Company description

Ashok Leyland (ALL) is owned by the Hinduja Group (which has an equity stake of 50.9%). ALL is the second-largest CV manufacturer in India, with a strong focus on medium and heavy commercial vehicles (MHCVs). The company's core product portfolio comprises MHCVs (goods vehicles and buses), and it also manufactures a range of vehicles suited for defense and special applications. Its recent successes in the export market are indicative of its product quality. Sales of spares and engines add to revenue and earnings, especially during cyclical downturns.

What's new

Ashok Leyland has announced it will enter into three JVs with Nissan – 1) a manufacturing JV (in which ALL will hold the majority stake), 2) a powertrain manufacturing JV (wherein Nissan will hold the majority stake), and 3) a technology development JV, in which both Nissan and ALL will hold 50-50 equity stakes.

Capital outlay remains undisclosed

Management indicated that capital outlay for all three projects, as well as the funding mix, will be disclosed at a later date (probably Oct.). We contend the manufacturing JV (with an ultimate capacity of over 100,000 units) will probably have an outlay of USD 200 million. Commercial production is forecast to commence 18-24 months from now. Execution risk remains the key risk in this initiative.

Mutually beneficial alliance

Ashok Leyland gets access to Nissan's engine / powertrain and product technologies. Nissan gets access to the high-growth Indian market. We think that it might also be able to utilize ALL's distribution network and vendor base. The ALL-Nissan ventures will have a complete product range spanning the light truck market, with payloads ranging from 0.35-4MT.

Reiterate Sell

Risk/reward ratio currently appears unattractive on ALL, even at the current stock price. Burgeoning capital outlay on various initiatives is a concern. Reiterate Sell (3L). Key Upside risks: a) a sharper-than-expected growth in HCV volumes over FY08E, b) decline in material costs and rebound in margins.

Investment thesis

We have a Sell / Low Risk (3L) rating on ALL - valuations being the primary concern. We believe the stock currently prices in all positives. Fundamentally, key reasons for a healthy growth outlook in commercial vehicles include a sustained pick-up in economic activity, a focus on infrastructure spending and astrong replacement cycle (27% of the existing fleet in India is more than 15 years old and needs to be replaced both for commercial and environmental reasons). Moreover, growth in the agriculture, infrastructure and manufacturing sectors – all of which have positive linkages to the freight business - should remain positive. ALL is raising capacity by c30% over the next two years to meet demand, and plans to launch new products. In the long term, exports couldemerge as a growth driver as ALL leverages off its low-cost competitive advantage to enter foreign markets.

Valuation

Our 12-month target price of Rs 39 for ALL is based on 8.55x FY08E cash earnings. Our target multiple is at a 20% discount to the multiple we assign toTata Motors, which we believe, correctly reflects ALL's substantially smallers cale of operations and less diversified revenue profile. (ALL is not present in passenger cars or utility vehicles and has an extremely modest presence in light commercial vehicles.) A c18% CAGR in cash earnings over FY06-08E should support these valuations. We prefer to use P/CEPS as a valuation metric to ensure proper comparison with historical trading bands, a restructuring of the balance sheet in FY03 and the capital-intensive nature of the business. At our target price, the stock would trade at a P/E of 13x FY07E EPS, in the middle of its recent trading band. This appears well supported by a 20% CAGRin earnings over FY06-08E.

Risks

We rate ALL Low Risk based on our quantitative risk rating system, which tracks 260-day historical share price volatility. The key risk factors to our target price are movements in economic variables - particularly GDP growth, interest rates and fuel prices, to which sales of commercial vehicles are very sensitive. Input costs are volatile and linked to global commodity prices for metals, plastics, etc. The profitability and viability of the STUs over the long term is an important risk factor, given that the STUs are the largest buyers of ALL buses. Key upside risks which could drive the shares above our target price include: 1) Greater-than expected volume growth on account of the Supreme Court ruling on overloading;2) Reduction in input costs (notably steel and aluminium) would benefit earnings; 3) Effective integration of the Avia acquisition could enable ALL to successfully penetrate the domestic LCV market.