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Clarity on margins makes Cummins a decent buy

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Authors: JordanET Intelligence Group: Investors’ interest may return to the stock of Cummins India Limited (CIL), an Indian subsidiary of Cummins Inc and maker of engines and genset, because of fading concerns of margin dilution due to outsourcing to group-related companies and diminishing competitive intensity in higher horsepower (HHP) engines segment. The stock of Cummins India has shed nearly 20 per cent since the beginning of the year mainly because of fears that increased outsourcing from the group companies, such as Cummins Technologies India Limited (CTIL) and Tata Cummins, is margin-dilutive and it could restrict revenue growth.

But now clarity seems to be emerging that investors’ concern could have been exaggerated. Although there has been a sizeable increase in outsourcing by the company, it is primarily from Tata Cummins Limited (TCL), which is a JV company with 50 per cent stake of the parent company.

In Cummins India, the parent stake is at 51 per cent.

Therefore, it will not change much for the profit of the parent, or move profit from one entity to other. Nomura said: “Tata Cummins has been manufacturing engines used in the CV segment, thus moving the up-fit of these engines to TCL by CIL is a decision justified by the economics of scale.” Secondly, the share of engine revenues of CTIL has not materially changed in the past few years.

The engine business contributed 15 per cent of the total revenues in FY16. Even on the financial parameters, it does not appear that outsourcing has been margin-dilutive.

The gross margin — revenues minus the cost of raw material — has been steady in the range of 35-38 per cent in the past three years and is in line with those of peers such as Greaves Cotton and Kirloskar Oil Engine.

Gross margin provides the correct picture of outsourcing as it captures the impact of traded goods in the total raw-material cost.

The margins, in the first nine months of FY18, are better than the previous two years, which may alleviate investors’ fear that rising outsourcing is diluting margins.

In fact, EBITDA margins compression of CIL is actually a reflection of underutilisation of capacity. The revenue growth of CIL is likely to be supported by growth from the data centre, pick-up in road construction and higher oil prices.

The company has been continuously gaining market share in the domestic engine market with an overall market share of 40 per cent and 70 per cent in the HHP segment.

The exit of import-dependent engine suppliers, such as Volvo and MTU, has favoured the company.

In the medium term, standby power for the data centre is likely to be a key growth driver for CIL as companies such as Tata Communication, NTT, Vodafone and IBM are planning to set up new data centres.

According to the Internet and Mobile Association of India, Indian data centre industry could reach $7billion by 2020 from $2.2 billion in 2015. CIL’s stock is trading at 23.3 times its FY20 projected earnings, which is at a 10 per cent discount to the sector average despite better return on equity.




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