The Hindu Business Line : Cummins India: Hold

Investors can retain their exposure to the stock of Cummins India (CIL), a leading manufacturer of diesel engines in the country. Responding to a buoyant demand for its products, the company has expanded.

Increasing demand for back-up power, expanding capacities across its major product segments, especially electrical gensets for back-up electricity, hold promise for earnings. The demand outlook is expected to be bolstered by the expansion of various IT and ITeS companies into Tier-II and Tier-III cities, which will call for large back-up power capacities, and by the emerging natural gas market in India.

At the current market price of Rs 373, the stock trades at about 22 times its likely FY-09 consolidated per share earnings. While we remain bullish on the growth prospects of the company, the positives appear to be factored into the current stock price. Besides, the recent rupee appreciation compared to the relatively stable yuan, which could curtail CIL’s cost-competitiveness compared to its Chinese counterpart, is also a concern. Investors with a long-term perspective, however, can consider accumulating the stock on dips.

Power-backed growth

The growth in service industries such as IT, telecom and retail is expected to keep the demand for back-up power applications buoyant. Notwithstanding the expected ramp up in the country’s power generation capacities, the demand-supply mismatch is likely to continue. This, combined with the limited reliability on the power grid for critical operations in non-Tier-I locations is likely to drive the demand for gensets.

The demand could also get a lift from the ongoing boom in housing and construction activities. Additionally, CIL is likely to benefit by way of increase in contribution from its replacement business, given the healthy growth in genset sales over the last couple of years. CIL’s industrial segment business could also gain from the increasing capital expenditure by oil, gas and mining companies.

In this regard, CIL’s liaison with players such as Coal India and BEML instil confidence. For the year ended March 2007, the power generation business contributed to about 40 per cent of the sales, while the industrial segment contributed to about 15 per cent.

CIL’s automotive business, however, could witness tardy growth over the medium-term, on account of tightening of interest cost and slowdown in commercial vehicle sales. While this concern cannot be ignored, it is unlikely to have any significant impact on CIL’s overall numbers, given that the segment contributed to only about 5 per cent of CIL’s overall revenues.

Moreover, with structural drivers such as expansion in road network and restrictions on truck overloading, concerns about slowdown in commercial vehicle sales could well be only temporary. Besides, with the opening up of newer markets following CIL’s joint venture with Tata Motors to supply 600 CNG (compressed natural gas) buses in Delhi, long-term growth prospects for the segment remain quite attractive.

Greater development of the natural gas market in the country could also spell opportunities for Cummins. Once the pricing policy for the new gas finds is finalised, and the flows begin, various industries will invest in gas-based back-up power. Cummins could emerge as a leading beneficiary of any such development, given its technology-driven leadership position in back-up power business in India.

Anticipating a rising demand scenario, CIL has laid out a capex of about Rs 100-150 crore for FY-08. Also, the completion of Pirangut plant for small engines and the expansion in capacity for 38- to 50-litre engines expected to be in place by December also lend strength to CIL’s revenue outlook.

Change in sales mix

Given the management’s guidance towards a low double-digit growth rate in exports and a high teens growth in domestic sales, the overall sales mix is set to change. Exports, which contributed to about 35 per cent of the overal l sales, could see a downtrend.

While prima facie this could appear negative, it may reduce CIL’s exposure to rupee appreciation, thus reducing the pressure on its margins.

While the recent rupee appreciation compared to the relatively stable yuan has not had any adverse impact on CIL’s cost competitiveness with its parent’s Chinese subsidiary, the possibility of this cannot be completely ruled out. In this regard, the proposed change in sales mix could prove beneficial.

For the quarter-ended June 2007, CIL recorded a profit growth of about 26 per cent on the back of 38 per cent increase in revenues.

However, profit margins, owing to an increased share of small engines in the overall product mix, witnessed a reduction.

This, plus a rising raw material cost could be attributed to the two percentage points decline in operating profit margins to about 13.6 per cent.

Concerns

While the business prospects of CIL look promising, exchange rate concerns and increasing competition are likely to exert pressure on overall margins. Export margins could witness a downtrend given the currency appreciation and a likely reduction in realisation.

This could curb CIL’s pricing power to some extent. Further, if the appreciating rupee-stable yuan scenario were to continue, the entry of Chinese players in domestic market could become an imminent threat. In this regard, tightening emission and noise norms in India may offer respite.

Further, CIL also stands to lose in case of any increase in diesel prices, since such an increase could render diesel engines economically less attractive. Besides, it could also result in a lower running time for the existing engines, affecting the spares business.

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