Statutory Warning: This is NOT an investment advice to buy or sell shares. Please make your own decision, as blindly acting on anyone else’s research and opinions can be injurious to your wealth. I do not own the stock, but my analysis may be biased, and wrong. I have been wrong many times in the past. I, Vishal Khandelwal, am a registered Research Analyst as per SEBI (Research Analyst) Regulations, 2014 (Registration No. INH000000578).
India commands around 2.5% of the global geographic area and has access to around 4% of the total water reserves. This supports a huge 18% of the total global population and 15% of the total global livestock. The lack of natural resources like land and water and increasing infrastructural development limits the ability to increase cultivable land. Hence, this makes a compelling case for increasing crop yields domestically. Farm mechanization i.e., usage of machinery and technology (e.g. tractors, tillers, transplanters, harvester, pumps, etc.) in farming is the most sought after solution for increasing farm yields. This is given increasing concerns over pesticide residues in our food value chain and shortage of farm labour on account of a shift in labour from rural to urban and diversion of workforce in MGNREGA.
Let me now talk a bit specifically about the tractor industry in India. The industry has seen a decent 8% CAGR in volumes over the last 40 years. During this period, growth was especially strong first during 1973‐2000 (10% CAGR in tractor volumes) and then 2003‐2014 (10%). However, the industry has gone through bad periods in its growth cycle, with 10 years of decline seen during these 40 years, which has largely been a result of two factors – weak monsoons and decline in farm incomes led by lower minimum support priced (MSP) for food grains. In fact, unlike what is the general belief that monsoons have been the most critical component in the growth of the Indian tractor industry, it’s the movement in MSPs that has played a larger role over the years. In fact, in periods following more than 10% MSP hikes, tractor demand has grown in double digits. However,when MSP hikes have been weak, tractor demand has remained weak (even in good monsoon years).
Talking about the growth potential, it remains promising. Consider that even after being the largest market in the world as far as tractor sales is concerned, India has amongst the lowest penetration of the machine per 1,000 hectare of land. And because of this and overall low levels of farm mechanization, India has one of the lowest agricultural yields in the world currently.
Currently, India produces around 110 million tonne of rice a year from 44 million hectare of land. That’s a yield rate of 2.4 tonne per hectare (t/ha), placing India at 27th place out of 47 countries. China and Brazil have yield of 4.7 t/ha and 3.6 t/ha, respectively. Egypt leads the world in rice yields at 6.6 t/ha. At Egypt’s yield rate, India could almost triple its rice output.
As far as wheat is concerned, India has a higher yield rate than for rice, but it still lags a large part of the world. With 93.5 million tonne of wheat from around 30 million hectares, India’s yield rate of 3.2 t/ha places it 19th out of 41 countries. Here, we do better than Brazil’s yield rate of 2.7 t/ha, but lag behind South Africa (3.4 t/ha) and China (4.9 t/ha). Of course, if we were to produce wheat at the rate at which New Zealand does (8.1 t/ha), the highest in the world, then we could produce 2.5 times what we currently do.
Increased farm mechanization is one of the key ways to improve the yields, which could drastically reduce the amount of land needed to produce the current quantity of food grains, which would subsequently free up that land for other purposes. While one could argue that penetration of tractors in India looks low due to highly fragmented land holdings, I believe that even after excluding marginal farmers, there is a huge scope of penetration growth.
Analysis of state‐wise data suggests that states with higher penetration of tractors, enjoy better and improving yields. For example, India’s biggest tractor markets of Punjab and Haryana have significantly higher yields compared with the rest of India. While irrigation has a major role to play in this, states like West Bengal, Uttar Pradesh, Andhra Pradesh, and Tamil Nadu have higher yields due to relatively higher tractor penetration.
Going forward, I see four growth drivers for the tractor industry in India – greater farm mechanization, cheap and widespread credit availability, and spread of contract farming where business establishments provide farmers with specialized farm equipment and various amenities to improve crop yield through the adoption of latest agricultural technologies.
About Swaraj Engines Ltd. (SEL)
SEL was set up by the Government of India in 1985 for the propose of manufacturing diesel engines for Punjab Tractors, which marketed their products under the Swaraj brand. The company commenced production at its facility in Mohali in 1988 and has been a profitable entity since then. It is currently a joint holding of Kirloskar Industries (17.4% stake) and M&M (33.2% stake) with M&M the main promoter consequent to its acquisition of Punjab Tractors in March 2007. SEL serves the requirements of M&M’s Swaraj brand of tractors.
It manufactures engines catering to tractors in the 20-50 hp segment and caters to around 85% of the total engine requirement at M&M’s Swaraj tractor division. The company has a current installed capacity to manufacture 105,000 units of engines. The company also manufactures hi-tech engine components for commercial vehicles for SML Isuzu (erstwhile Swaraj Mazda). The contribution to the topline from this business, however, remains limited to less than 3%.
Let me now analyse the company using a set of questions to test the underlying business and management quality.
- Has the company done well in terms of sales and profit growth over the past few years?
Despite the weak last two years on the back of poor monsoons and thereby decline in tractor demand, SEL has done extremely well over the long run. Over the last nine years (FY07 to FY16), its sales and net profits have grown at average annual rates of 17% and 15% respectively. Over the past five years, however, sales and profit growth have been muted at CAGR of 8% and 3% respectively, for reasons mentioned the at the start of this paragraph. What is important here is that despite this interim weakness in sales, the company has continued to see an increase in its market share in the volume sales of tractor engines. This has been a direct result of the increase in market share of the Swaraj brand of tractors that M&M sells, from 9.2% in FY08 to 13.8% in FY15, which is commendable given the intense competition the Indian tractor industry has faced over the years.
After having achieved 100% capacity utilization in FY14 (around 75,000 units), SEL undertook an expansion plan wherein it has expanded its capacity to 105,000 units. The company is also developing engines in the >50 hp segment that will further help augment sales and margins (high hp tractors are more profitable than low hp). Going forward with the government’s thrust on increasing farm yields through increasing penetration of farm mechanization and Swaraj tractor’s strong brand recall, I see SEL on a good footing.
- How profitably have retained earnings reinvested?
Extremely profitably. The return ratio profile for SEL has been superior with 5-year average RoE at around 28% during the FY12-16 period. The company has also managed 15% operating margin during this period. Going forward, on the back of a pickup in tractor demand in India, and specifically that of Swaraj brand, margins and return ratios are likely to inch up.
- Does the business have a durable competitive advantage?
SEL, after being acquired by M&M, has drastically improved its working capital cycle with net working capital days reducing from 42 days in FY08 to four days in FY09. Thereafter, the net working capital has either been marginally negative or zero thereby implying prudent capital management. This has resulted in strong cash flow generation for the company. Overall, since the company is the exclusive supplier to Swaraj brand of tractors, it doesn’t have to worry about competition, and thus the point of having a competitive advantage is almost irrelevant here.
- How has the management fared?
SEL’s management has a good, clean reputation and has done well on the execution front. The compensation levels of the top management team members are also within reasonable levels.
- What are the risks to the business?
SEL’s biggest risk arises from India’s monsoon. As the business is a proxy play on farm mechanization domestically, the company is not immune to the performance of the south west monsoons, which affects the purchasing power of domestic farmers. It has been observed that in case of below normal or deficient monsoons, SEL’s sales volume growth is adversely impacted. In FY13, for instance, when monsoons were below normal at 92% of long period average (LPA), sales growth was muted at under 4% compared to healthy double digit growth witnessed in the past. In FY15, when monsoons were deficient (88% of LPA), SEL witnessed sales volume de-growth of 13%, thereby showing its vulnerability to south west monsoons.
SEL’s stock is currently trading at around Rs 1,130, which implies a P/E multiple of 25.6x its trailing 12-months earnings of Rs 44 per share.
With timely expansion programmes (FY11; capacity increased from 36,000 units to 42,000 units; then to 60,000 units in FY12 and then finally to 75,000 units in FY13) coupled with increasing market share of the Swaraj brand of tractors and SEL being present in all major tractor hp segments, the company looks to be on a strong footing. You, as an investor, must however consider both sides of the case – opportunities and risks – plus ensure sufficient margin of safety in the stock’s price, before making any investment decision.
Statutory Warning: This is NOT an investment advice to buy or sell shares. Please make your own decision, as blindly acting on anyone else’s research and opinions can be injurious to your wealth. I do not own the stock, but my analysis may be biased, and wrong. I have been wrong many times in the past. I, Vishal Khandelwal, am a registered Research Analyst as per SEBI (Research Analyst) Regulations, 2014 (Registration No. INH000000578).[/show_to] [hide_from accesslevel=’almanack’]
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