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STRATEGY

October 2015

Analysts:

The Magic Formula and Value Traps

Aurobindo PharmaInox Wind

Apollo Tyres

Nitin [email protected]: +91 22 3043 3241

Gaurav Mehta, [email protected]

Prashant Mittal, [email protected]

Saurabh Mukherjea, [email protected]

Bhargav [email protected]

Deepesh [email protected]

Ashvin Shetty, [email protected]

Aditya [email protected]

Paresh Dave, [email protected]

Consultant: Anupam [email protected]

Ritu [email protected]

Strategy

October 06, 2015 Ambit Capital Pvt. Ltd.

CONTENTS

The Magic Formula and Value Traps ….........................................................3

Section 1: Value and value traps ……………………………………………………4

- Screening for value - The magic formula……………………………………...4

- Current ‘value’ plays on this screen ……………………………………………5

Section 2: A framework to identify ‘value traps’ ………………………………….7

- Filter 1: Accounting quality ………………………………………………………8

- Filter 2: Corporate governance ………………………………………………..10

- Filter 3: Capital allocation ……………………………………………………..10

- Filter 4: IBAS framework ………………………………………………………..12

COMPANIES

Apollo Tyres (NOT RATED)…………………………………………………………. 15

Aurobindo Pharma (SELL)………………………………………………………….. 29

Inox Wind (SELL)……………………………………………………………………...43

Ambit Capital and / or its affiliates do and seek to do business including investment banking with companies covered in its research reports. As a result, investors should be aware that Ambit Capital may have a conflict of interest that could affect the objectivity of this report. Investors should not consider this report as the only factor in making their investment decision.

The Magic Formula and Value Traps The recent correction in the stockmarket has prompted investors to search for stocks with deep value. We ran the ‘Magic Formula’ screen, ranking companies on return ratios and earnings yield. From this list, we flag three names – Apollo Tyres, Aurobindo Pharma and Inox Wind – which appear to be value traps. Our deep dive into these three stocks reveal concerns around issues such as lack of sustainable advantages and risk of capital misallocation. We provide a four-filter framework to help investors assess the deep value in stocks and thus to avoid stocks that look attractive but are, in fact, value traps.

The hunt for value…

The BSE200’s 8% correction from its March 2015 high has prompted investors to hunt for value stocks. Our Magic Formula – a modification of Joel Greenblatt’s screen – has delivered excellent results in the past (click here for our 13th September 2013 note). When we ran the screen on the current market, the results included some of our top BUYs such as ITC, Lupin and Coal India. However, even as the approach works well in general, like any other ‘value’ screen, this approach reveals some ‘value traps’ that need to be avoided. ...has some pitfalls

From the list of the top-50 stocks under the ‘Magic Formula’ screen, we highlight three midcap value traps – Apollo Tyres, Aurobindo Pharma and Inox Wind. All three stocks appear attractive on the ‘Magic Formula’ after the recent correction. However, we recommend that investors should avoid these stocks given that each of them has issues pertaining to lack of sustainable competitive advantages and risk of capital misallocation. Defining a value trap

In general, value stocks remain cheap for prolonged periods of time, irrespective of the overall direction of the markets. Our core thesis is that companies with poor management (tracked on capital allocation, corporate governance and accounting quality) and businesses without sustainable competitive advantages (tracked on our IBAS framework) are prime candidates for becoming value traps. Building a framework

Using our core thesis, we build a four-step filter to help investors identify value traps. We believe that value traps would fail on at least two of these filters. These filters are: (a) Accounting Quality: 11 ratios focusing on highlighting key issues in published accounts; (b) IBAS: Assessing sustainable competitive advantages, a key success factor for any business; (c) Capital Allocation: Evaluating management’s ability to efficiently use capital to fund growth; and (d) Corporate Governance: Commitment of promoters to protect all interests, including minorities.

Value trap summary

Company Accounting Quality

Corporate Governance

Capital Allocation IBAS Hypothesis

Apollo Tyres

Modest franchise with core business under threat from rising competition

Auro Pharma

Key issues in corporate governance and lack of moated revenues

Inox Wind

Absence of any sustainable competitive advantage; issues in accounting quality

Source: Ambit Capital research. Note: = rating of 4/4; =rating of 3/ 4 and so on.

THEMATIC October 06, 2015

Strategy

Value traps discussed in this report

Apollo Tyres NOT RATED

Target Price: NA Upside NA

Aurobindo Pharma SELL

Target Price: ̀ 414 Downside: 46%

Inox Wind SELL

Target Price: ̀ 370 Upside: 2%

Top-50 firms on ‘magic formula’ score NMDC Tech Mahindra

Hero Motocorp Guj.St.Petronet

Apollo Tyres Oracle Fin.Serv.

Engineers India B P C L

Indraprastha Gas Mphasis

Sun TV Network Tube Investments

Bajaj Auto Essar Oil

PC Jeweller Cyient

HCL Technologies Ajanta Pharma

Infosys Lupin

Supreme Inds. Balkrishna Inds

ITC UPL

Welspun India CMC

MRF P I Inds.

Mindtree Castrol India

TCS Inox Wind

Coal India Bajaj Corp

Hind.Zinc Oil India

JSW Energy Aurobindo Pharma

AIA Engg. Motherson Sumi

Tata Motors Hind. Unilever

Hexaware Tech. Arvind Ltd

Wipro Colgate-Palm.

SJVN GSK Consumer

Natl. Aluminium Titan

Analyst Details

Gaurav Mehta, CFA +91 22 3043 3255 [email protected]

Prashant Mittal, CFA +91 22 3043 3218 [email protected]

Consultant

Anupam Gupta [email protected]

http://reports.ambitcapital.com/reports/Ambit_Strategy_Thematic_13Sept2013.pdf

Strategy


Section 1: Value and value traps The BSE200 Index has corrected by almost 8% from its 3 March 2015 highs. This has prompted investors to hunt for ‘value’ in the Indian stockmarket especially in small-mid capitalisation stocks. The quest for value, however, can also lead to ‘value traps’, i.e., stocks that appear cheap but actually aren’t. In this note, we provide investors with a framework to identify ‘value’ traps and we discuss three stocks that, in our view, are offering a false sense of ‘value’ today.

Screening for value - The magic formula A credible way of screening for ‘value’, we believe is Joel Greenblatt’s ‘magic’ formula. Our detailed note on this approach, dated 13th September 2013, had shown that such an approach works in the Indian context.

The approach is premised on finding stocks that offer a good blend of return on capital employed and earnings yield. In particular, the formula ranks firms on a combination of the following two ratios: (1) EBIT as a proportion of Net Fixed Assets plus Net Working Capital (this ratio is akin to an adjusted RoCE); and (2) EBIT as a proportion to Enterprise Value (this ratio is akin to a firm’s earnings yield adjusted for capital structure).

We have historically used a slightly modified version of the formula with the following two measures for return ratio and earnings yield:

Our ‘return ratio’ is pre-tax RoCE which includes interest and dividend income along with EBIT in the numerator and total capital including cash in the denominator.

Our ‘earnings yield’ has the same numerator as pre-tax RoCE and the denominator is market value of capital (debt as well as equity without excluding cash).

Firms are then ranked on both these parameters individually. The two ranks are then added to arrive at the cumulative ranks for each firm; a firm with a better cumulative rank should have a good blend of high return ratios and inexpensive valuations.

The performance of quintiles constructed using this approach for the BSE200 universe over the last 18 years (1997-2015) is presented in Exhibit 2 below and suggests that the magic formula does work.

Exhibit 1: The magic formula over the past 18 years on average return basis*

Source: Capitaline, Bloomberg, Ambit Capital research. * Within each quintile, we take the raw average of the quintile’s constituents to calculate the return for the quintile as a whole. These quintiles are based on an annual rebalance on June 30th

-

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

199

71

998

199

92

000

200

12

002

200

32

004

200

52

006

200

72

008

200

92

010

201

12

012

201

32

014

201

5Gro

wth

of

INR

10

0 in

vest

ed in

'9

7

Year

Performance of 'magic' quintiles

Q1

Q2

Q4

Q3

Q5

CAGR

22%

21%

16%

14%

8%

http://reports.ambitcapital.com/reports/Ambit_Strategy_Thematic_13Sept2013.pdf

Strategy


Exhibit 2 clearly shows that the ‘magic formula’ does work over a long-term horizon. Further, the yearly performances of these quintiles suggests that the highest quintile, Q1, has outperformed the BSE200 in 12 of the last 18 years (see Exhibit 3), thus validating the approach’s utility from a more tactical standpoint as well.

Exhibit 2: Yearly quintile performance over 1997-2015*

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 CAGR

Q1 46% 46% 7% -19% 82% 24% 42% 54% 33% 38% -9% 8% 49% -1% -9% -8% 55% 15% 22%

Q2 21% 39% 56% -26% 17% 16% 59% 72% 37% 34% -13% 9% 44% -3% -14% -6% 59% 31% 21%

Q3 -19% 39% 12% -34% 19% 9% 46% 71% 49% 44% -9% -9% 33% 0% -3% 10% 35% 19% 14%

Q4 -16% 51% 26% -35% 34% 4% 47% 86% 30% 43% -7% 8% 26% -13% -16% 5% 64% 17% 16%

Q5 -20% 34% 35% -36% 31% -1% 29% 79% 24% 52% -8% -6% 15% -23% -21% -15% 58% -5% 8%

BSE200 -19% 26% 26% -31% 10% 15% 38% 48% 38% 42% -9% 7% 27% 3% -8% 9% 33% 12% 12% Q1minus BSE200 65% 20% -19% 12% 72% 9% 4% 6% -5% -4% 0% 1% 22% -4% -1% -17% 22% 3% 10%

Source: Capitaline, Bloomberg, Ambit Capital research. * Within each quintile, we take the raw average of the quintile’s constituents to calculate the return for the quintile as a whole. These quintiles are based on an annual rebalance on June 30th .Yearly performance in calculated from 1st July every year. For e.g. the 2014 performance is from 1st July 2014 – 30th June 2015. Years in which the magic formula has underperformed are marked in Red

However, it is important to note that the performances shown here are the average of all stocks in the quintile, and individual stocks within a quintile may have varying performances scattered around these averages. Thus, even as the approach works well in general, like any other ‘value’ screen, this approach too will throw up some ‘value traps’ alongside a bunch of ‘value’ picks.

Current ‘value’ plays on this screen The magic screen in the current context can be seen in Exhibit 4 on the next page, which plots the best 50 stocks on a blend of ‘earnings yield’ and ‘return ratio’ from a universe of Indian companies with a market-cap in excess of `60bn.

The top quintile has outperformed the BSE200 in 12 of the last 18 years over 1997-2015

Strategy


Exhibit 3: Top-50 firms ranked in descending order (best firm first) on the basis of the ‘magic formula’ score

Company Name Sector Ticker Mcap (US$ mn)

6M Adv (US$ mn)

FY15 RoCE

Earnings Yield

FY16E P/E (x)

FY16E P/B (x)

FY16E EV/EBITDA (x)

NMDC Mining & Mineral products NMDC IN 5,762 3.7 31% 26% 9.4 1.0 4.8

Hero Motocorp Automobile HMCL IN 7,713 23.1 55% 7% 18.0 5.7 12.0

Apollo Tyres Tyres APTY IN 1,499 8.6 27% 15% 8.4 1.6 4.8

Indraprastha Gas Gas Distribution IGL IN 1,013 3.4 31% 10% 14.1 2.7 7.7

HCL Technologies IT - Software HCLT IN 18,323 27.3 40% 8% 15.5 4.0 11.5

PC Jeweller Diamond, Gems and Jewellery PCJL IN 1,021 1.6 28% 11% 14.7 2.8 8.2

Sun TV Network Entertainment SUNTV IN 2,177 12.6 35% 8% 15.9 3.8 7.1

Engineers India Infrastructure Developers ENGR IN 1,023 2.0 28% 10% 19.4 2.4 15.2

Bajaj Auto Automobile BJAUT IN 10,462 14.3 42% 7% 17.8 5.3 12.9

Infosys IT - Software INFO IN 40,572 71.7 36% 6% 19.9 4.5 14.2

Supreme Inds. Plastic products SI IN 1,234 0.7 36% 6% 25.0 5.9 13.6

ITC Tobacco Products ITC IN 40,830 35.7 48% 5% 25.4 7.5 16.3

Coal India Mining & Mineral products COAL IN 32,609 27.6 27% 9% 13.5 4.9 9.0

Hind.Zinc Non Ferrous Metals HZ IN 9,081 2.3 19% 13% 7.9 1.2 4.1

TCS IT - Software TCS IN 80,915 49.7 51% 5% 21.9 7.8 16.2

MRF Tyres MRF IN 2,781 8.5 27% 8% 11.3 2.6 6.2

Welspun India Textiles WLSI IN 1,396 3.4 25% 9% 14.2 4.8 7.8

Tata Motors Automobile TTMT IN 16,359 53.2 19% 14% 7.3 1.4 3.3

JSW Energy Power Generation & Distribution JSW IN 2,343 3.8 19% 13% 11.4 1.8 5.9

AIA Engg. Castings, Forgings & Fastners AIAE IN 1,434 1.5 30% 6% 21.6 3.9 13.9

Hexaware Tech. IT - Software HEXW IN 1,170 6.2 34% 6% 19.3 5.5 13.1

Mindtree IT - Software MTCL IN 1,970 4.5 37% 5% 21.5 5.3 14.8

SJVN Power Generation & Distribution SJVN IN 1,607 0.3 17% 16% 8.0 1.0 4.6

Natl. Aluminium Non Ferrous Metals NACL IN 1,407 0.9 16% 22% 11.1 0.7 3.5

Wipro IT - Software WPRO IN 22,746 15.0 26% 7% 16.1 3.2 11.7

Guj.St.Petronet Miscellaneous GUJS IN 1,008 1.3 18% 11% 13.0 1.6 7.3

Cyient IT - Software CYL IN 963 0.8 25% 7% 16.4 2.9 11.6

UPL Agro Chemicals UPLL IN 3,007 19.8 22% 9% 13.8 2.8 8.2

Tech Mahindra IT - Software TECHM IN 8,279 26.0 28% 6% 17.8 3.6 11.9

Oracle Fin.Serv. IT - Software OFSS IN 5,162 3.4 29% 5% 24.0 7.4 16.4

P I Inds. Agro Chemicals PI IN 1,337 2.3 41% 4% 29.0 7.6 19.4

B P C L Refineries BPCL IN 9,677 21.2 18% 10% 11.1 2.4 7.3

MphasiS IT - Software MPHL IN 1,331 1.1 17% 10% 11.9 1.5 7.4

Tube Investments Miscellaneous TI IN 1,167 0.5 15% 11% 61.3 DNA 23.3

Essar Oil Refineries ESOIL IN 4,317 6.0 18% 9% 14.7 4.5 9.2

CMC IT - Hardware CMC IN 942 1.0 27% 6% 21.0 3.9 13.3

Balkrishna Inds Tyres BIL IN 976 0.9 18% 9% 11.8 2.3 7.5

Ajanta Pharma Pharmaceuticals AJP IN 2,037 5.1 57% 4% 33.2 11.5 22.0

Bajaj Corp FMCG BJCOR IN 1,034 1.1 50% 4% 26.9 12.3 22.1

Inox Wind Capital Goods INXW IN 1,211 N/A 29% 5% 15.2 4.3 10.0

Motherson Sumi Auto Ancillaries MSS IN 4,704 15.9 25% 6% 22.4 7.3 9.0

Castrol India Chemicals CSTRL IN 3,413 2.0 117% 3% 37.4 38.7 23.4

Oil India Crude Oil & Natural Gas OINL IN 4,063 2.7 13% 11% 7.9 1.1 5.4

Hind. Unilever FMCG HUVR IN 27,162 20.8 147% 3% 39.0 38.9 27.6

Lupin Pharmaceuticals LPC IN 14,355 46.6 40% 4% 37.0 8.5 23.0

Aurobindo Pharma Pharmaceuticals ARBP IN 6,843 28.4 28% 5% 22.2 6.0 15.4

Arvind Ltd Textiles ARVND IN 1,118 9.4 16% 8% 16.3 2.4 9.2

Titan Company Diamond, Gems and Jewellery TTAN IN 4,701 5.8 34% 4% 34.8 8.4 25.7

Colgate-Palm. FMCG CLGT IN 3,987 6.7 114% 3% 42.5 29.8 27.8

GlaxoSmith C H L FMCG SKB IN 3,889 1.3 41% 3% 36.1 10.2 27.7

Source: Capitaline, Bloomberg, Ambit Capital research. Note: * RoCEs and earnings yields based on FY14 financial statements for Engineers India and MRF; arranged by ‘magic’ score; RoCE is pre-tax RoCE which includes interest and dividend income along with EBIT in the numerator and total capital including cash in the denominator; earnings yield has the same numerator as pre-tax RoCE and the denominator is market value of capital (debt as well as equity including cash). FY16 estimates have been sourced from Bloomberg. The table values updated as of 05 Oct 2015.

From the list above, it is clear that not all of these names have ‘value’. Whilst many do have ‘value’, quite a few fall into the ‘value trap’ category. Whilst some of these names are obvious, we highlight three non-obvious ones in the next section.

Strategy


Section 2: A framework to identify ‘value traps’ In a September 2013 blog post, Aswath Damodaran, a Professor of Finance at the Stern School of Business at New York University, described value traps as “companies that look cheap on every metric but stay cheap forever” (source: http://goo.gl/Mzr9TP).

Value traps have many things in common beyond appearing cheap after every market fall and looking good on reported financials. In our view, these stocks are businesses without any sustainable competitive advantage which have benefited from a market cycle or exit of competition or a temporary factor that makes them look good. Chance, rather than merit or skill, has propelled the management that is likely lucky at best and mediocre at worst.

In our view, a great company – one with proven, sustainable competitive advantages – can survive bad management. But a company without any sustainable competitive advantage, irrespective of management quality is at high risk of value destruction, more so if it is saddled with poor management. These are the value traps that investors must avoid irrespective of how attractive valuations appear after a stock price correction. In all probability, there is further downside to the stock price.

In this section, we provide a framework to help investors identify value traps. We base our framework on proprietary filters that have held us in good stead in the past in identifying winners and avoiding losers.

To summarise:

Our core thesis is that companies with poor management (as captured by capital allocation, corporate governance and accounting quality) and businesses without sustainable competitive advantages (as tracked by our IBAS framework) are prime candidates for turning out be value traps.

Therefore, our filters include all four issues: accounting quality, IBAS framework, capital allocation and corporate governance.

Our filters will assign red flags, as applicable, for value traps on each of the parameters.

We summarise our filters in the table below before delving into each filter in detail.

Exhibit 4: Summary of value trap filters

Filter Methodology Purpose

Accounting Quality

Analyse overall published accounts for quality in general and misstatements and irregularities in specific

Stocks with weak accounting quality tend to underperform

Corporate governance

Analyse data such as insider trading, board composition and related party transactions

Evaluate management's attitude towards minority shareholders

Capital allocation Measure management's effectiveness in allocating capital for growth of the firm Critical for superior RoCEs

IBAS framework

Assess sustainable competitive advantages across Innovations, Brands and Reputation, Architecture and Strategic Assets

Helps in sustaining growth over long periods

Source: Ambit Capital research

Value traps have many things in common beyond appearing cheap after every market fall and looking good on reported financials

Companies with poor management and businesses without sustainable competitive advantages are prime candidates for value traps

Strategy


Filter 1: Accounting quality Accounting quality is not just one of the many factors affecting investment returns but rather a critical hygiene factor, the lack of which can be detrimental to portfolio returns. In our 22 December 2014 thematic report, “Forensic Accounting: Identifying the Zone of Trouble”, we established a model that looks at the following key categories of accounting irregularities: balance sheet misstatement, profit & loss misstatement, cash pilferage and audit quality.

We use 11 ratios to score our universe (excluding, banks and financial services firms) based on their accounting qualities. These ratios can broadly be categorised into four buckets.

Exhibit 5: Key categories of accounting checks Category Ratios

P&L misstatement checks (1) CFO/EBITDA, (2) change in depreciation rate, and (3) volatility in non-operating income (as a percentage of net revenues)

Balance sheet misstatement checks

(1) Cash yield, (2) change in reserves (excluding share premium) to net income excluding dividends, (3) provisions for doubtful debts as a proportion of debtors more than six months, and (4) contingent liability as a proportion of net worth

Cash pilferage checks (1) Non-operating expenses as a proportion of total revenues, (2) CWIP to gross block, and (3) cumulative CFO plus CFI to median revenues

Audit quality checks (1) CAGR in auditor’s remuneration to CAGR in consolidated revenues


Here is a brief description of the accounting ratios:

I - P&L misstatement checks

1 CFO/EBITDA: This ratio checks a company’s ability to convert EBITDA (which can be relatively easily manipulated) into operating cash flow (which is more difficult to manipulate). A low ratio raises concerns about the company’s revenue recognition policy (because this may imply aggressive revenue recognition through methods such as channel stuffing). We use a six-year median for this measure.

2 Change in depreciation rate: We calculate change in depreciation rates for each of the past six years (FY09-14). We then calculate the median of absolute changes and then sort the companies on this ratio such that the company with the smallest change in its depreciation rate receives the best score. The rationale is to penalise companies that have high volatility in their depreciation rate on a YoY basis.

3 Volatility in non-operating income: We calculate change in non-operating income (as a percentage of net revenues) for each of the past six years (FY09-14). We then calculate the median of absolute changes and then sort firms on this ratio such that the company with the least volatility receives the best score. The rationale is to penalise firms where volatility in non-operating income is unusually high, as this could imply intent to inflate profitability in years of low profits by resorting to such means as sale of assets, investments, and so on.

II - Balance sheet misstatement checks

4 Cash yield: This ratio is calculated as the yield earned on cash, investments and deposits. A low ratio could be a cause for concern, as it could mean that either the balance sheet has been misstated or that the cash is not being used in the best interests of the firm. We use a six-year median for this measure.

We use 11 ratios to score our universe based on their accounting quality

A low CFO/EBITDA raises concerns about the company’s revenue recognition policies

Our model penalises high volatility in depreciation rate

High volatility in non-operating income is a cause of concern!

A low cash yield may imply balance sheet misstatement or that the cash is not being used in the firm’s best interest

http://reports.ambitcapital.com/reports/Ambit_Strategy_Thematic_Forensicaccounting_22Dec2014.pdf

Strategy


5 Change in reserves (excluding share premium) to net income excluding dividends: This ratio is calculated by dividing the change in reserves (excluding share premium) on a YoY basis and dividing it by that year’s PAT excluding dividends. We then take a six-year median of this ratio. A ratio of less than one indicates direct write-offs to equity without routing these through the Profit & Loss account and may indicate aggressive accounting policies.

6 Provision for doubtful debts as a proportion of debtors more than six months: This ratio checks the conservativeness of a company’s provisioning policy. A low ratio raises the spectre of earnings being boosted through aggressive provisioning practices. We use a six-year median for this measure.

7 Contingent liabilities as a proportion of net worth: This is a check on a company’s off-balance-sheet liabilities. If this ratio is high, it raises concerns regarding the strength of the company’s balance sheet in the event that the contingent liabilities materialise. Given that contingent liabilities also include genuine items such as letters of credit, bill discounting and capital commitments, we seek to eliminate as many of these items whilst computing the figure for contingent liabilities. We use a six-year median for this measure.

III - Cash pilferage checks 8 Non-operating expenses as a proportion of total revenues: This ratio

checks a company’s expenditure policy. A high ratio raises concerns regarding the authenticity of such expenses. We use a six-year median for this measure.

9 CWIP to gross block: The idea here is to penalise firms that show consistently high CWIP relative to the gross block, as this may either indicate unsubstantiated capital expenditure or a delay in commissioning (which may in turn be motivated by a delay in the recognition of the related depreciation expense). We calculate the proportion of capital work in progress to gross block for each of the last six years and then take the 25th percentile observation (instead of a simple six-year median like in most other ratios). The reason for using the 25th percentile over the last six years for this measure as opposed to the median (which would be the 50th percentile observation) is to allow the benefit of doubt to firms that have invested wisely during the recent downturn. Hence, we are penalising companies only if the ratio has been consistently high over most of the last six-year period.

10 Cumulative CFO plus CFI to median revenues: We calculate the cumulative CFO (cash flow from operations) plus cumulative CFI (cash flow from investing activities) over the last six years and divide this by the last six-year median revenues for the company. The higher the ratio, the better our perception of the company’s accounts. The idea is to penalise firms which over such large periods have been unable to either generate positive cash flows from operations or alternatively where cash flow from investments have consistently eaten away cash generated from operations.

IV - Audit quality checks 11 CAGR in auditor’s remuneration to CAGR in consolidated revenues:

We calculate CAGR in standalone auditor’s remuneration and consolidated revenues over FY08-14. A lower ratio of CAGR in auditor’s remuneration relative to CAGR in consolidated revenues receives a high score. The rationale is to penalise companies whose growth in auditor’s remuneration has exceeded the growth in the firm’s revenues.

Implications for value traps: We highlight that not all value traps will have poor accounting quality. However, investors must use the above filters to carefully assess those stocks that show up on their value screen and only consider those companies whose ratios provide a high level of comfort on accounting quality.

A ratio of less than one on this check may denote direct write-offs through the balance sheet

A low provisioning raises the spectre of earnings being boosted through aggressive provisioning practices

A very high proportion of contingent liabilities to net worth indicates disproportionately high off-balance-sheet risk

A high proportion of non-operating expenses raises concerns regarding the genuineness of such expenses

A high CWIP to gross block ratio may either indicate unsubstantiated capex or delay in commissioning

Our model penalises firms that have not generated positive cash flows even on a six-year basis

We penalise firms where growth in auditor’s remuneration has been higher than the growth in the firm’s revenues

Strategy


Filter 2: Corporate governance Finally, we believe that high corporate governance standards are a measure of the company’s commitment to all shareholders, not just promoters. Whilst our first filter in ‘Accounting Quality’ will capture irregularities in published accounts, more subjective filters are required to gauge the intent of management and their attitude toward minorities. These filters include, but are not limited to, the following:

Related party transactions: Ideally, transactions between related parties should be at arm’s length. An arm’s length transaction would mean that both the parties seek to execute the transaction in their best interests. However, in several cases, related party transactions are conducted in a manner that is not in the best interests of one party. Overpaying for an asset purchased from a related party, sale of goods or other assets to related parties at a significant discount to their fair market values, loans given to related parties at exceptionally concessional rates or loans taken from related parties at exorbitant interest rates are just a few examples of how these transactions might not be in the best interests of minority shareholders. Likewise, unwarranted transactions with related parties should raise a red flag.

Insider trading: Investors should watch out for excessive insider trading in the company’s stock. These trades are required to be reported to the exchanges and anything suspicious – especially surrounding big announcements – should raise red flags to investors.

Board independence: The company’s Board should be visibly independent and contribute in a meaningful manner to key decisions. Boards where the number of independent directors is lower than the statutory limit or where independent directors have no merit or connection with the company’s core business should raise red flags for investors.

Questionable transactions that benefit promoters: These include transactions such as merger of unlisted entities at exorbitant valuations and transfer of profitable divisions at cheap valuations, which should immediately raise concerns for investors on the intent of the promoters.

Implications for value traps: Whilst companies with a track record of poor corporate governance should raise red flags in general, it is more important to identify these companies as value traps. In such cases, even if the core business performs well, there is no guarantee that the benefits will be shared with all the shareholders alike.

Filter 3: Capital allocation Efficient capital allocation is at the core of great companies. More importantly, effective capital allocation is not just about growing but growing profitably. Thus, capital allocation is perhaps the single most important decision through which a management adds value to the firm’s shareholders.

The exhibit below outlines the various choices that managements face towards allocation of capital.

High corporate governance standards are a measure of the company’s commitment to all shareholders, not just promoters

Whilst companies with poor corporate governance should raise red flags in general, it is more important to identify these companies as value traps

Efficient capital allocation is at the core of great companies

Strategy


Exhibit 6: Capital allocation choices


A firm should either use its capital for business expansion (capex/ acquisition) or return the surplus cash to its stakeholders (dividend/ share buyback/ debt repayment). However, we often see firms opting for a third choice of doing nothing and letting cash accumulate on their balance sheets. This clearly reduces return ratios and hurts shareholder returns.

We have explored capital allocation in great detail over the years, starting from our Greatness Framework in 2012 that analysed capital allocation decisions of India Inc to our thematic report dated 31st July 2013, “The Cashflow Conundrum for India Inc” that established RoCE as the single biggest driver for stock price performance. Capital allocation is the key to superior RoCEs.

Thus, in this report, we carry forward our focus on capital allocation as a key area for identifying value traps. Growth creates value only when it helps generate return on capital in excess of cost of capital. Using this measure, we analyse the trends in sources and utilisation of capital in the past decade.

Implications for value traps: Inevitably, value traps falter in any one or all of the areas of utilisation: excessive capex and/or acquisitions to fuel global ambition plans, which eventually hurt return ratios or refusal to return excess cash to shareholders or pare debt. Investors must convince themselves of the management’s ability to use capital judiciously to avoid falling for a value trap.

Capital allocation choices

Expand

Return

DividendsShare buybacks/ debt repayment

Organic: Capex

Inorganic: Acquisitions

Cash builds upDo nothing

Letting cash accumulate on balance sheets reduces return ratios and hurts shareholder returns

RoCE is the single biggest driver for stock price performance

Investors must convince themselves of the management’s ability to use capital judiciously

http://reports.ambitcapital.com/reports/Ambit_Strategy_Thematic_31Jul2013.pdf

Strategy


Filter 4: IBAS framework In our 22nd May 2014 thematic report, “Great Indian Midcaps”, we used the “IBAS Framework” to analyse how a select group of stocks sustained high levels of growth whilst maintaining return ratios. “IBAS” stands for Innovation, Brands and Reputation, Architecture and Strategic Asset. This framework was first enunciated by John Kay, the British economist and Financial Times columnist, in his 1993 book, “Foundations of Corporate Success”.

John states that “sustainable competitive advantage is what helps a firm ensure that the value that it adds cannot be competed away by its rivals”. He goes on to state that sustainable competitive advantages can come from two sources: distinctive capabilities or strategic assets. Whilst strategic assets can be in the form of intellectual property (patents and proprietary know-how), legal rights (licenses and concessions) or a natural monopoly, the distinctive capabilities are more intangible in nature.

Distinctive capabilities, says Kay, are those relationships that a firm has with its customers, suppliers or employees, which cannot be replicated by other competing firms and which allow the firm to generate more value additions than its competitors. He further divides distinctive capabilities into three categories:

Brands and reputation

Architecture

Innovation We summarise the four aspects of IBAS below. For a more detailed reading, including case studies and examples, please refer to our report, “Great Indian Midcaps”, which has exhaustive analysis on six stocks using the IBAS framework.

Brands and reputation In many markets, product quality, in spite of being an important driver of the purchase decision, can only be ascertained by a long-term experience of using that product. Examples of such products are insurance policies and healthcare. In many other markets, the ticket price of the product is high; hence, consumers are only able to assess the quality of the product only after they have parted with their cash. A few examples of such products would be cars and high-end TVs. In both these markets, customers use the strength of the company’s reputation as a proxy for the quality of the product or the service. For example, we gravitate towards the best hospital in town for critical surgery and we tend to prefer world-class brands whilst buying expensive home entertainment equipment. Since the reputation for such high-end services or expensive electronics takes many years to build, reputation tends to be difficult and costly to create. This in turn makes it a very powerful source for a competitive advantage. For products that we use daily, we tend to be generally aware of the strength of a firm’s brand. In more niche products or B2B products (such as industrial cables, mining equipment, municipal water purification and semiconductors), investors often do not have first-hand knowledge of the key brands in the relevant market. In such instances, to assess the strength of the brand, they turn to:

Brand recognition surveys conducted by the trade press.

The length of the warranties offered by the firm (the longer the warranties, the more unequivocal the statement it makes about the firm’s brand).

The amount of time the firm has been in that market (eg. “Established 1905” is a fairly credible way of telling the world that since you have been in business for over a century, your product must have something distinctive about it).

Strategic assets can be in the form of intellectual property, legal rights or a natural monopoly; distinctive capabilities are more intangible in nature

Reputation tends to be difficult and costly to create, making it a very powerful source for a competitive advantage

http://reports.ambitcapital.com/reports/Ambit_Strategy_Thematic_22May2014.pdf

http://reports.ambitcapital.com/reports/Ambit_Strategy_Thematic_22May2014.pdf

Strategy


How much the firm spends on its marketing and publicity (a large marketing spend figure, relative to the firm’s revenues, is usually a reassuring sign).

How much of a price premium the firm is able to charge vis-a-vis its peers.

Architecture ‘Architecture’ refers to the network of contracts, formal and informal, that a firm has with its employees, suppliers and customers. Thus, architecture would include the formal employment contracts that a firm has with its employees and it would also include the more informal obligation that it has to provide ongoing training to its employees. Similarly, architecture would include the firm’s legal obligation to pay its suppliers on time and its more informal obligation to warn its suppliers in advance if it were planning to cut production in three months. Such architecture is most often found in firms with a distinctive organisational style or ethos, because such firms tend to have a well-organised and long-established set of processes or routines for doing business. So, how can an investor assess whether the firm they are scrutinising has architecture or not? In fact, whilst investors will often not know the exact processes or procedures of the firm in question, they can assess whether a firm has such processes and procedures by gauging the:

extent to which the employees of the firm co-operate with each other across various departments and locations.

rate of staff attrition (sometimes given in the Annual Report).

extent to which the staff in different parts of the firm give the same message when asked the same question.

extent to which the firm is able to generate innovations in its products or services or production processes on an ongoing basis.

At the core of successful architecture is co-operation (within teams, across various teams in a firm and between a firm and its suppliers) and sharing (of ideas, information, customer insights and, ultimately, rewards). Built properly, architecture allows a firm with ordinary people to produce extraordinary results.

Innovation Whilst innovation is often talked about as a source of competitive advantage, especially in the Technology and Pharmaceutical sectors, it is actually the most tenuous source of sustainable competitive advantage, as:

Innovation is expensive.

Innovation is uncertain - the innovation process tends to be a “hit or miss”.

Innovation is hard to manage due to the random nature of the process. Furthermore, even when the expensive innovation process yields a commercially useful result, the benefits can be competed away, as other firms replicate the innovator and/or employees who have driven the innovation process tend to extract the benefits of innovation through higher compensation. In fact, innovation is more powerful when it is twinned with the two other distinctive capabilities we have described above – reputation and architecture. Apple is the most celebrated example of a contemporary firm which has clearly built a reputation for innovation (think of the slew of products from Apple over the past decade which first changed how we access music, then changed how we perceive our phones and finally, how we use our personal computers).

‘Architecture’ refers to the network of contracts, formal and informal, that a firm has with its employees, suppliers and customers

At the core of successful architecture is cooperation and sharing

Whilst most talked about, ‘Innovation’ is also the most tenuous source of sustainable competitive advantage…

Strategy


Strategic assets In contrast to the three distinctive capabilities discussed above, strategic assets are easier to identify as sources of competitive advantages. Such assets can come in different guises:

Intellectual property i.e., patents or proprietary know-how;

Licenses and regulatory permissions to provide a certain service to the public;

Access to natural resources such as coal or iron ore mines;

Political contacts either at the national, state or city level;

Sunk costs incurred by the first mover which result in other potential competitors deciding to stay away from that market; and

Natural monopolies i.e., sectors or markets which accommodate only one or two firms.

Implications for value traps: In our view, all value traps will face key hurdles on the IBAS framework. If the business has not developed and maintained sustainable competitive advantages, then the company – irrespective of superior financials and attractive valuations – will eventually get de-rated in terms of stock price.

Apollo Tyres, Aurobindo Pharma and Inox Wind – Three midcap value traps

We filtered the top-50 value stocks as per the Magic Formula in Exhibit 4 on the four filters mentioned in this section. Our filters throw up three stocks: Apollo Tyres, Aurobindo Pharma and Inox Wind. We summarise the key thesis that qualify these stocks as value traps.

Exhibit 7: Summary hypothesis for value traps

Company Name Ticker Mcap (US$mn)

6M ADV (US$mn)

FY15 ROCE

Earnings Yield (FY15

earnings) Hypothesis

Apollo Tyres APTY IN 1,499 8.6 27% 15% Modest franchise with core business under threat from rising competition; aggressive capex in Europe is a cause for concern

Aurobindo Pharma ARBP IN 6,843 28.4 28% 5% Key issues in corporate governance such as sub-par financial reporting; core business lacks moat and susceptible to competitive threats

Inox Wind INXW IN 1,211 N/A 29% 5% Absence of visible sustainable competitive advantage, key issues in accounting such as nil expenditure on warranties and R&D

Source: Capitaline, Bloomberg, Ambit Capital research. Note: RoCE is pre-tax RoCE which includes interest and dividend income along with EBIT in the numerator and total capital including cash in the denominator; earnings yield has the same numerator as pre-tax RoCE and the denominator is market value of capital (debt as well as equity including cash)

…’strategic assets’ on the other hand are easier to identify

All value traps will face key hurdles on the IBAS framework


Apollo Tyres has a relatively modest franchise with no clear dominance in any domestic segment. It faces threats in its core domestic truck tyre franchise from Chinese imports and global majors (Michelin and Bridgestone). We also have concerns around it capital allocation decisions (acquisition of Cooper Tire which did not materialise) and aggressive capex in Europe which would impact FCF/return ratios over the next few years. Whilst Apollo scores relatively well on accounting quality, there is lack of rotation of independent directors and numerous share purchases by promoters/promoter-owned entities (mainly in depressed markets). Given these challenges, we expect its discount to MRF (35% on FY17 consensus P/E multiple) to persist. Value trap summary Parameter Result Comment

Accounting quality Above average score on accounting quality driven by higher provisioning vs peers, lower contingent liabilities and strong FCF generation.

Corporate governance No major corporate governance issues but inadequate rotation of independent directors and significant insider transactions are worrying.

Capital allocation Aggressive and ambitious management as indicated by its attempt to acquire Cooper Tire and big capex bets in Europe. Mixed track record of acquisitions.

IBAS Average domestic franchise, significant threats from Chinese and MNC competition in the truck segment.

Source: Company, Ambit Capital research. Note: = rating of 4/4; = rating of 3/ 4 and so on. Apollo scores above average on accounting quality Apollo Tyres receives the second best score on accounting quality as compared to its peers. The above-average ranking is primarily driven by: (a) higher provisioning of debtors vs peers; (b) lower contingent liabilities; and (c) strong FCF generation. Apollo scores relatively lower than its peers on cash yield and non-operating expenses as a percentage of revenues. Reported number do not reveal the true picture of capital allocation Apollo’s historical RoCE and funds deployment do not capture the attempted acquisition of Cooper Tires (2.5x Apollo’s size), which if consummated, would have thrown the company’s debt levels/cash flows out of gear. The firm has a mixed track record of acquisitions (Vredestein Banden was a success but Dunlop South Africa was a failure). Today the company has big-ticket capex planned in Europe (€475mn) which appears aggressive given the lack of experience in the European truck bus radial market. This capex would result in a negative FCF (at the consolidated level) over the next 2-3 years. Modest franchise facing threats in the core domestic truck tyre segment Apollo has an average franchise in the domestic market without a dominant market share in any segment. Its peers (such as JK Tyres) are catching up on dealer network and capacities. With rising competition from Chinese imports and global majors, Apollo faces significant threat in its core truck tyre business. The JV break-up with Michelin in FY06 appears to be a big missed opportunity. Stagnant independent directors; significant insider transactions Four of the eight independent directors have been on the Board for at least the last eight years. Further, there have been several transactions in the company’s shares over the last five years by promoter/promoter entities mainly pertaining to share purchases during periods of low share prices. Discount to MRF to continue Apollo is currently trading at 7.8x FY17 consensus net earnings, which implies a discount of 35% to MRF’s multiples. Given significant threats to its domestic truck tyre franchise and ambitious management (which increases risks of adverse capital allocation), Apollo should continue to trade at such discounted multiples.

COMPANY UPDATE APTY IN EQUITY October 06, 2015

Apollo TyresNOT RATED

Auto & Auto ancillaries

Recommendation Mcap (bn): `93/US$1.4 3M ADV (mn): `617/US$9.3 CMP: `182 TP (12 mths): NA Downside (%): NA

Flags Accounting: AMBER Predictability: AMBER Earnings Momentum: AMBER

What will change our view?

Any government regulation which significantly curtails truck tyre imports

Significant demand recovery in e domestic or European replacement tyre market

Performance (%)

Source: Bloomberg, Ambit Capital research

Analyst Details

Ashvin Shetty, CFA +91 22 3043 3285

[email protected]

Ritu Modi

+91 22 3043 3292

[email protected]

70

80

90

100

110

120

Oct

-14

Nov

-14

Dec

-14

Jan-

15

Feb-

15

Ma

r-15

Apr

-15

Ma

y-1

5

Jun

-15

Jul-

15

Au

g-15

Sep-

15

Sensex Apollo Tyres

Apollo Tyres


Exhibit 1: Whilst EBITDA margins have recovered over the last 4 years, revenue has stagnated

Source: Company, Ambit Capital research Note: Consolidated accounts

Exhibit 2: Significant volatility in return ratios depending on the business cycles

Source: Company, Ambit Capital research Note: Consolidated accounts

Exhibit 3: Free cash generation over the years has led to reduction in net debt levels

Source: Company, Ambit Capital research; Note: Consolidated accounts

Exhibit 4: Apollo’s funds over FY06-15 have been mainly deployed for capex and interest payments

Source: Company, Ambit Capital research; Note: Consolidated accounts

Exhibit 5: On P/E, Apollo is currently trading at a 6% premium to the historical five-year average

Source: Bloomberg, Ambit Capital research. Note: P/E bands arrived at using Bloomberg consensus estimates for respective periods

Exhibit 6: On EV/EBITDA, Apollo is currently trading in line with its historical five-year average

Source: Bloomberg, Ambit Capital research. Note: EV/EBITDA bands arrived at using Bloomberg consensus estimates for respective periods

Exhibit 7: Explanation for our flags

Segment Score Comments

Accounting AMBER Apollo Tyres scores the second best on accounting quality in the peer set comprising MRF, JK Tyres and Ceat.

Predictability AMBER Quarterly earnings reported by the company tend to be unpredictable. Given the high level of fixed costs (including depreciation and interest expenses), any marginal outperformance/underperformance at the topline level tends to have a magnified impact at the net earnings level. However, this is an industry-wide phenomenon.

Treatment of minorities AMBER

We have not come across any significant corporate governance concerns surrounding the company. However, certain decisions such as acquisition of Cooper Tire were significantly detrimental to the interests of minority shareholders.


8.0%

9.0%

10.0%

11.0%

12.0%

13.0%

14.0%

15.0%

16.0%

-

20,000

40,000

60,000

80,000

100,000

120,000

140,000FY

06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

Revenue (Rs mn) EBITDA margin - RHS

5%

10%

15%

20%

25%

30%

35%

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

RoE RoCE (post-tax)

(0.5)

(0.3)

(0.1)

0.1

0.3

0.5

0.7

0.9

1.1

(7,000)

(4,000)

(1,000)

2,000

5,000

8,000

11,000

14,000

17,000

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

CFO FCF Net debt:equity (x) - RHS

` mn

Capex64%

Decrease in debt 6%

Investments7%

Interest19%

Dividends4%

`56.6bn

`16.7bn

3.0

4.0

5.0

6.0

7.0

8.0

9.0

10.0

11.0

Sep-

10

Jan-

11

May

-11

Sep-

11

Jan-

12

May

-12

Sep-

12

Jan-

13

May

-13

Sep-

13

Jan-

14

May

-14

Sep-

14

Jan-

15

May

-15

Sep-

15

Apollo 1-yr fwd P/E Avg 1-yr fwd P/E

2.5

3.0

3.5

4.0

4.5

5.0

5.5

6.0

Sep-

10

Jan-

11

May

-11

Sep-

11

Jan-

12

May

-12

Sep-

12

Jan-

13

May

-13

Sep-

13

Jan-

14

May

-14

Sep-

14

Jan-

15

May

-15

Sep-

15

Apollo 1-yr fwd EV/EBITDA Avg 1-yr fwd EV/EBITDA

Apollo Tyres


Accounting quality Apollo scores above-average on accounting quality

Apollo Tyres is the second best on accounting quality in the peerset (comprising MRF, JK Tyres and Ceat). The above-average ranking on accounting quality is primarily driven by: (a) higher provisioning of debtors vs peers; (b) lower contingent liabilities relative to competitors; and (c) strong FCF generation. Apollo’s scores are relatively lower than its peers on: (a) lower cash yield; (b) higher non-operating expenses as a proportion of revenues vs peers.

Exhibit 8: Apollo’s performance on accounting parameters vs peers

Apollo Tyres JK Tyres Ceat MRF

P&L Misstatement CFO/EBITDA 91% 91% 104% 97%

Change in depreciation rate 41 62 14 74

Volatility in non-operating income as % of sales 14 43 23 29

Balance sheet Misstatement Cash yield 1.5% 5.0% 3.6% 2.4% Change in reserves to net income excluding dividends 1.0 0.8 1.0 1.0

Provision for doubtful debts as % of debtors more than six months 98% 30% 82% 49%

Contingent liabilities as % of networth 3.3% 4.4% 30.2% 16.5%

Cash pilferage checks Non-operating expenses as a proportion of total revenues 2.5% 1.8% 1.9% 0.7%

CWIP to gross block 0.04 0.06 0.05 0.10

Cumulative CFO plus CFI to median revenues 0.17 (0.00) 0.13 0.00

Audit quality checks CAGR in auditor’s remuneration to CAGR in consol. Revenues (0.38) (0.59) (0.49) (0.38)

Overall

Source: Company, Ambit Capital research. Note: = ranking of 1; = ranking of 2 = ranking of 3

P&L misstatement checks Cash conversion – Remains strong but behind peers

Apollo’s CFO as a percentage of EBITDA over FY10-15 is 91%, which is lower than its peers like Ceat (104%) and MRF (97%). Apollo’s working capital days have been higher than Ceat (53 days in FY15 vs 49 days for Ceat). This has impacted Apollo’s cash conversion ratio.

Depreciation rate – Stable over the years except in FY11

The median volatility in the average depreciation rate (excluding land and goodwill from the gross block) over FY10-15 is 41bps, marginally lower than other tyre companies (average of 50bps). The average depreciation rate for Apollo has remained stable except in FY11, when the depreciation rate dipped to 4.5% from 6.6% in FY10. Whilst the proportion of ‘Plant and Machinery’ in overall fixed assets remained broadly stable in FY11, the depreciation rate on Plant & Machinery for the year declined, which led to the overall depreciation rate declining by 214bps YoY. A potential reason for this could be the timing of the capitalisation of plant and machinery. The average depreciation rate since then has remained largely similar to the FY11 levels.

Non-operating income – Stable in the last six years

Apollo’s non-operating income has averaged around 0.6% of revenues over FY10-15. This is marginally lower than the average non-operating income as a percentage of revenues for other tyre makers (0.8%). Unlike its peers, Apollo’s non-operating income as a percentage of revenues has remained stable in the last six years.

Apollo Tyres


Balance sheet misstatement checks Cash yield – Significantly lower than peers

Apollo’s six-year median yield on cash and liquid investments is only 1.5%, significantly lower than the median yield commanded by its peers (3.7%). Apollo’s average income rate is low, as nearly 82-92% of its cash/bank balances are lying in current accounts which do not earn interest. Apollo’s average income rate increased substantially from 0.7% in FY13 to 4.9% in FY14. This was on account of an increase in the proportion of cash/bank balances lying in deposit accounts. However, in FY15, the average income rate once again declined to 1.7% due to the lower proportion of cash lying in deposit accounts. For FY15, income on cash/cash equivalents accounted for 1% of PBT and cash/cash equivalent balance accounted for 14% of end-FY15 net worth.

Contingent liability as a proportion of net worth is not significant

Contingent liabilities accounted for only 1.4% of FY15 net worth. A significant portion of contingent liability is towards disputes related to income tax issues. At 1.4% of net worth, we do not expect contingent liabilities to have a material adverse impact on the company’s cash flows or net worth in case of an adverse outcome on disputed cases. Moreover, contingent liability as a percentage of net worth has come down from 7.1% as at FY10 to 1.4% as at FY15.

100% debtor provisioning

Apollo’s outstanding debtors for more than six months as a percentage of overall debtors have been very low (averaging 3.4%) over FY10-15. The company, unlike its peers has provided for 100% of debtors outstanding more than six months.

Cash pilferage checks Non-operating expenses as a proportion of total revenues is high but on a declining trend

Apollo’s six-year median of non-operating expense as a percentage of turnover was 2.5% of revenues, higher than peers like Ceat (1.9%) and JK Tyre (1.8%). However, this proportion has been declining since FY10 (from 3.7% of sales in FY10 to 2.5% in FY15).

Capex efficiency – Strong FCF generation

Over FY10-15, Apollo has incurred a cumulative capex of close to 2.3x the cumulative depreciation expense. The capex was mainly incurred towards truck bus radial (TBR) capacity at Chennai. During the same period, the company reported revenue CAGR of 10%. Despite seemingly high capex spends, Apollo’s strong cash conversion (as explained above) has led the company to score relatively better amongst its peers on FCF generation (relative to revenue). Furthermore, over the last five years, Apollo’s proportion of CWIP to gross block has been relatively low at 4%.

Audit quality checks Apollo’s auditor’s remuneration recorded 15% CAGR vs 10% CAGR in revenues over FY10-15 and accounted for 0.01% of revenues. Apollo ranks the lowest on CAGR in auditor’s remuneration to growth in consolidated revenues. Apollo’s accounts are audited by Deloitte Haskins & Sells. The breakup of audit fees between that paid for statutory audit and other services is reasonable.

Apollo Tyres


Corporate governance Board Composition: The Board currently comprises eleven directors, out of

which seven are independent directors, three are executive directors and one is a non-executive nominee director of the Government of Kerala. The proportion of independent directors appears reasonable.

Rotation of independent directors: Best Practices suggest that the maximum tenure for an independent director should be five years. However, four of the total seven independent directors have been on the company’s Board for at least eight years. We assign an AMBER FLAG.

Attendance of the Board: The attendance of the Board members has remained reasonable for the Board meetings held in FY13-15.

Share purchases/sales by promoters/management: There have been several share purchase/sale transactions by promoters/promoter owned entities/management over the last five years. It may be noted that most of the insider transactions appear to be share purchases undertaken during periods of low share prices. We have not been able to establish any direct correlation between these transactions and stock price movements. However, the sheer number of these transactions makes us assign an AMBER FLAG.

Exhibit 9: Snapshot of shares purchase/sales by promoters/management


No major related party transactions: The related party transactions at the consolidated level mainly consist of sale of finished goods to Apollo International Trading LLC, Dubai, and Apollo International Ltd. However, total sales to related parties are not significant (1.2% of total sales) and have remained more or less constant over FY12-15.

Apollo Tyres


Capital allocation “The vision for us is to clock revenues of US$6bn by 2016, which will put us among the top ten tyre makers in the world" - Neeraj Kanwar (source: Economic times1, December 2012)

Apollo’s RoCE and RoCE improvement have been in line with its peers. The company’s consolidated operational cash generation over the past decade has been healthy, with CFO before tax averaging 90% of EBITDA between FY06 and FY15. A significant portion of the operational cash flow has been invested in capex (64%), with the company’s net debt coming down from 0.8x as at end-FY06 to 0.1x as at end-FY15. However, we believe the reported numbers do not capture the true picture of capital allocation, as: (i) it does not reflect the aggressive ambitions of the management – more specifically the aggressive Cooper Tire acquisition, which if consummated would have thrown the company’s debt levels and cash flows out of gear; (ii) the company has a mixed track record as far as acquisitions are concerned (Vredestein a success, Dunlop South Africa a failure); (iii) the company has big-ticket capex in Europe (€475mn) where we believe there are strong odds against the company succeeding (more particularly in truck radials).

Standalone RoCE and RoCE improvement over FY11-15 have been in line with the peer group average

APTY’s standalone post-tax RoCE for FY15 at 19% is line with the peer group average of 18% (average of MRF, JK Tyres and Ceat). Its FY15 RoCE is lower than that of MRF (23%), in line with that of Ceat (19%) but higher than that of JK Tyres (12%). Apollo’s EBIT margin at 11.9% for FY15 is in line with that of MRF (11.8%) but higher than that of Ceat (10.0%) and JK Tyres (9.9%). However, APTY’s capital employed turnover is relatively lower than that of peers (at 2.3x in FY15, lower than the peer group average of 2.5x). The lower capital employed turnover could be attributable to challenges surrounding the domestic truck-bus segment of Apollo Tyres.

The standalone RoCE (post-tax) has improved from 10% in FY11 to 19% in FY15 on the back of the significant decline in commodity prices (mainly rubber). This has resulted in EBIT margin jumping from 7.0% in FY11 to 11.9% in FY15. The capital employed turnover has improved from 1.9x in FY11 to 2.3x in FY15; however, note that FY11 capital employed turnover was impacted due to a strike in APTY’s Perambra facility which lasted for over a quarter in FY11; as compared to FY12’s capital employed turnover of 2.3x, there has been no improvement in FY15. APTY’s RoCE improvement of 2x between FY15 and FY11 is similar to the peer group average of 2.1x.

1http://articles.economictimes.indiatimes.com/2012-12-02/news/35546833_1_neeraj-kanwar-tyre-makers-apollo-tyres-vice-chairman

Apollo’s higher than peer EBIT margin is offset by its low capital employed turnover

Apollo Tyres


Exhibit 10: Apollo’s EBIT margin is in line with peers; however, its capital employed turnover is lower than peers

Source: Company, Ambit Capital research; Note: Standalone accounts

Exhibit 11: Apollo’s RoCE is in line with the peer group average

Source: Company, Ambit Capital research; Note: Standalone accounts

Much of Apollo’s internal accruals have been used towards capex (similar to peers)

Apollo’s consolidated operational cash flow has been strong over the last ten years, with CFO pre-tax averaging 90% over FY06-15. The cumulative CFO generated of `83bn has been utilised mainly towards capex (64%), including setting up of greenfield TBR capacities in Chennai and payment of interest (19%). Furthermore, the company spent `5.4bn (excluding debt acquired) towards the acquisition of Dunlop’s South African operations in 2006 and Vredestein in 2009. Apollo’s capital allocation for the past decade appears more or less in line with that of MRF which similarly spent most of its cash generation towards capex (74%).

Exhibit 12: Apollo Tyres uses funds mainly for capex and interest payments

Source: Company, Ambit Capital research. Note: Size of the pie represents cumulative funds raised (through various sources such as CFO, equity, debt, etc) and spent (on capex, debt repayment, interest, dividend paid, etc) over FY06-15.

However, reported numbers do not reveal the true picture on capital allocation

(a) Mixed track record of acquisitions

Apollo has made two major acquisitions in the past ten years. The company acquired Dunlop’s South African operations in 2006 in an all-cash deal amounting to `2.9bn. Similarly, Apollo acquired the Netherlands-based Vredestein Branden B.V. from Russian company Amtel in May 2009 for `2.5bn (Enterprise Value of `10bn implying EV/sales of 0.5x). Whilst the South African operations catered to all vehicle categories, Vredestein is a niche player in the passenger car radial segment with specialisation in ultra-high performance tyres, especially winter tyres.

1.8

2.0

2.2

2.4

2.6

2.8

3.0

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

FY11 FY12 FY13 FY14 FY15

Apollo EBIT margin-LHS Peer EBIT margin-LHS

Apollo CE turnover Peer CE turnover

3.0%

5.0%

7.0%

9.0%

11.0%

13.0%

15.0%

17.0%

19.0%


Apollo RoCE (post-tax) Peer RoCE (post-tax)

Apollo Tyres


South African acquisition finally sold/ wound down

Whilst the South African operations reported a relatively stable performance until FY10, the operations faced significant challenges since FY11 in the form of a general slowdown in the South African economy, labour problems, high power costs and cheap Chinese imports swarming the market. These problems manifested in the form of muted revenue growth – CAGR of only 2% over FY11-14, EBITDA margin declining from 18.4% in FY10 to 3.4%% in FY13 and EBIT-level losses in FY12 and FY13. This prompted Apollo’s management to substantially scale down its South African operations by disposing off the passenger car plant and rights to the Dunlop brand name use for Africa to Sumitomo Industries for US$60mn (`3.6 bn) in FY14. The remaining part of the South African operations which is essentially the truck tyre plant at Durban continued to face business challenges, resulting in the company eventually closing down the plant in FY15.

On the other hand, Vredestein has performed well since its acquisition by Apollo on the back of recovery in the European passenger car tyres and strong growth in the winter tyre sales (which in part was driven by stronger enforcement of safety regulations surrounding winter tyres). Vredestein’s revenues have reported a healthy 12% CAGR and EBITDA have reported a 14% CAGR; this has proved to be a good investment by Apollo Tyres. Vredestein, though, is a relatively modest franchise with a market share of only about 3% in the European PCR tyre market. It, though, has somewhat higher brand recall in the winter tyre segment.

(b) Cooper Tire’s attempted acquisition reflective of very ambitious management

The Chairman’s letter to shareholders in the FY11 Annual Report outlined the company’s aim to be ranked amongst the top-ten tyre manufacturers in the world.

In line with this aim, the company on June 12, 2013, announced the acquisition of the US-listed Cooper Tire & Rubber Company (Cooper) in an all cash transaction valued at approximately US$2.5bn. To put this acquisition figure in perspective: (i) Enterprise valuation ascribed to Cooper was nearly 2x that of Apollo’s then EV; and (ii) the acquisition was to be entirely financed by debt which would have raised Apollo’s consolidated debt levels by a whopping 7.3x to `163bn (3.8x net worth). Whilst the combined entity would have become the world’s seventh-largest tyre maker, even one bad year of operations could have severely hampered Apollo’s ability to service the interest as well as the principal repayments.

The acquisition was eventually cancelled due to issues surrounding the control of Cooper’s Chinese joint venture and agreement with United Steelworkers representing Cooper’s US workers.

Exhibit 13: Cooper Tire’s acquisition would have significantly elevated the debt levels

Apollo Tyres’ consolidated balance sheet Pre-acquisition (̀ mn)

Post-acquisition (̀ mn)

Share capital 509 509

Reserves & Surplus 39,630 42,276

Networth 40,139 42,785

Net debt 22419 22,419

Add: incremental debt taken for acquisition 140,868

Total net debt 22,419 163,287

Net debt-equity ratio 0.56 3.8

Source: Company, Bloomberg, Ambit Capital research. Note: (1) Assumed INR/USD rate of Rs56 for conversion of USD into INR

Enterprise valuation ascribed to Cooper was nearly 2x that of Apollo’s then EV

Apollo Tyres


(c) Company’s big bet in Europe…limited upside potential high downside

The company has recently announced plans to set up a new greenfield facility in Europe (Hungary) involving an investment of €475mn (69% of end-FY15 consolidated net worth) over the next four years. Once ready, this facility will have a capacity to produce 5.5mn passenger car light truck (PCLT) tyres and 675,000 heavy commercial vehicle (HCV) tyres. The first tyre is expected to roll out in early-2017 from this facility. Whilst the size of the passenger car expansion from this facility is nearly similar to that of the existing Vredestein capacity of 6.2mn tyres, a foray into the European HCV market is a completely new venture for Apollo Tyres. We believe the size of this venture is aggressive particularly against the backdrop of the lack of experience of the European CV tyre business and given that APTY will compete against the likes of formidable players like Michelin, Bridgestone and Continental. The company has not outlined any strategy on how it plans to compete against the well-entrenched peers in this geography/segment. On the positive side, the demand for both PCR and TBR tyre is witnessing a growth in Europe (August replacement segment volumes up 4% and 13% respectively).

As a result of this huge capex in Europe, consensus expects Apollo Tyres to post a consolidated negative FCF of `2.47 bn over FY16 and FY17 as against positive FCF of `26 bn over F13-15.

Apollo Tyres


IBAS framework indicates a moderate franchise Exhibit 14: Summary of IBAS framework

IBAS Parameter Level of strength Comment

Innovation

No technical tie-up currently R&D spends higher than peers but does not reflect in superior

SKU strengths

Brand

No clear leadership across any segment No significant pricing premium over peers Brand spend marginally higher than peer group average

Architecture

Dealer network second largest/above average but no significant gap with the third largest player (JK Tyres)

Dealer commission levels not much different from peers

Strategic Asset

Highest capacity in the growing TBR segment but peers like JK tyres catching up fast

Source: Company, Ambit Capital research. Source: Company, Ambit Capital research. Note: = Strong; =

Moderate; = weak

Innovation: No technical tie-up

The company had entered into a partnership with Michelin in FY04. This partnership resulted in Michelin picking up a 14.9% equity stake in Apollo and the formation of a JV Michelin Apollo Tyres Private Limited. The JV aimed to manufacture TBR tyres in India with the dual brands of Michelin and Apollo, with Apollo retaining the right to exclusively distribute both the brands in India. Both parties intended to make an investment of US$75mn in the ratio of 51:49 for the plant in Ranjangaon (Maharashtra). However, Apollo exited from this JV in FY06 citing poor adoption of radial tyres in the Indian CV market. The company recovered almost its entire investment in the JV through sale of its 49% stake back to Michelin. In hindsight, given rapid radialisation in the truck-bus tyres in the recent years, we believe break-up of JV with Michelin was a big missed opportunity for the company.

Apollo currently does not have any technical tie-up for technology. The company’s R&D spends (standalone) is much higher than that of its domestic peers. However, the positive effect of the same is not visible in terms of innovative advantage over peers.

Exhibit 15: Apollo’s R&D spends have been higher than its peers’

Source: Company, Ambit Capital research

Brand: No clear advantage in any domestic segment

Apollo has a market share of around 27%2 in the TBR and 25%3 in the TBB segment. In the TBR segment, the company is the second-largest player behind JK Tyres (which claims a market share of around 31%4). The company has a smaller market share in the domestic PCR tyre segment of around 17%. Furthermore, the company is absent from the lucrative two-wheeler tyre segment.

2http://www.apollotyres.com/uploads/IRPresentation-Aug-2015/ 3http://www.apollotyres.com/uploads/IRPresentation-Aug-2015/ 4http://www.jktyre.com/Investor%20Presentation.pdf

0.00%

0.20%

0.40%

0.60%

0.80%

1.00%

1.20%

1.40%

Apollo Tyres MRF JK Tyre Ceat

FY14 FY15

Apollo currently does not have any technical tie-up for technology

Apollo Tyres


Exhibit 16: Truck-bus sales contribute close to 65% of Apollo’s standalone revenues

Source: Company, Ambit Capital research. This data is as of FY14.

Exhibit 17: Apollo does not have dominance in any tyre segment


Our discussions with dealers do not indicate any significant difference in the pricing of Apollo’s and peers’ brands.

At the standalone level, Apollo spent 1.6% of its revenues on advertising and sales promotion (excluding commission and discounts). This is only marginally higher than the peer group average of 1.4%.

Architecture – Second-largest dealer network but no significant gap with the third largest

Apollo has around 4,900 dealers across India (of which 1,600 are exclusive). Whilst the exact dealership figures for MRF are not readily available, out discussion with industry sources indicate that MRF has the largest dealership numbers. Apollo’s gap is also not significant as compared to the third-largest player i.e. JK Tyres which has around 4,000 dealers (1,000 exclusive). Our discussions with industry sources do not indicate any significant difference in dealer commissions between Apollo and peers.

Exhibit 18: Apollo has the second higher dealer network; JK Tyres not far behind

Apollo Tyres JK Tyre Ceat

Total dealerships 4,900 4,000 3500+

of which exclusive 1,600 1,000 300+


Strategic assets: Peers catching up on TBR capacities

Apollo currently has the biggest truck bus radial capacities in India of 360MT/day located in Chennai (based on/assuming 360 operational days per annum and weight of 60kgs/TBR tyre). This is bigger than that of JK Tyres which has 244MT/day at its facility in Chennai, 150MT/day for MRF and 81MT/day for Ceat. This has helped Apollo take the first mover advantage in the rapid radialisation of the truck bus tyres in India. Whilst Apollo has plans to double its TBR capacity with a total investment of `27bn over the next 3-4 years, other players such as JK Tyres too have large TBR expansion plans of adding 133MT/day at its Chennai. This is likely to be commissioned in 2016.

TBB, 37%

TBR, 27%

PCR, 17%

Farm & OTR, 11%

Light truck, 8%

25%

27%

17%

12%

14%

16%

18%

20%

22%

24%

26%

28%

TBB TBR PCR

Apollo’s advertisement spends are marginally higher than peers

% of revenues

Apollo 1.6%

MRF 1.1%

Ceat 1.7%

JK Tyres 1.4%

Peer group average 1.4%

Source: Company, Ambit Capital research. Note: all financials pertain to standalone entity

Apollo Tyres


Modest franchise facing threats in the core domestic truck tyre segment

Apollo has significantly higher proportion of revenues from the truck bus segment

We estimate the truck bus tyre segment (including OEM and replacement) to contribute to nearly 60-65% of Apollo’s domestic revenues. This proportion is significantly higher than domestic peers such as MRF and Ceat (40% of revenues). Only JK Tyre has a similar level of concentrated revenues, with truck tyres constituting nearly 68% of its FY15 revenues.

Going forward, we find this core domestic segment of Apollo Tyres coming under threat from the following factors:

Rising Chinese imports impacting truck bus tyre segment

Driven by the slowdown in the Chinese automotive industry, relaxation in anti-dumping duties and significantly cheaper pricing, India has seen a substantial rise in the level of Chinese imports since the last one year. According to Apollo’s FY15 Annual Report, Chinese tyre imports grew 138% YoY to 555k units in FY15 for the truck radial segment and accounted for 11% of the total truck radial market. These imported radials are not only 30% cheaper than domestic radial tyres, they are priced even at some discount to the domestic bias tyres. The share of these cheap imports is mainly concentrated in the replacement market accounting for nearly 20% of the TBR replacement market (FY15). This growth in Chinese imports has only accelerated in FY16 with nearly 30% increase QoQ in 1QFY16. As a result, the market share of Chinese imports has jumped to around the mid-to-high 20s which is nearly equivalent to the leadership position in the domestic TBR replacement market.

Furthermore, the acceleration in slowdown in the Chinese automotive market and the devaluation of Yuan in the recent months pose risks of further rise in the level of Chinese truck tyre imports.

Increasing focus of MNCs with technological advantages

Global major tyre makers have been absent in the Indian TBB segment, except for Continental Tyres which has some TBB tyre capacity owing to the acquisition of Modi Rubber in July 2011. However, with radialisation reaching a respectable level (from 8% in FY09 to 22% in FY13 and further to 33% in FY15) in the Indian truck-bus tyre market, several international players have recently forayed to set up TBR tyre capacities in India. Michelin has already commenced commercial production of TBR in 2014 from its greenfield Chennai facility and is planning to increase the production by nearly 45% from 11k tons in 2014 to 16k tons in 2015, which implies a market share of 3-4% in TBR (OEM and replacement put together) market5.

Our discussions with industry sources (dealers, domestic tyre companies and fleet operators) indicate that MNCs have clear technological/quality advantages over their domestic counterparts in the TBR segment, though they currently trail the distribution spread and competitive pricing offered by domestic incumbents.

Based on the current announcements available, we believe MNCs would account for nearly 20-25% of the total TBR capacities by FY18 vs negligible capacity currently.

5http://economictimes.indiatimes.com/industry/auto/news/tyres/michelins-chennai-plant-to-raise-2015-production-by-over-45/articleshow/48235043.cms

Apollo Tyres


Financials Balance sheet (consolidated)

Year to March (̀ mn) FY12 FY13 FY14 FY15

Shareholders' equity 504 504 504 509

Reserves & surpluses 27,824 33,397 45,134 49,914

Total networth 28,328 34,009 45,746 50,423

Minority Interest 8 - - -

Debt 28,720 26,507 16,134 11,062

Deferred tax liability 4,025 4,928 5,241 4,912

Total liabilities 61,081 65,444 67,122 66,397

Gross block 80,344 85,219 94,681 90,651

Net block 40,238 41,693 44,558 42,685

CWIP 4,225 3,878 883 2,890

Goodwill on Consolidation 1,338 1,436 1,376 1,165

Investments (non-current) 158 546 637 470

Cash & Cash equivalents 1,730 3,348 6,541 6,946

Debtors 11,458 9,908 10,427 9,589

Inventory 19,991 20,311 20,664 17,782

Loans & advances 4,781 4,136 5,254 4,326

Total current assets 37,961 37,703 42,885 38,644

Current liabilities 17,811 13,928 16,254 12,281

Provisions 5,028 5,884 6,963 7,176

Total current liabilities 22,839 19,812 23,217 19,456

Net current assets 15,121 17,891 19,668 19,187

Total assets 61,081 65,444 67,122 66,397


Income statement (consolidated)


Net Sales 121,533 127,946 134,085 127,778

% growth 37% 5% 5% -5%

Operating expenditure 109,872 113,380 115,365 108,547

EBITDA 11,661 14,567 18,720 19,232

% growth 19% 25% 29% 3%

Depreciation 3,256 3,966 4,109 3,883

EBIT 8,405 10,601 14,611 15,349

Interest expenditure 2,873 3,128 2,838 1,828

Non-operating income 326 944 1,014 612

Adjusted PBT 5,858 8,418 12,787 14,133

Tax 1,444 2,448 2,269 3,532

Adjusted PAT/ Net profit 4,393 5,958 10,518 10,601

% growth 0% 36% 77% 1%

Extraordinary Expense/(Income) (294) 169 (468) (825)

Reported PAT / Net profit 4,687 5,789 10,986 11,426


Apollo Tyres


Cashflow statement (consolidated)


Net Profit Before Tax 5,565 8,586 12,319 13,308

Depreciation 3,256 3,966 4,109 3,883

Others 2,825 2,817 1,111 2,694

Tax (953) (1,134) (2,386) (2,954)

(Incr) / decr in net working capital (3,100) (1,454) 1,302 (2,286)

Cash flow from operations 7,593 12,781 16,455 14,646

Capex (net) (7,895) (5,999) (4,905) (6,201)

(Incr) / decr in investments (43) (13) 3,640 (780)

Other income (expenditure) 58 67 314 142

Cash flow from investments (7,879) (5,944) (951) (6,839)

Net borrowings 3,372 (1,782) (8,897) (4,826)

Issuance of equity - 108 - 349

Interest paid (2,769) (3,085) (2,881) (1,912)

Dividend paid (293) (293) (297) (447)

Cash flow from financing 309 (5,053) (12,075) (6,836)

Net change in cash 23 1,784 3,429 971

Closing cash balance 1,730 3,347 6,541 6,946

Free cash flow (302) 6,782 11,550 8,445


Ratio analysis (consolidated) Year to March FY12 FY13 FY14 FY15

EBITDA margin (%) 9.6% 11.4% 14.0% 15.1%

EBIT margin (%) 6.9% 8.3% 10.9% 12.0%

Net profit margin (%) 3.6% 4.7% 7.8% 8.3%

Dividend payout ratio (%) 6% 4% 4% 10%

Net debt: equity (x) 1.0 0.7 0.2 0.1

Working capital turnover (x) 10.2 9.0 9.4 9.5

Gross block turnover (x) 1.8 1.5 1.6 1.7

RoCE (pre-tax) (%) 15.5% 17.9% 24.5% 26.0%

RoIC (%) 11.7% 12.7% 20.1% 19.5%

RoE (%) 16.7% 19.1% 26.4% 22.0%


Valuation parameters (consolidated)

Year to March FY12 FY13 FY14 FY15

EPS (`) 8.7 11.8 20.9 20.8

Diluted EPS (`) 8.7 11.8 20.9 20.8

Book value per share (`) 56.2 67.5 90.7 99.1

Dividend per share (`) 0.5 0.5 0.7 2.0

P/E (x) 20.9 15.4 8.7 8.7

P/BV (x) 3.2 2.7 2.0 1.8

EV/EBITDA (x) 8.7 7.0 5.4 5.3

EV/EBIT (x) 12.1 9.6 6.9 6.6



Key financials

Year to March FY14 FY15 FY16E FY17E FY18E Net Revenues (` mn) 80,998 121,205 136,808 161,507 184,744 Operating Profits (` mn) 21,328 25,637 30,499 40,098 47,528 Net Profits (` mn) 11,737 15,758 19,733 27,268 32,336 Diluted EPS (`) 40.3 27.0 33.8 46.8 55.5 RoE (%) 36.9 35.4 31.9 32.7 29.2 P/E (x) 22.3 27.3 13.2 9.6 12.7 P/B (x) 7.0 8.3 3.7 2.7 3.3


Aurobindo has corporate governance issues such as inferior financial reporting, less than ideal disclosures and taxation issues relating to promoters. Moreover, the company also faces structural issues around absence of ‘moated’ revenue/profit streams and long-term growth drivers. Also, it faces potential revenue/margin erosion as incumbents return and regain market share post FY18 through competitive pricing in complex injectables, controlled substances and cephalosporin. Value trap summary

Parameter Result Comment

Accounting quality

Low cash flow generation and high loans and advances as a percentage of net worth

Corporate governance Opaque tie-ups with relatively unknown companies

Capital allocation Vertical integration and improvement in product mix is a positive; gross block turnover in line with peers

IBAS

Lack of investment in innovation and no moats around its business; revenues exposed to return of competition

Source: Company, Ambit Capital research. Note: = rating of 4/4; = rating of 3/ 4 and so on.

Accounting quality – Poor cash flow generation Aurobindo has poor cash flow generation (CFO/EBITDA of 56% vs peer average of 85%) led by an extended working capital cycle (93 days vs peer average of 65 days). Its accounting practices have raised issues before, leading to undisclosed income of `300mn during raids by income tax authorities in 2012 (click here). Capital allocation – Improvement in product mix and vertical integration Aurobindo moved up the value chain from an API manufacturer to a formulation manufacturer. Its acquisition track record is yet to be established; though the Actavis acquisition looks promising, we would wait before giving too much credit as pharma companies have struggled with profitability in Western Europe. Corporate governance – Distribution agreement impairs upsides Mr. Nithyanand Reddy (Chairman, ex-MD) appears to be a connected person. Aurobindo Pharma was named in a charge-sheet filed on a disproportionate asset case for which court proceedings are underway. Also, Aurobindo’s distribution agreement with Citron Pharma and Celon Labs for the US market is opaque and impairs upsides from product-specific opportunities. IBAS – Lack of spending on innovation; no moats in its business Aurobindo incurs 4.4% of R&D as a percentage of sales vs peer average of 6.3%. Out of these, some/none of the investments are longer-term growth drivers like NCEs, biosimilars and NDDS-based products. Also, the company has a limited presence in the branded business (moats), which provides sustainable revenue as compared to the lumpy business from US generics. Expect discount to front-line peers to expand as earnings growth abates Aurobindo’s earnings deserve a lower multiple vs peers due to corporate governance issues and lack of moats. Valuations of 16.3x FY17E EPS are expensive vs being optically cheap and may begin to de-rate, as incumbents return to the US, and revenue/margins/RoCE starts declining from FY18E.

COMPANY UPDATE ARBP IN EQUITY October 06, 2015

Aurobindo PharmaSELL

Healthcare

Recommendation Mcap (bn): `418/US$6.4 6M ADV (mn): `1854/US$28.2 CMP: `716 TP (12 mths): `414 Downside (%): 42

Flags Accounting: RED Predictability: AMBER Treatment of minorities: RED


Better cash generation

Investment in long-term growth drivers / moated business

Clarification / visibility in third-party agreements and / or promoter issues

Performance (%)


Analyst Details

Aditya Khemka +91 22 3043 3272 [email protected]

Paresh Dave, CFA

+91 22 3043 3212 [email protected]

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Sensex Aurobindo

http://timesofindia.indiatimes.com/city/hyderabad/Aurobindo-Pharma-declares-hidden-income/articleshow/11856594.cms

Aurobindo Pharma


Exhibit 1: EBITDA margins and revenue growth over the last ten years


Exhibit 2: RoCE and RoE over the last ten years; poor cash conversion not reflected here


Exhibit 3: Sources of funds over the last ten years; if cash conversion had mirrored industry average, debt would have been lower


Exhibit 4: Utilisation of funds over the last ten years was primarily towards capex and acquisition of Actavis brands


Exhibit 5: Forward P/E evolution over the past ten years


Exhibit 6: Forward P/B evolution over the past ten years



Segment Score Comments

Accounting RED Aurobindo’s accounting practises raise RED flags on: (a) admission of undisclosed income in the past; (b) continuation of the same auditor despite undisclosed income issues; (c) lower than peer EBITDA/CFO ratios; and (d) higher than peer working capital cycle.

Predictability AMBER Overall, the management has made timely announcements in its earnings calls, meetings and interviews regarding product filings, acquisitions and business outlook. However, the unpredictability of segments like ARV sales, RoW formulation sales and API sales make us assign an AMBER flag on predictability.

Treatment of minorities

RED Apart from concerns raised in our accounting analysis wrt undisclosed income and low cash generation, the company has entered into partnerships with unknown/small companies to market/develop high value products, thus impairing profits.


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RoCE RoE, RHS

CFO, 52.7%

Proceeds from

shares, 2.9%

Debt raised, 42.3% Interest

received, 2.0%

Net Capex, 62.9%

Purchase of

investment, 14.0%

Dividend paid, 6.6%

Interest paid, 11.3%

Increase in cash and

cash equivalent,

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Aurobindo Pharma


Accounting quality P&L misstatement + revenue pilferage checks

Revenue recognition: Aurobindo’s pre-tax CFO/EBITDA ratio has consistently been significantly lower than the peer average over the past few years mainly on account of higher working capital requirements. Aurobindo’s working capital days have deteriorated from 186 days in FY10 to 217 days in FY14. Given Aurobindo’s lack of material exposure to the branded generic markets where terms of trade are more benign, its working capital days remain ahead of peers.

Even in years when EBITDA growth was healthy, CFO/EBITDA has deteriorated, as working capital needs have expanded. For instance, in FY11, whilst EBITDA improved by 17%, CFO declined by 9% owing to higher working capital (205 days in FY11 vs 186 days in FY10) on account of a significant jump in inventory and debtors during the year (32% and 29% respectively).

In FY13, pre-tax CFO/EBITDA deteriorated significantly again due to higher working capital. We highlight that the working capital in FY13 at 49% of EBITDA was higher than 23% of EBITDA in FY12. Not only is the FY13 cash conversion lower than peers but it is also at a 7-year low. We assign a RED FLAG.

Exhibit 8: Revenue recognition checks

Company/Metric Pre-tax CFO as a % of EBITDA

YoY change in CFO as a % of EBITDA (bps)

Volatility (measured

by SD*) FY11 FY12 FY13 FY14 FY15 FY14 FY15

Aurobindo 55% 65% 46% 46% 68% 67 2,113 10%

Cadila 81% 64% 82% 98% 80% 1,621 (1,746) 12%

Torrent 124% 118% 41% 91% 85% 4,919 (538) 33%

IPCA 74% 85% 77% 82% 100% 498 1,818 10%

Lupin 88% 60% 79% 92% 102% 1,337 914 16%

Average(ex-Aurobindo)

92% 82% 70% 91% 92% 2,094 112 18%

Divergence -37% -16% -24% -44% -24% (2,026) 2,001 -7%

Source: Company, Ambit Capital research. Note: All financials pertain to the consolidated entity. * SD refers to standard deviation.

Working capital days: Aurobindo’s high debtor and inventory levels can only be partly explained by Aurobindo’s business model, which is predominantly that of a generic drug supplier with relatively lower negotiating power (hence longer payment cycles). This is in comparison with peers that have a mix of generic as well as branded drug businesses. Both API and generic finished dosages in the Western markets are highly competitive.

Whilst the higher debtor days can also be justified for new entrants trying to break into the business, Aurobindo has had a presence in the generic business for nearly a decade. Hence, we raise a RED FLAG on Aurobindo’s overall cash conversion cycle.

Exhibit 9: Working capital days

Company/Metric Average Debtor days Average Inventory days Average Creditor days

Average Working Capital days

FY12 FY13 FY14 FY15 FY12 FY13 FY14 FY15 FY12 FY13 FY14 FY15 FY12 FY13 FY14 FY15

Aurobindo 97 88 95 93 118 108 97 90 56 51 52 51 160 146 140 132

Cadila 57 53 53 57 66 66 65 61 48 35 40 42 76 84 78 76

Torrent 61 69 78 106 73 83 84 81 104 110 109 128 30 42 53 59

IPCA 63 49 48 47 88 92 88 103 32 33 34 38 118 108 103 112

Lupin 77 74 75 73 76 70 66 66 74 66 58 66 79 78 83 74


64 61 64 71 76 78 76 78 64 61 60 68 76 78 79 80

Divergence 33 27 32 22 43 31 21 12 (8) (10) (8) (17) 84 68 61 51

Source: Company, Ambit Capital research. Note: All financials pertain to the consolidated entity.

Perpetually low cash flow generation due to higher working capital investment

Higher working capital days due to business of generic drug supply

Aurobindo Pharma


Expense manipulation: The average depreciation rate for Aurobindo was almost constant in FY11-14. The depreciation rate has been in line with the peer average. We do not have any significant concerns on the depreciation rate and hence we assign a GREEN FLAG.

Exhibit 10: Expense manipulation checks - Depreciation

Company/Metric Average depreciation rate

YoY change in depreciation rate (bps)

FY11 FY12 FY13 FY14 FY15 FY14 FY15

Aurobindo 7.1% 7.3% 7.3% 7.9% 6.9% 60 (96)

Cadila 4.8% 4.8% 4.6% 4.3% 6.0% (21) 161

Torrent 7.1% 7.6% 6.6% 6.4% 7.7% (23) 130

IPCA 6.0% 6.3% 6.0% 6.0% 8.1% (6) 216

Lupin 6.9% 7.2% 8.4% 5.9% 9.0% (252) 305

Average(ex-Aurobindo) 6.2% 6.5% 6.4% 5.7% 7.7% (75) 203

Divergence 0.9% 0.8% 0.8% 2.2% -0.8% 136 (299)


Investment income analysis: Aurobindo’s investment income as a percentage of cash is low vs its peer group. However, the primary reason for this appears to be that a significant portion of Aurobindo's cash/bank balances are kept in current accounts, on which no interest income is earned. Over FY10-15, current accounts averaged 75% of total cash bank balances (except FY11 when it was 34%). Interest income calculated on pure bank deposits work out to 7.3% for FY13 which appears reasonable. The significant jump in FY12 was on account of cash of `1.2bn (63% of FY11 cash) which was temporarily parked in interest-bearing securities. Aurobindo does not have any significant investments in marketable securities, resulting in negligible dividend income over the years.

Exhibit 11: Investment income analysis

Company/Metric

Investment income as a % of cash and marketable investments

Change in investment income as a % of cash and marketable

investments (bps)


Aurobindo 0.3% 4.4% 2.1% 2.0% 4.8% (14) 285

Cadila 4.1% 8.7% 4.8% 5.5% 5.7% 74 18

Torrent 6.1% 6.5% 5.9% 4.6% 3.4% (125) (127)

IPCA 14.4% 17.1% 20.4% 21.6% 22.7% 115 109

Lupin 1.8% 2.2% 2.8% 2.4% 5.0% (36) 261


6.6% 8.6% 8.5% 8.5% 9.2% 7 65

Divergence -6.3% -4.2% -6.4% -6.6% -4.4% (21) 220

Source: Company, Ambit Capital research. Note: (a) All financials pertain to the consolidated entity; (b) Investment income comprises interest income, dividend income and profit on sale of current investments

Cash manipulation: Aurobindo’s loans and advances as a percentage of net worth have been volatile over the years under consideration. The increase in FY14 was on account of: (a) Export rebate claims receivable at `1.4bn vs `0.9bn in FY12 and `1.2bn in FY13 (accounting for 12% of FY14 loans and advances) and (b) MAT credit entitlement amounting to `2.5bn vs `.1.3bn in FY13. Apart from these, the loans and advances schedule includes Advances recoverable in cash or kind. Whilst the proportion of such loans has decreased substantially from 36% in FY11 to 10% in FY14 and 1% in FY15, no disclosures have been provided with regard to these advances. We believe these require further probing and hence we assign an AMBER FLAG.

Loans and advances schedule includes high percentage of advances recoverable in cash or kind with no disclosures

Aurobindo Pharma


Exhibit 12: Cash manipulation checks

Company/Metric Loans and advances as a % of networth


Aurobindo 31.2% 20.3% 21.8% 18.1% 22.1% 31.1% 19.9%

Cadila 20.5% 19.2% 20.9% 22.4% 25.3% 24.3% 20.6%

Torrent 29.5% 18.1% 24.5% 23.4% 24.5% 28.1% 31.7%

IPCA 13.2% 14.6% 11.2% 18.2% 15.3% 15.8% 14.7%

Lupin 19.5% 18.5% 18.9% 20.5% 18.4% 13.1% 9.1%

Average(ex-Aurobindo) 20.7% 17.6% 18.9% 21.1% 20.9% 20.3% 19.0%

Divergence 10.5% 2.7% 2.9% -3.1% 1.2% 10.8% 0.8%

Source: Company, Ambit Capital research. Note: All financials pertain to the consolidated entity; we have excluded capital advances from loans and advances to calculate the above ratio.

Provisions for debtors: Aurobindo’s debtors over 6 months as a percentage of gross debtors declined from 5.7% in FY12 to 3.8% in FY15 (in absolute terms it has increased by 75% in FY15). Aurobindo’s debtors over 6 months are in line with its peers. Whilst Aurobindo’s debtor days are higher (see Exhibit 9), percentage of debtors over 6 months is at par with its peers, implying better realisation/certainty on a relative basis. Also, Aurobindo has higher and stable provision for doubtful debts as a percentage of debtors over six months. We assign a GREEN FLAG.

Exhibit 13: Provisioning for debtors

Company\Metric Provision for doubtful debts as % of debtors over six months

Provision for doubtful debts as % of gross debtors

Debtors over 6 months as a % of gross debtors

FY12 FY13 FY14 FY15 FY12 FY13 FY14 FY15 FY12 FY13 FY14 FY15

Aurobindo 40.2% 42.7% 41.1% 51.3% 2.3% 1.7% 1.2% 1.9% 5.7% 4.0% 2.9% 3.8%

Cadila 50.9% 51.0% 40.4% 13.4% 1.2% 1.3% 0.8% 0.2% 2.4% 2.5% 2.1% 1.6%

Torrent 45.3% 32.5% 58.5% 69.8% 2.9% 1.8% 2.6% 2.3% 6.3% 5.4% 4.4% 3.3%

IPCA 3.7% 0.0% 4.8% 4.2% 0.1% 0.0% 0.1% 0.2% 2.4% 2.7% 3.0% 4.6%

Lupin 42.3% 24.1% 48.2% 31.0% 0.5% 0.6% 1.5% 0.9% 1.2% 2.4% 3.2% 2.9%

Average(ex-Aurobindo) 35.5% 26.9% 38.0% 29.6% 1.2% 0.9% 1.3% 0.9% 3.1% 3.2% 3.2% 3.1%

Divergence 4.7% 15.8% 3.1% 21.6% 1.1% 0.8% -0.1% 1.1% 2.7% 0.7% -0.2% 0.7%

Source: Company, Ambit Capital research. Note: All financials pertain to the consolidated entity

Contingent liability as a proportion of net worth: As compared to its peers, contingent liabilities not provided for by Aurobindo are below the peer average. We assign a GREEN FLAG.

Exhibit 14: Contingent liabilities for Aurobindo vs its peers

FY15 Contingent

liabilities as % of networth

Contingent liabilities

(` mn)

Net Worth (` mn)

Aurobindo 2.4% 1,231 51,559

Cadila 5.8% 2,467 42,516

Torrent 1.4% 337 24,906

IPCA 1.1% 237 22,084

Lupin 11.6% 10,270 88,741

Average(ex-Aurobindo) 4.95%

Divergence -2.56%


Exhibit 15: Contingent liabilities not provided for by Aurobindo

Description

Contingent liabilities Contingent liabilities

(` mn) as % of networth

FY13 FY14 FY15 FY13 FY14 FY15

Claims arising from disputes not acknowledged as debts

-Indirect taxes 196 223 772 0.5% 0.6% 1.5%

-Direct taxes 105 105 309 0.3% 0.3% 0.6%

-Other duties / claims 493 150 150 1.3% 0.4% 0.3%

Total disclosed disputed liabilities 794 478.6 1231 2.1% 1.3% 2.4%


Aurobindo Pharma


Auditors Accounting practices of the company have raised issues in the past: Media reports (http://goo.gl/zLaLsp) suggest that the company had declared `300mn of undisclosed income for FY12 post an income tax raid on its premises in February 2012.

The fact that company acknowledged undisclosed income during the tax raids in February 2012 calls into question the independence of both the statutory auditors (S R Batliboi & Associates) as well as the internal auditors. This issue itself makes us raise a RED FLAG.

The statutory auditors of Aurobindo Pharma are S R Batliboi & Associates who were appointed in 2008-2009, replacing Batliboi & Company who had been auditors of Aurobindo at least since FY01. Both the statutory auditors are essentially a part of Ernst & Young auditors and the auditors have remained unchanged for more than 12 years now. AMBER FLAG

S R Batliboi and Associates are statutory auditors of 46 companies including Adani Ports, Bharti Airtel, Biocon, Cairn India, GMR Infra, GVK Power, Lanco Group, Sobha Developers, Spice Jet and Sun TV among others. The signing partner Mr Vikas Kumar Pansari (Membership No. 93649) is also a signatory to the accounts of ILFS Engineering, GVK Power, and Hyderabad Industries.

The internal auditors of Aurobindo Pharma are currently KPMG who were appointed only in FY10-11. Prior to KPMG, M/s K Nagaraju & Associates were the internal auditors of Aurobindo Pharma. M/s K Nagaraju also happens to be the statutory auditors of Axis Clinicals and Trident Chemphar, which are the holding companies of the promoters of Aurobindo Pharma. AMBER FLAG

“The Audit Committee”, as on 31 March 2015, comprises three members (all of whom are non-executive independent directors of the company). Mr. M. Sitarama Murthy took over the chairmanship from Dr. K. Ramachandran wef 3 May 2011. Prior to taking the chairmanship, Mr. M. Sitarama Murthy was a member of the audit committee. Most members of the committee attend meetings, and we do not have any major concerns in this regard.

Aurobindo’s payment to auditors is in line with its peers and its audit fees as a percentage of sales are also close to the peer group average. For the purpose of calculation of audit fees, we have included fees for tax audit, out-of-pocket expenses and other audit expenses. GREEN FLAG

Lack of rotation of auditors; undisclosed income found in tax raids was not checked by auditors

Aurobindo Pharma


Corporate governance Board Composition: The Board currently comprises ten directors, out of which

four are independent directors and four are executive directors. Although the percentage of independent directors is higher than the 30% prescribed by Indian company laws, it is lower than global best practices of 50%. AMBER FLAG

In the past, former employees have been classified as independent directors and have occupied positions on critical Board committees such as the Audit Committee. Mr Srinivas Lanka who was on the company’s Board between 2002 and 2007 was classified as an independent director; he was overseeing the company’s operations in manufacturing and marketing up to early-2002 until he resigned from his executive duties and was inducted as a non-executive independent director on the Board. Moreover, Mr Lanka was also a member of the all-important Audit Committee until his resignation in 2007.

We believe that the purpose of the independent directors on the Board is to safeguard minority interest. A former employee holding an ‘independent’ director designation on the Board is not ideal practice, in our opinion. AMBER FLAG

Rotation of independent directors: Over the past 10 years, Aurobindo’s Board has seen significant churn amongst the independent directors. The Best Practices Code suggests that the maximum tenure for an independent director should be five years. Note that there was significant churn amongst independent directors during 2006-2008 when Aurobindo Pharma’s financial performance was poor and it also had a stretched balance sheet and poor cash flows. We highlight that a number of independent directors resigned from the Board in FY06-08, as per annual report, which was not articulated either in the media or in the company’s press releases.

Attendance of the Board: The attendance of the Board members has remained reasonable for the Board meetings held in FY11-13.

Insider trading closer to key events: Several stock transactions by insiders raise questions over corporate governance practices. For instance, towards the end of CY10 and early CY11, there was selling by insiders. This was shortly followed by issues relating to US FDA strictures against an injectable facility becoming public, which lead to significant correction in the stock price. Similarly towards the end of CY11, there was heavy insider buying which was followed by news flow on regulatory issues gradually getting resolved. We assign an AMBER FLAG.

Promoter involved in legal issues due to political connections: Aurobindo Pharma has also been haunted by legal issues in the past due to alleged political connectivity. The Central Bureau of Investigation in India (equivalent to the FBI in the US) had charge sheeted the former MD and current Board member, Mr. Nithyanand Reddy, in a case involving disproportionate assets. However, the company disclosed that the investments were made by the promoters (if any) and the listed entity had nothing to do with the case. The charges were also later dropped by the CBI, as per management. Though media article suggest otherwise.

Media reports regarding this issue are http://goo.gl/3N8OXo

Click the link for media reports suggesting that the case is still pending trial (http://goo.gl/hbklMG).

Accounting practices of the company have created issues in the past: Media reports also suggest that the company had declared `300mn of undisclosed income for FY12 post an income tax raid on its premises in February 2012.

Former employees classified as independent directors

Promoter named in charge sheet filed against a politician for disproportionate asset case

http://timesofindia.indiatimes.com/city/hyderabad/Aurobindo-Pharma-declares-hidden-income/articleshow/11856594.cms

Aurobindo Pharma


Upsides from interesting products impaired due to partnerships: Aurobindo’s distribution agreement with Citron Pharma on at least 39 oral products and 12 injectables for the US (possibly other emerging markets as well) would impair the upside for Aurobindo from these products, as it would have to pay distribution margins. Further, Aurobindo’s agreement with Celon Labs for hormones and oncology product manufacturing for the US (a 60:40 JV called Eugia) would also impair the potential upside from these ventures.

Exhibit 16: Snapshot of insider transactions


Managerial remuneration: Aurobindo’s managerial remuneration as a percentage of PBT is low vs its peers except for FY12. In FY12, the company reported lower PBT due to the INR depreciation, resulting in forex losses in foreign currency loans. We assign a GREEN FLAG.

Aurobindo Pharma


Capital allocation Average Positives – Improvement in product mix and vertical integration albeit temporary

Aurobindo scores high on sales improvement and pricing discipline under our ‘greatness’ framework. Whilst improvement in product mix (move from API to formulations) has led to a higher score in pricing discipline, gaining traction in oral solids due to vertical integration has helped the score on sales improvement. We highlight that both these advantages seem temporary, as the decline in contribution from API sales would be more gradual, and Aurobindo is not vertically integrated in injectables, which form a large chunk of its pipeline. The management may have to rethink the portfolio strategy once scale becomes an obstacle to growth.

We have to credit the company for achieving sales growth in a short span of time post resolution of issues with FDA at Unit VI. Also, gross block turnover of ~3x is in-line with its peers. Whilst Cymbalta has been a major contributor to sales and EBITDA in FY14, the resumption of cephalosporin sales and controlled substances along with general injectables has been within a very short span of time, exhibiting excellent execution.

Exhibit 17: Aurobindo Pharma - Relatively poor score on our ‘greatness’ framework

Company Scores out of 0.17 for each measure

Total Score-using Adj PAT

Rank Investment

Sales Improve

Pricing discipline

EPS and CFO increase

Bal Sheet Discipline

Ratios improve

IPCA 17% 17% 17% 17% 17% 17% 100% 1

Sun Pharma 17% 17% 17% 17% 8% 17% 92% 2

Cadila 17% 17% 17% 17% 17% 8% 92% 2

Lupin 17% 8% 17% 17% 17% 8% 83% 4

Strides 17% 8% 17% 17% 8% 17% 83% 4

Torrent 8% 17% 17% 13% 13% 17% 83% 4

Cipla 17% 4% 17% 17% 17% - 71% 7

Dr Reddy's 8% 8% 17% 17% - 17% 67% 8

Aurobindo 8% 13% 17% - 8% 8% 54% 9

Glenmark - 8% - 8% 8% - 25% 10


In Exhibit 17 above, we have shown how Aurobindo Pharma stacks up on our proprietary ‘greatness’ framework relative to its other Pharma peers.

The framework essentially hinges on using publicly available historical data to assess which firms have, over a sustained period of time (FY09-14), been able to relentlessly and consistently:

(a) Invest capital;

(b) Turn investment into sales;

(c) Turn sales into profit;

(d) Turn profit into balance sheet strength;

(e) Turn all of that into free cash flow; and

(f) Invest free cash flows again.

For each of these parameters, we look at both the absolute improvement as well as the consistency in improvement over the last six years. Thus, a score of 17% on Investments would mean that the company does well on both absolute investment in Gross Block as well as the consistency with which it has invested in its Gross Block.

Improvement in product mix has led to a higher score in pricing discipline

Aurobindo Pharma


In case of Aurobindo Pharma, whilst the company scores high on pricing discipline and sales improvement, it lags in cash flow increase, balance sheet discipline and investments.

Negatives – Working capital dampens cash flows

The ever-expanding working capital cycle for Aurobindo has had an adverse impact on balance sheet improvement and cash flows (please refer to Exhibit 9 – working capital table)

Whilst the company has guided towards a meaningful decrease in debt levels, we would wait and watch for the improvement in balance sheet before giving credit to the management, given the patchy track record on this front.

Aurobindo Pharma’s acquisition track record yet to be established

The company’s acquisition of Actavis looks promising, but given that most pharma companies have struggled with profitability in Western Europe, we would wait and watch before giving much credit to the company.

Exhibit 18: History of clustered acquisitions by Aurobindo Name of Joint venture / Acquisition

Nature Year Geography Particulars

Milpharm Acquisition 2006 UK Acquired Milpharm (UK), engaged in generic formulation manufacturing, mainly in the UK market. Milpharm had over 100 products approved from the UK regulator and it helped Aurobindo to tap the UK generic market.

Sandoz manufacturing, R&D and distribution facility

Acquisition 2007 US Purchased fully integrated R&D, formulation manufacturing and distribution facility from Sandoz in the US.

Pharmacin International BV Acquisition 2007 Netherlands Acquired Pharmacin International BV to help reduce Aurobindo's time to market and build portfolio in the generic value chain.

Trident Life Sciences Acquisition 2009 India Acquired majority stake in the group company, Trident Life Sciences, which provides Aurobindo with additional capacity in non-oncological and non-infective injectables.

Hyacinths Pharma Acquisition 2013 India Acquired Hyacinths Pharma, an API manufacturer; strategic location of land ideal and convenient for expansion plans for the company.

Actavis's Europe operations Acquisition 2014 Europe Acquired Actavis's operations in 7 European nations, which includes personnel, commercial infrastructure, products, marketing authorisations and dossier license rights.

Natrol Inc. Acquisition 2014 US Acquired Natrol to enter the OTC market in the US. Natrol manufactures and sells nutritional supplements.


Aurobindo Pharma


IBAS framework Exhibit 19: Summary of IBAS framework IBAS Parameter

Level of strength

Comment

Innovation

We credit the company for moving up the value chain from API to formulation manufacturing, but it lacks investment in innovative pursuits.

Brand

No presence in branded generic markets and vulnerable to competition in the US market from incumbents that have been absent from the markets due to cGMP issues.

Architecture

Credible business heads with rich experience in MNC pharma companies but issues with the bottom of the pyramid employees, resulting in frequent strikes.

Strategic Asset

Vertically integrated with 19 manufacturing facilities but the company does not have intellectual property nor has it made any investments to develop the same.


Innovation Moving up the value chain - From domestic API to formulation exports: Aurobindo initiated operations in 1986 by locally trading antibiotic molecules. In 1988, the company started manufacturing and marketing on its own in India and began exporting APIs in 1992. The company began manufacturing formulations in 2002 and discontinued its Indian formulation business (50/50 JV with Citadel Fine Pharmaceuticals) in February 2006 due to continued losses. The company entered the US formulations market in 2003 when it filed its first ANDA and it has been investing heavily in manufacturing and R&D capabilities ever since. The business appears to be snowballing in the US with a 178 ANDA strong pipeline pending final approval and with a 201 currently approved portfolio. The company harbours ambitions of becoming a large generic player in the US and the regulated markets of Western Europe.

Lack of investment in innovative pursuits: As on FY15, Aurobindo incurs 4.4% of R&D as a percentage of sales vs the peer average of 6.3%. Out of these, some/none of the investments are in longer-term growth drivers like NCEs (New Chemical Entity), biosimilars, NDDS (Novel Drug Delivery Systems) based products. Investments are largely in less complex products like oral solids, general injectables, controlled substances and cephalosporins, which have yielded significant revenues owing to excellent execution in the US driven by vertical integration.

Brands/Reputation Aurobindo does not have any branded business in India. The company withdrew from the India business in 2006 due to loss-making operations, implying an inability to establish its brands. Aurobindo earns most of its revenues from me-too products in the US, for which no branding is done.

Also, lack of differentiation in its currently marketed portfolio makes Aurobindo more vulnerable to incremental competition from incumbents like Hospira (general injectables), Ranbaxy (cephalosporins) and Nesher (controlled substances), which have been out of the market due to FDA-related issues. As the incumbents return to the market, we expect them to regain market share through competitive pricing. Also, as compared to Aurobindo, these incumbents have a broader product basket to offer to the channel partners thus having higher bargaining power to negotiate. Therefore we believe, recent stellar revenue and EPS growth has been primarily a function of luck due absence of incumbents and expect revenue/margins/RoCE to decline materially as these companies return to the market post FY18E.

Aurobindo has moved up the value chain from API to formulation exports

Lack of branded business and a beneficiary of absence of incumbents

Aurobindo Pharma


Architecture Credible business heads: Aurobindo has in place credible business heads for important markets. Mr. Robert Cunard (CEO at Aurobindo Pharma, USA) and Mr. Ronald Quadrel (CEO at AuroMedics Pharma LLC) have worked with established MNC pharma giants like Glaxo, Mylan and Pfizer. Recently, the company appointed Mr Sanjeev Dani (former senior executive with Ranbaxy; COO and head of the formulation business) as the head of front-end operations of emerging markets and Europe. Mr. Sanjeev Dani had spent over a decade in managing emerging markets like India, Middle East and Africa.

However, issues with bottom of the pyramid employees: In three different instances, workers at the Aurobindo facility have gone on strike to protest against the policies of the management. In November 2014, the management suspended 1,500 employees at its Unit XI facility in Srikakulum, Andhra Pradesh, which manufactures ~50% of the company’s overall production. The strike was to seek salaries at par with neighbouring pharma units like Dr. Reddy, Mylan and Hetero Drugs.

August 2012 - Strike at Aurobindo Pharma's unit (http://goo.gl/ZSZMJp)

November 2104 - Suspension of 1,500 employees cripples Aurobindo unit operations (http://goo.gl/HafUic)

September 2015 - Tension prevails at Aurobindo Pharma in Srikakulam (http://goo.gl/bFxhwJ)

Strategic assets Aurobindo’s operations are vertically integrated with a network of 19 manufacturing facilities (eight formulations and eleven API and intermediates) in India and abroad. Whilst the company faced cGMP issues with the US FDA in 2011-12, the issues stand resolved and all its facilities are approved by the regulator.

The company does not have any intellectual property, as it produces ‘Me Too’ products. Further, no R&D investment is incurred on innovative pursuits to create patented/proprietary products.

In terms of licences and regulatory permission to provide certain service, Aurobindo is enrolled with WHO/NACO (National Aids Control Organisation) to submit tenders for ARV products in the Africa region.

Regular employee unrest in its manufacturing facilities

Lack of investment in innovative pursuits

Aurobindo Pharma


Financials Revenue mix

Year to March (` mn) FY14 FY15 FY16E FY17E FY18E

Formulations

USA 34,028 48,317 55,495 74,175 92,337

ARV 8,402 9,639 11,029 12,132 13,346

Europe 6,721 31,947 34,060 37,204 39,064

ROW 4,634 5,683 5,566 6,122 6,734

Total formulations 53,785 95,586 106,149 129,633 151,480

API

SSP 9,778 8,640 11,210 11,770 12,359

Cephs 8,755 9,300 10,500 10,500 10,500

ARVs and others 10,110 9,122 11,591 12,750 14,025

Total API 28,643 27,062 33,301 35,020 36,884

Dossier Income 165 77 150 150 150

Total 82,593 122,725 139,600 164,803 188,514


Income statement


Net revenues 80,998 121,205 136,808 161,507 184,744

Material Cost 36,060 55,056 62,238 68,857 75,287

General Expenses 21,059 35,058 37,914 45,284 53,615

R&D Expenses 2,551 5,454 6,156 7,268 8,313

Core EBITDA 21,328 25,637 30,499 40,098 47,528

Depreciation 3,125 3,326 4,226 4,264 5,314

Interest expense 1,087 843 846 621 395.742

Adjusted PBT 15,334 21,679 25,627 35,413 41,994

Tax 3,635 5,966 5,894 8,145 9,659

Reported net profit 11,737 15,758 19,733 27,268 32,336


Balance sheet


Total Assets 77,503 98,386 101,450 118,826 140,824

Fixed Assets 30,314 41,253 35,887 41,623 51,308

Current Assets 64,386 87,647 92,070 107,830 124,019

Investments 198 198 198 198 197.9

Total Liabilities 77,504 98,386 101,450 118,826 140,824

Shareholders' equity 292 292 292 292 291.5

Reserves & surplus 37,210 51,267 70,656 95,532 125,030

Total networth 37,502 51,559 70,948 95,823 125,321

Total debt 37,691 44,511 28,191 20,691 13,191

Current liabilities 16,037 28,286 25,347 29,467 33,343

Deferred tax liability 2,054 2,058 2,054 2,054 2,054


Aurobindo Pharma


Cash flow statement


PBT 15,334 21,679 25,627 35,413 41,994

Depreciation 3,125 3,326 4,226 4,264 5,314

Tax -3,440 -4,956 -5,894 -8,145 -9,659

Net Working Capital -10,591 -8,417 -4,207 -10,002 -9,409

CFO 6,471 12,368 20,398 21,952 28,460

Capital Expenditure -3,741 -7,459 -7,500 -10,000 -15,000

Investment -236 -6,860 - - 0

Other investments -4,211 234 200 200 176.794

CFI -8,187 -14,085 -7,300 -9,800 -14,823

Issuance of Equity 35 68 - - 0

Inc/Dec in Borrowings 1,737 2,669 -8,346 -8,121 -7,896

Net Dividends -596 -1,805 -1,732 -2,393 -2,837

Other Financing activities - - - - 0

CFF 1,176 932 -10,077 -10,514 -10,733

Net change in cash -540 -785 3,021 1,638 2,903

Closing cash balance 1,786 4,691 5,291 6,929 9,833

FCFF -1,481 5,143 13,098 12,152 13,637


Ratio analysis

Year to March FY14 FY15 FY16E FY17E FY18E

Revenue growth 38.3 49.6 14.1 18.1 14.4

Core EBITDA growth 139.9 20.2 21.7 31.5 18.5

APAT growth 236.5 34.3 25.1 38.2 18.6

EPS growth 234.9 34.3 25.1 38.2 18.6

Core EBITDA margin 13.2 15.2 26.3 20.9 22.3

EBIT margin 20.3 18.6 19.4 22.3 22.9

Net profit margin 14.4 13 14.4 16.9 17.5

ROCE (%) 24.2 26.3 28.2 33.4 25.6

Reported RoE (%) 36.9 35.4 31.9 32.7 29.2

Debt Equity ratio (X) 1.0 0.9 0.4 0.2 0.1

Current Ratio 4.0 3.1 3.6 3.7 3.7


Valuation parameters


EPS 40.3 27.0 33.8 46.8 55.5

Book Value ( per share) 128.7 88.3 121.7 164.4 215.0

P/E (x) 22.3 27.3 13.2 9.6 12.7

P/BV (x) 7.0 8.3 3.7 2.7 3.3

EV/EBITDA(x) 13.9 18.3 9.3 6.9 8.7

EV/Sales (x) 3.7 3.9 2.1 1.7 2.2

EV/EBIT (x) 18.1 20.9 10.7 7.6 9.8

CFO/EBITDA (x) 0.3 0.5 0.7 0.5 0.6

Gross Block turnover (x) 2.8 3.8 4.0 4.2 4.0

Working Capital Turnover (x) 1.3 1.5 1.4 1.5 1.4



Although Inox Wind is a new entrant, it has captured a market share of 12% in FY15 (vs NIL in FY10) with an EBITDA margin of 17% which is the highest amidst its peers. Lack of any sustainable competitive advantage alongside the rebirth of Suzlon (thanks to its recent balance sheet re-capitalisation) and shift in the Indian market from wind towards solar should cap future revenue growth. The high probability of warranty provisions and competition from solar should impact margins. The promoter’s poor capital allocation coupled with sub-par corporate governance is likely to remain an overhang on multiples.

Value Trap Summary

Parameter Result Comment

Accounting quality

Several unanswered questions over industry-highest EBITDA margin

Capital allocation Weak return ratios of Group companies

Corporate governance Lack of independence of Board; related party transactions

IBAS

Lack of innovation; dependence on vendors for critical components


Accounting quality - Several questions remain unanswered Although Inox is not an integrated manufacturer, its average gross margin over FY11-15 at 27% was higher than an integrated manufacturer’s 24%. Also, Inox pays significantly lower royalty (highest paid was 1.8% of revenue in FY14) vs R&D spend incurred by peers at 3.1% of revenue over FY11-15. Moreover, unlike its peers, which provide 4-5% of revenue as warranty provision, Inox does not provide for any warranty provision. Capital allocation – Unrelated diversification by group companies Inox has limited history of capital allocation as it was incorporated only in FY10. However, the capital allocation history of the Group isn’t impressive with both Gujarat Fluorochemicals (GF) and Inox Leisure reporting sub-optimal RoCE. Furthermore, diversification into non-related businesses is a concern. The group has diversified into air products, entertainment, chemicals, cold storage products, renewable and capital goods. Corporate governance - Lack of independence of directors Two of the four independent directors are on the Board of Inox’s promoter (GF). Inox’s non-promoter CEO is not a part of the Board. Moreover until FY13, a significant part of Inox’s business was coming from the Group and promoter-owned-entities (34%/100%/100% in FY13/FY12/FY11). All the wind sites for future development in Rajasthan, Gujarat and Kerala are held by GF. IBAS - Lack of spending on innovation; lack of strategic assets Inox stands out as a weak player on our IBAS framework due to lack of in-house innovation, dependence on AMSC (a financially fragile company) for technology, a weak brand (due to a limited third-party execution track record), weak architecture (due to lack of decentralisation) and high dependence on vendors for critical wind turbine generator (WTG) components. Attractive valuations, but what after FY17? Inox’s valuation of 13.2x FY17E P/E looks attractive given its strong EPS CAGR of 40% in FY15-17E and impressive 36% RoE in FY17E. However, Inox’s revenue growth seems likely to plateau beyond FY17E, as we believe wind power will go out of favour with the Government withdrawing incentives such as generation based incentives (GBI) and feed-in-tariff (FIT) post FY17-end. Poor YTD poor order inflow at 310MW (vs our estimate of 913MW) imply a likely cut in revenue and PAT by 8%-10% for FY17 making the current multiple expensive.

COMPANY UPDATE INXW IN EQUITY October 06, 2015

Inox WindSELL

Capital Goods

Recommendation Mcap (bn): `80/US$1.3 3M ADV (mn): `92/US$1.4 CMP: `359 TP (12 mths): `370 Upside (%): 3

Flags Accounting: RED Predictability: AMBER Treatment of minorities: RED


Inox streamlining its accounting policy in line with its peers by providing warrant provisions

Inox building a credible in-house R&D team to update/upgrade its technology

Performance (%)

Source: Bloomberg, Ambit Capital research.

Analyst Details

Bhargav Buddhadev


Deepesh Agarwal


80

100

120

140A

pr-1

5

Apr

-15

May

-15

Jun-

15

Jul-

15

Jul-

15

Au

g-1

5

Sep-

15

Sep-

15

Sensex Inox

Inox Wind


Exhibit 1: Whilst revenue increased at 147% CAGR over FY11-15, it is likely to stagnate post FY16 with 11% revenue CAGR over FY16-18E…


Exhibit 2: …and RoIC is likely to decline by 290bps over FY16-18E


Exhibit 3: Debt and equity capital raise accounted for 66% of cash inflows over FY11-15…


Exhibit 4: …and investment in working capital accounted for 63% of cash outflows over FY11-15


Exhibit 5: Inox is trading at a 4% discount to global peers

Company Country Mcap (US$mn)

P/E (x) P/B (x) EV/EBITDA (x)

RoE (%) CAGR over FY15-17E

FY16E FY17E FY16E FY17E FY16E FY17E FY15 FY16E FY17E Revenue EBITDA EPS

Inox Wind India 1,314 17.4 14.5 5.5 4.9 11.1 9.2 32.6 33.0 35.6 40.2 49.0 46.9

Indian WTG players

Suzlon India 1,505 NA 16.5 NA NA 25.9 13.2 NA 8.3 (13.5) (19.8) 46.3 NA

Divergence with Inox

NA -12% NA NA -57% -30% NA NA NA NA 270bps NA

Global WTG players

Gamesa* Spain 3,669 14.8 12.8 1.9 1.7 6.0 5.5 11.5 13.1 13.6 8.9 9.5 17.3

Vestas* Denmark 11,181 16.2 17.4 3.1 2.8 6.8 7.2 21.8 20.9 17.0 0.4 0.8 1.3

Nordex* Germany 2,137 19.6 17.4 3.4 2.9 7.6 7.0 17.6 19.6 18.1 3.5 14.0 19.4

Xinjiang Goldwind* China 5,537 11.5 9.6 1.9 1.7 9.9 8.2 16.7 16.9 17.8 9.8 19.5 17.3

Median 15.5 15.1 2.5 2.2 7.2 7.1 17.2 18.3 17.4 6.2 11.7 17.3

Divergence with Inox 12% -4% 117% 119% 54% 30% 1540bps 1470bps 1810bps 3400bps 3730bps 2960bps

Source: Bloomberg, Ambit Capital research; Note: Prices as on 29 September 2015, * - calendar year ending


Field Score Comments

Accounting RED In our accounting analysis of capital goods companies, Inox's scores are similar to the median score due to its stretched conversion cycle at 106 days in FY15 and high related party transactions.

Predictability AMBER Lack of availability of historical quarterly financial and extremely bullish management commentary renders limited predictability on the numbers.

Treatment of Minorities RED Lack of independence of independent directors (two independent directors are also directors of Inox’s promoter i.e. GF) and ownership of wind sites for future development in the states of Rajasthan, Gujarat and Kerala in the name of promoters (GF) and other group company (Inox Renewables) are matter of concern.


12%

14%

16%

18%

20%

22%

24%

26%

-

10,000

20,000

30,000

40,000

50,000

60,000

FY1

1

FY1

2

FY1

3

FY1

4

FY1

5

FY1

6E

FY1

7E

FY1

8E

Revenue (Rsmn) EBITDA margin (%) on RHS

-

20.0

40.0

60.0

80.0

100.0

120.0

140.0

FY1

1

FY1

2

FY1

3

FY1

4

FY1

5

FY1

6E

FY1

7E

FY1

8E

RoIC RoCE RoE

Borrowings, 36.8%

CFO before

WC, 33.4%

IPO proceeds,

29.0%

Others, 0.8%

WC investment,

63%

Capex, 15%

Inter-Corporate deposits,

12%

Interest payment,

9%

Inox Wind


Accounting quality Although Inox is not an integrated manufacturer, its average gross margin over FY11-15 at 27% was higher than an integrated manufacturer’s 24%. Also, Inox pays far lower royalty (highest paid was 1.8% of revenue in FY14) vs R&D spend incurred by peers at 3.1% of revenue over FY11-15. We wonder why other players are not emulating Inox Wind, as R&D costs impacts their EBITDA margin and in-house manufacturing impacts RoCE. Moreover, Inox does not provide for warranty expenses vs an average warranty provision of 4-5% by peers over FY11-14. This is a risk as several warranties are provided by the equipment supplier, which includes performance guarantees of WTGs, machine availability, etc. Lastly, Inox’s cash conversion cycle at 106 days (second-worst in industry) remains a concern; peers reported cash conversion cycle of -10 days in FY14 (FY15 data not available).

Cash conversion cycle: Inox has the second-worst cash conversion cycle given its high receivable days of 141 in FY14 (FY15 data not available for peers) vs peers’ 89 days. Moreover, the cash conversion cycle deteriorated from an average of 23 days in FY12 to 104 days in FY14 and to 106 days in FY15. Whilst Inox’s poor cash conversion cycle can be attributed to the higher share of turnkey projects (88% of projects executed in FY15), industry participants highlight that Gamesa is also an aggressive player in turnkey projects but still its cash conversion cycle stood at -33 days in FY14 (FY15 data not available). Note that a comparison with Suzlon does not depict a true picture, as Suzlon’s negative cash conversion cycle is due to its inability to pay its creditors. Hence, we raise a RED FLAG on Inox’s cash conversion cycle.

Exhibit 7: Inox cash conversion at 104 days in FY14 is second highest amidst peers

Company Receivable days Inventory days Payable days

Customer advance days

Cash conversion cycle

FY12 FY13 FY14 FY15 FY12 FY13 FY14 FY15 FY12 FY13 FY14 FY15 FY12 FY13 FY14 FY15 FY12 FY13 FY14 FY15

Inox Wind 22 99 141 144 48 31 41 47 46 58 76 77 0 0 2 8 23 71 104 106

Suzlon 152 520 187 251 66 313 136 109 197 761 391 494 11 140 86 35 10 (68) (155) (169)

Vestas 35 137 93 NA 112 395 172 NA 22 90 56 NA 25 117 78 NA 100 325 130 NA

Gamesa 59 92 39 NA 79 231 86 NA 92 201 93 NA 17 84 66 NA 29 39 (33) NA

Regen 78 113 84 NA 39 59 52 NA 57 96 99 NA 20 16 23 NA 41 60 14 NA

Median (excl. Inox) 69 125 89 NA 72 272 111 NA 75 148 96 NA 18 100 72 NA 35 49 (10) NA

Divergence (47) (26) 52 NA (24) (241) (70) NA (28) (90) (20) NA (18) (100) (70) NA (12) 22 114 NA

Source: Company, MCA, Ambit Capital research; Note: FY15 figures for Vestas, Gamesa and Regen are not available

Revenue recognition: Consequent to deterioration in the cash conversion cycle from 23 days in FY12 to 106 days in FY15, Inox’s CFO has been negative over FY12-15. The management is guiding for an improvement in the working capital cycle to ~80 days by FY17 led by better credit terms in recent contracts. Our recent interaction with industry expert suggest that credit terms are improving as IPPs are desperate to get the WTG projects commissioned before FY17 given uncertainty beyond FY17. However, post FY17, we expect the cash conversion to deteriorate, as IPPs start shifting towards solar.

Exhibit 8: Inox’s CFO over FY13-15 has been negative due to rising investment in working capital

`mn unless specified FY11 FY12 FY13 FY14 FY15

CFO before change in WC 110 1,160 1,652 1,509 3,548

WC investment (68) (664) (2,862) (2,389) (4,607)

CFO 42 495 (1,210) (880) (1,060)

Revenue growth NA 764% 70% 48% 73%

Cash conversion cycle

23 71 104 106


Inox has the second worst cash conversion cycle in the industry

Inox’s CFO has consistently been negative over FY12-15

Inox Wind


Inox’s gross margin is similar to global peers even though Inox is not an integrated manufacturer: Although Inox is not a fully integrated manufacturer; its gross margins are higher than the average margins of global peers. Inox outsources WTG design, gearbox, generator, electrical control systems and towers (partial outsourcing policy for towers). Inox’s higher margin is incomprehensible, given the industry thumb rule of manufacturers earning higher gross margin than aggregator companies. This is also corroborated from the data given in the exhibit below where Gamesa and Suzlon, which are virtually fully-integrated manufacturers, make gross margin of more than 30% vis-à-vis an aggregator like Vestas which makes gross margin of 14%. We raise a RED FLAG on this unexplainable high gross margin.

Exhibit 9: Inox’s gross margins are significantly higher for an aggregator company

Gross margin (%) FY11 FY12 FY13 FY14 FY15 Average over

FY11-15

Inox 29% 32% 27% 23% 25% 27%

Suzlon India# 34% 36% 19% 23% 36% 30%

Gamesa*^ 27% 32% 29% 33% 32% 31%

Vestas*^ 17% 12% 11% 15% 17% 14%

Nordex*^ 27% 26% 22% 25% 23% 24%

Goldwind*^ 23% 16% 14% 20% 26% 20%

Average (excl. Inox) 25% 24% 19% 23% 27% 24%

Source: Company, Ambit Capital research; Note: * We taken the financials of the global entities, as the gross margin data for the Indian arm of these companies are not available; ^ Calendar year ending, # we have taken Suzlon India’s financials for Suzlon, as the consolidated business includes the operations of Senvion

Exhibit 10: Inox is less integrated vis-a-vis global peers and Suzlon…

Criticality Inox Suzlon Gamesa Vestas Nordex

Design

Outsourced In-house In-house In-house In-house

Rotor blades

In-house In-house In-house Partial in-house Partial in-house

Towers

Partial in-house In-house In-house Partial in-house In-house

Hubs

In-house In-house In-house In-house In-house

Nacelle


Generator


Gearbox

Outsourced Partly In-house Outsourced In-house

Electrical control system


Source: Company, Industry, Ambit Capital research

Note: - Highest; - High; - Moderate; - Low.

Exhibit 11: …which is also corroborated by Inox’s lowest fixed asset per MW sold FY15 figures Inox Gamesa Nordex Goldwind Vestas Suzlon

Fixed Assets (US$mn) 40 682 163 1,772 3,898 101

Sales (MW) 578 2,623 1489 4,728 6,053 454

Fixed asset (US$mn per MW) 0.07 0.26 0.11 0.37 0.64 0.22


Exhibit 12: Gearbox and generator are regarded as critical components; both together account for ~84% of WTG failure (as per WindInsider)

Source: WindInsider, Ambit Capital research

Gearbox, 59%Generator, 25%

Rotor blades, 8%ECS, 3%Nacelles, 2% Others, 3%

Although Inox is not a fully integrated manufacturer, its gross margins are higher than the average margins of global peers

Inox Wind


Several questions over EBITDA margins: Inox reported the highest EBITDA margin vs its peers, both domestic and foreign. Whilst Inox reported 17% EBITDA margin in FY15 vs Suzlon’s -17% and MNC peers’ average of 8% for FY14 (FY15 financials not available for MNC peers), its average EBITDA margin over FY11-15 at 17.1% was also higher vs average EBITDA margin of -20.8% for Suzlon and 5.5% for MNC peers (FY11-15). Inox’s superior EBITDA margin can be attributed to NIL R&D expenditure (see Exhibit 16 below) and NIL provisioning on warranties (see Exhibit 14 below). Compared with average warranty provision at 4.5% of revenue over FY11-14 for its peers, Inox’s warranty provision was NIL.

Exhibit 13: Inox’s EBITDA margin at 17% in FY15 is the highest amidst peers, as it does not spend on R&D and also does not provide for warranties

Source: Company, MCA, Ambit Capital research; Note: * We take FY14 EBITDA margin for Vestas, Gamesa and Regen, as their FY15 financials are yet not available on MCA

NIL warranty provisioning: The lower provisioning cost is a risk, as several warranties are provided by the equipment supplier, which includes performance guarantees of WTGs, machine availability, etc. Inox provides its WTG customer with a warranty of about two years against all defects in components, materials and engineering from the date a WTG is commissioned. Whilst Inox has back-to-back warranties with its vendors, in some cases, the warranties provided by suppliers may be for shorter periods than the warranties provided to the customers. In other cases, the extent of losses can exceed the limits of that provided by the vendor/insured by the insurance company. We raise a RED FLAG.

Exhibit 14: Inox’s highest EBITDA margin vs its peers is led by lower provisioning cost Warranty provision as a % of revenue FY11 FY12 FY13 FY14 Average*

Inox 0.0% 0.0% 0.0% 0.0% 0.0% Gamesa 3.7% 4.7% NA NA 4.2% Suzlon 6.8% 3.9% 10.4% 9.0% 6.3% Regen 2.2% 0.5% 0.8% 1.3% 1.1% Average (excl. Inox) 4.2% 3.0% 3.7% 3.4% 4.5%

Source: Company, MCA, Ambit Capital research; Note: Warranty provisioning for Gamesa in FY13 and FY14 and Vestas over FY11-14 is not available in their MCA filings; * we have calculated average warranty claim on cumulative warranty claim made and cumulative revenue

NIL R&D expense: Inox has a perpetual licence from AMSC Austria GmbH to manufacture 2MW WTGs in India based on AMSC’s proprietary technology. AMSC is a Nasdaq-listed company (mcap of US$84mn), offering a host of electronic controls and systems as well as wind turbine designs and engineering services which aid in maximising turbine availability. However, AMSC has been facing financial difficulties since FY03 (and has made profit only once in the last 13 years) given the potential loss of a key customer and changes to its senior management. Its stock price has corrected by ~69% in the last one year and by ~98% in the last five years. Inox procures Electronic Control Systems (ECS) from AMSC and its affiliates. We raise a RED FLAG on NIL R&D spend.

-20.0%-15.0%

-10.0%-5.0%

0.0%5.0%

10.0%

15.0%20.0%

Inox Vestas* Gamesa* Suzlon Regen*

EBITDA margin (%)

Compared with average warranty provision at 4.5% of revenue over FY11-14 for its peers, Inox’s warranty provision was NIL.

Inox’s technology partner AMSC has been facing financial difficulties since FY03

Inox Wind


Exhibit 15: AMSC’s sustained losses are a worry US$mn unless specified FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15

Operating performance Revenue 112 183 316 287 77 87 84 71 Gross Profit 32 52 115 (22) (6) 15 11 3 EBITDA (17) (7) 39 (89) (101) (55) (43) (46) PAT (25) (17) 16 (186) (137) (66) (56) (49) Financial position

Net worth 208 222 281 293 165 125 112 80 Debt - - - - - 18 13 8 Cash 106 110 142 240 52 39 43 20 Ratios

Revenue growth YoY (%) 115% 63% 73% -9% -73% 14% -4% -16% Gross margin (%) 29% 28% 36% -8% -8% 18% 13% 4% EBITDA margin (%) -16% -4% 12% -31% -132% -63% -51% -65% RoE (%) -16% -8% 6% -65% -60% -46% -47% -51% RoCE (%) -11% -3% 16% -31% -44% -36% -32% -43%

Source: Bloomberg, Ambit Capital research, Note – March year ending

In the event, of any bankruptcy at AMSC, there can be no assurance that Inox will continue to update and upgrade the technology that it licenses from them. Whilst Inox’s agreement with AMSC provides that the source codes for ECS will be released to Inox, there can still be no assurance that Inox will be successful in updating and upgrading technology to keep pace with its competitors that use other technology for their WTGs. Given Inox’s NIL spend on R&D over FY11-14 vs average of 1.7% of revenues for its peers like Suzlon, Regen, and Gamesa, it remains to be seen how Inox will be able to compensate for the loss of AMSC.

Exhibit 16: Inox’s R&D spend is the lowest amidst peers Particulars FY11 FY12 FY13 FY14 Average*

R&D spend (`mn)

- Inox NIL NIL NIL NIL - Gamesa NA NA 93 5 - Suzlon 764 1,023 2,172 390 - Regen 195 53 58 52

R&D spend as a % of revenue

- Inox - - - - - - Gamesa NA NA 0.8% 0.0% 0.2% - Suzlon 1.7% 1.5% 12.4% 1.3% 2.7% - Regen 1.7% 0.2% 0.3% 0.2% 0.5%

Average (excl. Inox) 1.7% 0.9% 4.5% 0.5% 1.7%

Source: Company, MCA, Ambit Capital research; Note: R&D spend for Gamesa in FY11 and FY12 and Vestas over FY11-14 is not available in their MCA filings; we have calculated average on cumulative R&D spend and cumulative revenue

Royalty paid by Inox is negligible vs R&D cost incurred by global peers: If one assumes that the NIL R&D spend for Inox is due to royalty payment to AMSC, note that the royalty expense of Inox is significantly lower than the R&D spends of the global WTG peers. The highest royalty paid by Inox in its limited existence has been 1.8% of revenues in FY14. This is really surprising, as globally the R&D spend incurred by players is much higher at 3.1% of revenue over FY11-15. Even domestic players like Suzlon, Gamesa and Regen have spent 1.7% of revenue on R&D over FY11-15. Further, Inox now does not need to pay any royalty on WTG models of 93 meter and 100 meter rotor diameter with hub height of 80 meters and 80/92 meters respectively, as the royalty was to be paid only on the first 450 WTGs supplied. It is surprising that other players have not entered into similar arrangements as Inox, as R&D costs impact EBITDA margins by 2-4% across various players.

If AMSC goes bankrupt, there is no assurance that Inox will be able to update and upgrade the technology

Highest royalty paid by Inox is 1.8% of revenues which is much lower than the 3.1% of revenues paid by its global peers

Inox also has a unique arrangement of not paying royalty beyond a certain number of WTGs supplied

Height Royalty condition

Upto 110 meters On first 450 WTGs

Above 110 meters On first 245 WTGs


Inox Wind


Exhibit 17: Inox’s royalty and R&D spend is inferior to foreign peers As a % of revenue FY11 FY12 FY13 FY14 FY15 Average over FY11-15

Inox's royalty spend 1.6% 1.2% 1.3% 1.8% 0.8% 1.3%

R&D spend

Gamesa* 1.4% 2.3% 2.8% 1.9% 1.9% 2.1%

Vestas* 5.4% 3.4% 3.5% 4.0% 2.3% 3.7%

Nordex* 5.0% 6.8% 7.5% 3.6% 3.1% 5.2%

Goldwind*

0.5% 0.9% 2.2% 2.4% 1.5%

Average 3.9% 3.2% 3.7% 2.9% 2.4% 3.1%

Source: Company, Ambit Capital research, Note: * We have taken financials of the global entities; ^ Calendar year ending, data for royalty payments by Inox in FY15 is not available

Contingent liability as a proportion of net worth: Inox’s contingent liabilities as a percentage of net worth at 8.3% is not alarming, as it is entirely contributed by tax-related disputes and unexecuted capital contracts.

Exhibit 18: Contingent liabilities as a percentage of net worth at 8.3% in FY15 `mn FY14 FY15

Tax related 131 206

Unexecuted capital contracts 108 949

Total Contingent liability 239 1,154

As a % of net worth 5.6% 8.3%


Auditors Inox’s accounts are being audited by M/s Patankar & Associates since FY14 (prior to FY14 M/s Deewan PN Chopra & Co were the auditors) and Mr SS Agarwal is the signing partner. M/s Patankar & Associates is a less known firm; The Inox group of companies are their large clients. We believe a company of Inox’s size (FY15 revenue at `27bn) should be audited by one of the big-4 auditing firms. Moreover, SS Agarwal is the signing auditor for Inox’s group companies as well i.e., GF and Inox Leisure, which we believe poses a risk to the auditor’s independence, as GF is the promoter of Inox Wind. Thus, we raise a RED FLAG. “The Audit Committee”, as on 31 March 2015, comprises four members (three of whom are independent director and one is non-executive director). Mr Shanti Prasad Jain is the chairman of the audit committee. The attendance of one member i.e. Ms Bindu Saxena was only 20% in FY15.

Exhibit 19: Composition of Audit Committee Name Position in Audit Committee Directorship Attendance

Shanti Prasad Jain Chairman Independent 5/5

Deepak Asher Member Non-executive 5/5

S Rama Iyer Member Independent 4/5

Bindu Saxena Member Independent 1/5


Inox’s payment to auditors at 0.01% of FY15 is in line with the industry practice. For the purpose of calculation of audit fees, we have included fees for tax audit, out-of-pocket expenses and other audit expenses.

Exhibit 20: Audit fees as a percentage of revenue is reasonable

Particulars Audit Fees (`mn) As a % of revenue

FY14 FY15 FY14 FY15

Audit fees 0.9 1.1 0.01% 0.00%

IPO related 2.0 2.0 0.01% 0.01%

Other matters 1.0 0.8 0.01% 0.00%

Total 3.9 4.0 0.02% 0.01%


Inox Wind


Corporate governance Board Composition: Are independent directors independent?

The Board currently comprises eight directors, out of which four are independent directors, two are executive directors and two are non-executive directors. Mr Devansh Jain and Mr Rajeev Gupta are the executive promoters on the Board. The proportion of independent directors is reasonable at 50%. However, Mr Shanti Prashad Jain and Dr S Rama Iyer cannot be said to be independent, as they have a presence on the Board of the group companies including GF which is the promoter of Inox Wind.

The CEO Mr Kailash Lal Tarachandani is not a part of the Board of directors. Consequently, we assign a RED FLAG.

Exhibit 21: Snapshot of Board of directors

Director Designation Education Other directorship Summary

Directors

Devansh Jain Whole-time Director

Bachelor’s in economics and BA from Carnegie Mellon University, USA

None

He joined the group as a member of corporate management group at GF in March 2008. He has been leading the group’s foray into the wind equipment business. He is on the National Council of the Indian Wind Power Association and he is the Secretary of the Indian Wind Turbine Manufacturers Association.

Rajeev Gupta Whole-time Director

B.Tech (Chemicals) from IIT, Delhi

None

He has more than 35 years of experience in various management and operational areas. He was involved in setting up GFL’s chemical complex at Dahej and production plants for Aditya Birla Group and TOA Group of Companies.

Deepak Asher Non-executive director

Bachelor’s in commerce and law, CA, ICWA

Inox Leisure, Inox Leasing, Inox Motion, Inox Infrastructure, Inox Renewables, Frame Motion Pictures, Shringar Films, Fame India, GF

He has been associated with the Inox Group since the past 25 years. He is the founding president of the Multiplex Association of India and a member of the FICCI Entertainment Committee. He has also been awarded the Theatre World Newsmaker award in 2002.

Siddharth Jain Non-executive director

Bachelor’s Degree in Mechanical Engineering from the University of Michigan; MBA from INSEAD, France

Inox Leasing, Inox India, Inox Air Products, Inox Leisure, Siddhapavan Trading & Finance, Devnansh Gases, Rajini Farms, Kingston Smith, Megnasolace City, Crysogenic Vessel Alternative

He has been associated with the group since the past 12 years. Currently he is looking after product development at Inox Air products.

Chandra Prakash Jain

Independent Director

CA, Bachelor’s in Law ILFS Energy, ILFS Infrastructure Development Corporation, Adani Power, PCI

He is the former CMD of NTPC. He had been the chairman of the Standing Conference of Public Enterprises (SCOPE) for FY03-05. He has also served on the advisory committees of RBI, CAG and CII.

Shanti Prashad Jain

Independent Director

CA Inox Renewables, Inox Infrastructure, GF

He has more than four decades of experience as an auditor and tax consultant. He is the senior partner of M/s Shanti Prasad & Co.

Dr S Rama Iyer Independent Director

BE (Chemicals) from Jadhavpur University; MTech and PhD from IIT, Mumbai

L&T Infotech, Thirumalai Chemicals, GF, Inox Renewables, Deepak Fertilisers

He has over five decades of experience in the engineering, chemical, petrochemicals and oil and gas industry. He is a member of the Indian Institute of Chemical Engineers. He has been awarded the ‘Business Leader of the Year Award’ by the Chemtech Foundation in 2005.

Bindu Saxena Independent Director

Bachelor’s in Law and Commerce

None She has over 25 years of experience as a corporate attorney. She is a partner at Swarup & Company (New-Delhi-based law firm).

Other key executives (non-director)

Kailash Lal Tarachandani

Chief Executive Officer

BE (Electricals), IIT Kanpur; MBA, INSEAD

None

He has more than 22 years of experience in strategy management, global project execution, product management and business development; he was instrumental in building organisations, setting up their plants, acquiring technologies and developing their management teams. Prior to joining Inox Wind in 2013, he worked with Kenerseys, Vestas, Alstom Power and L&T.

Raju Kaul Chief Financial Officer

CA; MBA, FMS (Delhi) None Prior to joining Inox Wind, he was the CFO of Punj Lloyd. He has also worked with SAE India, Blue Star and Hotel Corporation of India.


Inox Wind


Since Inox was incorporated in FY10 and went public in FY15, the rotation of independent directors is not comparable.

Attendance of the Board: The attendance of the independent directors at the Board meetings has been poor in FY15 (details for FY14 are not available). Apart from Mr Shanti Jain who attended all the Board meetings, the attendance of other three independent directors was not more than 50%. Mr Chandra Jain attended only one out of the eight Board meetings. We assign an AMBER FLAG.

Exhibit 22: Attendance of independent directors at the Board meetings has been poor

Director Designation FY15

Devansh Jain Whole-time Director 8/8

Rajeev Gupta Whole-time Director 7/8

Deepak Asher Non-executive director 8/8

Siddharth Jain Non-executive director 1/8

Chandra Prakash Jain Independent Director 1/8

Shanti Prashad Jain Independent Director 8/8

Dr S Rama Iyer Independent Director 4/8

Bindu Saxena Independent Director 3/8


Insider trading: No insider transaction has taken place since the listing of Inox in March 2015.

Managerial remuneration: Inox’s managerial remuneration as a percentage of PBT at 0.92% in FY15 is reasonable.

Exhibit 23: Managerial remuneration is reasonable

FY15, in ` mn Designation Salary &

Commission Sitting fees Total

As a % of PAT

Directors

Devansh Jain Whole-time Director 12.1 - 12.1 0.31%

Rajeev Gupta Whole-time Director 5.9 - 5.9 0.15%

Deepak Asher Non-executive Director - 0.3 0.3 0.01%

Siddharth Jain Non-executive Director - 0.0 0.0 0.00%

Chandra Prakash Jain Independent Director - 0.1 0.1 0.00%

Shanti Prashad Jain Independent Director - 0.3 0.3 0.01%

Dr S Rama Iyer Independent Director 1.2 0.2 1.4 0.04%

Bindu Saxena Independent Director - 0.1 0.1 0.00%

Key executives (Non-director)

Kailash Lal Tarachandani Chief Executive Officer 12.6 - 12.6 0.32%

Raju Kaul Chief Financial Officer 3.0 - 3.0 0.08%

Total

34.8 1.0 35.7 0.92%


Inox Wind


Capital allocation Capital allocation strategy appears reasonable Per MW capex low but not comparable

Inox has spent `1.5bn on capex over FY14-15 for its capacity expansion from 800MW currently to 1,600MW (expected by end-FY16). Whilst this capex appears low on a per MW basis (`2mn-2.5mn per MW vs peers’ `4-5mn), note that Inox’s facility is not integrated and hence to that extent it is not comparable. Although capacity expansion appears rational, given its opening order book of 1,178MW in FY16 vs current installed capacity of 800MW (we calculate capacity on blade manufacturing capacity), we believe industry growth should stagnate at 3.5GW after FY17, which means that Inox may be left with excess capacity.

Moreover, Inox has not undertaken any acquisition since its incorporation in FY10.

Negatives – Working capital dampens cash flows; group companies capital allocation strategy questionable

Deteriorating cash conversion cycle from 23 days in FY12 to 106 days in FY15 coupled with 63% revenue CAGR over FY12-15 has meant that CFO generation has been negative over FY13-15 (see Exhibits 7 and 8). Whilst the company is guiding for an improvement in its cash conversion cycle to ~80 days in two years, we are not enthusiastic about its guidance, as Inox’s peers are operating at negative cash conversion cycle (FY14 median cash conversion cycle for peers stood at -10 days).

Since Inox has been incorporated only six years ago (in FY10), we also analyze the capital allocation history of the other group companies; GF and Inox Leisure.

As per our Chemicals analyst, amidst fluorine players, SRF is a much better play than GF, given its product portfolio, scale, management bandwidth, and R&D capability. Whilst SRF has a dominant share of the fluoro chemicals business (commercialised 20 modules so far), a large portion of GF’s revenues are driven by the commodity product, caustic soda. Also, whilst SRF has been investing 6-7% of PBT into R&D, GF has not focused much on specialty chemicals and has largely focused on commodity fluoro products such as Teflon. Whilst GF’s FY15 EBITDA margin at 21% is superior to Navin Flourine’s 12% and SRF’s 18%, GF earns lower RoE than both (as seen in the exhibit below).

Even the Inox Leisure business (entertainment business) lacks a competitive edge vs its peers. Despite its revenue at `9.7bn in FY15 being similar to PVR’s `14.7bn, its FY15 EBITDA margin/RoE at 12%/5% was lower than PVR’s 14%/6%.

Exhibit 24: GF’s RoE is lower than its peers


Average over FY11-15

EBITDA margin (%)

- GF 34.4 35.8 44.0 16.6 21.4 30.4

- Navin Fluorine 26.2 35.5 15.3 13.5 11.6 20.4

- SRF 28.2 22.7 17.4 14.8 18.2 20.3

RoE (%)

- GF 16.1 22.2 17.2 3.0 14.2 14.5

- Navin Fluorine 23.0 56.7 8.7 9.6 8.9 21.4

- SRF 33.2 22.2 13.4 10.4 13.5 18.5

Source: Ace Equity, Ambit Capital research; Note: We have taken standalone financials for GFL, Navin Fluorine and SRF

Exhibit 25: Even Inox Leisure’s RoEs and margins are lower than its peers


Average over FY11-15

EBITDA margin (%)

- Inox Leisure 9.7 12.9 12.8 14.0 12.0 12.3

- PVR Cinema 17.7 14.0 13.8 15.2 13.8 14.9

RoE (%)

- Inox Leisure 0.5 7.7 6.2 8.7 0.8 4.8

- PVR Cinema 0.1 8.1 9.6 9.7 3.2 6.1

Source: Ace Equity, Ambit Capital research; Note: We have taken consolidated financials for PVR

Inox has not undertaken any acquisition since its incorporation in FY10

CFO generation has been negative over FY13-15

Other group companies earn returns lower than their peers.

Inox Wind


IBAS framework Exhibit 26: Summary of IBAS framework IBAS Parameter

Level of strength

Comment

Innovation

It is dependent on AMSC for technology support. Despite the high probability of AMSC going bankrupt, Inox has yet not spent on in-house R&D.

Brand

Limited execution history with non-related party and lack of manufacturing of critical components has meant a moderate brand name for Inox.

Architecture

Inox is a promoter-driven company with lack of decentralisation of decision-making (which is evident from lack of representation of a professional CEO on the Board).

Strategic Asset

Inox does not manufacture critical WTG components such as generator, gearbox, and electrical control system. High dependence on vendors is a concern.


Innovation Lack of in-house R&D alongside weak financial position of technology partner is a concern:

Inox Wind forayed into WTG equipments post the technical collaboration with AMSC for design and electrical control systems in FY10. Over the past six years, technology support from AMSC for 2MW wind turbines has helped Inox to improve its market share from NIL in FY10 to 12% in FY15.

However, the continuity of technology support from AMSC remains a question mark, as AMSC has been facing financial difficulties since FY03 (and has made profit only once in the last 13 years) given the loss of a key customer and changes to its senior management. Its stock price has corrected by ~98% in the last five years. In the event of bankruptcy at AMSC, there can be no assurance that Inox will continue to update and upgrade the technology that it licenses from them.

Whilst Inox’s agreement with AMSC provides that the source codes for ECS will be released to Inox, there can still be no assurance that Inox will be successful in updating and upgrading technology to keep pace with its competitors that use other technology for their WTGs. Given Inox’s NIL spend on R&D over FY11-14 vs average of 1.7% of revenues for its peers like Suzlon, Regen, and Gamesa, it remains to be seen how Inox will be able to compensate for the loss of AMSC. If Inox fails to update technology in-house then it may fall behind in the fast-changing technology curve of the WTG industry.

Brands/Reputation Limited execution history with non-related party has meant moderate brand recall for Inox

Inox’s turbines (commenced operations in 2010) have a moderate track record beyond its captive consumers. Whatever third-party business has gone to Inox Wind may be attributed to the reputation enjoyed by its group companies, GF and Inox Leisure. Until FY13, a significant part of Inox’s wind business was coming from the group and promoter-owned companies (34% in year-ended 31 March 2013, 100% in year-ended 31 March 2012 and 100% in year-ended 31 March 2011).

Also, until FY13, Inox had executed projects only in Rajasthan and Tamil Nadu, with ~83% of the projects being executed in Rajasthan. Suzlon’s financial woes during FY11-15 allowed Inox to gain market share during this period, as only Suzlon, Gamesa and Inox provide turnkey solution. However, with Suzlon back in the market given the recent equity infusion of `18bn by Dilip Sanghavi & Associates and stake sale in Senvion for `70bn, Inox is losing ground to Suzlon.

Continuity of technology support from AMSC remains a question mark, as AMSC has been facing financial difficulties since FY03

If Inox fails to update technology in-house then it may fall behind in the fast-changing technology curve of the WTG industry

Until FY13, a significant part of Inox’s wind business was coming from the group and promoter-owned companies

Inox Wind


Exhibit 27: Limited track record of turbines from third parties, as majority of sales happened to related parties until FY13

Sales in MW FY11 FY12 FY13

Related party sales

- GFL 2 52 -

- Inox Renewables - - 134

Others - - 130

Total 2 52 264

Sales to related parties as % of total 100% 100% 34%


Architecture Promoter-driven company

Our discussion with Inox’s customers and visit to job portals like Glassdoor suggest that Inox is a promoter-run company which lacks decentralisation. This is corroborated by the fact that Inox’s CEO is not even a part of the Board of Directors.

All the wind sites for future development in the states of Rajasthan, Gujarat and Kerala are held by the promoters (GF) and by Inox Renewables (IRL, a group company). In the event, the framework agreement entered into with the promoters does not hold up, the company may lose all the wind sites. Management’s view on this happening is very limited as GF and IRL are not engaged in wind equipment manufacturing. Further there is no possibility of GFL and IRL allowing any other developer other than Inox to use these sites. Lastly, the brand Inox is not owned by the company. It belongs to the Jain family (represented by Pavan Kumar) which are the promoters of GF.

Strategic assets Inox is not a fully integrated manufacturer, as it outsources critical WTG equipment such as design, gearbox, generator, electrical control systems and towers (partial outsourcing policy for towers). Dependence on vendors for critical components suggests weak control over strategic assets.

Exhibit 28: Inox is less integrated vis-a-vis the global peers and Suzlon

Criticality Inox Suzlon Gamesa Vestas Nordex

Design


Rotor blades

In-house In-house In-house Partial in-house Partial in-house

Towers

Partial in-house In-house In-house Partial in-house In-house

Hubs


Nacelle


Generator


Gearbox

Outsourced Partly In-house Outsourced In-house

Electrical control system


Source: Company, Industry, Ambit Capital research

Note: - Highest; - High; - Moderate; - Low.

Inox’s CEO is not even a part of the Board of Directors

All the wind sites for future development in the states of Rajasthan, Gujarat and Kerala are held by the promoters and by group companies

Inox outsources critical WTG equipment from vendors

Inox Wind


Exhibit 29: Gearbox and generator are regarded as critical components; together they account for ~84% of WTG failures (as per WindInsider)

Source: WindInsider, Ambit Capital research

Attractive valuation but what after FY17? Inox’s current valuation of 14.5x FY17E P/E looks attractive given strong EPS CAGR of 40% over FY15-17E and impressive RoE of 36% in FY17E, an improvement of 310bps over FY15-17E. However, we believe Inox’s revenue growth would flatten out from FY18 onwards, as we believe wind power would go out of flavor with the Government withdrawing incentives to support solar power. We believe Inox will not foray into solar, as there are no competitive advantages for domestic solar equipment manufacturers. Our recent discussions with consultants suggest that the WTG industry ordering may fall to 1.5-2.0GW in FY17 from ~3.5GW in FY16E given the shift towards solar at rapid pace which implies a material downside risk to our FY17 industry ordering assumption of at 4.1GW. Moreover, Inox’s poor YTD poor order inflow at 310MW (vs our estimate of 913MW for FY16) imply a likely cut in revenue and PAT by 8%-10% for FY17 which makes the current multiple even less attractive.

Exhibit 30: Inox is trading at 4% discount to global peers

Company Country CMP# Mcap

(US$mn)

P/E (x) P/B (x) EV/EBITDA (x) RoE (%) CAGR over FY15-17E

FY16E FY17E FY16E FY17E FY16E FY17E FY15 FY16E FY17E Revenue EBITDA EPS

Inox Wind India 379 1,314 17.4 14.5 5.5 4.9 11.1 9.2 32.6 33.0 35.6 40.2 49.0 46.9

Indian WTG players

Suzlon India 20 1,505 NA 16.5 NA NA 25.9 13.2 NA 8.3 (13.5) (19.8) 46.3 NA

Divergence with Inox NA -12% NA NA -57% -30% NA NA NA NA 270bps NA

Global WTG players

Gamesa* Spain 12 3,669 14.8 12.8 1.9 1.7 6.0 5.5 11.5 13.1 13.6 8.9 9.5 17.3

Vestas* Denmark 44 11,181 16.2 17.4 3.1 2.8 6.8 7.2 21.8 20.9 17.0 0.4 0.8 1.3

Nordex* Germany 24 2,137 19.6 17.4 3.4 2.9 7.6 7.0 17.6 19.6 18.1 3.5 14.0 19.4

Xinjiang Goldwind* China 13 5,537 11.5 9.6 1.9 1.7 9.9 8.2 16.7 16.9 17.8 9.8 19.5 17.3

Median

15.5 15.1 2.5 2.2 7.2 7.1 17.2 18.3 17.4 6.2 11.7 17.3

Divergence with Inox 12% -4% 117% 119% 54% 30% 1540bps 1470bps 1810bps 3400bps 3730bps 2960bps

Source: Bloomberg, Ambit Capital research; Note: Prices as on 29 September 2015, * - calendar year ending, # Local currency prices

Gearbox, 59%Generator, 25%

Rotor blades, 8%ECS, 3%

Nacelles, 2% Others, 3%

Inox’s poor YTD poor order inflow at 310MW (vs our estimate of 913MW for FY16) implies a likely cut in revenue and PAT by 8-10% for FY17E

Inox Wind


Financials Income statement


Operating income 15,668 27,099 45,035 53,303 55,867

% growth 48% 73% 66% 18% 5%

Gross Profit 3,537 6,753 12,097 14,538 14,982

EBITDA 1,953 4,298 7,994 9,546 9,407

% growth -1% 120% 86% 19% -1%

Depreciation 116 204 245 345 391

EBIT 1,837 4,094 7,749 9,201 9,016

Interest expenditure 460 622 1,293 1,758 1,717

Non-operational income / Exceptional items 91 143 355 723 749

Exceptional Items

PBT 1,468 3,615 6,810 8,165 8,048

Tax (45) 927 1,973 2,365 2,331

PAT 1,513 2,688 4,837 5,800 5,717

% growth 0% 78% 80% 20% -1%


Balance sheet


Cash 40 7,096 14,453 14,981 15,346

Debtors 7,096 14,322 16,809 18,873 19,475

Inventory 2,707 4,238 5,552 6,572 6,888

Loans & advances 2,030 3,436 4,565 5,403 5,663

Investments 450 0 - - -

Fixed assets 1,993 2,519 3,719 3,719 3,719

Other Current assets 482 337 1,144 609 1,228

Total assets 14,798 31,948 46,243 50,157 52,319

Current liabilities & provisions 4,802 9,300 11,767 13,887 14,606

Debt 5,567 8,743 19,073 19,073 19,073

Other liabilities 151 (14) (14) (14) (14)

Total liabilities 10,520 18,029 30,825 32,945 33,664

Shareholders' equity 2,000 2,219 2,219 2,219 2,219

Reserves & surpluses 2,278 11,700 13,199 14,992 16,435

Total networth 4,278 13,919 15,418 17,211 18,655

Net working capital 7,512 13,032 16,304 17,569 18,647

Net debt (cash) 5,526 1,647 4,620 4,091 3,726


Inox Wind


Cash flow statement


PBT 1,278 3,891 6,810 8,165 8,048

Depreciation 116 204 245 345 391

Interest 460 622 1,293 1,758 1,717

(Incr) / decr in net working capital (2,389) (4,607) (3,271) (1,265) (1,078)

Tax (334) (800) (1,973) (2,365) (2,331)

Others (11) (370) (355) (723) (749)

Cash flow from operating activities (880) (1,060) 2,749 5,916 5,997

(Incr) / decr in capital expenditure (440) (1,039) (1,445) (345) (391)

(Incr) / decr in investments (454) 465 0 - -

Others 474 (909) 355 723 749

Cash flow from investing activities (420) (1,483) (1,090) 378 358

Issuance of equity - 6,923 - - -

Incr / (decr) in borrowings 1,789 3,255 10,329 - -

Others (465) (593) (1,293) (1,758) (1,717)

Cash flow from financing activities 1,324 9,585 9,036 (1,758) (1,717)

Net change in cash 25 7,042 10,696 4,535 4,638


Ratio analysis

Year to March (%) FY14 FY15 FY16E FY17E FY18E

EBITDA margin 12.5 15.9 17.7 17.9 16.8

EBIT margin 11.7 15.1 17.2 17.3 16.1

Net profit margin 9.7 9.9 10.7 10.9 10.2

RoIC 24.1 25.8 32.7 33.1 29.8

RoCE 23.0 19.2 19.3 18.5 17.3

RoE 36.1 32.6 33.0 35.6 31.9

FCF / Capital employed (15.9) (12.9) 4.6 15.7 15.1

Pre-tax CFO/EBITDA -28% -6% 59% 87% 89%


Valuation parameters


EPS (`) 6.82 12.11 21.80 26.14 25.76

Book value per share (`) 19.3 62.7 69.5 77.6 84.1

P/E (x) 50.8 28.6 15.9 13.2 13.4

P/BV (x) 17.9 5.5 5.0 4.5 4.1

EV/EBITDA (x) 42.1 18.2 10.2 8.5 8.6

EV/Sales (x) 5.3 2.9 1.8 1.5 1.4


Inox Wind


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 / Infra / Cement / Industrials (022) 30433241 [email protected]

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

Abhishek Ranganathan, CFA Retail / Mid-caps (022) 30433085 [email protected]

Achint Bhagat, CFA Cement / Roads / Home Building (022) 30433178 [email protected]

Aditya Bagul Consumer (022) 30433264 [email protected]

Aditya Khemka Healthcare (022) 30433272 [email protected]

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

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

Deepesh Agarwal Power Utilities / Capital Goods (022) 30433275 [email protected] Gaurav Mehta, CFA Strategy / Derivatives Research (022) 30433255 [email protected]

Girisha Saraf Mid-caps / Small-caps (022) 30433211 [email protected]

Karan Khanna Strategy (022) 30433251 [email protected]

Kushank Poddar Technology (022) 30433203 [email protected] Pankaj Agarwal, CFA Banking / Financial Services (022) 30433206 [email protected]

Paresh Dave, CFA Healthcare (022) 30433212 [email protected]

Parita Ashar, CFA Metals & Mining (022) 30433223 [email protected]

Prashant Mittal, CFA Derivatives (022) 30433218 [email protected]

Rakshit Ranjan, CFA Consumer (022) 30433201 [email protected]

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

Ritesh Gupta, CFA Oil & Gas / Chemicals (022) 30433242 [email protected]

Ritesh Vaidya, CFA Consumer (022) 30433246 [email protected] Ritika Mankar Mukherjee, CFA Economy / Strategy (022) 30433175 [email protected]

Ritu Modi Automobile (022) 30433292 [email protected]

Sagar Rastogi Technology (022) 30433291 [email protected]

Sumit Shekhar Economy / Strategy (022) 30433229 [email protected]

Utsav Mehta, CFA E&C / Industrials (022) 30433209 [email protected]

Sales

Name Regions Desk-Phone E-mail

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

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

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

Hitakshi Mehra India (022) 30433204 [email protected]

Krishnan V India / Asia (022) 30433295 [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]

Shaleen Silori India (022) 30433256 [email protected]

Singapore

Pramod Gubbi, CFA – Director Singapore +65 8606 6476 [email protected]

Shashank Abhisheik Singapore +65 6536 1935 [email protected]

USA / Canada

Ravilochan Pola - CEO Americas +1(646) 361 3107 [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

Inox Wind


Aurobindo Pharma Ltd (ARBP IN, SELL)


Apollo Tyres Ltd (APTY IN, NOT RATED)


Inox Wind Ltd (INXW IN, SELL)


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Explanation of Investment Rating

Investment Rating Expected return (over 12-month)

BUY >10%

SELL <10%

NO STANCE We have forward looking estimates for the stock but we refrain from assigning valuation and recommendation

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contained herein has been obtained from published information and other sources, which Ambit Capital or its Affiliates consider to be reliable. None of Ambit Capital accepts any liability or responsibility whatsoever for the accuracy or completeness of any such information. All estimates, expressions of opinion and other subjective judgments contained herein are made as of the date of this document. Emerging securities markets may be subject to risks significantly higher than more established markets. In particular, the political and economic environment, company practices and market prices and volumes may be subject to significant variations. The ability to assess such risks may also be limited due to significantly lower information quantity and quality. By accepting this document, you agree to be bound by all the foregoing provisions.

Additional Disclaimer for Canadian Persons

18. AMBIT Capital is not registered in the Province of Ontario and /or Province of Québec to trade in securities and/or to provide advice with respect to securities. 19. AMBIT Capital's head office or principal place of business is located in India. 20. All or substantially all of AMBIT Capital's assets may be situated outside of Canada. 21. It may be difficult for enforcing legal rights against AMBIT Capital because of the above. 22. Name and address of AMBIT Capital's agent for service of process in the Province of Ontario is: Torys LLP, 79 Wellington St. W., 30th Floor, Box 270, TD South Tower, Toronto, Ontario M5K 1N2

Canada. 23. Name and address of AMBIT Capital's agent for service of process in the Province of Montréal is Torys Law Firm LLP, 1 Place Ville Marie, Suite 1919 Montréal, Québec H3B 2C3 Canada.

Additional Disclaimer for Singapore Persons 24. This Report is prepared and distributed by Ambit Capital Private Limited and distributed as per the approved arrangement under Paragraph 9 of Third Schedule of Securities and Futures Act (CAP

289) and Paragraph 11 of the First Schedule to the Financial Advisors Act (CAP 110) provided to Ambit Singapore Pte. Limited by Monetary Authority of Singapore. 25. This Report is only available to persons in Singapore who are institutional investors (as defined in section 4A of the Securities and Futures Act (Cap. 289) of Singapore (the “SFA”).” Accordingly, if a

Singapore Person is not or ceases to be such an institutional investor, such Singapore Person must immediately discontinue any use of this Report and inform Ambit Singapore Pte. Limited.

Disclosure 26. Ambit and/or its associates have financial interest in Hero Motocorp, Infosys, Lupin, ITC, UPL, HUL, Wipro, Cipla, Glenmark, Motherson Sumi and Suzlon.

Analyst Certification Each of the analysts identified in this report certifies, with respect to the companies or securities that the individual analyses, that (1) the views expressed in this report reflect his or her personal views about all of the subject companies and securities and (2) no part of his or her compensation was, is or will be directly or indirectly dependent on the specific recommendations or views expressed in this report. © Copyright 2015 AMBIT Capital Private Limited. All rights reserved.

Ambit Capital Pvt. Ltd. Ambit House, 3rd Floor. 449, Senapati Bapat Marg, Lower Parel, Mumbai 400 013, India. Phone: +91-22-3043 3000 | Fax: +91-22-3043 3100 CIN: U74140MH1997PTC107598 www.ambitcapital.com

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