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Strong operating performance aided by exports

Expect cost elements to return from 3Q

* Cummins India (KKC)’s 1QFY21 revenue came in at INR11.8b (2-yr CAGR: - 6%) and was 12% ahead of our expectation. Adj. PAT came in at INR1.3b and was 8% ahead of our expectations.

* The demand outlook is strong, driven by a) the unlocking of the domestic economy and likely pent-up demand playing out for a few months, b) road construction likely to favor the Industrial segment, and c) the export market holding well.

* While 2QFY22 is likely to be another strong quarter for Cummins, aided by a low base, we expect earnings growth to be subdued from 3Q as cost elements normalize. Notably, of the 200bps expansion in EBITDA margins in FY21, 170bps is attributable to lower royalties, warranty provisions, and sales commissions.

* We expect the larger portion of these cost elements to normalize from 3Q. The sales mix was also favorable in FY21 as Powergen sales (lower margin) were weaker. The management denied any plans to consolidate listed and unlisted entities. We maintain our Sell rating, with TP of INR695.

Exports and pent-up demand support topline

* 1QFY22 snapshot: Revenue increased 138% YoY to INR11.8b and was 16% ahead of our expectation (2-yr CAGR at -6%). EBITDA came in at INR1.5b and was 19% ahead of our expectation. The EBITDA margin came in at 12.6% v/s our expectation of 12.2%.

* Other income declined 18% YoY to INR549m. Thus, adjusted PAT came in at INR1.3b and was 8% ahead of our expectation. The company recognized exceptional gains of INR1.3b (pre-tax) on profit from the sale of property. Thus, reported PAT came in at INR2.4b.

* The mix tilted in favor of exports sequentially, leading to gross margin expansion of 120bps QoQ. Other cost elements, such as employee costs and warranty provisions, are likely seeing a normalization trend, leading to decline in EBITDA margins by 80bps QoQ to 12.6% (still better than our estimate of 12.2%).

Key management call highlights

* Strong demand outlook: KKC has introduced newer products in the Powergen segment as well as several products in the Industrial segment. It is seeing a sequential improvement in various markets post the opening up of the economy. The demand outlook remains positive, although the total market recovery outlook is curtailed by the possibility of a third COVID wave.

* Clean energy: In India, clean energy applications are currently coming up in Transportation (such as buses). For Cummins’ product offerings, the cycle, perhaps, is a seven-year one. Cummins has products related to hydrogen globally, but major opportunities in India would come after five years.

* The management has denied any plans to consolidate listed and unlisted entities as of now.

Valuation and view

* We maintain our long-term thesis on structural issues in the current business of Diesel Gensets, as power availability continues to improve in India. Also, longterm disruption from solar energy and battery storage, among others, cannot be ruled out. Exports remain the best growth opportunity for the company, but in the last decade, the same has been captured best in the unlisted entity. The management’s denial to consolidate listed and unlisted entities leaves us concerned over the long-term prospects of the existing business.

* While the demand outlook looks robust, aided by pent-demand across the domestic and export markets, we remain cautious on margins. Notably, of the 200bps expansion in EBITDA margins in FY21, 170bps is attributable to lower royalties, warranty provisions, and sales commissions. We expect the larger portion of these cost elements to normalize from 3Q. The management indicated that royalties would form 0.6–1.0% of sales in FY22 v/s 0.3% in FY21. Thus, royalties alone would eat away ~50bps of margins towards 2H.

* We forecast an FY21–24E revenue / EBITDA / adj. PAT CAGR of 15%/18%/14%. Note that other income formed 43% of PBT in FY21 (FY24E: ~30%), of which rental income formed 45%. Thus, rental income formed ~20% of PBT in FY21. We broadly maintain our FY23E/FY24E EPS, but increase FY22E by 9%, factoring in the 1QFY22 performance. Maintain Sell, with TP of INR695 (higher PE multiple of 25x v/s 20x earlier to account for sector re-rating). Any slowdown in exports could be a de-rating catalyst on the stock.

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