Crompton Greaves: Buy

At a time when corporate earnings have begun to mirror the slowdown felt by the economy, Crompton Greaves has managed to sustain sales and earnings growth, amidst stiff raw material costs and marginal slowdown in demand. In what could be termed as a tough quarter (December 2008), the company posted a 49-percent growth in net profits on a year-on-year basis.

That the company’s order inflows have been healthy and there have been no cancellations so far from slowing markets such as Europe and the US also suggests that the medium-term earnings visibility remains relatively strong.

Investors can consider accumulating the stock of Crompton given the sharp correction it has undergone, even as its prospects are relatively unaffected. At the current market price of Rs 130, the stock trades at 9.7 times its annualised consolidated per share earnings for FY-09 and 8.5 times its expected earnings for FY-10.

Investors should, however, note that companies such as Crompton that manage a handful of foreign subsidiaries would face a more challenging cost environment compared to those with domestic operations alone. Risks of demand slowdown are also higher in the countries in which these subsidiaries operate. Under these circumstances, pressure on profit margins to keep the volume robust may be a plausible response by corporates to tackle the slowdown.

Crompton appears to have come up with such a response, especially for its industrial segment and consumer products, two segments whose demand is under pressure.

Profit margin pressure would, therefore, remain a risk for the company especially its subsidiaries. However, we believe that Crompton, with a return on equity (40 per cent as of March 2008) that is superior to industry average, can afford to take a dent in profitability to counter a slowdown.
How it managed

Crompton’s consolidated revenues for the latest ended quarter grew 25 per cent even as net profits grew at twice this pace.

Crompton’s diversified presence across geographies as well as its wide product offerings have been the key reasons for the company sustaining growth during tough times.

The company’s foreign subsidiaries have largely enabled such a diversification; the acquisition of these companies over the last two years, therefore, appear well-timed in retrospect.

The performance over the quarter has, however, not been smooth. Crompton saw a 0.5 percentage point dip in its operating profit margins to 10.4 per cent as a result of muted performance in its industrial systems and consumer product segment.

The management has admitted that pricing has remained under pressure for these segments, on the back of an attempt to maintain growth. The consumer segment too, despite witnessing revenue growth, saw decline in profit margins.

We expect these two segments, especially industrial systems, to remain under pressure over the next few quarters on the back of reduced/postponed capex plans of industries locally and abroad.

The positive feature remains that the company has not had any order cancellations even in the industrial segment.

Power segment, the biggest contributor to revenues, however stole the limelight with a 2.7 percentage point increase in EBIT margin to 15.1 per cent. Here again, the demand for distribution transformers (DT) has been turbulent. Demand for DTs, which is the final link to supplying power to the consumer, has been affected by slowdown in housing.

However, the management has stated that growth in this segment has been made up by wind energy transformers. While volume from this segment may not have been significant, the emphasis on ‘green’ energy in Europe and the US (with the new Government) could translate into sizeable demand for wind transformers over the long-term.

The power segment growth is expected to be steady over the next nine-12 months as well, since over 90 per cent of the order backlog arises from this division.

The company’s overall consolidated order book at Rs 6,700 crore grew 28 per cent on a Y-o-Y basis. Order inflows for the quarter at 23 per cent over December 2007 also suggests healthy demand scenario.

The current orders combined with the fact that there have been no cancellations so far is likely to provide revenue visibility for the company over the next one year.

Investors may have to watch for order inflows from hereon to gauge the long-term revenue prospects of the company. For now, orders of over Rs 300 crore (in the line of Crompton’s business) are expected to be floated by Power Grid Corporation over the next couple of months.

On the net profit front, Crompton has received some relief from reduced depreciation rates as a result of switching from Belgian GAAP standards followed by its subsidiaries. Forex loss accounting in compliance with Accounting Standard 11 has, on the other hand, depressed earnings by Rs 35 crore for the quarter.
Continuing capex

Crompton has been a steady investor in capital expenditure programmes with a 10-15 per cent expansion in its transformer capacity every year over the past few years, including the current one.

The company has planned a capex of Rs 250-300 crore over the next couple of years. Being comfortable on cash, Crompton may not face the nagging issue of fund availability, be it for capacity expansion or acquisitions, the latter being its more successful strategy in recent times.

The company has also been proactive in the development of large-sized transformers to suit new programmes of the Government for bulk transmission of power. For instance, the company is gearing itself to meet the 1200 kV ultra high voltage power transmission system envisaged by Power Grid Corporation.

Crompton recently announced the successful development of the 1,200kV capacitive voltage transformer towards meeting the new challenges.