Cummins India - Open offer by the parent appears increasingly likely - PhillipCapital

The sharp fall in the rupee (25% YTD and 40% since Jan, 12), limited options for Cummins Inc. to use its annual free cash of ~$1bn along with the increased focus on India makes a voluntary open offer by the parent Cummins Inc. increasingly likely, in our view. While the company's end markets (domestic and exports) continue to remain weak, a voluntary open offer by the parent represents a key risk to our SELL call on Cummins India.

Sharp fall in the rupee makes it attractive for the parent to increase its stake in Cummins India. The rupee has fallen 25% YTD and 40% vs. the dollar since Jan, 2012. This offers an attractive opportunity for the parent, Cummins Inc. to increase its stake in Cummins India. Cummins Inc. currently holds 51% stake in Cummins India and would need $400mn(at the current exchange rate of Rs68/dollar) to increase its stake to 75%. To put it in perspective, it would have needed $500mn at the start of the year and $550mn as of Jan,'12. We have used Rs411 as the open offer price which is the average price of Cummins India over the last 60 days and has to be the minimum offer price as per SEBI regulations. Note that the slide in Cummins India's price over the past 4 months (-40%) also results in a lower open offer price to be offered as per SEBI regulations.

Cummins Inc. has an annual free cash flow of ~$1bn and is devoid of options to put it to use. In 1H13, Cummins Inc. generated free cash flow (Operating cash flow less capex) of $700mn and should easily generate >$1bn in FCF for CY13. On top of this, it already has $1.4bn in cash and marketable securities (Net cash: $880mn) on which it barely earns 1.8%. If it decides to buy back an additional 24% stake in Cummins India ($400mn investment), it would be earnings accretive to the parent as it yields 6% (on additional earnings being consolidated) vs. the 1.8% it is getting as interest income currently. Plus, there is no M&A risk involved in buying an additional stake in its own subsidiary in India. The management has been repeatedly under pressure from investors and analysts to put its large cash pile to work; note that Cummins Inc. has a $1bn buy back offer currently on and repurchased $290mn worth equity in 1H13.

India is the global export hub for the parent as also a key power gen market (12% of sales); parent would be inclined to have a higher controlling stake. India contributes 5% to Cummins Inc.'s overall revenues (incl. other unlisted subs) and we also note that Cummins India has been designated the global export hub (<200kva) for its low kva gensets. The growing importance of India in the parent's portfolio is also visible from the new plant being set up at Phaltan for the domestic and export markets; the fall in the rupee makes India even more competitive as a sourcing hub. In our view, Cummins Inc. would be inclined to increase its stake to 75% given the growing importance of India to its core portfolio.

Valuations: We retain our SELL rating on the stock and our target price of Rs370. Our target price is derived by applying a 15x multiple to our FY15e EPS of Rs.26. Weakening demand in the domestic and global DG set market combined with lower margins (on higher cross charges to parent) will hurt continue to hurt earning.

Source : Equity Bulls

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