Varroc decides to consolidate. Divesting out of the challenging operations in US and Europe.

Target Date - September 30, 2022

This is what some investors had wanted and that’s exactly what Varroc Engineering Ltd (VEL) has decided.

Key announcements –

  • VEL has entered into a definitive agreement with Compagnie Plastic Omnium SE, France to divest its 4-Wheeler lighting business in the Americas and Europe
  • Agreed consideration is an Enterprise Value of EUR 600 mn (approx Rs 4,800 cr) for 100% of the entities located in the Americas and Europe along with acquisition of the global R&D operations in India (Pune)
  • Net Cash Accretion to VEL, post-tax and net of escrow, estimated to be between Euro 160- 175 mn (i.e,. Rs 1,280-1,400 cr) subject to closing adjustments ; escrow of Euro 35 mn (i.e., Rs 280 crore) to be released over the next 2-3 years
  • Transaction is expected to close by the end of Q2FY23 i.e., September 30, 2022.
  • As the R&D operations in Pune is part of the divestment deal, VEL is setting up a new wholly owned subsidiary to separately carry out the research and development activities.

Key implications of the transaction –

Decision is primarily targeted towards reorganisation of VEL’s focus as well as financials.

Checkout the following two key charts/ tables.

Post divestment, VEL will be primarily focused on the Indian market and some selective international business. The retained business mix will have lower revenues but better margins and most importantly a debt-free status.

So does it make Varroc an attractive buy now?

  • In terms of focus, I personally believe this is a right decision. Managing international operations is not everyone’s strength and given the available opportunities within India, VEL may be better suited to significantly focus on the same. However, some investors may consider this transaction to be a compromise on the future growth potential in US and Europe and hence may not be happy. Many might also consider the divestment to be happening at the bottom with related implications on the agreed consideration value. General consensus is that going forward the chip supply is going to improve and commodity prices might also normalise – and hence also the prospect of VEL business in these markets.
  • Divested business revenues are approx Rs 6,000 crore annually and selling this at an approximate consideration of Rs 4,800 crore implies a valuation of 0.8x of trailing revenues. This prima facie does seem to be on a lower side.
  • Retained business key metrics –
    • Annual revenues of Rs 6,000 crore, expected to grow at about 10-15% in the foreseeable future.
    • Current EBITDA margins of about 7%, expected to increase to 10-12% over next couple of years. Factoring this, I would expect an EBITDA of about Rs 650 crore by FY24. Once transaction closes, company will be debt free and hence negligible interest cost. Net of depreciation and taxes that would mean a PAT of about Rs 250-300 crore.
    • Current market cap of the Company is Rs 7,000 crore implying a 2 yr fwd P/E of > 20x. This doesn’t seem too attractive currently and hence I will keep the stock under watch and would not be in a hurry to invest.

Key monitorables for me –

  • New business wins especially in the EV space. As of now it primarily works withe Bajaj in EVs – 2 wheeler and 3 wheelers.
  • Any significant correction in the stock price making it’s valuations attractive.
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