITDAestimates are ahead of consensus estimates as well for FY15 and FY16. However, thedifference is high at 20% and 33% due to the positive impact of operating leverage

(as articulated on Exhibit 6) and higher margins in the switchgear business.Exhibit 10:

Ambit vs consensus estimates for Finolex

Consensus Ambit % change

Sales ( mn)

FY14E 23,922 23,310 -3%

FY15E 27,361 28,592 5%

FY16E 31,732 35,804 13%

EBITDA ( mn)

FY14E 2,052 2,360 15%

FY15E 2,522 3,030 20%

FY16E 2,975 3,944 33%Source: Bloomberg, Ambit Capital research


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Valuations - steep discount to peers;crying for a P/E re-ratingFinolex is trading at 1.4x FY16 P/B despite its FY16 RoE of 23% and FY14-16 EPSCAGR of 31%. As compared to its peers, it is trading at a steep discount of 55% onFY16 earnings despite its FY14-16 EPS CAGR of 31% (vs peers 22%) and FY16 RoE of

23%, which is similar to its peers. Such a steep valuation discount to its peers doesnot appear fair. Also, as compared to its cross-cycle average one-year forward P/Bover FY04-09 (as FY09-13 is not comparable due to derivative loss), the stock istrading at a 36% discount despite its FY04-08 RoE of 9.6% and EPS CAGR of 32%.

DCF valuation TP of 159/share

We value Finolex Cables using a DCF methodology wherein EBITDA margin, workingcapital turnover and capital expenditure are the key variables controlling thevaluation. Furthermore, we use a free cash flow to firm methodology given thatFinolex is a cash-surplus company. We undertake a combined valuation for all the

segments given the homogeneous nature of the product market, combined cost andinter-segmental revenue. We value the stock at `159/share, which implies avaluation of 8.1x FY16 EPS. The assumptions underlying our valuation are:

Two-stage valuation model: We have valued Finolex Cables using the two-stagefree cash (FCFF) model:

High-growth period (FY14-19):We have modelled revenue CAGR of 18% overFY14-19 due to: (a) rising market share in north and east India given thebrownfield expansion at Roorkee; (b)addition of new products (we have assumedshare of these products to reach to 6% of overall revenues by FY19) whichincludes switchgears, motors and transformers; and (c) recovery in industrialcapex in 2HFY15 (~85% of the business is driven by industrial capex). We expect23.8% core RoE in FY16, an improvement of 520bps as compared to FY14.

Declining-growth period (FY20-24): We have modelled a decline in revenuegrowth, with FY24 revenue growth of 10% and FY20-24 CAGR of 10%. Further,we expect EBIT margin to gradually decline to 8.5% in FY24 from 9.4% in FY19,with FY20-24 average EBIT margin of 9.0%.

Terminal valuation: We have assumed a terminal growth rate of 2% on free cashflow from FY25 onwards.

Decline in RoCE: We expect Finolexs RoCE to decline to 12.8% in FY14 ascompared to 15.5% in FY13, given the muted growth in the first three quarters.Further, we expect average FY15-21 RoCE to increase to 17.7% (led by an increase inmargins) and to decline gradually to 16.6% in FY24.

Capex: Finolex has undertaken major capacity expansion at the Roorkee plant in

FY13 and FY14 and expects the expanded unit to commence operations in FY15. Wehave modelled higher capex of `1.6bn in FY16 given that the management intends toincur major capex on the switchgear facility in FY16. For other years, we havemodelled maintenance capex based on the expected depreciation on the assets.

15% WACC and 2% terminal growth:We assume a WACC of 15.0%. The terminalgrowth rate is 2% given the commoditised nature of the business. Based on theseassumptions, our FCFF model values the business at Finolex Cables at `118/share.

Assumption on WACC

Cost of equity 15%Cost of debt NA

Debt/Equity -

Corporate Tax Rate 30%

WACC 15%



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Finolex Cables


Exhibit 11:

Our free cash flow (FCF) valuation for Finolexis 118/share

Particulars in mn unless specified

Net PV of free cash flows 10,446

Terminal value 8,646

Total value of firm 19,092

less net debt (cash) 1,067

Total Equity Value 18,025

Number of shares outstanding (mn) 153

Value per share ( /share) 118


Exhibit 12:

FCF profile FCF is to likely increase on aconsistent basis


Finolex Cables also has a large investment book of ~`3.2bn which is equivalent to~35% of FY13 net worth. Market value of these investments is ~3.5x of the bookvalue with the market value of Finolex Industries accounting for 80% of the total

value. We value Finolexs cables stake in Finolex industries at a 50% discount to themarket value. We assign a higher discount to market price because these investmentsare illiquid.

Exhibit 13:

Details of Finolex Cables investments (in mn unless specified)

Particulars Book value Market value

Non-trade (A) 2,174 9,844

Finolex Industries 1,519 9,003

IndusInd Bank 4 176

Bharat Forge 1 13

Unquoted equity shares 171 171

Joint venture 481 481

Trade Investments (B) 1,067 1,421

Equity shares 6 116

Mutual Funds 1,061 1,189

Total Investment value (A+B) 3,241 11,264

Per share value 21 74

Source: Company, Moneycontrol, Ambit Capital research; Note: For unquoted equity shares and joint ventures,we have assumed market value to be equal to book value; Valuation as on 6 May 2014

Adding the value of investments of `41/share (which values Finolex Industries at 50%discount to market value and others at cost) to the DCF valuation ascribed to thebusiness of `118/share leads to a target price of `159/share. This implies FY16 P/E

and P/B of 8.15x and 1.7x respectively.

Relative valuation unjustified steep discount to peersExhibit 14:

Finolex trades at a 54% FY16 earnings discount to its peers

CMP M Cap P/E (x) P/B (x) EV/EBITDA (x) ROE (%) EPS CAGR (%)

(INR) (US$ mn) FY15 FY16 FY15 FY16 FY15 FY16 FY15 FY16 FY14-16

Havells India 905 1,882 20.4 17.4 5.1 4.2 13.8 11.6 28% 26% 19%

TTK Prestige 3,000 566 23.3 18.4 5.7 5.3 15.2 12.2 25% 30% 30%

Sterlite Technologies 12 195 12.9 12.9 0.9 0.9 13.6 13.6 7% 7% 7%

V-guard industries 523 260 16.6 14.3 4.0 3.4 10.7 9.3 27% 26% 25%

Finolex Cables* 127 321 8.4 6.4 1.6 1.4 6.7 5.2 20% 23% 31%

Average (excl. Finolex) 16.3 13.9 3.5 3.0 12.0 10.4 21% 23% 22%

Divergence from Mean -48% -54% -54% -55% -44% -50% -100bps 0 900bps

Source: Bloomberg, Ambit Capital research; Note: Valuation is as on 6 May 2014; * Reported RoE

10%

12%

14%

16%

18%

20%

-

1,000

2,000

3,000

4,000

FY13 FY15 FY17 FY19 FY21 FY23

PV of FCF (Rs mn) (LHS) RoCE (%) (RHS)


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Finolex Cables


Exhibit 15:

Finolex is trading at a 36% FY16 earnings discount to its global peers

CompaniesCountry Mcap P/E (x) P/B (x) EV/ EBITDA (x) ROE (%)

EPS CAGR(%)

US$ mn FY15 FY16 FY15 FY16 FY15 FY16 FY15 FY16 FY14-16

Nexans SA# France 2,324 13.5 11.0 0.9 0.9 5.0 4.6 7% 9% 53%

Sumitomo Electric Japan 11,150 11.9 10.7 0.9 0.8 6.4 5.9 8% 8% 18%

General Cable Corp # USA 1,162 11.0 8.7 0.7 NA 5.9 5.6 8% NA 38%Furukawa Electric Co Japan 1,655 11.1 9.2 0.9 0.8 8.7 8.0 9% 10% 73%

Fujikura Japan 1,598 12.5 10.8 0.7 0.7 6.5 6.1 6% 6% 58%

Finolex Cables* India 321 8.4 6.4 1.6 1.4 6.7 5.2 20% 23% 31%

Average (excl. Finolex) 12.0 10.1 0.8 0.8 6.5 6.0 8% 8% 48%

Divergence from mean -30% -36% 89% 67% 3% -15% 1200bps 1500bps -1700bps

Source: Bloomberg, Ambit Capital research, Note: Valuation as on 6 May 2014, # December year ending, * Reported RoE

Cross cycle valuation: Steep discount to FY04-09

valuation despite higher EPS CAGR and higher ROEThe stock is currently trading at a 71% and 39% premium to its five-year consensusone-year forward P/B and P/E multiple respectively. We believe the comparison withthe five-year average is not fair due to the concerns over derivative losses fromoutstanding derivative instruments. Finolex had incurred a loss of `3bn (~33% ofFY13 net worth) over FY08-13 due to investments in these derivative options. Also,the management during this period had shied away from meeting investors.

However, if we compare the current one-year forward P/B with the average one-yearforward P/B over FY04-09, the stock is trading at a 36% discount despite its FY04-08RoE of 9.6% being lower than its FY14 RoE of 17% and EPS CAGR of 32% over FY04-08 only marginally higher to EPS CAGR of 31% over FY14-16. Now, with no exposureto these derivative options (as on FY13 there are no exotic derivative options

outstanding in the books) and with the management also committing to stay awayfrom these contracts in the future, the biggest concern which persisted in the last fiveyears has ended.

With our expectation of an EBIT margin improvement to 9.1% over FY14-19 vs 8.2%in FY13 coupled with the rising share of the consumer portfolio from ~40% ofrevenues to ~50% by FY19, we expect the valuation multiples to rerate. Our targetprice of `159/share implies FY16 P/B of 1.7x and FY16 P/E of 8.1x.

Exhibit 16:

Finolex is currently trading at a 71% premiumto its five-year one-year forward P/B


Exhibit 17:

Finolex is currently trading at a 39% premiumto its five-year one-year forward P/E


0

30

60

90

120

150

180

Jan-04

Jan-05

Jan-06

Jan-07

Jan-08

Jan-09

Jan-10

Jan-11

Jan-12

Jan-13

Jan-14

1.8x

0.5x

1.4

0

30

60

90

120

150

180

Jan-04

Jan-05

Jan-06

Jan-07

Jan-08

Jan-09

Jan-10

Jan-11

Jan-12

Jan-13

Jan-14

14.0x

3.0x

8.0x


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Finolex Cables


Exhibit 18:

However, Finolex is trading at a 36% discount to its average one-year forward multiple over FY04-09


Risks to our BUY stanceGroup company investments: Finolexs investment book, which accounted for 20%of the FY13 capital employed, yielded only a paltry return of 6% in FY13. This is

dragging down Finolexs overall RoCE. Had Finolex invested this money in thebusiness, the RoE would have increased to 25% in FY13.

In FY13, Finolex had investments of `2.2bn in group companies. The largestinvestment chunk was in the group company, Finolex Industries Ltd, of `1.5bn, at anacquisition cost of `38/share. The other investments are in the JV with J-PowerSystems of `480mn, Finolex Infrastructure Ltd (`53.4), Finolex Plasson Industries(`10mn) and Corning Finolex Optical Fibre Pvt Ltd (`0.5mn). If Finolex continues tofurther enhance its investment book, its RoCE will continue to be lower. Further, noneof the group companies are subsidiaries, and thus, minority shareholders have noaccess to the detailed financial statements of the group companies. Lastly, Finolexdoes not report the share in profits from associates in its P&L, which further dilutesthe RoCE.

Expansion into highly competitive business: The annual report highlights thatFinolex wants to diversify into the manufacturing of transformers and switchgears. InFY13, the transformer industry was the worst hit in the entire electricals space, withindustry revenue declining by 26% YoY. This was due to inconsistencies ingovernment procurement policies and the tendering procedures of the government-sponsored power utilities, which are the largest customers for transformermanufacturers. Also, the delivery schedules of state transmission and distributioncompanies were extended, as these companies faced a credit squeeze. Switchgear isfacing intense competition especially from MNC players like Schneider, Legrand, andPanasonic, given their superior technology (from strong parental pedigree) andhigher margins (Havells makes EBIT margins of more than 30%). Further, thesecompanies have also increased their advertisement budgets given the success of

Havells. This could hurt Finolex which is not only a late entrant in this segment butalso does not have any clear advertising strategy in place.

CatalystIncrease in infra spends by telcos:Reliance Jio is the only telecom player which isexpanding its backhaul fibre infrastructure currently. We believe if other telecomcompanies start spending on fibre optics infrastructure, given the recent successfultelecom auctions, Finolex could emerge as a major beneficiary. The recent telecomauction saw bids aggregating to `611bn vs government expectations of `401bn.Another positive surprise could be NOFNs single order in FY15 for laying ~15mnfkms as compared to ~7mn fkms laid in India in FY13.

Success in switchgears: If Finolex is able to successfully launch its switchgears in

FY15, then this could lead to the valuations being re-rated, due to the superiormargins (of more than 20%) in switchgears and the large annual market size of`50bn. More importantly, the company perception would also change from anindustrial company to a consumer electrical company.

-5

10

15

20

25

30

Jan-04

Jul-04

Jan-05

Jul-05

Jan-06

Jul-06

Jan-07

Jul-07

Jan-08

Jul-08

Jan-09

Jul-09

Jan-10

Jul-10

Jan-11

Jul-11

Jan-12

Jul-12

Jan-13

Jul-13

Jan-14

P/E (x) Pre-derivative average P/E (x) Post-derivative average P/E

Commencement ofderivative losses

Fall in average P/E due toderivative losses


14/18

Finolex Cables


Accounting analysis Clean chitExhibit 19:

Accounting flags

Field Score Comments

Accounting GREEN

In our accounting analysis of cable companies, Finolex has the best CFO/EBITDA ratio on account of lowerworking capital cycle. However, cash conversion for Finolex at 59 days in FY13 is higher than peers averageof 53. RoEs for Finolex have been lower at 15.7% in FY13 on account of forex losses on exotic options andlower exposure to consumer durable categories like switchgears and lightings. Also, Finolex reported asignificant improvement in FY13 RoE due to higher PAT margins.

Predictability REDOver the last five years, the company has curtailed interactions with the analyst community given the hugeforex losses on exotic options.

Earnings momentum GREENOver the last three months, consensus EPS estimates for FY14 and FY15 have been revised marginallyupwards by ~4%.



15/18

Finolex Cables


Balance Sheet

Year to March ( mn) FY12 FY13 FY14E FY15E FY16E

Cash 490 398 1,130 2,165 2,687

Debtors 1,141 1,497 1,533 1,958 2,550

Inventory 2,811 3,296 3,576 4,152 5,003

Loans & advances 815 938 958 1,175 1,471

Other Current Assets 121 193 193 193 193

Investments 2,372 3,241 3,241 3,241 3,241

Fixed assets 4,413 4,478 4,999 5,243 6,276

Miscellaneous 0 0 0 0 0

Total assets 12,163 14,041 15,630 18,127 21,421

Current liabilities & provisions 2,467 2,988 3,257 4,152 5,493

Debt 1,366 1,465 1,465 1,465 1,465

Other liabilities - Deferred Tax Liability 326 345 345 345 345

Total liabilities 4,159 4,798 5,067 5,961 7,303

Shareholders' equity 306 306 306 306 306

Reserves & surpluses 7,698 8,937 10,258 11,859 13,812

Total networth 8,004 9,243 10,564 12,165 14,118

Net working capital 2,422 2,936 3,003 3,326 3,724

Net debt (cash) 876 1,067 335 (700) (1,221)


Income statement


Operating income 20,640 22,707 23,550 28,885 36,169

% growth 1.4 10.0 3.7 22.7 25.2

Operating expenditure 18,892 20,410 21,191 25,857 32,225

EBITDA 1,748 2,297 2,360 3,028 3,944

% growth 0.9 31.4 2.8 28.3 30.3

Depreciation 395 466 488 530 600

EBIT 1,353 1,830 1,872 2,497 3,343

Interest expenditure 261 134 138 138 138

Non-operational income / Exceptional items 0 12 523 574 646

PBT 1,093 1,708 2,257 2,934 3,852

Tax 111 255 497 645 847

Reported PAT 982 1,453 1,761 2,288 3,004

Adjustments (364) (230) - - -

Adjusted PAT 1,346 1,683 1,761 2,288 3,004

% growth 11.1 25.1 4.6 30.0 31.3



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Finolex Cables


Cash flow statement


PBT 1,093 1,708 2,257 2,934 3,852

Depreciation 395 466 488 530 600

Interest paid 249 125 138 138 138

Direct taxes paid 49 (335) (497) (645) (847)

(Incr) / decr in net working capital 153 (478) (67) (323) (398)

Others 126 86 (304) - -

CFO 2,064 1,572 2,015 2,633 3,345

(Incr) / decr in capital expenditure (461) (498) (705) (774) (1,634)

(Incr) / decr in investments (56) 22 - - -

Others 214 152 - - -

CFI (304) (325) (705) (774) (1,634)

Issuance of equity - - - - -

Incr / (decr) in borrowings (884) 90 - - -

Dividends paid (124) (142) (440) (686) (1,052)

Others (652) (404) (138) (138) (138)

CFF (1,660) (456) (578) (824) (1,189)

Net change in cash 100 792 732 1,035 522

FCF 1,760 1,248 1,310 1,859 1,711


Ratio analysis

Year to March (%) FY12 FY13 FY14E FY15E FY16E

Revenue growth 1.4 10.0 3.7 22.7 25.2

EBITDA growth 0.9 31.4 2.8 28.3 30.3

APAT growth 11.1 25.1 4.6 30.0 31.3

EPS growth 11.1 25.1 4.6 30.0 31.3

EBITDA margin 8.5 10.1 10.0 10.5 10.9

EBIT margin 6.6 8.1 8.0 8.6 9.2

Net profit margin 4.8 7.4 7.5 7.9 8.3

Reported ROCE 12.8 15.5 12.8 15.2 17.9

Reported ROE 12.9 16.8 17.8 20.1 22.9

Adjusted ROCE 12.8 15.5 12.8 15.2 17.9

Adjusted ROE 19.0 24.8 18.6 21.1 23.8

Debt:Equity ratio (x) 0.2 0.2 0.1 0.1 0.1

Current ratio (x) 2.1 2.1 2.2 2.3 2.1


Valuation parameters

Year to March FY12 FY13 FY14E FY15E FY16E

EPS (`) 8.8 11.0 11.5 15.0 19.6

Book value per share (`) 52.3 60.4 69.1 79.5 92.3

P/E (x) 14.2 11.4 10.9 8.4 6.4

P/BV (x) 2.4 2.1 1.8 1.6 1.4

EV/EBITDA (x) 11.7 8.9 8.7 6.7 5.2

EV/Sales (x) 1.0 0.9 0.9 0.7 0.6

EV/EBIT (x) 15.1 11.2 10.9 8.2 6.1

CFO/EBITDA 115% 83% 106% 108% 106%

Gross Block Turnover (x) 2.4 2.5 2.4 2.8 3.1

Working Capital Turnover (x) 7.7 8.5 7.9 9.1 10.3



17/18

Finolex Cables


Institutional Equities Team

Saurabh Mukherjea, CFA CEO, Institutional Equities (022) 30433174 [email protected]

Research

Analysts Industry Sectors Desk-Phone E-mail

Nitin Bhasin - Head of Research E&C / Infrastructure / Cement (022) 30433241 [email protected]

Aadesh Mehta Banking / Financial Services (022) 30433239 [email protected]

Achint Bhagat Cement / Infrastructure (022) 30433178 [email protected]

Aditya Khemka Healthcare (022) 30433272 [email protected]

Akshay Wadhwa Banking & Financial Services (022) 30433005 [email protected]

Ashvin Shetty, CFA Automobile (022) 30433285 [email protected]

Bhargav Buddhadev Power / Capital Goods (022) 30433252 [email protected]

Dayanand Mittal, CFA Oil & Gas / Metals & Mining (022) 30433202 [email protected]

Deepesh Agarwal Power / Capital Goods (022) 30433275 [email protected]

Gaurav Mehta, CFA Strategy / Derivatives Research (022) 30433255 [email protected] Khanna Strategy (022) 30433251 [email protected]

Krishnan ASV Real Estate (022) 30433205 [email protected]

Nitin Jain Technology (022) 30433291 [email protected]

Pankaj Agarwal, CFA Banking / Financial Services (022) 30433206 [email protected]

Pratik Singhania Real Estate / Retail (022) 30433264 [email protected]

Parita Ashar Metals & Mining / Oil & Gas (022) 30433223 [email protected]

Rakshit Ranjan, CFA Consumer / Real Estate / Retail (022) 30433201 [email protected]

Ravi Singh Banking / Financial Services (022) 30433181 [email protected]

Ritika Mankar Mukherjee, CFA Economy / Strategy (022) 30433175 [email protected]

Ritu Modi Automobile (022) 30433292 [email protected]

Tanuj Mukhija, CFA E&C / Infrastructure (022) 30433203 [email protected]

Sales

Name Regions Desk-Phone E-mail

Sarojini Ramachandran - Head of Sales UK +44 (0) 20 7614 8374 [email protected]

Deepak Sawhney India / Asia (022) 30433295 [email protected]

Dharmen Shah India / Asia (022) 30433289 [email protected]

Dipti Mehta India / USA (022) 30433053 [email protected]

Nityam Shah, CFA USA / Europe (022) 30433259 [email protected]

Parees Purohit, CFA UK / USA (022) 30433169 [email protected]

Praveena Pattabiraman India / Asia (022) 30433268 [email protected]

Production

Sajid Merchant Production (022) 30433247 [email protected]

Sharoz G Hussain Production (022) 30433183 [email protected]

Joel Pereira Editor (022) 30433284 [email protected]

Nikhil Pillai Database (022) 30433265 [email protected]

E&C = Engineering & Construction


18/18

Finolex Cables

Explanation of Investment Rating

nvestment Rating Expected return(over 12-month period from date of initial rating)

Buy >5%

Sell

finolex cables (buy) -err grp- play on industrial capex recovery

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