Margin improvement, better product mix puts Escorts in a sweet spot

ET Intelligence Group: The stock of tractor maker Escorts has gained 80% over the past six months, outperforming the country’s largest tractor maker Mahindra & Mahindra, which gained 67% during the period. While the tractor segment is expected to benefit from the rising rural income and good monsoon, Escorts looks poised to outperform considering a strong margin improvement, capacity expansion, and better product mix amid rising demand.Escorts was able to expand the operating margin (EBIT margin) of tractor segment by 970 basis points year-on-year to 20% in the September quarter due to cost optimization, lower raw material costs and superior product mix which improved realization per unit.This is one of the highest margins for the company's tractor division in any quarter. In FY16, the company had operated at a single digit margin of over 8%. The margins have been consistently improving since then except for FY20 when 12% contraction in sales volume affected the profitability.The better margin performance is owing to better cost management – other expenses relative to sales fell by 360 basis points year-on-year to 10.4% in the September quarter while the proportion of raw material costs in sales fell by 340 basis points to 63.6%.The company’s strategy to improve product mix by selling more of high-horsepower tractors improved realization by 7% to Rs 5.4 lakh per unit. Nearly 67% of the tractors sold in the second quarter were of more than 40 horsepower compared with 45% a year ago.In the first half of the current fiscal year, the tractor division’s margin was 17.7% compared with 10.6% in the corresponding period of the previous year. Analysts expect 17-18% margin for FY21 and FY22.The company has upgraded its industry guidance for the tractor segment volume to low double-digit growth from the earlier expectation of a single digit growth.Escort’s tractor volume grew by 4.4% to 42,591 units in the six months to September 2020. It needs to maintain a monthly average sales volume of 9,000 units to be able to post at least 10% growth for the full year.Tractor demand is likely to remain upbeat given a higher sowing area of Kharif crop and better yield, that could improve cash flow of farmers. The total kharif crop sowing area this year increased by 5.7% to a record 1113.63 lakh hectares from the year ago. In addition, to improve the liquidity of farmers, the government has increased procurement of paddy to 42.5 lakh metric tonnes, 35% higher than the year ago. Also, the number of procurement centres for Rabi & Kharif seasons combined rose to 64,515 in FY20 from 48,550 in FY17.To meet the growing demand, Escorts is ramping up the tractor capacity to 12,500 units per month compared with 10,000 units currently with an investment of Rs 1,000 crore. According to analysts, the company’s total installed capacity at the end of FY21 would be 1,23,940 units annually.At Wednesday’s closing price of Rs 1,233, the stock was trading at a one-year forward price-earnings multiple of 20, which is at 40% premium to the long-term average. This may sustain given the company’s growth prospects.

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