Clutch Auto Ltd.

Company Background

Clutch Auto, established in 1971, is India's largest clutch manufacturer and exporter with over three
decades of undisputed leadership. Its production facility is located at Faridabad. The company enjoys over
60% market share in tractors and commercial vehicles (CVs). Its clientele includes Tata Motors, Ashok
Leyland, Maruti Udyog, Mahindra & Mahindra, Bajaj Auto, TAFE, Toyota, BEML, Escorts and State-run
transport undertakings. In CVs, it is a major supplier to Tata Motors with a 60% market share. It has
dominant market share of 80% in tractors and supplies to all manufacturers in India.

CAL is growing both organically and inorganically. In FY05, it expanded clutch plate capacity by 122% to
2 millions pieces and trebled clutch cover capacity to 1.5 millions pieces at capital expenditure (capex) of
over Rs 5 crore. It acquired the clutch division of Pioneer Inc, US, in March 2006, which was renamed
Pioneer Clutch Inc.

Thrust on exports
CAL is targeting the US heavy-duty clutch market (estimated at $550 million) with its patented products.
The acquisition of the clutch division of Pioneer Inc will strengthen its foothold in the US. Pioneer is a
quasi manufacturing and distribution company in the US with a warehouse facility of over 55,000 square
feet, access to 7 warehouses, 20 marketing networks, sales force of over 100 people, and most importantly
a client base of 500 companies in the replacement market. Pioneer's established distribution would help
CAL acquire the formers' clients.

The company has bagged a five-year order worth US$60 million from Fleet Pride, which should further aid
its export growth. Fleet Pride's established network would also enable CAL tap the formers' clients. We
expect export revenues to grow at a CAGR (FY06-08) of 78.8% to Rs 153.6 crore in FY08.

Product patents - a competitive advantage

CAL manufactures 500 different types of clutches including 16-patented products. It has 7 product patents,
which have been approved but are awaiting registration. The company is confident of receiving the
registrations in the current year. Further, it also has another 14 products under patent filing. Out of the 21
products, patents for 12 (10 in the US) are pending for overseas market. The approval of patents would
open up a huge export market for the company.

Debt restructuring to boost net profit

The company is repaying its high-cost debt with funds raised by issuing preferential warrants worth Rs 49
crore. It has also managed to raise funds at cheaper interest rates from the Technology Development Board
(TDB) and a few banks, which would further ease finance cost pressure on net profit. Net profit margin
(NPM) would improve from 8.5% in FY06 to 13.3% in FY08.

Concerns
• Eaton is the leading player in the US clutch market with a whopping 98% market share in both the
OEM and replacement markets. The success of CAL depends on how it can penetrate the US
market. Export revenues will be a major trigger and the company's inability to earn the expected
revenue growth is a major concern for our earning estimates.
• The increasing competition from the unorganised sector in the domestic market could impact its
market share and revenue growth.
• Steel is the major raw material for clutch manufacturing and any rise in steel prices can affect
EBITDA margins.
Auto Ancillaries Sector in India
• The fortunes of the auto ancillary sector are closely linked to those of the auto sector. Demand
swings in any of the segments (cars, two-wheelers, commercial vehicles) have an impact on auto
ancillary demand. Demand is derived from original equipment manufacturers (OEM) as well as the
replacement market. Replacement demand accounts for close to 57% of total demand, while OEMs
account for 27%, with exports accounting for the balance 16%.
• ACMA, the Indian auto component industry body had an estimated 498 players registered with it in
FY06. The industry has grown at a CAGR of 20% between 2000 and 2005 with total output in
value terms touching US$ 10 bn in 2005. Exports have grown at a much higher rate of 34% CAGR
during the same period with output touching US$ 1.8 bn.
• Margins in the replacement market are higher than the OEM market. OEM’s requirements increase
or decrease, depending upon general demand scenario and launch of vehicles. This market is very
competitive and component manufacturers have to compromise on margins to bag bulk orders.
Moreover, delivery schedules and quality standards have to be adhered to very strictly.
• Indian auto ancillary sector has traditionally suffered from poor quality. While this still holds true
for the unorganized sector, the organized sector has been resorting to increased automation to
reduce the defect levels. Defect rates in domestic auto ancillaries (including the popular suppliers)
are in the range of 1,000 parts per million (ppm) against a global average of 200 ppm.
• One area where domestic units compare favourably with their international peers is in terms of
costs. Lower labour costs gives Indian auto ancillary companies an absolute cost advantage. Just to
put things in perspective, ACMA numbers suggest that wage cost accounts for 3%-15% of revenues
for Indian manufacturers as compared to 20%-40% for US players. India's strength in exports lies
in forgings, castings and plastics historically. But this is changing with more component
manufactures investing in upgradation of technology in recent years

Industry Structure
• Supply Low for high technology products. Unorganized sector dominates the domestic component
market due to excise benefits. Generally, excess supply persists.
• Demand Linked to automobile demand. Export demand is linked to the increasing acceptance
towards outsourcing.
• Barriers to entry Capital, technology, OEM relationships, customer service, distribution network
to meet replacement demand.
• Bargaining power of suppliers Low with OEMs. Relatively high in the replacement market
• Bargaining power of customers Companies operating in the export market face competition at a
global level. At the domestic level, market structure is fragmented for a large number of ancillary
products. Most companies adopt low cost and differentiation strategies. In some products (like
batteries), only two or three companies control over 80% of the market.
• Competition In future competition will intensify, as global players will enter the market leading to
consolidation. Dereservation of SSI will result in access to capital and technology

Prospects
• There has been a conscious effort by manufacturers to improve productivity of the suppliers in the
past few years. Though the number of active vendors has declined significantly for auto
manufacturers, technology transfer and fresh fund infusions have resulted in improved productivity
in the remaining ones. This is a big positive for the industry, as historically, the sector has been
deprived of proper technical know-how and lack of funds. Relaxation of FDI norms for the small-
 scale sector could emerge as one of the key growth drivers in the long run. The Indian automotive
components industry has lined up sizeable investment schedules for the next few years.
• The automobile sector is cyclical and dependent on the growth of the economy and improvement in
infrastructure. Factors like increased public spending, favorable interest rates and general
improvement in per capita income points towards higher demand for automobiles in the future.
Also, government's initiatives in the infrastructure sector such as the Golden Quadrilateral project
and NHDP (National Highway Development Programme) is likely to give boost to four-wheeler
sales especially CVs. Just to put things in perspective, we expect CV segment to grow by 22-25%,
two-wheeler demand to increase by around 12% to 15% and passenger car sales growth at 12-15%
in FY07. This is a positive for auto ancillary manufacturers.
• In the long term, the growth of this sector will depend partly on pace of indigenisation levels across
all segments. The prospects look bright as most companies are increasing the indigenous
components, in an effort to reduce their currency losses and remain competitive. Given the fact that
many global players are launching models through the CKD route, there is a fair chance that
domestic ancillary manufacturers will witness faster growth going forward. Also, the fact that auto
manufacturers like Ford, Hyundai and Maruti are exporting cars, prospects look encouraging.
• In the future however, auto ancillary companies in India will face tough times, because as
competition increases, manufacturers will find it difficult to increase prices and will try to cut costs.
This will put pressure on margins of auto ancillary manufacturers. In the near future, companies
will need to have manufacturing lines that can be adapted for new models, have strong technology
backing, an ability to export to developed markets, market dominance in specific products and a
growth plan driven by volumes and product innovations. Companies will have to focus on quality
and abide by delivery schedules if they want to survive. As manufacturers sourcing components are
keen to get components from fewer sources in future, as compared to what is happening currently,
this will lead to consolidation in the sector. Many players have to face extinction, bulk of them in
the small-scale sector.
• The growing number of Free and Preferential trade agreements being signed by India with
countries like Thailand, Singapore and other ASEAN countries will hurt the cost competitiveness
of Indian companies as Indian players play significantly higher duties than its Asian counterparts.
Therefore, Indian companies might lose out on big orders if the duty structure is not rationalized.

Financial Year '06

• With slowdown in growth of passenger vehicles and commercial vehicles in FY06, auto component
industry also witnessed a slowdown in domestic growth as output increased by 15% in FY06 as
against 30% in previous year. Exports however, continued with its strong performance and grew by
29%.
• In light of increased competition in the global market and over supply situation, bigger auto majors
faced significant pressure on margins. However, the imperative to invest in new product
development increased. This resulted in select global majors increasing budget for outsourcing of
components in order to save cost. In fact, Bharat Forge won an order from Europe’s largest
passenger carmaker in FY06.
• Capacity utilisation rates of the auto ancillary sector as a whole increased significantly in light of
higher exports as well as growth in domestic demand in FY06. The demand for commercial
vehicles increased by 26% in FY05. For instance, Bharat Forge had to ramp up capacity to meet
demand as opposed to capacity utilisation of just 68% in FY03. The same was the case with Exide
and Sundaram Fasteners.
• The year was also witness to increase in overseas acquisitions by domestic companies. While
Bharat Forge acquired Imatra Kilsta of Sweden, other players like Amtek Auto also geared up their
activities on this front
 Sector Financials 31/03/2004 31/03/2005 31/03/2006

NET SALES Rs m 83,419 108,370 132,494

SALES GROWTH % - 29.9 22.3

GROSS PROFIT MARGIN % 15.6 15.8 14.7

PAT Rs m 7,475 10,912 11,619

PAT GROWTH % - 45.4 3.1

WORKING CAPITAL TO SALES % 12.0 13.4 17.4

ROCE % 22.7 25.1 18.4

RONW % 31.2 34.6 25.8

DEBT TO EQUITY RATIO x 0.5 0.5 0.6

MKT CAP Rs m 14,539 22,626 36,098

MKT CAP / SALES x 1.4 1.5 1.9

P/E RATIO x 11.7 12.4 18.6

PRICE/BOOK VALUE RATIO x 3.6 4.3 4.8

Clutch Auto Financials

Year ended Rs. cr

year 2007/03 2006/03 var %
Sales Income 235.50 149.32 57.72
Expenditure 195.26 125.64 55.41
Interest 9.47 6.01 57.74
Gross Profit 30.85 17.77 73.63
Depreciation 5.15 4.71 9.56
Tax 4.18 0.40 944.00
PAT 21.52 12.66 69.95
Equity 15.52 14.00 10.86
OPM (%) 17.09 15.86 1.23
GPM (%) 13.07 11.83 1.24
NPM (%) 9.13 8.48 0.65

Key Financial Ratios

2006/03 2005/03 2004/03 2003/03 2002/03
EPS 8.97 6.47 -0.43 -0.66 0.10
CEPS 13.35 11.62 5.98 5.33 4.73
Book Value 38.08 23.61 17.14 17.57 18.23
Dividend/Share 1.00 0.00 0.00 0.00 0.00
OPM 17.14 16.87 13.75 16.24 16.65
RONW 24.01 29.19 -3.90 -0.29 -0.43
Debt/Equity 1.28 2.60 3.98 3.68 3.39
Interest Cover Ratio 3.72 2.85 2.04 2.01 1.56

Valuation
Current market target price of Rs 125
Q: Derive the intrinsic value of the shares of clutch Auto, and recommend buy / sell decision