AIA Engineering's Q2FY20 results (Downgrade to Neutral) - Volumes disappoint;guidance cut

Q2FY20 result highlights

• Adj. PAT grew 26% yoy to Rs1.52bn: on lower tax. 
• De-stocking by clients impacts volumes: with 1% yoy drop (-4% qoq) to 61,220 tons. Volumes were muted due to de-stocking across markets in mining (flat yoy/qoq; impact of ~4-5ktons for the quarter). Moreover, realizations fell 5% yoy to Rs110.5/kg led by lower ferro chrome prices, driving a 6% yoy decline in revenues to Rs6.96bn. 
• Margins expanded 216bps yoy to 22%: led by improved revenue mix. Hence, EBITDA grew +4.2% yoy to Rs1.54bn. Other income fell 42% yoy on lower forex gains – Rs257mn in 2Q19 vs Rs55mn in 2Q20, high base. Higher depreciation: +23% yoy; capex for new capacity; IndAS 116 impact, partially offset by lower finance cost (-11% yoy to Rs15mn).
• PAT growth was led by reversal of Rs207mn: of deferred tax liabilities (DTL) led by shift to new tax regime (4% tax rate for the quarter vs 31.1% in 2Q19). Excluding this reversal, PAT growth was at 8.7% yoy to Rs1.32bn (20% tax rate for 1H20 excl DTL reversal).

Conf call highlights: (1) AIAE cut its volume guidance to flat yoy (~265k tons) due to challenges faced by its client in Brazil and global uncertainty on mining driving lower off take by clients; (2) Continue to see addition in clients eg. added 15k customer in 2Q20; more in pipeline; (3) Value proposition intact – EEMS offering has allowed AIA to offer a complete solution from optimising design to process to supply, etc enabling lower wear rates, power costs as also higher throughput; eg. India client saw 45% savings in power vs anticipated 15% savings (4) no update on Brazil customer volumes re-starting; (5) Lower RM prices will likely drive higher margins, albeit to be passed to clients with a lag; 2Q20 saw utilisation of old stock with higher RM prices (6) Working capital has reduced led by inventory rationalisation (7) Capacity expansion: 50k grinding media and 50k mining liner by Dec-20; Rs2.5bn FY20 capex (1H20 at Rs700m)

Impact on financials: FY21E EPS cut by 6.9% to Rs66; FY20E at Rs60

Valuation and view

AIA has a strong value proposition, particularly with the EEMS tie up that would enable market share gains & customer stickiness over the long term. However, the muted volumes and the sharp cut in guidance (flat volumes for FY20) has been a key disappointment indicating that volume scale up is taking longer than anticipated. This in turn is impacting earnings growth (10.5% CAGR over FY19-21E; post tax cut). Accordingly, we believe valuations at 26x FY21E earnings are capturing the positives. Downgrade to Neutral.