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VST Tillers Tractors Ltd

Buy Rs.900/- and hold for 5 years. 15th Apr, 2014

Increasing productivity is the key to Indias food security

Farm mechanization sector to gain from structural up-cycle...

The value of agriculture in India can hardly be overemphasized.

While its share in GDP has come down over the years, agriculture continues to employ

the largest chunk of Indian population. The industry has seen massive change over the

years- vast chunks of land getting fragmented, shift from human and animal power to

the use of farm machinery, migration from rural to urban areas etc.

Amid the challenges like high dependence on monsoons and shrinking land and labor

supply, the need for food to feed India's ever-growing population has gone up. Further

thrust on food security and on getting more area under irrigation, improvement in the

logistics and increase in the minimum support prices suggest that a lot more can be

expected from this sector in the years to come.

Keeping in mind the challenge s that the sector is facing, there is only one way to meet

the demand for increased farm product. That is, to improve farm yield (output

production per hectare) from the limited assets. And this explains the huge scope ahead

for farm mechanization. The same is likely to lead to faster turnaround of farm work,

multi cropping and higher yields, despite shrinking resources.

Following factors are likely to support the trend further:

Shortage of labor supply in agriculture due to urban migration and rural

employment guarantee

Rising wage pressure and increasing costs of using animal power.

Favorable financing environment for farm machinery (for. e.g. tractor loans

qualify as priority sector lending and are less likely to go bad) and rising

penetration of the private sector lenders in this space

Rise in minimum support prices.

Farm subsidies, subsidy on the sale of farm equipments (e.g. subsidy on tillers) .

Increase in farm exports.

And, low penetration in most of the Indian states (as far as use of farm power per

hectare is concerned).

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One should note that while the land available for farming has remained almost

constant, the land holdings over a period of time have been getting smaller. Around

80% of the farms in India are small and marginal. This I believe will boost the demand

of machinery that is relatively scale neutral (such as use of low Horse Power tractors).

As such, there is a lot of ground to cover with regards to first time users. Also, once the

demand is created, it is likely to stay. This is because as a farmer moves up in the

technology; he is unlikely switch back to conventional ways of farming. Multiple uses of

farm equipments (like tractors) for off farm work such as transportation and

construction are likely to support the demand. Even in the case of smaller land holdings,

the demand is likely to be robust due to the trend of custom hiring. Hence, in the long

term, the penetration of farm machinery in India is likely to rise and firms catering to

the same have huge scope to grow.

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About VST Tillers Tractors Ltd

VST Tillers Tractors Ltd (VTTL) is in the business of manufacturing and sale of farm

equipments such as power tillers and small tractors. Besides this, the company is also in

the trading business of farm equipments such as rice transplanters, harvesters, front end

loaders etc. It also manufactures diesel engines and precision components for captive

use as well as for sales. The company was incorporated in the year 1967 in Bangalore,

India. The company is promoted by the V.S.T Group, a well known business house in

South India. It started with technical collaboration and joint venture with Mitsubishi

Heavy Industries and Mitsubishi Corporation, Japan for the manufacture of power tillers

and diesel engines. In 1984, the company entered into an additional technical and

financial collaboration with Mitsubishi Agricultural Machinery Company Ltd, Japan to

introduce small tractors (18.5 HP and 4 wheel drive).

The company has its manufacturing plant located in Whitefield Industrial area near

Bangalore a combined capacity of over 30,000 power tillers and small tractors. Towards

the end of March 2014, the company commissioned its new tractor plant at Hosur. The

plant has been funded largely through internal accruals and it will have a capacity of

producing 36,000 tractors per annum.

The main products of the Company namely Power Tillers and Tractors are used in the

agricultural sector all over the India. Power Tillers and Tractors are exported to whole of

Africa. The Tractors are also exported to Middle East, Russia and Turkey. The

component parts are exported to Europe, Korea and Thailand.

The company has a nation-wide presence through its dealers. It is known for its after

sales support and services. The company has taken various steps towards increasing

customer satisfaction such as on-time supply of spare parts, provision of service tools

and equipments, making available service information through technical literature,

instruction manuals etc., and imparting training to end users namely the farmers.

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Key Management Personnel

Mr. V.P. Mahendra, is the Chief Executive Officer of VST Tillers Tractors Limited and

has been serving as a Managing Director of the Company since 1989. He has also served

as a Non-Executive Director with Kirloskar Electric Co and Cholamandalam Investment

& Finance Co. in the past. He is a graduate in engineering from the University College

of Engineering, Bengaluru.

Mr. R Thiyagarajan is the Vice President and Chief Financial Officer, of the company.

He is a Chartered Accountant by qualification

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Geared for higher growth, better cash flows and margins...

The changing business mix with a greater focus on tractors makes this company a

compelling investment even now...

Do you often find yourself looking for that perfect investment idea? Where do you look

for that perfect idea? It is observed that many investors tend to ignore their existing

investments and look for the proverbial newer, greener pastures. Is this always the best

thing to do?

Who would be a better person to answer this than Peter Lynch, one of the most

successful money managers ever? Let us tell you that during the thirteen years (1977 to

1990) when he ran the Fidelity Magellan Fund he outperformed the market by a

whopping margin, delivering average annual returns of over 29%. One of his key

investing principles was this: "The best stock to buy may be the one you already own. "

In fact, many of the minor purchases by the Magellan Fund later went on to become

major holdings. Here is one simple truth that all investors must remember. The number

of great businesses is limited. Instead of looking for newer investments ideas, why not

buy more of an existing investment that still has great future potential.

The company has been in the business of manufacturing and marketing of power tillers

and tractors. Over the last nine years, the share of power tillers to the overall revenue

has been, on an average, about 61%. However, recent trends in the business mix suggest

that the share of tractors is on the rise.

The managements focus can be ascertained from the fact that towards the end of March

2014, the company commissioned its new tractor plant at Hosur. This plant, which has

been funded largely through internal accruals (Rs 700 m), will have a capacity of

producing 36,000 tractors per annum. This is indeed a very significant move. While in

FY13, the company sold 6,233 units, the volumes for FY14 are expected to be in the

range of 7,300 to 7,500 units (During 9MFY14, company has sold 5,545 units). Now, with

the new capacity coming in, the volume growth in this line of business is expected to

remain very strong. In the overall domestic tractor industry, VST has a market share of

around just 1%. As such, the overall build up in capacity is not expected to impact the

sector significantly.

Moreover, what makes VST stand apart from the rest is its focus on a niche segment of

the industry the sub-20 HP (horse power) segment, where in farmers having smaller

land parcels are targeted as prospective customers.

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VST continues to have a strong hold in the western regions, and is also looking to

expand its reach in other states as well. Also, the company has indicated that it would be

launching certain models in the 20+ HP segments.

With the contribution from the tractor business rising, the dependence on the traditional

power tillers business will reduce as a proportion of the total revenues. The latter is a

segment that is marked by high competition (especially from low cost Chinese products)

as well as issues related to delayed subsidy payments by the government. I believe that a

greater contribution from the tractor segment will improve VSTs cash flow generation

as well as margin profile.

Factors such as burgeoning farm labor costs, rising food demand and the consequent

demand for higher productivity point at a structural change towards farm

mechanization. And here we have a great business with a proven track record, solid

financial health and a compelling future growth strategy. It stands to benefit

tremendously from the structural changes in the agriculture sector.

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How VST Tillers Tractors Ltd will improve its fortunes

Farm mechanization to help growth momentum

The Indian government is concerned about the food security. It has set an

ambitious target of 4% agricultural growth for the 12th 5-year plan (2012-17). A

large part of this focus is on increasing productivity. However, due to

industrialization, farmland area is contracting with each passing year. At the

same time, people are migrating from the rural areas to urban cities. This is

creating a shortage of labor in the farmlands. All this is hindering the growth of

agricultural production in the country. Only way forward is farm mechanization

which helps to increase the productivity of farmlands. The use of farm

equipments such as power tillers, tractors etc are ways to go for farm

mechanization.

Therefore, farm mechanization would remain as a focus area for the government

in the foreseeable future. The central and state governments have allocated a

subsidy scheme of Rs 45,000 to 60,000 for power tillers. In addition to this farmers

also get loans at subsidized rates due to governments focus on priority sector

lending. Besides this, the government is gradually increasing minimum support

price of agricultural produce. As a result, income levels of farmers have been on

the rise which would put them in a better position to buy farm equipments. All

this would help increase the market for farm equipments like tillers. VTTL has a

strong presence in this segment and is well poised to reap the benefits from this

growing opportunity.

Strong presence in farm equipment markets

VTTL is the market leader in the power tiller segment business. The company

commands around 40% to 45% share of the total market. Despite presence of

cheaper Chinese products, the company has done well to maintain market share.

The products of VTTL are superior in terms of quality and are believed to last for

about fifteen-twenty years.

In the past, the company had introduced one more farm equipment - Paddy

Translators. This product has not witnessed much success so far. However, this

product also holds a good future prospect in light of growing labor shortage.

Leading position in power tillers segment and long experience in the farm

equipment area would help the company continue to grow in the future.

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After sales service is the key

Besides having quality products, VTTL has a nation-wide presence through its

extensive dealer network. As a result, the company is well positioned to exploit

the growing potential of farm equipment market. However, key to success lies in

the after sales service. Auto equipments need constant servicing to run properly.

With wider presence, the company is able to cater to the needs such as spare-part

replacement as well as servicing. This leads to higher customer satisfaction.

Needless to say, this would help the company to maintain its market leadership

position and grow well in the future.

This also helps the company dominate in the market despite the presence of

Chinese products at lower prices. Chinese products particularly lack in the area of

after sales service.

Robust financial health

For the past five years, VTTL has witnessed a stellar performance at both top line

as well as bottom-line levels. During this period, revenues and net profits of the

company grew at an average rate of 21% and 28% respectively on compounded

annual growth rate basis. As compared to earlier periods, FY13 was a tough year

for the company on account of various factors such as the poor monsoons, higher

interest rates and supply chain issues. The companys operating margins have

however been on the rise, as the contributions from the tractor segment have

been increasing. With the same likely to continue in the future, I expect the

companys margins to remain above the long to medium term average margins.

Coming to the balance sheet, the same has been clean with minimal debt on

books. This has been the case for many years now. In FY13, the company had not

debt on books. When it comes to managing the working capital, the same has

risen in the past two years, largely due to higher amount blocked in receivables.

But if we see a longer term horizon, it has averaged to about 18% (non cash

working capital) of sales over the past eight years. Further, the company has been

consistently rewarding shareholders. The dividend payout averaged to 16% over

the past five years (16% in FY13 as well). The average return on equity has also

stayed above 30% over the past five years.

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Key challenges for VST Tillers Tractors Ltd

Not much control on pricing and receivables

At present, the business of power tillers in India runs on the subsidy support

given by the government. A central subsidy of Rs 45,000 on power tillers is

administered through the states. Many states top it up with additional state

subsidy ranging from Rs 10,000 to Rs 15,000. The practice in the state is that the

subsidy is paid to the company or its authorized dealers. This leads to higher

delays in receiving payments - which could range from 60 to 180 days that is

paid to the manufacturers such as VTTL.

Further, the prices are also to be authorized by all the states once a year. The

company has to maintain the decided price irrespective of any increase in input

prices. This poses a threat for the profitability of the tiller business.

Rising competition in the tiller and tractor segments

While the company has been facing issues related to cheaper import of tillers for

a while now, which it has done well to control, one cannot ignore the possibility of

the scenario worsening from here on. Imported power tillers from China- the

largest producer of power tillers in the world are also eligible for subsidies.

Such tillers form near 30% of the overall market. But while they have the cost

advantage against the domestic manufacturers such as VTTL, the latter have an

edge in terms of quality and service (as mentioned earlier in this report) which

are aspects that mitigate such a risk.

In the tractor space, given that the niche sub 20 HP segment has been growing

fact, it has attracted competition from competitors. For example, Mahindra &

Mahindra had launched its small tractor under brand name Yuvraj. Other

players have also entered this segment in recent times. While VTTL continues to

enjoy the first mover advantage and a strong brand name in the space it operates,

one cannot ignore the risks from competition.

Poor monsoon season

Given that VTTLs business is directly dependent on the agriculture, one cannot

ignore the possibility of poor monsoon season impacting the sales volumes of the

company. With increasing threats of the El Nio impacting the monsoons this

year, this would be a big concern for the company.

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End of subsidy scheme

As mentioned earlier, the business is run on the support of government subsidy

scheme. Therefore growth of the market depends on the growth of subsidy. In the

worst case scenario, at some point if the government decides to end the subsidy

scheme; the business of the company will be adversely impacted. But looking at

the government focus on agriculture in the 12th five year plan, this situation is

very unlikely.

Interestingly, the management of the company finds this adverse situation a good

opportunity. According to them, the business may suffer for short term. But after

that, when markets stabilize, the company would be able to control the pricing

better.

Risky small caps

It is important to note that small caps are inherently more risky as compared to

the blue-chip or mid cap stocks. That is the reason we do not recommend small

caps to those having a low risk profile. Even for investors having an appetite for

slightly more risk, it is advisable to invest not more than 15% of one's portfolio in

small-cap stocks.

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Risk Analysis

Regulatory Risk

Some businesses are subject to regulations by external government agencies.

These companies are subject to regulatory risk since they do not have the liberty

to operate in a free environment. Excessive regulations can create bureaucratic

hassles and impede growth. Thus, higher the regulation, higher is the risk for any

business. The tiller business in India is one that faces regulatory risks in the form

of subsidies and limited pricing ability of the tiller manufacturers. Not to

mention the issues related to the delay in payments on account of the same.

However, with the contribution from the tractor business on the rise, this risk is

curbed to some extent.

Cyclicality Risk

A business cycle is characterized by alternating periods of expansion and

contraction. Businesses whose fortunes typically swing with industry cycles are

known as cyclical businesses. Cyclical businesses do well during an industry

upturn and vice versa. On the other hand, there are some businesses that are not

very cyclical. These businesses are more immune to changes in industry cycles in

the sector and have less risk. In short, if the business is cyclical, the risk is higher.

Given that the tractor and power tiller business is dependent on the agricultural

sector, which in turn relies on monsoons, in addition to other factors such as

interest rates and credit availability.

Competition Risk

Every industry is characterized by competition. However, some industries where

entry and exit barriers are typically low have higher competition risk. Low

barriers means more players can enter into the industry thereby intensifying

competition. While the competition in the power tiller and tractor segment is

significant, VST does stand out on account of strong market share in the

segments in which it operates.

Sales Growth

Over the ten year period (actual history of past 5 years and explicit forecast for

the next 5 years) I expect sales CAGR of around 22.9%.

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Net Profit Growth

Over the ten year period (actual history of past 5 years and explicit forecast for

the next 5 years) I expect a net profit CAGR of around 28%.

Operating Margin

The operating margin is a measurement of what proportion of a company's

revenue is left over after paying for variable costs of production such as raw

materials, wages, and sales and marketing costs. A healthy operating margin is

required for a company to be able to pay for its fixed costs, such as interest on

debt. The higher the margin, the better it is for the company as it indicates its

operating efficiency. VST's average operating margin over the ten year period

(actual history of past 5 years and explicit forecast for the next 5 years) stands at

16.6%, which is moderate.

Net Margin

The net margin is a measurement of what proportion of a company's revenue is

left over after paying for all the variable and fixed costs inclusive of interest and

depreciation charges. Net margin is the final measure of profitability. It reflects

the total profits the company takes home. Higher the margin, better it is for the

company as it indicates better pricing power and effective cost management. For

VST, the average net margin over the ten year period (actual history of past 5

years and explicit forecast for the next 5 years) stands at 11.1%.

Return on Net Worth (RoNW)

RoNW is an important tool to assess a company's potential to be a quality

investment by determining how well the management is able to allocate capital

into its operations for future growth. RoNW of above 15% is considered decent for

companies that are in an expansionary phase. The average RoNW over the ten

year period (actual history of past 5 years and explicit forecast for the next 5

years) for the company stands at 28.8%, which is good.

Earnings quality

This measure helps us assess the quality of earnings reported by the company.

For instance, some companies may follow aggressive accounting practices and

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recognize revenues earlier than warranted. Earlier recognition of revenues boosts

profits. However, at the same time they do not generate sufficient operating cash

flow (OCF). This signifies debtors are not liquidated on time as sales were booked

in advance. Such companies face working capital issues and their quality of

earnings is poor. We assess earnings quality by dividing operating cash flow to net

profits. Higher the ratio better is the quality of earnings. For VST the average

OCF/net profit ratio over the ten year period (actual history of past 5 years and

explicit forecast for the next 5 years) stands at 0.6 which is healthy.

Transparency

Transparency is the key to any business. Transparency can be gauged by

assessing the past dealings of the company with various stakeholders, the way it

displays its financial information and the frequency of management's desire to

communicate with external shareholders whenever some unfortunate incident

happens. The easiest way to gauge the same is checking the level of disclosures in

the company's quarterly financial updates and annual reports. Transparent

managements would get a higher rating. In our view, the company's level of

disclosures is not up to the mark, as per industry standards

Capital allocation

Apart from transparency, capital allocation skills are equally important in

assessing management quality. By capital allocation we mean how the

management chooses to deploy capital in the business. There are many instances

where growth is given priority over returns on the investment. This results in a

company with larger size but with poor returns. Managements are enticed to

increase the size since their compensation is tied to the size of organization they

manage. Also, they sometimes destroy shareholder wealth by making expensive

acquisitions or by diversifying into unrelated areas. Hence, capital allocation

skills assume great importance in gauging management quality. Capital

allocation skills are good when return ratios depict resilience. In short, more

stable/higher the return ratios better the capital allocation skills. VST's return

ratios and the managements capital allocation decisions over the years have been

reasonably good.

Promoter pledging

Promoters typically pledge their shares to take a loan which is generally infused

in the company. This exercise is generally resorted to when all other sources of

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external liquidity dry out. The risk with this strategy arises when share price falls.

This triggers margin calls. If management is unable to provide some sort of a

collateral to the lending party from whom the money is borrowed that party may

sell the shares to recover its money. This accentuates the share price fall. Hence,

higher the promoter pledging higher is the risk. With none of the promoter

equity being pledged..

Debt to equity ratio

A highly leveraged business is the first to get hit during times of economic

downturn, as companies have to consistently pay interest costs, despite lower

profitability. We believe that a debt to equity ratio of greater than 1 is a high-risk

proposition. The D/E ratio for VST over the last five years has stayed low. In fact,

the company became completely debt-free in FY13. The average D/E ratio over

the ten year period (actual history of past 5 years and explicit forecast for the next

5 years) stands at 0.03 times.

Interest coverage ratio

The interest coverage ratio is used to determine how comfortably a company is

placed in terms of payment of interest on outstanding debt. It is calculated by

dividing a company's earnings before interest and taxes (EBIT) by its interest

expense for a given period. The lower the ratio, the greater are the risks. Given

the low debt levels and strong cash flows of VST.

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Finance at a Glance

Standalone (Rs. M) FY13 FY14E FY15E FY16E FY17E FY18E

Sales 4817 6129 8072 9935 12162 14830

Sales Growth (%) -9.20% 27.20% 31.70% 23.10% 22.40% 21.90%

Operating Profit 722 1128 1372 1699 2110 2572

Operating Profit margin (%) 15.00% 18.40% 17.00% 17.10% 17.40% 17.30%

Net Profit 483 742 896 1116 1393 1706

Net Profit margin (%) 10.00% 12.10% 11.10% 11.20% 11.50% 11.50%

Balance Sheet FY13 FY14E FY15E FY16E FY17E FY18E

Current Assets 2358 2830 3700 4853 6193 7911

Fixed Assets 915 1271 1357 1437 1512 1582

Investments 42 42 42 42 42 42

Other assets 44 44 44 44 44 44

Total Assets 3358 4186 5142 6376 7791 9578

Current Liabilities 682 906 1134 1460 1743 2143

Net Worth 2444 3047 3775 4683 5815 7202

Loan Funds 0 0 0 0 0 0

Other Liabilities 233 233 233 233 233 233

Total Liabilities 3358 4186 5142 6376 7791 9578

Valuation FY13 FY14E FY15E FY16E FY17E FY18E

Revenue (Rs. m) 4817 6129 8072 9935 12162 14830

PAT (Rs. m) 483 742 896 1116 1393 1706

EPS (Rs.) 55.9 85.8 103.8 129.2 161.3 197.4

Price to Earnings (x) 17.8 11.6 9.6 7.7 6.2 5.1

Price to Sales (x) 1.8 1.4 1.1 0.9 0.7 0.6

Price to Book value (x) 3.5 2.8 2.3 1.8 1.5 1.2

Comparative Valuations

Parameters VST Tillers Tractors Ltd Escorts Ltd Swaraj Engines

Year - End Mar-13 Spe-12 Mar-13

Net Sales (Rs. m) 4817 38939 4790

EBITDA margin (%) 15.40% 5.80% 16.10%

Net margin (%) 10.10% 1.70% 10.30%

ROCE (%) 30.60% 8.70% 41.90%

Debt / Equity (x) - 40.00% -

TTM P/E (x) 11.70 8.90 13.30

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Why is the stock worthy of investment?

A strong focus and a proven capability in tiller manufacturing, an impressive track

record, strong financials and a shareholder-friendly management make VST Tillers Ltd

a good long term investment. The company's products are well-accepted in the country

and its recent foray into tractor manufacturing is a huge positive.

VST Tillers has been able to grow its revenues and profits at a compounded annual

growth rate (CAGR) of around 21% and 28% respectively over the last five years. The

company generates strong cash flows and the return on invested capital (RoIC) has

averaged an impressive 25% during the same period. All this while, the company has

hardly required any debt to fund its growth.

For long term target expecting Rs.3,300/- and Rs.5,600/-