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Accelerating Forward

Persistent power shortages & a diversified client base are expected to help Cummins India post robust growth…

Cummins India Ltd. (CIL), the country’s largest engine manufacturer, is on a roll. It has sold more engines in the first nine months of FY11 than it did in the whole of FY10. Earnings per share (EPS) too has kept pace. EPS for the nine months ended December 2010 has outstripped the EPS for the whole of FY10. The company is now developing additional capacity at Pune in order to take advantage of both domestic and global opportunities.

Opportunities
Power shortage to drive revenues: Cummins’ generator sets are used in a variety of sectors: IT, hospitality, agriculture, commercial, infrastructure, residential and healthcare. This diversity provides comfort. Cummins’ revenues are cushioned from the lean patches that an individual sector may go through (for instance, the realty sector currently). Hence, at a time when the Capital Goods Index is down 18 per cent y-o-y (January 2011), Cummins’ domestic sales have recorded a 20 per cent y-o-y growth for the nine months ended December 2010.
Power deficit is likely to continue in India: by 2015 it is expected to be of the order of 14-15GW. This presents a huge opportunity to Cummins which generates 35 per cent of its total revenue from power generation. According to Dhirendra Tiwari, senior vice president, institutional equity research, Motilal Oswal, domestic demand is expected to grow 20 per cent in FY12 and 19 per cent in FY13.
However, Q3FY10 sales were down 6 per cent y-o-y, partly due to a maintenance shutdown in that quarter and due to a strike at its Kothrud plant. As a result, a lot of order backlogs had to be cleared in Q3FY11. This affected the bottomline to the tune of Rs30 crore in Q3FY11. However, the company’s long-term growth prospects remain sound. In a recent conference call with analysts, Anant Talaulicar, managing director, Cummins India said that he expects the domestic business to grow in the high teens over the next five years.
Opportunities in the standby market: From being a prime market (where power generation is important), India is moving towards becoming a standby market (where providing backup power is important). The demand for these systems is currently in the nascent stage (it derives less than 10 per cent of its revenues from this segment) but is slated to rise in future.
Stricter emission norms: The new, Bharat Stage III, emission norms come into effect in April 2011. These norms will affect the off-highway wheeled construction equipment industry (pavers, compactors, wheel loaders, skid steer loaders, motor graders and cranes) which account for about 30 per cent of the $3.2 billion (Rs1,42,000 crore) construction equipment market in India. Cummins, which has a product line in emission technology, is expected to benefit from this opportunity.
Gas-based gensets: With gas reserves being discovered within the country and its supply increasing, a market for gas-based gensets, currently estimated at 200 MW, is developing. This has the potential to become a new niche area of growth for the company. The cost of power generated by gas gensets is significantly lower than of power produced by traditional diesel gensets, which tilts the scales in favour of these gensets. Cummins, which possesses a lean-burn natural gas product line, could benefit from the increasing use of gas for generating power.
Growth in exports: Exports account for 30 per cent of Cummins’ sales and are slated to go up. Cummins Inc., the US-based parent of Cummins India (which holds 51 per cent stake in the company), has decided to make India the hub for manufacturing all sub-200KvA gensets. Barring the US, Cummins India will supply these gensets globally, focusing especially on markets such as the Middle East, Asia and Africa. From Rs488 crore in FY10, exports are expected to rise to Rs1,500 crore by FY15.
Capacity expansion: Cummins is building a new facility at Phaltan, Pune, which will involve a total capex of $500 million (Rs2,215 crore). Cummins India and its parent are both expected to invest 50 per cent each on the project. The Indian subsidiary plans to invest Rs400-500 crore as capex each year for the next two-three years out of its internal accruals. This investment will involve upgradation of Cummins’ research and development facilities, a new technology centre at Pune, reconditioning of power generators and high horsepower engines, and a new corporate office.
The facility will have an initial capacity of 15,000 units (in FY11), which will jump to 40,000 units by FY13. The entire incremental capacity is expected to service exports. As a result of these capacity additions, total capacity is expected to increase by 20 per cent CAGR over the next two-three years.
Margins expected to remain steady: Cummins’ EBITDA margin for the nine months ended December 2010 stood at 19.7 per cent, higher than the 18.5 per cent margin the company had reported for FY10. Cummins managed to beat its previous year’s margin despite a 30 per cent increase in pig iron prices over the last three quarters owing to strong volume growth, cost cutting, and a superior product mix. Margins are expected to remain stable at around 20 per cent in FY11. If raw-material prices rise further, the company could hike prices by 1-3 per cent in the current financial year in order to preserve its margins.

Threats
Slowdown risk: Though Cummins’ products cater to a wide variety of industries, a slowdown in the overall economy could put the brakes on its growth plans. The key sectors that it caters to include realty, infrastructure, healthcare, engineering and auto. Realty and infrastructure sectors are no longer growing rapidly and their near-term outlook remains muted. Agriculture is another key sector for Cummins. If the monsoon is deficient, sales to this sector could be affected.
Rising commodity prices: Commodity prices, especially those of steel and copper, have been firm this year. Margins could come under pressure if commodity price inflation does not cool down, and if the company is unable to raise prices materially owing to competition.

Valuation
Cummins trades at a three-year PEG ratio of 0.9. The company’s revenue has grown at a compounded annual rate of 19 per cent over the last five years. The company’s management expects revenue to grow annually at the rate of 20 per cent over the next five years. EPS has grown faster at around 27 per cent (over the same period) and reflects the company’s strength in the Indian market. Cummins’ return on capital employed (ROCE) has been in the 40 per cent range in the last two years. Moreover, the company is debt free. Cash and cash equivalents stand at near Rs800 crore (December 2010 figure).
Cummins India is one of the better plays on the Indian capital goods sector and appears to be a sound bet for investing with a five-year horizon.