Sharda Motors - Emission tailwinds or EV threat to exhaust systems?

Hello friends,

It’s been 9 years since I joined this wonderful community of selfless investors. Here’s my first attempt at initiating a thread on a business that I feel is potentially under-priced. The business is an auto-ancillary called Sharda Motor Industries Limited (to be referred as SMIL, henceforth).

But first, some initial caveats and disclosures:

  • There is an existing thread here on this forum. However, that thread is closed and hence, I created a new one. I am happy to move this content to the other thread if the admins unlock it.
  • I am not a SEBI registered analyst.
  • The goal of this thread is to collaborate with other investors who may be tracking this business, uncover blind spots and possibly, do some scuttlebutt with automotive experts in this forum.
  • I am invested in SMIL with an allocation of 3% at an average price of Rs. 769.

Summary of why this business could be interesting:
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  • SMIL has 30% market share in exhaust systems in passenger vehicles/LCV segment
  • Entered into a JV with Eberspaecher for exhaust systems in MHCV segment. Eberspaecher brings in technological know-how and is a segment leader in US/Europe. This JV brings the capability to scale up in MHCV segment and capture market share.
  • Legislation tailwinds - BS VI emission norms along with RDE has the potential to increase content per vehicle in PV/LCV segment. CEV-V and TREM V regulations in 2024 will bring all Construction Equipment Vehicle and Tractors under emission regulation. This has the potential to double the target addressable market in value.
  • Optionalities in EV, sub-component exports and make-for-the-world in the Eberspaecher JV
  • High ROCE business, negative working capital, healthy cash generation
  • Net cash balance sheet. Available at EV/EBITDA of ~9x TTM

Detailed Analysis
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About the company
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CMP as on July 28, 2022 - Rs. 736
Market Cap - 2183 crore

SMIL is an established auto ancillary company offering products and services in the following market segments:

  • Emission control and Exhaust systems
  • Suspension systems
  • Roof systems

It has also entered into the EV space through a JV with Kinetic Green, India. In the initial phase, the JV will focus on assembly of EV battery packs and BMS, primarily for 2W and 3W. It will also explore sub components that go into BMS.

Brief History of the company:
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1986 - Inception of SMIL
1998 - Foray into Exhaust systems for passenger vehicles with Chennai unit and agreement with Hyundai
2002 - Ventured into Suspension assembly business. Established R&D for exhaust system.
2010 - Established R&D for emission control
2018 - Entered a technical partnership with Bestop Inc. USA for manufacturing of roof systems
2019 - Eberspaecher and SMIL enter into a JV to manufacture CV exhaust systems in India. Eberspaecher brings in global know- how for the local market
2020 - To resolve a family dispute, demerged NDR Auto component limited into a separate listed entity.
2021 - Kinetic Green and SMIL enter into a JV for assembly of Lithium batteries along with BMS for Electric Vehicles – 2W, 3W and Stationary applications

Product Portfolio and market share
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  1. Exhaust systems - This forms 90% of SMIL’s revenue and therefore, the bulk of the revenue. It caters to the following sub-segments:
  • Passenger Vehicles and Light Commercial Vehicles - SMIL treats PV and LCV as a same sub-segment because the engine sizes are similar and hence, exhaust sytems are same. SMIL has 30% market share of exhaust systems in the PV/LCV segment. It is a supplier to all major PV/LCV OEM’s except Maruti. SMIL has an in-house intellectual property for these exhaust systems.
  • Medium/Heavy Commercial Vehicles - SMIL has entered MHCV exhaust systems market through a 50:50 JV with Eberspaecher in 2019. Currently, it has 10% market share in this segment. As per management commentary, SMIL is a supplier to the 2 major MHCV OEMs in the country. Currently, this JV is a loss making entity contributing ~120 crores of revenue. As per management, the JV will breakeven at ~200 crore.
  • Tractors - Currently, SMIL primarily caters to the export market in tractors where TREM 5 regulations are in place. This is a very small contributor to overall revenue.
  • Construction Equipment Vehicle - Currently, SMIL doesn’t cater to CEV as the current emission standards don’t require their exhaust systems. However, I am mentioning it here as a sub-segment as this is going to substantially change in the next couple of years.
  1. Suspension systems - This contributes to ~6% of revenue. SMIL has 10% market share in this segment.
  2. Roofing systems - This is a niche category and SMIL entered this market with a technical collaboration with Bestop Inc. SMIL does convertible canopy and soft top canopy in this segment. This is only a minor contributor to SMIL’s revenues.
  3. EV battery assembly and BMS - SMIL has entered into 74:26 JV with Kinetic Green Energy for developing battery packs and BMS for EVs. The initial focus will be on 2W/3W EVs. Kinetic Green will be an anchor customer and already has a presence in electric 3W vehicles. Currently, there is no revenue out of this vertical and production is expected to start from Q3, FY23.

Competitive Landscape
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As per management commentary:

  • Competitive intensity is relatively low in exhaust systems with market share split between 3 major players.
  • PV has more competitive intensity relative to CV/Tractors. This is because the technology involvement is higher in the CV/Tractor segment.
  • Apart from SMIL, the other players are MNCs. As per management, one is an American company and another is a French company.
  • As per an HDFC report shared publicly here, these MNC competitors appear to be Tenneco and Faurecia.

[The competitive landscape requires more detailed work and the management claims need to be independently verified. I have also ignored “Suspension Systems” business from competitive analysis as it only contributes 6% to revenue.]

Legislation tailwinds
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The below slide from SMIL’s investor presentation captures the legislation tailwinds:

To summarize from the above slide:

  • BS VI RDE norms by Apr 2023 has the potential to increase the content per vehicle by 10%-15%
  • CEV V and TREM V norms will bring in all construction vehicles and tractors under its ambit and this has the potential to double the market size SMIL serves today. SMIL already has existing relationships with tractor OEMs and expects a sizable market share in this segment.

Key Risks
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  • The biggest risk to SMIL’s business is the gradual move towards EVs that will make the exhaust systems business redundant. This means assigning a terminal value of 0 to that line of business. As per management, the following is their thought process on this risk:
    • They see the electrification happening rapidly in 2W/3W space and hence, their JV with Kinetic on EV batteries/BMS to take advantage of this opportunity.
    • However, in the PV space, they see the shift to happen gradually in India and for CVs and off-road segment, they don’t see the electrification happening in the next 10 years. This needs to be independently validated. Tube Investments recently invested in IPL Tech Electric Pvt Ltd, an electric heavy commercial vehicle startup, as per the news here. It is possible that this transition may happen sooner.
    • The management is also exploring the sub-component export market and intends to be power train agnostic
  • The other risk is the delay in implementation of the emission norms which will push the new market opportunity further down the road. As per management, delays in order of months could happen but not more.
  • Cyclicality in autos is definitely a risk and needs to be managed via the valuation one pays and the allocation

Financials
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Pasting the screenshot of financials from screener below:

Important things to note

  • The auto seating business demerged in 2020 as NDR Auto. Therefore, the long term numbers should be seen in that context i.e numbers before 2021 also include the seating business revenues.

  • In the auto-ancillary space, OEMs tend to have a bargaining power. It is notable that SMIL has a negative working capital cycle as an auto-ancillary. It indicates that they may have some bargaining power with OEMs in terms of receivable days and also with their suppliers in terms of payables.

  • ROCEs are therefore, high for the business as the capital employed is less due to negative working capital and high asset turns. Management has indicated that only incremental capex is needed to grow the business indicating lower capital intensity in the business. This needs to be investigated more.

  • CFO/EBITDA is > 84% for the last 2 years

  • Management has provided a slide on adjusted ROCE excluding the seat business. Here is the screenshot:

  • As can be seen, the adjusted ROCE for last 2 years has been 57% and 116% respectively.

Valuations
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Since SMIL is a net cash business, EV/EBITDA is a suitable valuation metric:

Current market cap - 2183 crore
Net cash as on March 2022 - 454 crore
Enterprise Value - 1729 crore
TTM EBITDA - 228 crores
EV/TTM EBITDA - 7.5
Average EBITDA of last 2 years - 178.5 crores
EV/Avg EBITDA - 9.7

The valuation range is [7.5 - 9.7] based on what one chooses as denominator.

Reverse DCF

  • I did a reverse DCF on Tijori finance. Below is the screenshot:
  • At a terminal multiple of 10, the market is pricing is 3.5% of growth over the next 10 years.
  • It appears that the market is pricing in a faster de-growth in the PV/CV exhaust systems than the growth due to tailwinds in CEV/Tractors and optionalities in EV and sub-component export market.

Missing pieces in the story

  • I have not done a checklist on Management Quality yet. Aashim Relan, the CEO, sounds competent in the conf calls. However, I have not done an objective check on walking the talk, capital allocation history and related party transactions.
  • Most of the information here is from conf calls and research reports. I am yet to go through Annual Reports and look at possible accounting tricks.
  • It is not clear why Maruti is not a customer of SMIL when all other major OEMs are. This needs to be digged into.
  • All claims of the management in terms of regulations need to be independently verified through scuttlebutt.

I have heard @Rokrdude in the conf calls and would be happy to hear his thoughts on this business.
Of course, since valuepickr is a collaborative community, I am looking forward to views from everyone.

Sources

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Excellent writeup. You really have done your homework on this stock.

Thanks for the starting this thread on Sharda Motors. I have also been studying the company for the last one month and its good to have fellow VP members to discuss this stock with and gather more information on its businesses.

A few open questions for me, request folks to share answers to these if they have any insights (Especially people who may be related to the auto/emission industry). I will also write to the IR team of the company seeking answers to these questions:

  1. What is the share of traded items in their topline? It appears that they purchase catalysts at the request of certain OEMs and supply it to them at no added cost (Its a complete pass through which only adds to revenues not gets subtracted out in COGS and therefore adds no value at gross margin levels or below). This would help us gauge their true profitability and growth.

  2. What is the true moat in their products? The products aren’t very capital intensive (NFA turnover between 8-10x and doesn’t require substantial incremental capex to either increase volumes or change products for PV/LCV/HCV/CEV/Tractors). They have a large R&D Centre in Chennai with over 100 employees. Is the moat in design IP? It would be great to understand this better from some experienced folks. The industry doesn’t seem to have too many competitors, especially MHCVs and off-road vehicles due to high technology barriers. I understand that tying up with Eberspaecher gives them a technology edge, but that’s only for the JV, how strong and what are their moats for the standalone business where they supply to PVs and LCVs?

  3. Why is the Eberspaecher JV taking so much time to ramp up? FY22 revenues seem to be flat YOY at around 120Cr. They have two plants catering to two major CV manufacturers - my guess is Tata and Ashok Leyland? They have said that one of their CV clients has had a lot of issues in scaling up a new engine for which the SMIL JV has the exhaust system contract due to semiconductor and precious metal shortage issues. While I am disinclined to cast doubts on Management without proof, this reason does not really seem tenable to me especially in Q4 when semiconductor supplies started easing out. Could there be something else wrong with this customer’s supplies? The Q1 JV numbers will be critical to track here.

  4. How long are MHCVs expected to continue on fossil fuels? SMIL expects that post 2025, 80% of their revenues will come from MHCVs and off-highway vehicles where they don’t see any EV related disruption for the next decade (i.e. till 2035). How realistic is this assumption as per experts? This will have a major bearing on terminal value for the company.

  5. How well is Kinetic Green (https://kineticgreenvehicles.com/) placed to capture share in the Indian EV 2W/3W market? The JV with Kinetic Green is going to manufacture BMS and assembly battery packs (not cells) for captive usage by Kinetic Green 2W and 3W. Therefore the JVs success depends, to a large extent, on Kinetic Green’s 2W/3W offtake.

They tied up in Jan with a Chinese 2W manufacturer Aima and are talking about aggressively ramping up their production and no. of models

  1. How well and how fast can the company start exports? They plan to supply exhaust system sub-components to Tier I auto ancillaries and other non-auto engine manufacturers such as generator makers in North America and Europe by leveraging their technology and low costs due to backward integration. They are being questioned on this in every concall, but there aren’t any developments yet. Will watch this closely to check how enterprising the Management is - can it unlock export opportunities on its own?

In addition to 400Cr of cash in the balance sheet, the company also has 2 parcels of land near NCR which its willing to monetise as and when they need cash. The value of land is in 3 figures Crs. Great cash conversion, good ROCEs, high NFA turnover business, debt free with huge cash balances, legislation tailwinds, JV with a top global company - the company seems to have a lot going for it. Will the execution match the narrative?

Have a 2% position. Will add once the story becomes clearer and confidence in Management builds.

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Steady results from Sharda. 1.6% QoQ growth in revenues and 9.7% EBITDA margins, marginally less than 10.4% margin in the last quarter.

Interestingly, at consol level EPS has increased QoQ from 14.8 to 15.2 because the Eberspaecher JV has turned a profit for the first time (46 Lakhs PAT) in its existence. As per previous management commentary, this must mean that the JV has started hitting 50Cr+ quarterly revenue run rate. Good news!

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Some quick notes from Sharda Motors investor call.
(partial notes since was not able to join for first 30 minutes due to conflict):

  • TREM 4 may not be significant, however from regulatory framework perspective will pave way for TREM5 which is significant for Sharda. So far, TREM 5 proposed date is April’24 however may see some delays depending on TREM 4 implementation.

  • BS6 RDE is net neutral or slight positive on revenue since will require scale down of some parts and addition of new parts.

  • Eberspaecher JV clocked ~40 Crs and broke even for this quarter. In general, guidance of 200 Crs. per year for break even.

  • JV capacity can be augmented quickly since it’s an asset light model.

  • Have been approved under PLI scheme for existing set of products. Are still studying the finer details. However, some parts from TREM 5 will fall under the beneficial category of PLI.

  • Kinetic Green JV - Prototypes has been submitted and expected to have trail run in Q3/Q4. Will supply for both 3W and 2W for Kinetic. Positive is that Kinetic has now tied-up with a China based player for 2W tech. They are not replacing any existing vendor with Sharda. This is day-one business with Sharda.

  • Cash Utilization - Significant 500Crs+ of cash in books. Also, expecting decent cash accrual for coming years since mostly asset light. Looking for M&A opportunities in Powertrain agnostic solutions (quoted suspension as an example).


IMHO there may not be significant incremental growth in PV side hereon since they have garnered good ~60% marketshare ex-Maruti. Immediate next leg of growth driver is CV market penetration and scale-up. Asked couple of questions to clarify CV market positioning for them:

  • Question: CV Market size in value/volume terms. Who all/ how many key vendors catering to CV segment. Sharda’s relationship with each of the two major CV OEMs.
    Answer: CV market size is as big as current PV market size. Predominantly two CV OEM and two vendors play. Sharda is supplying for 1-1 engine specific models for both the OEMs.

  • Question: Sharda’s marketshare in CV segment was in the range of 10% -15% a year back. Is there any change to market position now?
    Answer: In the range of what it was a year back (inference ~15%)

  • Question: One of the CV OEM has own subsidiary into emission control products. Why would they source from Sharda?
    Answer: Currently that subsidiary is manufacturing multiple parts of the emission products. Also, that sub is into other lines of manufacturing (i.e engine parts etc.) Sharda is doing canning work for them on emission control products. Going ahead Sharda can look at supplying the end to end emission control product.

[not fully convincing answer though].

  • Question: Second major CV player may be working with a different vendor for the emission control products for their PV business. Would they not prefer working with the same vendor for CV side of business as well?
    Answer: CV Emission solutions are much more complex then PV. Hence, vendor capability to be evaluated independently.

@nirvana_laha - Noticed that you joined the call and asked couple of questions . Please share your notes (specially for first 30 mins of the call).

Disc: No Investment
Regards,
Tarun

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My questions on Sharda concall and the answers:

Q1. Company mentions in presentation that TREM V may be delayed by 1 year
A. That’s company’s assumption, given TREM IV has been delayed from Apr to Oct 2022. May not get delayed as much, have to wait and see.
Q2. When will the company start seeing orders for TREM V given a launch date post Apr 24?
A. The company is already in talks with all major tractor manufacturers regarding design of TREM V products. Company expects to take market share equal to or more than its PV/LCV market share (Around 30%) in the tractors segment and so far traction with OEMs is in line with those ambitions. They expect 2 major suppliers including them to be active in TREM V orders with the 3rd CV incumbent not as active in the tractor segment
Q3. Management had earlier guided that Eberspaecher JV needed 50Cr Qtrly value added revenue run-rate to break even, but it has delivered 50Lakhs profit this Q on a value added turnover of 44Cr, have costs come down?
A. Costs have partially come down due to efficiencies but numbers are ball-park in the region of earlier guidance. Next few Qs should be profitable for JV given uptick in CV demand.
Q4. How many engine systems is Sharda supplying to for each of the 2 CV clients under the JV? What ball-park proportion is this number of the total engine programs run by these 2 clients?
A. Sharda is currently supplying to 1 engine program each under the JV. Not aware of total number of engine programs that are run by these clients (Surprising that he doesn’t know, may be did not want to disclose)
Q5. Given that the standalone business (PV + LCV) is capital light and capital doesn’t become a barrier for entry, what makes Sharda the only Indian company capable of fighting a 3-4 horse race in this segment with other competitors who are predominantly subsidiaries of foreign originated companies?
A. [passionate answer here given by Aashim Relan] There are several reasons for this:

  1. Sharda entered the emissions space for BSIV/BSVI very early in the late 90s. That has given them a big competitive advantage in terms of developing their R&D capabilities.
  2. R&D is the moat for them = 100+ engineers in R&D Centre in Chennai (10% of total employee base). Their technologies are now on par with global counterparts and hence they see exports as a large upcoming opportunity
  3. Full backward integration with tube mills and stamping plants which gives them a cost advantage that can’t be replicated easily
    Any new entrant will take several years to build these capabilities as per Mr. Relan.
    Q6. Will the Kinetic JV supply to Kinetic’s 2W only or 3W also (Kinetic has a good market traction in 3W)? If yes, will Sharda-Kinetic JV replace existing BMS supplier for 3W? When is Kinetic expected to manufacture their first 2W batch?
    A. Yes, JV will supply to 2W/3W both. They may not replace the existing vendor but will share the business/focus on a share of incremental volumes (Hesitant answer here, I think he was being diplomatic. My expectation is they will try to replace the vendor once POC is done; Otherwise why make a JV for captive supply?). Kinetic EV 2W production schedule is still dynamic and he isn’t sure of timelines but tie-up news with China’s Aima in Jan was very positive news as per him. Expect trial supplies to start from Q3 FY23.

Apart from this, some general notes on the call:

  1. They keep getting questioned on why they can’t divulge split of revenues into value added and pass-through. Their answer is that this is confidential information and they are yet to receive approval from 2-3 clients to divulge this. Once they get the approval they will stat disclosing the split.

  2. They also keep getting questioned on why revenue numbers don’t align with volume/revenue growth numbers of CV/PV players YOY. For e.g. Growth rate of revenues for OEMs has been far higher than Sharda revenues YOY for the last few Qs. Their answer is that their sales numbers are linked to engine production numbers and not to vehicle sales numbers. There are a lot of stages between their supply and vehicle sales : Sharda supply to OEM, OEM maintains exhaust inventory → OEM manufactures engine and maintains engine inventory → Based on semi-con availability, OEM assembles cars and maintains car inventory → Car sales happen as per demand. As per Mr. Relan, this long supply chain makes 1:1 correlation of retail/wholesale OEM sales and Sharda sales difficult. I am not entirely convinced by this answer, maybe part of the reason is inventory stocking and de-stocking at OEM end. Management has repeatedly assured that they have not lost any market share and hope to grow faster than OEM growth rates this year as they have done for the last several years.

  3. Exports and acquisitions - Still scanning for acquisitions and export opportunities, will update when there is a material development. For exports, they have received some RFPs/bid for some RPQs and expect developments in the future. For acquisitions they are looking at powertrain agnostic options (I don’t mind them taking a few Qs more but if they can nail the right acquisition in a powertrain agnostic space, that might increase their terminal value substantially)

  4. Plans with 500Cr B/S cash - First priority is to deploy it in business i.e. acquisitions. If acquisitions don’t materialize, then will look at returning it back to shareholders via dividends (No timelines given)

  5. Capex plans - Only incremental capex needed to capture future growth including CEV V and TREM V, capex expected to be in line with last few years’ trend.


My views:
PV/LCV segment : They have a large market share here, so unless they crack Maruti, explosive growth opportunities here will be limited, they will grow as per ex-Maruti industry growth. BS VI RDE will only provide incremental additional value added revenues.

MHCV : Growth opportunity is lucrative here. They are at 180Cr run-rate and can do max 400Cr without additional capex. Enrolled with one engine program each with 2 leading CVs, if they can get themselves enrolled in a few other programs or these engines scale up fast for the OEMs, growth here can be fast. Exports in Asia are another lucrative opportunity due to low cost base for Eberspaecher out of India.

CEV/Tractors : Can add a new market as large as existing PV/LCV market. This is the most exciting growth lever especially as Sharda is already supplying TREM V compliant systems to these players for their exports. So there is not much technical challenge to scale, the market seems to be there for the taking and Sharda’s inputs on trials etc. already having started is quite bullish. Can provide a great revenue and EBITDA spike FY24 onwards.

Exports: With the kind of technical capabilities they claim to have, there is not reason they can’t get a small foothold in exports either in the standalone business or in the JV (JV exports are more exciting to me as standalone exports are likely to be low value add)

Open questions for me:

  1. Why can’t Sharda crack Maruti? Does Maruti have an in-house supply system?
  2. Who are the 2 CV clients for the JV - are they TATA and AL or TATA And Mahindra? Which one of them has a subsidiary manufacturing exhaust systems (@T11 Maybe you can answer this)
  3. How many engine systems do these 2 CV clients have and what will it take for the JV to increase their market share with these 2 players? Will it be a slow ramp up as the clients test out their supplies for a period of years and then allow them to apply for other engines or can they exploit the opening created by OBD II?
  4. What is the expected kit value of BMS + cell assembly for 2W/3W (Can we get this info from other players in India/abroad)? How serious is Kinetic’s bid to become a major player in India EV 2W market? I have shared links above which mention big numbers like 500000 units per year ambition, but does the Kinetic Group have what it takes?

Disclosure : Invested.

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