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Plant Visit – The Unsung Champion

We raise our TP to Rs360 (previously Rs305) and upgrade the rating to BUY for Kirloskar Ferrous Industries Ltd. (KFIL). The upgrade stems from a better understanding of KFIL’s leadership position in the casting business (mainly from our plant visit), which is very much comparable to an auto ancillary business and therefore deserves higher valuations than a commodity producer.

We also learned that demand for KFIL’s castings is clearly much larger than current capacity due to its continuous efforts on customer addition and machining. Further, we expect the pig iron and casting division to add at least 500bps to historical margin trends due to the planned Rs2.4bn cost savings. We expect this underrated company to witness robust growth and also become the lowest cost casting manufacturer in next 3 years.

* Demand running well ahead of current capacity: Our visit to the Koppal and Solapur foundries and discussion with the foundry head and marketing had an unequivocal takeaway: demand for castings at KFIL is much higher than their current capacity, which gives us assurance that the 15% volume growth guided by the management is realisable. Continuous customer additions, incremental demand from existing customers, large traction from CV-related exports and earth moving equipment validates the product acceptance and leadership achieved by this KFIL over the last decade. Improved acceptability of machined castings from OEMs and new orders being booked with machining contract assures value addition for the casting business.

* Plant visit gives us insights into sustainable margin trajectory: We learned from the plant visit that cost saving projects are expected to be completed on schedule, with groundwork already begun for some. These projects will structurally augment margins for both divisions. We expect pig iron division and casting division to add at least 500bps to their historical margin trends on a sustainable basis post the completion and ramp up (especially waste heat power plant) of these projects. This will offset commodity price risk for the pig iron business in down-cycles. We expect cost savings of Rs2.4bn on full ramp up of these projects.

* Castings division deserves higher valuation: From observations on the progress of KFIL’s castings business (over the last decade) at the plant, we believe that the business has garnered wallet share of all leading domestic OEMs (tractor and CV) and is the leading choice for global OEMs. Post the cost saving measures; it will also be the lowest cost producer of castings, pursuing continuous value addition along with pricing power. These qualitative parameters are on par with auto ancillary peers. Further its margins, return ratios and growth trajectory are also very much comparable to auto ancillary peers, due to which we believe it deserves much higher valuation than a commodity company.

* Valuation and risks: We shift to SOTP valuation and attribute 11x multiple to the Casting division’s Sept’23E EBITDA (~30% discount to 15.8x - average FY23E EV/EBITDA multiple for auto ancillary peers) and a 5.5x EV/EBITDA multiple to the pig iron Sept’23E EBITDA (higher multiple for its complete backward integration and rise in margins) to arrive at a TP of Rs360/share. On CMP, KFIL trades at 6.1x FY23E EV/EBITDA. We have lowered our earnings for FY22/FY23 to account for the surge in coking coal prices and lower cost saving estimates. Key risks: Rise of electric vehicles, commodity price volatility and tractor down-cycles.

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