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Target Price: Rs. 256 by July 2013 Potential Upside: 65%+ in 1 year; Rating: Buy
Originally Recommended on May 23rd 2012 Quote: Rs. 152 Report on Aug 23rd 2012, Current Market Price: Rs. 154
Century Partners
For Queries Kindly Write To: Century.Partners03@gmail.com
Report on Aug 23rd 2012, Current Market Price: Rs. 154; Re-Rating: Buy
Intrinsic Value (from DCF Analysis): Rs. 256 Market Cap: Rs. 2226 Cr ($405million) Margins (EBITDA: 16.43%, PAT: 9%) Current Ratio: 0.96 Margin of Safety: 66% Risk: Low Current Price: Rs. 154 Avg. Daily Volume: $65,000 52 Week Range: Rs. 107 - Rs. 166
EPS: Rs. 13
P/B: 2.16
EV/EBITDA: 4.9 (Avg. EV/EBITDA of Last 3 years: 6) Total Income 3Yr. Growth Rate: 10% Institutional: 17.82%
Debt/Equity: 0.08
ROE: 19%
Div & Yield: Rs. 4 (2.6%) Share Holding: Promoters Holdings: 67.17%
ROCE: 23%
Head Office: Pune, India; Established: 1946 Recommendation: Buy, Target Price: Rs. 256 by July 2013 We believe considering the Margin Of Safety of 66%, present price per share of Kirloskar Oil Engines Ltd. (KOEL) at Rs. 154 (Aug 23rd, 2012) is undervalued by a considerable margin to it's Intrinsic Value of Rs. 256. Due to KOEL's ability to grow economic profit, we anticipate KOEL to get a higher valuation multiple from the markets which will help company to reach it's Intrinsic Value soon. We think in an emerging market like India there is lot of room for growth in the Engines and Gen-sets segment just to come at par with the global benchmark. Kirloskar's able management has strategically positioned itself well to take advantage of this growth opportunity.
Conversions: $1 = Rs. 55; Rs. 1 Crore (Cr) = $181,000; 1Cr = 10 million, 1 Lakh = 100,000
INVESTMENT THESIS
We think that Kirloskar Oil Engines Ltd. (KOEL) has positioned itself well by becoming a leader in the manufacturing of Diesel Engines, Agricultural Pumpsets and Generation Sets. KOEL provide products for the power generation, off-highway and agricultural sectors. KOEL has an in-house Research and Engineering facilities and deploys value engineering and lean manufacturing concepts. (R&D/Sales Ratio of 2%) Under Power Generation segment KOEL provides both Air-cooled and Liquid cooled Diesel Engines and Generating Sets across a wide range of power output from 5kVA to 3000kVA for applications during standby and power requirements. Under Large Engines, KOEL manufactures Diesel Engines from 2,400 HP to 11,000 HP for power plants. Under Agri arm they manufacture Diesel Pumpsets from 3 HP to 130 HP for farmers. Under Off-Highway segment they manufacture Diesel Engines from 20 HP to 800 HP for earth movers and other industrial purposes. KOEL strives to increase it's market share by producing diversified, efficient and higher quality products at lower cost. KOEL is confident that it's products will meet the requirements of revised emission norms before it's effective post June 2013. Managements drive to strengthen backend operations (service, distribution, manufacturing) has paid off by KOEL increasing it's market share (value terms) to 21%. In FY12, KOEL reported a top-line of Rs. 2,276 Cr, and exceeded the analyst expectations. Revenues for Q1FY2013 of Rs. 603 Cr showed a 6% yoy growth from Q1FY2012 Rs. 566 Cr. Reported Q1FY2013 EBITDA stood at Rs. 88 Cr, reflecting 4% yoy growth with improving margins from Q1FY2012 EBITDA of Rs. 85 Cr. This improvement in the margins is driven by 15% lower employee expenses (offered VRS and shifted plant to Kagal, where employee costs are one-third of that of Pune) and 5% yoy decline in other expenses. Reported FY12 PAT characterize, Rs. 24 Cr increase in other income, 7.3% increase in depreciation and ammo. expense to Rs. 91.29 Cr. In FY2011, Company changed it's method of providing depreciation in respect of Electrical Installation and Aircraft from Written Down Value basis to SL Method causing a lower depreciation amount in FY2011 by Rs. 7.7 Cr. Lower taxes of 27.3% in Q1FY13 vs. 32.1% in Q1FY12 is also going to add to the bottom line. Owner Earnings (FCF) CAGR of 23% will help the company in taking care of their FY13E CAPEX requirement of Rs. 120 Cr and ECB maturities due in FY13E. KOEL in recent years have started focusing on exports and customer focused business, which will be a key driver in increasing the revenues. Company has improving EBITDA Margins, which will lead to higher ROE and re-rating. On valuation front company is selling at a significant lower multiples relative to it's historic average and peers. Both the undervalued part combined with high growth opportunity due to demand and supply gap in this space makes it a good investment opportunity for long term investors.
CATALYSTS
After analyzing growth prospects, KOEL is entering a new market segment with the launch of a Portable Diesel Genset. Along with this new addition company has substituted 4 cylinder engines in place of 6 cylinder engines in the 100-125kVA power range. This helps company moving up in the value chain. KOEL's plan to vacate Khadki, Pune plant and shift operations to Kagal is going to save money on rental, taxes and operational expenses. Seeing low valuation, KOEL has announced to buy-back shares worth Rs. 73.62 Cr by Jan 2013. Increased government spending and improvement in lifestyles will ensue sustained business growth. With an experienced management and company's strong & diverse revenue streams and present undervalued status leads us to provide a Buy Rating on Kirloskar Oil Engines Ltd. (KOEL) with a one year time horizon to reach it's underlying intrinsic value of Rs. 256.
RISKS
If India's economy slowed down that will lead to lower IIP & reduced customer spending and can affect company's revenues in the short run. Reduction in peak power deficit due to increase in Installed Capacity (GW) & new SEB projects can lead to lower than forecast demand. Domestic companies face increased competition from imports on appreciation of local currency. Company faces competition with low cost Chinese imports and from unorganized Indian manufacturers. Availability of Government subsidies and higher import duties though helps in creating demand for company's products. Also a better network for service support helps in maintaining customer base. Rising commodity price (for input raw material, pig iron) is one more area of concern in this segment. Stationary power plant segment of the large business group suffered due to high furnace oil price and continues to be a area of concern. Low buying by Telecom operators was an area of concern expressed by the management. Company is trying to ward off all these challenges by offering better products and services in diverse range and lowering it's cost via increasing operational efficiency.
Kirloskar Oil Engines Ltd. qualifies well on our above mentioned basic criteria to find undervalued & growing companies. Expected Value from DCF of Rs. 256 in 1 year provides us a ROR of well over 30%+ It also qualifies the Hurdle Rate > 2 * Long Term Govt. Bond Yield (7.5%) of 15%. Book Value of Kirloskar Oil Engines Ltd. is on continuous rise which will ensure that the Intrinsic Value of Rs. 256 should be reached soon.
Company Profile:
Kirloskar Oil Engines Ltd. (KOEL) is the flagship company of The Kirloskar Group, (est. 1888, a $1.6Billion+ Sales) engineering conglomerate. KOEL is Indias leading Engine and Gen-sets manufacturer in the medium engine category. It manufactures a wide range of engines, Diesel Generating (DG) sets. KOEL caters to power-generation, industrial, infrastructure, agricultural, naval & telecom sectors. KOEL has over 100 clients in it's portfolio and presence through-out India and is a global brand; Employees: 3500; Present day Kirloskar Oil Engines Ltd. (KOEL) was formed during 2009 by demerger of original Kirloskar Oil Engines (now known as Kirloskar Industries Ltd.) with engine business going to Kirloskar Engines India Ltd. (now known as Kirloskar Oil Engines Ltd., KOEL). Due to increase in Government spending and industry trends favouring higher equipment usage, KOEL can be a major beneficiary of the increased demand. KOEL has planned increase in capacity utilization (currently at 60%) and whose partial benefits of increased turnover should be evident in FY13E itself. KOEL has won new orders worth Rs. 396 Cr from Nuclear Power Corporation of India Ltd. (NPCIL), which is to be implemented over the next 3-year period. There has been an increasing demand for KOEL's engines and auto components in the international market. Presently, exports contributes 7% of the revenues and is expected to show rapid growth. KOEL has already initiated investments to increase capacity to cater to this growth. KOEL signed an agreement with Daihatsu Diesel Co., Japan in Q4FY2011 for manufacturing diesel engines in the range of 610-2,560 KW to cater Commercial Marine segment. KOEL seeing high growth in it's Customer Support segment (spares & service) is widening it's service dealership network. KOEL offers value for money in it's segment with a focus on delivering high quality diverse mix of environment friendly, efficient products and reliable services. Management's strategy to provide diverse range of products and increase operational efficiency will ensure economic value addition.
Power Generation (PG) segment accounted for 37% of FY2012 revenues. KOEL focuses on manufacturing air and water cooled engines, Diesel Gen-sets across industries with power output ranging 5-750kVA. Also company focuses on 2100-6300kVA range for both standby & continuous duty DG Sets. Power Gen Revenue Mix: Cellular business (upto 40kVA) accounts for 4%, 40-320kVA product mix accounts for 80% of the revenue and >321kVA accounts for about 16% of the revenues. Industrial and Off-Highway Segment accounted for 21% of FY12 revenues. In this sub-segment KOEL cater to Construction Equipment Sector with a market share of 55%. KOEL supplies products to 35 OEMs (Escorts, GC, Hyundai, Ingersoll Rand, L&T, Volvo). Major setback for KOEL recently was losing JCB, one of it's main customer with ~35% sub-segment revenue, possibility of losing GC. Customer Support Segment accounted for 17% of FY12 revenues; Revenue Ratio (Spares:Service) is 80:20. KOEL have over 100 service dealers for Power Gen & Industrial segment, have 237 service dealers for Agri segment. KOEL in this segment has seen high growth and successfully increased it's revenues/service dealer. Agriculture Segment accounted for 15% of FY12 revenues. KOEL offers products like Diesel Gen-sets and pump sets in wide range of 3-130 HP and has 20%+ (by value) Agri engines market share. Agri segment Q1 FY2013 at Rs. 83 Cr represents 30% yoy increase. Large Engines Segment accounted for 7% of FY12 revenues. KOEL caters to Nuclear Power Plant, and Naval vessel frigates in wide range of 2,400-11,000 HP. Automobiles (Bearings) Business has been hived off since Sep 30, 2011 with a profit of Rs. 47.71 Cr. Exports contributes 7% of FY12 revenues and company is focusing to increase its exports to important markets like Africa, South Asia and Middle East.
Source: Company
Source: Company
Revenue (2011-12): Rs. 2,276 Cr; Operating Expenditure: Rs. 2011 Cr EBITDA: Rs. 304 Cr; Reported Net Profit: 192 Cr Return on Capital Employed (ROCE): 23% Sales of the company is growing at a CAGR of 7%+ and profit margins are stable Earnings have been on consistent continuous rise & future growth is expected to rise D/E of 0.08 represent KOEL to be a debt free company and very stable capital structure Owners Earnings (FCF) is growing at 23% CAGR ECB due in June 2013, to be paid of by excess free cash flow Dividend Yield of 2.6% is attractive given low valuations of the company Lower effective tax rate due to tax incentives to be received for the Kagal Plant Inventory & Receivables (Days) reduced to 25 & 41 in Q1FY13 from 31 & 53 in FY12 Respectively Depreciation & Amortization Expense for FY2012 was Rs. 91 Cr (SL Method) Profit on sale of Bearings business resulted in Exceptional item (Income) of Rs. 47.7 Cr CAPEX plans for FY13E: Rs. 120 Cr
Source: Company
Operating Profit Margin Ratio show a marginally downward trend but Net Profit Margin Ratio shows slight improvement, this is mainly aided by value engineering benefits. Gross Profit Margin has come down from 11.54% in FY10 to 8.32% in FY12 averaging down at 15% /year. ROCE, RONW both shows marginal downward trend whereas ROA have improved from 46.72% in FY2010 to 70.91% in FY2012. D/E Ratio has shown favorable trend, company is soon planning to be debt free.
KOEL HAS 21% MARKET SHARE AND UNDERVALUED RELATIVE TO ITS PEERS
Source: MoneyControl
The market for Gen-sets is approximately 135,000 units annually and growing at 13%/year and to grow steadily for the next 10 years. Players like Mahindra, KOEL and Greaves Cotton are extremely strong in 15-200 kVA range, KOEL and Volvo Penta are extremely competitive in the <600 kVA range. Few niches - MTU (subsidiary of Diamler Chrysler) is recognized in the 1000 kVA machines and Volvo Penta is popular in the 500 kVA machines. Players like Cummins and KOEL have manufacturing facilities in India; Rest all import and sell in India. Cummins has by-far the highest distribution touch points (spares) at 400, followed by KOEL at 338. Caterpillar and Cummins sell their products at a premium, Perkins and Volvo Penta are in mid range and KOEL and Greaves Cotton sell it's product with 25% to 30% price differential. Chinese products are sold 30-40% lower than KOEL & GC and 10-20% lower than local players. Perkins (subsidiary of Caterpillar) is investing USD 150 mn for a manufacturing set-up at Shendra Industrial Estate, Aurangabad, India. The facility will have capacity to produce 3000 engines per year, scaleable upto 5000 engines per year. The facility is expected to commence operations in June 2013.
Cummins India trades at P/E of 22.4 and P/B of 6.52 (vs. KOEL's P/E of 12.3 and P/B of 2.24) which reflects two things, one that market is willing to pay more for better performing players in this segment and secondly if Cummins India is not able to maintain it's high performance level, there are chances of downgrades.
Greaves Cotton trades at P/E of 9.24 and P/B of 2.61 (vs. KOEL's P/E of 12.3 and P/B of 2.24). Greaves Cotton has slightly better performance in all of the metrics except ROA where KOEL has exceptional returns of 70.91% in FY2012 compared to Greaves Cotton's ROA at 26.42% in FY2012 and is in declining trend for last 2 years.
INDIAN ECONOMY GROWTH SCENARIO AND ENGINES & GENSET MARKET OUTLOOK As per company's surveys on engines and gen-sets segment, the market is estimated to grow at 10% CAGR for the next 5 years and more. In terms of GDP (PPP), India has surpassed Japan in 2011 to become the world's third largest economy. As per numerous surveys, India is going to be one of the important markets for engines and gen-sets. Indian Government is investing heavily in the infrastructure, agriculture and power related industries which will help companies offering products and services to grow constructively. Indias thrust on achieving higher economic growth rate has intensified construction activities all across the country. This has also created huge demand for power supply. According to market research findings, there is a demand-supply gap of about 15% in power generation. This has created huge market opportunities for companies providing power backup. The power backup market in India is growing at 15-20% CAGR, varying within the three different segments Generators, UPS and inverters. Major players like Kirloskar Oil Engines Ltd (KOEL), Mahindra-Powerol, Cummins India, Greaves Cotton, Ashok Leyland, Eicher, Caterpillar, MTU and few other imported brands are seeing huge market potential to grow. (Source: Company) Engines & Genset segment has Above average but fading returns. Companies in this kind of competitive life cycles have above average reinvestment rates & economic returns (earn their COC on average). Engines & Genset segment is a stable & mature industry, where top players are more conducive to sustainable value creation & add value by Product refinement, Investment in service quality & Process innovation. Industry has a high concentration ratio & leads to more opportunity for coordination. As the Demand variability is limited in this segment, so companies can coordinate their internal activities & with competitors. Overall Industry has lot of growth opportunities so companies can create shareholder value without undermining their competitors. Industry doesn't display any Disruption & Disintegration trend. There is a steady demand of products from this segment, despite minor threats from Alternative energy options. Trade-off between higher earning curve advantages and lower future cost advantages leans in favor to the incumbent and deters new entrant in this declining process costs industry. Barriers to entry are large as it is very tough for a new entrant to put the upfront capital commitment to replicate the required infrastructure, technical know-how and gain market share. Also asset specificity, the level of the min. efficient production scale, excess capacity, & incumbent reputation deters the entry to this market. There are some disorganized players in the market but they don't create a dent in the existing market leaders beneficially. Industry has interactive networks & work on positive feedback from existing customers. Switching costs for those customers rise as the network becomes more significant. The final source of added value is external, or govt. related. Issues here include subsidies, import duties, tariffs, quotas, & both competitive & environmental regulation. Historically stringent emission norms for diesel engines have helped technological leaders increase their market shares and profit margins.
Promoter's Remuneration is consistently in line with the profits they are able to generate for the company. Last 3 years average for remuneration/pre-tax profits stands at 5.19% and remuneration/post-tax profits at 7.69% Related Party Transactions: During the past 3 years under review, there were no materially significant related party transactions made by the Company with its Promoters, Directors, Management or Subsidiaries that may have potential conflict with the interests of the Company at large. Loans and Advances to Promoter Group: For past 3 years, there are no loans and advances in the nature of loans to firms/companies in which Directors are interested. There are no investments in the firms/companies in which Directors are interested. No Suspicious Nature Transaction
Source: Company
KOEL & ENGINES-GENSET INDUSTRY DOES WELL ON THE PORTER'S MODEL (OF POTENTIAL FOR VALUE CREATION) AVERAGE SCORE: 4.03 (ON A SCALE OF 1 TO 5; 1: MOST UNFAVORABLE & 5: MOST FAVORABLE TO A INDUSTRY & INCUMBENTS)
Five Forces How much leverage do suppliers have?3(suppliers have choices to supply their products to several competitors in the mkt.) Can companies pass supplier increases to customers? 5 (quality & specifications keeps customer to pay marginally more) Are there substitute products available? 3 (main competitors and local players offer similar products) Are there switching costs? 3 (ease of switching is medium unless a customer has created a huge setup on few products) How much leverage do buyers have? 4 (quality & product differentiation from the incumbents creates leverage in its favor) How informed are the buyers? 4 (products are for tech & specific uses, so buyers are well informed and know value to price)
Barriers to Entry What are the entry and exit rates like in the industry? 4 (high setup cost, tech know-how deters new entrants) What are the anticipated reactions of incumbents to new entrants? 4 (to come up with better products at lower cost) What is the reputation of incumbents? 5 (top leaders enjoys good market share due to brand recognition) What is the level of asset specificity?3(products can be manufactured & imported from another country & sold in India) What is the minimum efficient production scale? 4 (favors incumbents due to high setup costs, medium level margins) Is there excess capacity in the industry?4(due to innovation & tech specifications, products evolve, medium capacity) Is there a way to differentiate the product? 5 (better quality, efficiency due to innovation, norms requirement helps in this) What is the anticipated payoff for a new entrant?4(new entrants face significant headwinds to take incumbents mkt. share) Do incumbents have precommitment contracts? 5 (present customers are satisfied and stay, govt. gives new contracts) Do incumbents have licenses or patents? 5 (technical expertise is a key and lots of tech. and operations licenses & patents) Are there learning curve benefits in the industry? 5 (entrants are deterred by the tech. & network level of incumbents) Rivalry Among Existing Firms Is there pricing coordination?3(pricing is not the sole criteria, product range differs, low margins, low scope for coordination) What is the industry concentration? 4 (top 4 incumbents has 60% of the market share by value, so highly concentrated) What is the size distribution of firms? 4 (top 4 has majority market share by volume, so less fragmented) How similar are the firms in terms of incentives, corporate philosophy, ownership structure? 3 (similar so rivalry is intense) Is there demand variability? 3 (due to high fixed costs and capacity utilization during economic cycles changes) Are there high fixed costs? 4 (companies need one time fixed investments, later on it's innovation driven) Is the industry growing? 5 (growing at 10%+ CAGR due to rapid industrialization of India) Disruption/Disintegration Is the industry vulnerable to disruptive technology? 5 (some threats from alternative energy but more or less stable) Do new technologies foster product improvements? 5 (in favor of incumbents, increases learning curve for new entrants) Is the technology progressing faster than the market's needs? 4 (changes are there but not to make incumbents obsolete) Have established players passed the performance threshold? 3 (incumbents are established players, so margins are medium) Is the industry organized vertically, or has there been a shift to horizontal markets? 4 (product range creates horizontal shift)
Source: CRISIL
VALUATION METHOD
Method used here is 2 Stage Discount cash flow valuation with an aim to find the intrinsic value of Kirloskar Oil Engine Ltd. based on the present cash flow, growth and risk. Assuming the life of the assets, here 20 years, to estimate Free cash flows, and Discount rate (r) to apply to get the present value. Free cash flow = Cash from operating activities Capital Expenditure Future Free cash flow growth based on past revenue growth rate of KOEL from 2010-11 (Rs. 233 Cr) to 201112 (Rs. 287 Cr) ~ 23%. Taking a very conservative approach due to slowdown in economy and expecting a modest free cash flow growth of: Year 1- 5, growth rate - 5%, Year 6-10, Growth Rate - 2.5%. Perpetuity value (Year 11 to 20) = FCFn+1/(r-gn), FCFn+1 = FCFn * (1+ gn )/(r- gn), where n = 10 years, Perpetuity Growth (gn) = growth of Indian economy in future (Historic Avg. of Indian economy last decade: 6%), Cost of Equity (COE) = r = Risk free rate + Beta* Risk premium KOEL has good credit rating from CRISIL, so enjoys lower credit cost. Risk free rate = 7.5 % (Average Indian Government Bond Yield for 10 Year Notes Rate) Beta = 0.75 for KOEL ; Risk premium = 7.5% (Average Indian Historic implied equity risk premium) Therefore COE (r) = 7.5% + 0.75 *7.5% ~ 13% Free cash flow (year 1-20) = Free cash flow (year 1- 5) at 5% + Free cash flow (year 6- 10) at 2.5% + Perpetuity value (Year 11- 20). All the three values are discounted at COE. Net value = DCF Estimate (Rs. 260) + Present (Cash-Debt) (- Rs. 4) Using the above values and steps KOEL's Per share value is coming out to be Rs. 256 This value is based on Discounted Free Cash Flow Analysis. Present value of Rs. 154 (As of Aug 23rd, 2012) shows a Margin of Safety of 66%.
Disclaimer: This Report is for information purpose only and express our views about the company, not an offer to buy or sell. Risks involved in investing is not suitable for all kinds of investors. Seek professional advice if this research is suitable for you.
KOEL OWNER'S EARNINGS RS. 287CR (MAR 2012); CAGR 23% (AS PER BUFFETT'S FCF MODEL)
KOEL'S INTRINSIC VALUE: RS. 256; MOS: 66% (AS PER DCF ANALYSIS)