Edelweiss has upgraded their recommendation on Bajaj Auto to accumulate from reduce on greater visibility on volume outlook, new product launch, and margin improvement.

Edelweiss report on Bajaj Auto:

Bajaj Auto’s Q1FY08 results were lower than ours and consensus estimates. Adjusted net profit was down 18.1% Y-o-Y to Rs 2.26 billion. EBITDA fell 23.7% Y-o-Y to Rs 2.75 billion. EBITDA margins were at 13.1%, down 330bps Y-o-Y. We believe the margin outlook for the next 2-3 quarters is much better and margins are expected to improve to 15% on account of price revisions, ramp up of Uttarakhand plant, and launch of a new bike (on September 9, 2007) that is likely to be much more profitable than the company’s other low-end products in the segment. We are upgrading our recommendation on the stock to ‘ACCUMULATE’, post the recent price correction and improving margin and volume outlook for its core business.

Key Highlights

Lower than expected results in Q1FY08

Net sales (at 21.09 billion), were down 4.2% Q-o-Q, primarily on account of falling volumes, though average realisations improved 8.5% Y-o-Y on the back of improving product mix. EBITDA fell 23.7% Y-o-Y to Rs 2.75 billion and EBITDA margins were at 13.1%, down 330bps Y-o-Y. Adjusted net profit was down 18.1% Y-o-Y to Rs 2.26 billion. Further, staff costs, as a percentage of sales, increased 80bps Y-o-Y due to bonuses and increments given in the quarter. In addition, other expenses increased 44bps because of higher advertising expenditure.

Margins set to improve

We expect the company to improve its margins to 15% in the second half of FY08 on back of price revisions, ramp up of Uttarakhand plant, and launch of a new bike that is likely to be much more profitable than the company’s other low-end products in the segment. The new bike’s contribution to the company will be similar to that of Discover. We expect at least 70bps improvement in margins only from lower staff costs on account of non-recurring items worth Rs 150 million.

Other highlights

We believe that outlook for the rest of the year for the core auto business of Bajaj Auto is much better:

We expect margins to improve Q-o-Q Q2FY08 onwards to reach 15% in the second half of the year through the recent price increases on the Platina and Discover 135, and ramp up of its Uttarakhand facility.

Inventory levels have come down to around 4-5 weeks of sales among dealerships, compared to 6-7 weeks in April.

The company is set to launch its new bike on September 9, 2007 which is likely to have a higher margin contribution than the company’s current low-end bikes like Platina. The new product is based on a new digital twin spark swirl induction (DTSSi) technology, to provide higher torque and power together with higher fuel efficiency along with a hot of other features. The management expects to sell 15,000 units of this model initially and ramp up to 50,000 units in 3-4 months.

The company has launched the Pulsar 200cc, the Discover 135cc, and the Pulsar 220cc in the past few months.

The company has test marketed a new fuel efficient 2-stroke three-wheeler in the threewheeler passenger segment, in which it already enjoys a dominant position. Over the medium to long term, the company expects to replace the three-wheeler product range with a light vehicle platform it is currently developing, which it expects to launch in 2009.

The company expects to incur a capex of Rs 4 billion for FY08 for capacity expansion at Uttarakhand and Chakan plant, and a new product launch from the Waluj plant. In addition, the company will start work on the new plant in Chakan for manufacturing the light vehicle. The market value of its investments is around Rs 90.77 billion as on June 30, 2007 as against Rs 86.48 billion as on March 31, 2007.

Valuation

Our EPS estimate stands at Rs 143 and Rs 172 for FY08E and FY09E respectively. At CMP of Rs 2195, the stock trades at 15.3x and 12.8x FY08 and FY09 estimates respectively. Our SOTP valuation for Bajaj Auto is Rs 2,546 per share, with the insurance business being valued as per the agreement with Allianz, and with a 25% holding company discount. We are upgrading our recommendation on the stock to ‘ACCUMULATE’ from ‘REDUCE’ on greater visibility on volume outlook, new product launch, and margin improvement.