Shanthi Gears: Buy

Industrial gears maker Shanthi Gears' restructuring exercise can be expected to trigger a re-rating in the stock. This makes it a good growth play for investors with a two-three-year perspective. While the company's shift in focus to customised gear products has propped up profit margins, its likely forward integration into compressors/mining equipment and manufacturing of high-end gears can be expected to reduce risks of being present in a low-end segment. The company's cash-rich and almost nil debt status make it a relatively safe play in the small-cap market segment.

With a market cap of Rs 670 crore, the stock of Shanthi Gears fell 8 per cent year to date as against the 25 per cent decline seen in BSE Small cap and 17 per cent dip in Sensex. The stock's performance appears to be buttressed by sound fundamentals. Investors can take limited exposure to the stock. At Rs 41, the stock trades at eight times its expected per share earnings for FY-13. We have not considered the additional earnings (which could be significant) from newer products, pending their production.

Coimbatore-based Shanthi Gears makes a wide range of standardised and customised gears for a number of industries, including steel, textiles, cement, infrastructure, power and wind energy. Gears are used in almost every equipment-making/consuming industry. The market for Shanthi Gears' products is therefore driven by both demand for new equipment as well as replacement demand.

In an effort to reduce/discontinue low-end standardised products, the company declined accepting orders with poor margins and shifted some of its equipment in two of its units to other locations; to be used in a more flexible manner for custom-built products. This also meant scaling down of operations in FY-10. Sale of gear wheels and accessories, for instance, dipped by 39 per cent in FY-10. This was the case with another major revenue driver, gear box and accessories.

However, with a part of the restructuring exercise being complete, operations bounced back significantly in FY-11. Production levels though remain lower than in FY-09, with two units being underutilised.

Despite this, sales for FY-11 expanded a healthy 32 per cent to Rs 160 crore, while profits increased 72 per cent to Rs 28 crore. EBITDA margins jumped 5 percentage points to 45 per cent in FY-11 and FY-10 compared with earlier years. Shanthi Gears has a notable advantage of owning its own foundry, a key for controlling costs and quality of its gears. This is one reason for the company enjoying very high operating profit margins.

Scaling up

The scaled down operations now provide scope for more custom-built products (with existing machinery) as well as forward integration. As part of its restructuring plan, the company is in the process of manufacturing products where gears play a predominant role. Compressors or mining equipment products are typical examples.

While the compressor market now has dominant players such as Atlas Copco and Elgi Equipments, Shanthi Gears may not find it to difficult to capture market share for two reasons: One, import of compressors of all kinds (in volume) is over a third of domestic consumption (CMIE 2009-10), which means that there is sufficient scope for local production to substitute imports.

Given that Shanthi Gears is targeting high-end products — typically addressed by imports — the option appears viable. Two, Shanthi Gears has itself, in the past, supplied gear box to foreign players such as Atlas Copco or David Brown.

Its proposed forward integration may mean that it can produce the end product too. We expect the results of the restructuring plans to be visible from FY-13. Its restructuring plan also entailed hiring a professional CEO.

Currently, Shanthi Gears generates over 50 per cent of revenues from customised products. While these enjoy very high margins of 50-60 per cent, a further focus on such products would result in prolonging delivery time to three-four months from just a few weeks for standard products. To this extent, longer working-capital cycles and, perhaps, relatively lumpy revenues may be an inevitable change.

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