Varroc Engineering: Business Analysis

2nd largest Indian auto ancillary company.

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A Thread

1/ Tier-1 Auto ancillary company

2 business lines:
- Varroc Lighting Systems (VLS): Provides exterior lighting to global PV OEMs for ex. Tesla, VW | 66% of rev
- India business: Polymer, Electrical-Electronics and Metallic components to 2W (majorly), 3W, and 4W OEMs | 34% of rev

2/ Before we go deeper, Let's look at the financials: P&L

While Rev has constantly grown, The margins have suffered

Gross margins are down from 37-38% pre-covid to 30-30-32% now & EBITDA from 9% to 3%; resulting in big losses.

Depreciation has shot up from 250crs to 900crs!

3/ Balance Sheet & CashFlow

Varroc started its capex (6Kcrs since FY15) & even though cashflows remained +ve; had to take on a ton of debt to meet those obligations

2 events hit them: Global Automotive slowdown since the end of 2018 (cyclic industry) & COVID-19.

4/ The promoter had big plans for FY21 by when they planned to reach 20Kcrs rev.

However, this growth hunger led to the current descent as capacity expansion is already complete but the demand for parts from OEMs is not there due to supply or demand-side challenges.

5/ The situation turned so bad, such that the very question of survival has come into play.

However, one has to understand the obligations at this point in time.

6/ All Capex is done, nothing other than maintenance is required which is taken care of by the Indian business that continues to make 400-500crs of OCF now; this is also enough to take care of the interest costs of 150crs a year

Note: No incremental Working capital requirements.

7/ The Semiconductor shortage is the biggest challenge in the next 1yr which looks to have already seen its worst & easing as we write this.

The thing is if Varroc is able to persist through this period & nothing else hits the automotive industry, the future looks better.

8/ Strengths:

Robust sticky relationships with global OEMs: would take years to switch to an alternate supplier (as lightings take 2-3 years to develop)
- One of the reasons why they are struggling now as products that came into the order book in 2018 will get dev only by 2021.

9/ Promoter ownership at 75% (was 85% after IPO: decreased recently through QIP to comply with SEBI rules) & engagement with the investor’s community is high.

Promoter hasn't missed a single concall since the IPO, always explaining his challenges in detail & with utmost honesty.

10/ Have spent 6K+crs in capex & 2.5K+crs in R&D (hired 1200 engineers in 15 R&D centers) over the last 6 years.

Low-cost nearshore operations: To service Europe, plants are situated in the Czech Republic, Morocco, etc. & to service the USA, plants are situated in Mexico.

11/ R&D driven organization: 173 valid patents globally; 183 patents applied | 4-6% of Rev is spent on R&D yearly

One of the leaders in the 2W & 3W EV component space.

Gaining market share in VLS: from 4.3% in 2016 to 5.6% in 2020 (market growing at 5-6%)

12/ Weaknesses:

High debt which will take ~2 good years to clean out: low capital flexibility till then.

Layed off partial R&D team (300-400); could come to bite in an upcycle where scale-up could take longer.

13/ Complex capital structure: Very difficult to ascertain the movement of cash.

High client concentration+ Geographical concentration (50% of rev from Europe)+ Vehicle type concentration (65% from global PV & 30% from India 2W market)

14/ Conclusion

At less than 0.4x P/S; a lot of negatives seem priced in if they are able to survive through this extended harsh environment.

A probable operating & financial leverage could play out in the years to come if the Auto upcycle plays out across the world.

End.