The Setco Automotive stock is a good bet on the cyclical turnaround in commercial vehicle (CV) sales. Setco’s market leadership position in the supply of clutches to trucks and buses, and its diversified clientele provide good visibility to earnings growth in the next one to two years.

Market volatility has seen the stock price drop over 20 per cent from the one-year high of ₹293 it touched in early January 2015. Valuations too, are reasonable at 26 times trailing 12-month earnings.

Other small-cap CV parts makers, such as Jamna Auto Industries and ZF Steering, trade at around 30 times. Hence, the current price of ₹231 seems an attractive entry point for investors. But it is advisable to take limited exposures, considering that the stock is a small-cap one (market capitalisation is just ₹610 crore).

Strong momentum Setco supplies clutches to medium and heavy truck and bus manufacturers through the ‘Lipe’ brand and has about 85 per cent market share in this segment.

The company caters to the entire requirement of Tata Motors, Volvo and Bharat Benz in India, and 60-70 per cent of the requirement of Ashok Leyland. Eicher Motors and AMW are also among its customers.

The turnaround in commercial vehicle sales bodes well for the company. From a 25 per cent drop in volumes in 2013-14 compared to the previous year, medium and heavy trucks and buses showed a convincing revival during the last fiscal year, growing 16 per cent. The trend has continued in the first three months of this fiscal too, with sales volumes growing by 23 per cent year-on-year.

With manufacturing and mining activities slowly recovering, greater demand for freight carriage can aid volume growth in commercial vehicle sales in the coming months. Interest rate cuts by banks will also serve as a springboard for a further pick-up in volumes.

Diversification strategies put in place by the company augur well. Setco has recently expanded its offering to light commercial vehicles and is also getting into tractor clutches.

This diversifies the revenue base as tractor sales are independent of the CV cycle. For instance, in the thick of the auto industry slowdown in 2013-14, the tractor industry recorded a volume growth of over 20 per cent.

In contrast, as CV sales are recovering now, tractors are passing through challenging times. Ditto with light CVs.

While the heavy trucks segment is always the first to be affected in any auto industry downturn, light trucks tend to hold up better during the initial leg of a slowdown.

Besides, while Setco provides spares to the replacement market through authorised stores of vehicle manufacturers, it is also building an independent sales network. Venturing into independent sales towards the end of fiscal 2013-14, the company quickly ramped up revenue in this segment to 18 per cent of the total revenue in 2014-15. This segment should help bring higher margins as bargaining power of auto part suppliers is generally higher in independent sales.

Better times Setco’s financials looked up last fiscal, in line with improving CV sales. The company’s net sales grew 39 per cent year-on-year to ₹458 crore for the year ended March 2015.

Net profit moved up to ₹23.5 crore, clocking a 48 per cent growth. Operating margin improved 200 basis points to 12 per cent. Apart from independent spares sales, backward integration should also boost the company’s profitability.

In May 2014, Setco entered into a joint venture with Spanish company Lingotes Especiales to manufacture machined ferrous castings that go into making various components.

The company has also set up an in-house manufacturing capacity for diaphragm springs to substitute imports of this input.

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