Cummins India - Weakness in end markets to persist; Downgrade to Neutral - Phillip Capital

We met with the senior management team of Cummins India to understand the current business environment and outlook for FY15. Key takeaways are:

Weakness in DG set markets to persist; limited pre buy impact. (a)As per management, DG set demand is expected to remain weak till the time there is a pickup in infrastructure spending (at least a couple of quarters away, in our view) and new manufacturing capacity addition. Key end markets of realty, infrastructure, process, textiles, engineering remain depressed. For FY15, volumes are expected to be down 10-15% YoY which would offset the increase in prices (~20-25%) due to the new emission norms, (b). Expect a limited pre buy impact in Q115 since there is sufficient inventory in the channel alongside weak demand. (c) Cummins India is focusing on increasing market share and volumes in the LHP segment (8-40kva), defend share in the mid to high kva range and enter new geographies and markets (telecom, O&G, defence), (d) Capacity utilization is currently at 60%; however, management does not expect any significant uptick in margins from current levels despite increased utilization, (e) Mechanical engines are being continued for meeting new CPCB II norms and may look at electronic engines only post CPCB III norms. Note peers such as Perkins, MTU, Volvo have already got electronic engines.

LHP gensets to drive growth in export and domestic markets. (a) Despite having begun its <200kva LHP gensets export facility in Phaltan in July, '13, management has acknowledged a slow ramp up in production (currently at 6,000 units/annum vs. capacity of 15,000 units). It is focusing on the markets of LATAM, Africa and the M. East for its LHP exports; expects to reach sales of Rs20bn (Rs2.4bn in 9M14) in the next 5-6 years, (b) It expects to gain market share in domestic LHP segment on account of the new emission norms (to be implemented from 1st Jul,'14. Currently, Cummins holds a 5% market share in this segment and expects to grow it to ~20% over the next few years (c) Domestic LHP segment had grown in the 1H14 (unlike MHP and HHP which declined in 1H14) but degrowth has been seen since Q314.

Industrial segment to see growth driven by marine engines and railways. (a) Key end markets of construction, mining and compressors expected to remain subdued; however, marine (driven by propulsion engines, 15% CAGR in sales) and railways are large opportunities over the next few years, (b) Sales to the construction segment have remained flat despite overall weakness in markets as OEM's increasingly using Cummins engines for exports out of India.

Distribution segment to focus on increasing services revenues. (a) To benefit from new emission norms as engines become more complex and therefore serviced only by Cummins authorized dealers, (b) Rebuild engines not cannibalizing sales since the customer gets to exchange his old engine with a new one and therefore stays with Cummins than going to another competitor, (c) Currently, 55-60% of engines sold by Cummins are serviced by it which management intends to increase to 80%; we note that 10% of the distribution segment revenues are currently got from the services business.

Estimates and Valuations: In our view, end markets for Cummins India are expected to remain muted till we see a pickup in infrastructure and industrial capex. Export markets while being a large longer term opportunity would not compensate for the weakness in the domestic market. We downgrade our ratings on Cummins India to Neutral with a revised target price of Rs415 derived using a target PE of 16x on our FY16 EPS of Rs26.

Source : Equity Bulls

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