The Hindu Business Line : Kirloskar Oil Engines: Buy

Business is on a strong footing with medium- and small-range engines fuelling growth. We believe the current market price does not adequately capture the value of the company's core business.

WITH RURAL demand to pick up substantially in the coming quarters, the outlook for engines used for agricultural applications appears bright. — M. Srinath

Fresh exposure can be considered in the Kirloskar Oil Engines (KOEL) stock. At Rs 183, the stock trades at 13 times its 2006-07 sustainable per share earnings. We believe the stock has potential to appreciate, considering the improving realisations, better growth prospects for exports, and higher market share due to the implementation of emission norms. After adjusting for its investment book, the company's core business is valued at 10 times its expected 2006-07 per share earnings.

Core business

KOEL's core business is on a strong footing with medium and small HP (horse power) range engines fuelling growth. The former have been KOEL's growth engine over the past few quarters and continue to record a 49 per cent rise in sales in the quarter-ended June 2006. The demand from construction and industrial machinery segment remains robust and that from the telecom segment is also picking up for diesel gensets up to 20 kVA (kilo volt ampere) range.

However, this quarter, small engines too have shown tremendous improvement in offtake, up 74 per cent in value. These engines are primarily used to power farm machinery. With rural demand to pick up substantially in the coming quarters, the outlook for engines used for agricultural applications appears bright. Agricultural machinery accounts for 41 per cent of small engines and 10 per cent of medium HP engines sold by KOEL, in value terms.

KOEL also plans to enhance its product offerings in the farm segment to capture the rising demand.

The company has received orders for large engines, predominantly for marine applications. The revenue stream for this segment is usually erratic and unpredictable as it depends on the order backlog. These orders are usually large in value and enjoy high margins.

KOEL recently bagged orders worth Rs 250 crore from shipyards. As the order-book will be implemented over a three-year period, the prospects for this segment too appear good.

With the implementation of the new emission norms, KOEL has seen its per engine realisations increase and market share improve. The implementation of emission norms has kept a number of smaller unorganised players at bay, giving KOEL an opportunity to increase its market share.

So far, the urban areas have adhered to the norms while implementation has lagged in Rural India. As awareness increases and implementation becomes more stringent across various applications and in the rural areas too, realisations may improve further.

The operating profit margin for the engine segment improved by over 200 basis points to 10.4 per cent on higher realisations. Operating profit too was up 54 per cent for the quarter ending June 2006.

Rising exports

Exports have been on a steady uptrend, more than doubling from Rs 60 crore in 2003-04 to Rs 130 crore in 2005-06. The company has embarked on developing the original equipment manufacturer (OEM) segment for achieving export growth. This strategy appears to be working as it has started receiving orders from OEM clients abroad for engines as well as valves and bearings. The company is setting up an export-oriented unit for valves to meet the rising demand. The management has targeted a Rs 200-crore export turnover for this year. Though exports, as a percentage of the total turnover, are still small at 10 per cent, growth is strong.

On an expansion mode

Encouraged by the demand prospects, KOEL has almost doubled its planned outlay for capacity expansion to Rs 150 crore. It had spent Rs 68 crore in 2006 to increase capacity by 60 per cent.

In 2006, auto component sales were affected due to capacity constraints. With the new capacities coming on stream, volumes should improve this year.

Investment book

The company is now valued at a market capitalisation of Rs 1,775 crore. Its investment book, as in its balance-sheet, is valued at Rs 500 crore.

This may unlock value over a period. Adjusting for the investment book, we believe the valuations do not capture the growth prospects for the core business.

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