Stock Review: Cummins India

 

Cummins India is the country's largest engine manufacturer with a 40 per cent market share. It produces engines ranging from 31 horsepower (hp) to 3,500 hp, which can operate on diesel, gas, and dual fuel. Being a 51 per cent subsidiary of Cummins USA, its competitive advantage lies in the fact that it enjoys access to its parent's technology.

Cummins India manufactures engines that are used in sectors like power generation, automobile, construction, mining, marine, locomotive and fire-fighting. The company sells its engines to original equipment manufacturers (OEMs) that manufacture generators and vehicles. This enables it to focus entirely on the technology and manufacturing of engines. One division of the company provides service-based solutions.

While 70 per cent of Cummins India's revenue comes from the domestic market, 30 per cent comes from exports.

 

 

Sources of economic moat

As said earlier, Cummins India's competitive advantage comes from its access to its parent's technologies. Cummins USA is the world's largest designer and manufacturer of diesel engines. It possesses the best technology for manufacturing engines that find application across segments. It also possesses the technology to address the growing demand for gas and dual-fuel engines.
Cummins USA is among the few MNCs that are investing in their listed subsidiary in India. The parent company wants that Cummins India's contribution to global revenue should increase from the current 10 per cent to 15 per cent.

 

What could cause moat to be breached

The competition that Cummins India faces is mostly in the lower horsepower segment. In mid- and higher horsepower engines, where technological superiority counts, the company is the clear leader. Analysts do not expect its leadership position to be challenged anytime soon, given the company's technological strength, scale of operation, its parent's technological strengths and deep pockets.

 

Growth drivers

Domestic outlook improving. After the global financial crisis, demand for engines was sluggish till the first half of FY10. Since then demand has recovered. According to analysts at Motilal Oswal, revenue from the domestic market is expected to grow at a compounded annual growth rate (CAGR) of 26 per cent between FY10 and FY12.

Strong demand from power sector. Power is Cummins India's most important segment, accounting for 45 per cent of its revenue. The company offers power generation solutions to industry, services, and the real estate sector. About 25 to 30 per cent of the country's industrial power needs are met through captive power plants. India's continuing power deficit situation will ensure that the demand for diesel-powered generators and inverters remains high.

Industry. This segment accounts for 15 per cent of total sales. Some of the key sectors to which Cummins India supplies engines include construction, mining, compressors, oilfields, marine, defence, and railways. India is set to invest a huge amount of money on expanding infrastructure. Hence, demand from sectors such as construction and mining is expected to be particularly strong.

In the first half of 2011, India is likely to adopt India Stage-III emission norms. This will provide additional growth opportunities to the company as it already has engines that meet these norms.

Automotive sector. This sector accounts for 10 per cent of the company's sales. The company supplies 300 hp engines to Tata Motors for its heavy trucks. The demand for heavy trucks being strong, this segment is likely to put up strong growth in future.

Many Indian cities will adopt CNG buses in times to come. The engines for these buses will be supplied to their manufacturers by Cummins India.
Gas. With new gas discoveries, in future many power plants around the country are likely to be fuelled by gas. According to estimates, around 200 MW of capacity for gas-fuelled power plants could be set up each year. The key reason for preferring gas as fuel is that the cost of generating electricity using gas is much lower than using coal. Cummins India has a strong lean burn natural gas product line and stands to benefit from this opportunity.

Sales and services. This division offers after-sales services to the engines sold by the company. It replaces and re-conditions old engines. In recent years revenue from this segment has grown at the rate of 15 per cent annually. As the count of engines sold by the company increases, the after-sales division's revenues will also grow.

Meanwhile, the company's margins are likely to expand due to the following three reasons:

Cost-cutting programmes. In 2005 Cummins India initiated the accelerated cost-cutting exercise, which aimed to cut spending on raw materials by 30 per cent in three years. Thereafter, the company initiated another cost-cutting program called Trims, which aimed at bringing down spending on materials and services by another 30 per cent in three years. Thus the company has been able to cut down its raw material costs substantially.

Favourable pricing environment. In mid- and high horsepower engines, the company faces less competition and hence enjoys better margins.

Sale of higher-value engines to grow. For engines to meet higher emission norms, more high-value components have to be added to them. With India set to adopt higher emission norms, Cummins India will be able to sell more value-added engines, which will in turn improve its margins.

Another factor that will drive the compa ny's growth is capacity expansion:
Capacity expansion. Cummins USA plans to triple its investment in India from the current $150 million to $500 million by 2015.

Cummins India plans to spend Rs 140 crore in FY12 and Rs 90 crore in FY13 on capacity expansion.

The company is setting up a greenfield manufacturing facility at Phaltan near Pune in Maharashtra for manufacturing more engines and generators. By FY13 this facility will have a capacity of 40,000 units. This manufacturing unit will be developed within a Special Economic Zone (SEZ) and will be meant entirely for export.

Strong export growth. The export business will benefit from Cummins USA's commitment to source medium and high horsepower engines (of up to 50L) and small generators of less than 200 KVA from India. About
75 per cent of its exports are engines in the high horsepower category, and 25 per cent are generators of up to 200 KVA.

Growth in exports will be driven both by the existing portfolio and by the addition of new products. New products that the company could supply to its parent include engines for industrial applications.

In recent times, Cummins USA has been raising its sales guidance. From $10.8 billion in 2009, its sales are expected to increase to $20 billion by 2014, a CAGR of 13 per cent. This augurs well for Cummins India, which the parent intends to use as a manufacturing hub.

In FY10 Cummins India's exports amounted to Rs 480 crore. In that year demand shrank in the US and European markets. But with demand in overseas markets improving (albeit slowly) now, Cummins India's exports are expected to rise to Rs 1,500 crore by FY12.

 

Concerns

The key risk to the company arises from the fear of an impending economic slowdown. According to analysts at Edelweiss, Cummins belongs to the capital goods industry. This, they say, is the first sector to be affected by a slowdown and the last to benefit from an upturn. The ongoing slowdown in industrial capex has the potential to affect the company's sales.

With markets like US and Europe slowing down once again, Cummins India's exports too could get affected.

 

Valuation
The stock is currently trading at a price-to-earnings ratio of 18.93. This is slightly higher than its historic (five-year) median PE of 22.7. It is trading at a five-year trailing price-earnings to growth (PEG) ratio of 0.68. Buy this stock.