CG Power and Industrial Solutions Ltd - Stock Valuation and Financial Performance

We are removing CG Power & Industrial Solutions from coverage due to complicated business, variety of related party transactions and tough to resolve business operations. We recommend SELL.

About the company

CG Power is into power and industrial solutions. CG Power was one of the best performers stock in 2003-2010 which benefitted from tailwind in capacity expansion across the country. Later it expanded operations in EU markets. The financials deteriorated due to slowdown in foreign markets. 

Our Opinion

We were passively tracking CG power as the company was reviving its European operations and showing intention to reduce debt. We were giving the company benefit of doubt that it may revive once domestic capex cycle kickstarts.

However, there are more governance issues coming to light. Recent reports by board investigation suggests that there were many lapses in governance, transactions and accounting practices.

Currently the board has indicated that they will liquidate non-core assets, sell off overseas subsidiaries and restructure existing operations to bring back profitability. We expect new management to be reinstated under current board of directors. 

We were cautious on the company as there were apprehensions over the management’s decision making wherein they had bought aircraft in 2011, pursued aggressive acquisition abroad from 2006-10 and in 2016 the promoters sold out their entire stake in consumer durable business – high ROE business model. These new negative developments haven’t been a surprise.

Valuation

Because the domestic business is good, we tried to study standalone entity if there is value and what it amounts to at enterprise level. We found that there are too many complications in terms of related party transactions, equity dilution, etc. We concluded that there is a long winter before the company revives. We recommend SELL and removing the stock from coverage from 31st August.

P.S. CG Power, erstwhile Crompton Greaves Limited, demerged consumer goods company Crompton Greaves Consumer Electricals in Mar-16 along with brand Crompton Greaves. It is one of the leaders in fans and lightening. Consumer durables business is well run and held by a private equity player. CGCE has no impact from above the company’s woes.

Sale of overseas power subsidiaries: Crompton Greaves Ltd. has sold its loss making (for the past five years) overseas power business to First Reserve international, a US based private equity firm, for an enterprise value of Rs. 850 Cr. (Euro 115 million) on a debt free, cash free basis. Sales will include T&D business of Indonesia, US, Hungary, France, Belgium and Ireland. The Systems business in Brazil, US and UK are not part of the sale agreement. Crompton Greaves expects to sign the share purchase agreement within the next one month and to close the deal over the next six months. The CG management has indicated its intent to refocus on the Indian power and industrial business post this sale.

Will also sell Systems business: CG’s systems business too has suffered heavy losses of Rs. 200 Cr in FY15.  While the Brazil business has already been shut down, the company will sell off the US business in a months’ time and will close down the UK Systems business by June-July, 2016. The UK systems business is likely to incur an additional Rs 180 – 200 Cr (EUR2.5-3m) of losses each quarter till the time it is closed down.

Will retains Drive business and sell-off Automation business: Crompton will retain its drives business. Drives business currently has revenue of Rs. 300 cr (EUR40m) and operating margin of 8-9%. Its automation business (ZIV) with revenue of Rs 740 Cr (EUR100m) will be sold off by the end of FY17.

Deal helps repay debt and save money: CG will initially receive Rs 620 Cr (Euro 84 million) on closure of the deal and will earn the remaining Rs 230 Cr (Euro 30 million) over the next 12-18 months. The deal allows CG to save Rs 500 Cr annually and helps it pare down debt. On a consolidated basis, Crompton Greaves has gross debt of Rs 1600 Cr and net debt of Rs 900 Cr. Rs 620 Cr of debt will be paid off as part of the deal and the working capital loans of Rs 280 Cr will be paid off using the deal’s balance payment.

Possible write-off: Crompton Greaves has provided loans of Rs. 1200 Cr to its foreign subsidiaries to support business operations. This entire amount may need to be written off against the reserves in the company.

What should investors do?

We assume a five year sales CAGR of 9% with EBITDA margins of 9-10%. Assuming a free cash flow yield of 10x, we value Crompton Greaves (ex-sales and demerger) at Rs. 50. Our DCF analysis yields similar results.

We would like to buy the company at a good discount, giving the uncertainty around the business. Assuming a 30% margin of safety, we arrive at a discount price of Rs. 35.

We will update our users on the consumer business (now Crompton Greaves Electricals Ltd.) separately.

Crompton Greaves shares traded ex-date post spin off on 15th March 2016 (http://tinyurl.com/hlgzyfl). Crompton Greaves Ltd. will be operational in industrials and power business segments. Shareholders of Crompton  Greaves Ltd. will be awarded one share of Crompton Greaves Consumer electronics for every share held in Crompton Greaves Ltd.

Shares of Crompton Greaves Consumer Electronics will be listed on the exchange in the month of April. We will revalue two different companies and inform our valuation at the earliest.

On 1st February 2013, we issued an Analyst note on Crompton Greaves, asking investors with high risk appetite to buy the stock of the company. Subsequently, on 16 July 2013, during Crompton’s buy back offer, we had asked high risk appetite investors to stay invested for long term capital appreciation.

What should investors watch out for now?
 

Promoters selling their controlling stake (42.7%) to an overseas investor:

There is speculation that Group Chairman, Mr. Gautam Thapar wants to sell his controlling stake in Crompton Greaves to an overseas investor.

This may be extremely good for the company if big established power players with greater technological expertise buy into the company. This may also trigger an open offer in the CG stock at higher valuations.

While the direction will only be clear in the coming 3-4 months, the events unfolding in the run-up need to be watched closely.

What should investors do?

We currently advise investors to stay invested in the company, even though the CMP is above our MRP. This is because a positive direction in the events leading to the sale of the company could lead to a rerating of the stock as well as a change in our valuations.

However, investors need to be aware that the company’s stock price will witness higher volatility in this period. Chances of a rerating will be higher if a multi-national power company buys into CG. However, if an Indian company like L&T buys into CG we do not expect a significant rerating of the stock.

Crompton Greaves Ltd. has announced a ‘Buy Back’ offer for its shares for a maximum price of about Rs. 125, which amounts to a maximum value of Rs. 265.7 Cr. On successful completion of buy back, the equity shares would decline by 3.4% at higher end and ~5% at CMP of Rs. 87. The promoter holding would increase from 41.7% to ~43.1% at maximum price.

Procedure: The Company will buy back shares from the open market through stock exchanges. Basically, this means that investors will have to sell their shares as they normally do through their broker when the desired price is reached.

As per the new norms on buy back offers, CGL has to complete the buy back within six months from the opening date, i.e. 16 July, 2013 and it will have to buy back shares worth at least 50% of the amount earmarked for the buy back.

Business Outlook

Stabilising overseas business

The company’s international business has suffered significantly in the past two years due to client deferrals on final deliveries, high costs, pricing pressures etc. The company, thus, underwent a restructuring exercise for its overseas business. As a part of which, the company has shifted its power transformer restructuring capacity from Belgium to Hungary, to take advantage of the lower manpower cost. The exercise is expected to result in savings of Rs. 100 Cr. per annum.

Improving order book to give boost to revenue

The company has a healthy order book of Rs. 10,544 Cr. as of end FY 13, thus, giving a strong revenue visibility. Order received grew at a healthy rate of 32% in the 4^th quarter of FY 13.

Margins recovery to be the key growth driver

The company enjoyed very high margins till FY 11. We saw a sudden fall in margins, both domestic and international, post change in management. Going ahead, recovery in power systems margins will be the key valuation driver. While cost savings after restructuring are expected to result in margin improvement of 3-4%, this still remains way below expectations. A further improvement in margin could be seen if there is a pricing improvement across the sector. However, this remains highly uncertain given the existing pricing pressures due to high competition.

Concern over high percentage of pledged shares

The percentage of pledged shares has gone up dramatically in the last four quarters. As of FY 13 ~61% of the promoter holding was pledged, which remains a cause for high concern.

What should investors do?

On the core business front, the company remains to be strong. The company has a strong revenue visibility with an order book of around Rs. 10,000 Cr., a 9% increase over previous year. However, we expect the profit margins to remain subdued in the medium term.

Pledged shares continue to remain a worry. The management has pledged almost 60% of its shares. Also, past issues like very high auditor fees and buying and selling of an aircraft put a considerable doubt over management quality.

While a margin improvement will lead to considerable improvement in the performance of the company, the scenario remains highly risky.

We expect the EPS to grow at 20% CAGR in the next five years and feel the company is fairly valued at 17 times its EPS, arriving at a fair value of Rs. 131.

We, thus, feel the current buy back offer of the company gives a good exit route to the investors.

We advise investors to sell their shares in the range of Rs. 120-125. However, the caveat remains that since the company is going to buy back shares through the stock exchanges, investors will have to wait for the desired price to be reached before selling the stock. Since the buyback is for a small percentage as compared to its current market cap (~5%), there is a chance that the stock may not run up to the maximum buy back price levels.

Investors should thus at their own discretion exit the stock on short term rallies and invest the money in better capital good plays. They can re-enter Crompton Greaves once the structural problems in the company are addressed.

Also, investors with high risk apetite can continue to stay invested for long term capital appreciation.

Crompton Greaves Q3 update:

On a consolidated basis, the company’s sales declined by 1.85%, however it reported a net loss of Rs. 189 Cr. This includes many one offs. Losses include onetime restructuring costs of its international business. Revenues were affected due to 20 day shutdown in its Nashik factory plus a large order deferment by GIS.  Given below are the key takeaways:

1. International business to stabilize post restructuring: Since, June 12 the company had embarked on shifting production from its Belgium Factory to Hungary(low cost location). This has now been completed and the costs have been completely booked. It is expected to result in annual savings to the tune of Rs. 100 Crs. given lower employee and operating costs. Also, management has indicated there will be no incremental costs related to restructuring and all costs have been provided for.

Regarding, Hungary operations, the expanded facility is expected to stabilize in 1-2 quarters with key focus on customers picking up deliveries.

The management will now focus on improving quality of its international products where it faces 23% rejection rate vs 0% in India.

2. Strong order book growth: For 9M ended FY13, the company’s order book has grown by 14%. However, the growth is slower as compared to last year. We expect the order growth to pick up on improving macro scenario. This could further improve once the capex cycle in India picks up.

3. Domestic Power business: Domestic power business revenues declined on back of-
a. Explosion in Nashik plant leading to 20 days loss in production
b. Deferment of a GIS project
c. Delay in execution of an export order

Though orders from PGCIL have improved this quarter, managements expects weak outlook due to decline in ordering and rising competition

4. Industrial business – margins stable; growth to recover: Margins have remained stable over the past few quarters. We expect margins to remain stable going ahead. Also, management expects growth to recover on back of demand from segment like Railways. The management is working to improve efficiencies in order to improve profits. This along with revenue growth will help company grow its earnings.

5. Consumer business – Momentum continues: Revived revenue growth is a huge positive. The company has also been restructuring this business in consultation with BCG. It plans to expand its reach in India from 40% to 60% and focus on new products like LED and consumer appliances. Though margins were down this quarter, the company expects to maintain margins going ahead.

Continued demand in this segment, will help support company’s growth in future.

What should investors do?
 

Upside triggers for the company include improving capex investment climate in India, reforms for power sector & international operations stabilising. A further fall could be triggered by continued losses in international subsidiaries, poor margins, any further restructuring costs and questions over management integrity.

Despite being currently below DP, we have not generated any trigger, in anticipation that prices may remain subdued for some time ahead. However, investors with a high risk appetite can start buying into the stock in tranches over the next 1 year.