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Attractive valuations versus near-term weakness

We hosted the Kirloskar Oil Engines Ltd (KOEL) management for an interactive session on current trends in the genset industry and other areas, such as the emission norm change in industrial engines, export markets, and KOEL’s plans for B2C and Arka Fincap. The genset industry is undergoing a transition phase with near-term weakness seen in volumes, which will normalize in a few quarters. The company is ready for the CEV5 norm shift in the industrial segment from Jan’25 onwards and is gradually increasing its presence in export markets. Despite decline in volumes seen in its key powergen segment on YoY basis, we remain positive on KOEL on its 1) strategy to grow the share of high kVA rating products over medium to long term; 2) ability to benefit from the strong distribution network versus other smaller players in the industry; and 3) sharp valuation discount versus the market leader. We cut our estimates for FY25/26/27 by 7%/4%/1% to factor in lower revenues in the powergen segment. We reiterate BUY on KOEL with a revised SOTP-based TP of INR1,540 based on 29x P/E on two-year forward estimates.

Powergen volumes to ramp up in a few quarters

For the powergen segment, overall industry volumes, which used to hover at ~35k gensets per quarter last year, witnessed a transient dip to ~28k-29k in 2QFY25, post the implementation of CPCB 4+ norms. KOEL is confident of a sequential improvement to ~30k in 3QFY25 and a broad-based normalization in ensuing quarters. Historically, the company has been a dominant player in the LHP and MHP nodes (~30% market share). However, following the emission norm change, it is seeing the entry of MNC players in LHP nodes as well owing to the technologically advanced nature of products. The CPCB 4+ transition has resulted in price hikes of 30-40% and the company saw a small price correction in certain nodes during 3QFY25. On the other hand, players such as Cummins, Caterpillar, MTU, et al have been predominant in the HHP space, while KOEL has only recently forayed into the same. It currently has a high single-digit market share (>750kva) and aspires to reach a high double-digit, ultimately targeting a 25-30% market share on the back of its new launches and strong service network. Notably, it has already started getting inquiries from data centers and high tension segment.

Industrial segment benefiting from robust demand trend

The industrial segment is witnessing a growth upswing as the company is reaping the benefits of its targeted efforts in this segment. KOEL has outlined its intent to grow its defense and railways sectors, where the company sees robust opportunity potential over the coming years. However, it will take some time to scale up. The upcoming BSV norms will not see a similar pre-buying trend as the CPCB 4+ norms, as industrial customers have their own production schedules. The norm shift is both a risk and an opportunity as customers tend to switch vendors during norm transitions only.

Export growth to fructify gradually

Alongside HHP and distribution segments, KOEL has identified exports as a key growth driver in its overall strategy. While we have seen near-term weakness in exports for the company, KOEL is confident of scaling up the business sustainably, with a strong foundation already in place. The company will approach each geography on its own merits; it will take a calculated call in terms of tying up with GOEMs and distributors, entering into JVs, or directly operating in the market based on the regulatory requirement, competitive landscape, etc. KOEL has earmarked the Middle East and US as its key focus markets. Pertinently, it has already received certifications for certain products in the US and has set up a company to operate as a GOEM.

B2C production to stabilize following the planned plant relocation

The B2C segment saw a transient dip in 2QFY25 on account of a planned relocation to the new facility, where it has consolidated five of its manufacturing locations into a single unit. This resulted in lower production and dispatches, which is slated to stabilize in the coming 1-2 quarters. This new facility will see improved cost efficiencies, streamlining of operations, and reduced delivery time. Its current product range is largely commoditized in nature (small pumps) and the company aims to move up the value chain so as to reduce the twin risks of price sensitivity and seasonality, which it is currently exposed to.

Targeting retailization of the Arka Fincap loan book

Arka’s current loan book of ~INR62.8b is largely comprised of wholesale corporate loans, real estate loans, and SME loans (average ticket size of ~INR20m). The company plans to increase the granularity of the loan book and expand into retail lending. This expansion will be led by additions to its existing network of physical branches coupled with the scaling up of its digital presence. Management believes there is sufficient headroom to take additional debt to fund this growth, while equity funding from KOEL will be the last option.

Financial outlook

We revise our estimates downwards by 7%/4%/1% for FY25/26/27 to factor in slight weakness in the powergen segment. We expect a revenue CAGR of 17% over FY24- 27, driven by 15%/21%/18%/20%/16% CAGR in powergen/industrial/distribution/exports/B2C. Over FY24-27E, we bake in 340bp expansion in margins to build in better product mix and operating leverage benefits. We expect a PAT CAGR of 30% over the same period.

Valuation and view

The stock is currently trading at 34x/26x/20x FY25E/26E/27E earnings. Adjusted with subsidiary valuation, KOEL is trading at 31x/23x/18x FY25E/26E/27E EPS, which is still at a 45-50% discount to the market leader. We continue to reiterate BUY on KOEL as we expect it to benefit from improved sales from higher HP segments, exports, and improving trajectory of the B2C segment.

Key risks and concerns

Demand slowdown, competitive intensity, higher costs for B2C division, the risk of further fund infusion in Arka Fincap, and technology risks are the key risks for KOEL.

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