Competitive overhang clouds Cummins India's medium-growth outlook

At the current price, the stock is trading at 30x its FY23 earnings estimates

The stock of Cummins India, which makes diesel and natural gas engines, was up 6 per cent since its lows last month after a better-than-expected December quarter performance. A record showing in the quarter led to upward revisions in the earnings estimates of 6-11 per cent for 2021-22 (FY22) and FY23.  

Revenues in the quarter for the capital goods major was up 22 per cent over the year-ago quarter. This was led by a 23 per cent uptick in the domestic business and 18 per cent growth in exports. The realisations in exports, which accounted for 26 per cent of revenues, were higher than in the domestic market. The company highlighted that growth was led by demand from data centres, commercial real estate, infrastructure, health care, and manufacturing.

Despite commodity price pressures, Cummins India was able to limit the same at the operating level. While gross margins were down 232 basis points (bps) year-on-year (YoY) to 33.6 per cent due to higher raw material prices and supply-chain issues, the hit to the operating profit margin was contained at 129 bps to 15.6 per due to price hikes, cost controls, and localisation.

Over the nine-month period in FY22, the company’s revenues are up 50 per cent YoY, while operating margins have improved 56 bps.

The company expects the supply-chain situation to ease gradually, with near-term challenges to remain on the back of shortages related to semiconductor chips, critical parts, and material.

The management expects growth to revive in FY23, aided by new launches for railways, higher demand for construction equipment, and steady growth in mining and marine segments.

The company’s strong performance over the past few years has come after the 15 per cent revenue growth over 2012-13 through FY20, but flat profits due to severe competition and absence of broad-based growth. But this seems to be changing.

Say Aditya Mongia and Teena Virmani of Kotak Institutional Equities: “The company has report­ed over 50 per cent higher operating profit versus pre-Covid run rate, making it the best performer in our capital goods coverage, along with Carborundum Universal. This has been driven by a fairly broad-based growth across key business segments, localisation, and operating leverage-driven margin expansion.”

Brokerages are, however, split on the company’s prospects, given the competitive environment, challenges after the implementation of new pollution norms, and the ability to sustain cost savings and consequently margins.

The first hurdle is the im­­p­lementation of the Cen­t­ral Pollution Control Board norms (CPCB IV) from July 2023 and the challenge of passing on the higher costs to customers.

Highlighting this, Nomura Res­e­arch points out that the CPCB II norm changeover in FY16 costs inc­r­eased 10 per cent, but due to stiff competition in a price-sensitive market, gross margins declined over FY16-20. Even the relatively less price-sensitive US market witnessed margin and volume contraction when the Environment (Prot­ec­tion) Act IV norms (similar to CPCB emission control norms) were implemented in 2015.

Further, the Ministry of Power’s draft amendment, discouraging the use of diesel generator sets, clouds the company’s medium-growth outlook, according to Jefferies Research. Highlighting the danger of growth optimism, the brokerage points out, “Gross block rose fourfold in 2008-09 through 2018-19, while sales is up only 1.7x. We believe the expansion plans factored in stronger domestic and export growth, compared to the reality that panned out. Return ratios will bear the brunt of the demand overestimation, capping return-on-equity to 18 per cent levels despite recovery in FY22.”

Countering this, Kotak Research believes that stiffer emission norms in the power generation segment from July 2023 will further dent the ability of its peers to compete on price. The company, according to the brokerage, expects to gain market share and envisages this to be an operating profit-neutral or positive development. Further, analysts point out that the company is leveraging its scale, improving levels of localisation, and mixing the benefit of exports to cement a meaningful lead versus competition.

The other factor the Street will watch out for is the ability to contain costs. Nomura Research says that the current levels of other expenses below 9 per cent of sales are too low and unsustainable in the longer run.

At the current price, the stock, which has generated single-digit returns over the past year, is trading at 30x its FY23 earnings estimates. Given the multiple headwinds, inve­s­tors should await revenue and margin improvement over the next few quarters before considering the stock.