Century Partners Kirloskar Oil Engines Ltd Aug 2012
EQUITY RESEARCH REPORTKirloskar Oil Engines LimitedNSE: KIRLOSENG; BSE: 533293ISIN: INE146L01010; Reuters: KIRO.NS; Bloomberg Ticker: KOEL:INTarget Price: Rs. 256 by July 2013Potential Upside: 65%+ in 1 year; Rating: BuyOriginally Recommended on May 23rd 2012 Quote: Rs. 152Report on Aug 23rd 2012, Current Market Price: Rs. 154Century PartnersFor Queries Kindly Write To: Century.Partners03@gmail.com
Kirloskar Oil Engines Ltd. (BSE: 533293) Century Partners; Maneesh NathSector: Engines & Gen-setsRecommended on: May 23rd 2012, Quote: Rs. 152; Rating: BuyReport on Aug 23rd 2012, Current Market Price: Rs. 154; Re-Rating: BuyHead Office: Pune, India; Established: 1946Recommendation: Buy, Target Price: Rs. 256 by July 2013● We believe considering the Margin Of Safety of 66%, present price per share of Kirloskar Oil EnginesLtd. (KOEL) at Rs. 154 (Aug 23rd, 2012) is undervalued by a considerable margin to its Intrinsic Valueof Rs. 256. Due to KOELs ability to grow economic profit, we anticipate KOEL to get a higher valuationmultiple from the markets which will help company to reach its Intrinsic Value soon.● We think in an emerging market like India there is lot of room for growth in the Engines and Gen-setssegment just to come at par with the global benchmark. Kirloskars able management has strategicallypositioned itself well to take advantage of this growth opportunity.Conversions: $1 = Rs. 55; Rs. 1 Crore (Cr) = $181,000; 1Cr = 10 million, 1 Lakh = 100,000Intrinsic Value(from DCF Analysis):Rs. 256Margin of Safety: 66% Risk: Low Current Price:Rs. 154Avg. Daily Volume: $65,000 52 Week Range:Rs. 107 - Rs. 166Market Cap:Rs. 2226 Cr($405million)Revenues FY2012:Rs. 2276 Cr ($414mm)EPS: Rs. 13 P/B: 2.16 P/E: 11.87(Avg. P/E of Last 3 years: 14)EV/EBITDA: 4.9(Avg. EV/EBITDA ofLast 3 years: 6)Margins(EBITDA: 16.43%,PAT: 9%)Debt/Equity: 0.08 EBITDA 3Yr. Avg.:10%ROE: 19% Div & Yield:Rs. 4 (2.6%)Total Income 3Yr.Growth Rate: 10%Current Ratio: 0.96 Quick Ratio: 0.77 Book Value/Share:Rs.71ROCE: 23% Share Holding:Promoters Holdings: 67.17%Institutional:17.82%
INVESTMENT THESISWe think that Kirloskar Oil Engines Ltd. (KOEL) has positioned itself well by becoming a leader in themanufacturing of Diesel Engines, Agricultural Pumpsets and Generation Sets. KOEL provide products for thepower generation, off-highway and agricultural sectors. KOEL has an in-house Research and Engineeringfacilities and deploys value engineering and lean manufacturing concepts. (R&D/Sales Ratio of 2%)Under Power Generation segment KOEL provides both Air-cooled and Liquid cooled Diesel Engines andGenerating Sets across a wide range of power output from 5kVA to 3000kVA for applications during standbyand power requirements. Under Large Engines, KOEL manufactures Diesel Engines from 2,400 HP to 11,000 HPfor power plants. Under Agri arm they manufacture Diesel Pumpsets from 3 HP to 130 HP for farmers. UnderOff-Highway segment they manufacture Diesel Engines from 20 HP to 800 HP for earth movers and otherindustrial purposes. KOEL strives to increase its market share by producing diversified, efficient and higherquality products at lower cost. KOEL is confident that its products will meet the requirements of revisedemission norms before its effective post June 2013.Managements drive to strengthen backend operations (service, distribution, manufacturing) has paid off byKOEL increasing its market share (value terms) to 21%. In FY12, KOEL reported a top-line of Rs. 2,276 Cr,and exceeded the analyst expectations. Revenues for Q1FY2013 of Rs. 603 Cr showed a 6% yoy growth fromQ1FY2012 Rs. 566 Cr. Reported Q1FY2013 EBITDA stood at Rs. 88 Cr, reflecting 4% yoy growth withimproving margins from Q1FY2012 EBITDA of Rs. 85 Cr. This improvement in the margins is driven by 15%lower employee expenses (offered VRS and shifted plant to Kagal, where employee costs are one-third of thatof Pune) and 5% yoy decline in other expenses. Reported FY12 PAT characterize, Rs. 24 Cr increase in otherincome, 7.3% increase in depreciation and ammo. expense to Rs. 91.29 Cr. In FY2011, Company changed itsmethod of providing depreciation in respect of Electrical Installation and Aircraft from Written Down Value basisto SL Method causing a lower depreciation amount in FY2011 by Rs. 7.7 Cr. Lower taxes of 27.3% in Q1FY13vs. 32.1% in Q1FY12 is also going to add to the bottom line. Owner Earnings (FCF) CAGR of 23% will help thecompany in taking care of their FY13E CAPEX requirement of Rs. 120 Cr and ECB maturities due in FY13E.KOEL in recent years have started focusing on exports and customer focused business, which will be a keydriver in increasing the revenues. Company has improving EBITDA Margins, which will lead to higher ROE andre-rating. On valuation front company is selling at a significant lower multiples relative to its historic averageand peers. Both the undervalued part combined with high growth opportunity due to demand and supply gapin this space makes it a good investment opportunity for long term investors.
CATALYSTS○ After analyzing growth prospects, KOEL is entering a new market segment with the launch of aPortable Diesel Genset. Along with this new addition company has substituted 4 cylinder engines inplace of 6 cylinder engines in the 100-125kVA power range. This helps company moving up in thevalue chain.○ KOELs plan to vacate Khadki, Pune plant and shift operations to Kagal is going to save money onrental, taxes and operational expenses.○ Seeing low valuation, KOEL has announced to buy-back shares worth Rs. 73.62 Cr by Jan 2013.○ Increased government spending and improvement in lifestyles will ensue sustained businessgrowth.With an experienced management and companys strong & diverse revenue streams and present undervaluedstatus leads us to provide a Buy Rating on Kirloskar Oil Engines Ltd. (KOEL) with a one year time horizon toreach its underlying intrinsic value of Rs. 256.RISKS○ If Indias economy slowed down that will lead to lower IIP & reduced customer spending and canaffect companys revenues in the short run.○ Reduction in peak power deficit due to increase in Installed Capacity (GW) & new SEB projects canlead to lower than forecast demand.○ Domestic companies face increased competition from imports on appreciation of local currency.○ Company faces competition with low cost Chinese imports and from unorganized Indianmanufacturers. Availability of Government subsidies and higher import duties though helps increating demand for companys products. Also a better network for service support helps inmaintaining customer base.○ Rising commodity price (for input raw material, pig iron) is one more area of concern in thissegment. Stationary power plant segment of the large business group suffered due to high furnaceoil price and continues to be a area of concern.○ Low buying by Telecom operators was an area of concern expressed by the management.Company is trying to ward off all these challenges by offering better products and services in diverse rangeand lowering its cost via increasing operational efficiency.
KIRLOSKAR OIL ENGINES QUALIFIES ON OUR BASIC VALUATION CRITERIA●Valuation of a company primarily involves Earnings, Growth Rate and Cost of Capital●Price = Avg. Earnings/(Cost of Capital - Growth Rate) = Rs. 14/ (13 - 6) = Rs. 200●Sales & Earnings Growth (last 5yrs) > 15%, Low PEG Ratio, High Earnings/PBV Ratio●Return on Retained Earnings > 15%; Initial Rate of Return > 20%●Market Capital close to Book value, Return On Equity > 20%, Return On Asset > 15%,●Return On Invested Capital > 15%, Earnings Yield > 15%, Current Ratio > 2, Debt/Equity < 1●Present P/E < 0.75 * Historical P/E (Average of last 3 years)●Good Credit Rating, Insider Share Buybacks, Stable Capital Structure, Stable Inventory TurnoverKirloskar Oil Engines Ltd. qualifies well on our above mentioned basic criteria to find undervalued & growingcompanies.Expected Value from DCF of Rs. 256 in 1 year provides us a ROR of well over 30%+ It also qualifiesthe Hurdle Rate > 2 * Long Term Govt. Bond Yield (7.5%) of 15%. Book Value of Kirloskar Oil Engines Ltd. ison continuous rise which will ensure that the Intrinsic Value of Rs. 256 should be reached soon.FINAL CHECKLIST FOR KIRLOSKAR OIL ENGINES●Business: Understandable, Economic Moat, Growth Potential, No Catastrophic Risk●Customers: Stickiness to The Company, Loyalty●Suppliers: Relationship With The Company●Management: Intellect, Initiative and Integrity (3Is)●Board of Directors: Background of The Members●Financial: ROE, ROIC and Other Ratios, Capital Structure●Value: Earnings vs. Value, Margin Of SafetyKirloskar Oil Engines Ltd. does very well on all of the above mentioned Valuation and Final Checklist Criteria,hence we issue a Buy Rating on Kirloskar Oil Engines Limited with a Target Price of Rs. 256 by Jul 2013.
KIRLOSKAR OIL ENGINES BUSINESS AND PRODUCTSCompany Profile:Kirloskar Oil Engines Ltd. (KOEL) is the flagship company of The Kirloskar Group, (est. 1888, a $1.6Billion+ Sales) engineeringconglomerate. KOEL is India’s leading Engine and Gen-sets manufacturer in the medium engine category. It manufactures a wide range ofengines, Diesel Generating (DG) sets. KOEL caters to power-generation, industrial, infrastructure, agricultural, naval & telecomsectors. KOEL has over 100 clients in its portfolio and presence through-out India and is a global brand; Employees: 3500;Present day Kirloskar Oil Engines Ltd. (KOEL) was formed during 2009 by demerger of original Kirloskar Oil Engines (now known asKirloskar Industries Ltd.) with engine business going to Kirloskar Engines India Ltd. (now known as Kirloskar Oil Engines Ltd., KOEL).Due to increase in Government spending and industry trends favouring higher equipment usage, KOEL can be a major beneficiary of theincreased demand. KOEL has planned increase in capacity utilization (currently at 60%) and whose partial benefits of increased turnovershould be evident in FY13E itself. KOEL has won new orders worth Rs. 396 Cr from Nuclear Power Corporation of India Ltd. (NPCIL), whichis to be implemented over the next 3-year period. There has been an increasing demand for KOELs engines and auto components in theinternational market. Presently, exports contributes 7% of the revenues and is expected to show rapid growth. KOEL has already initiatedinvestments to increase capacity to cater to this growth. KOEL signed an agreement with Daihatsu Diesel Co., Japan in Q4FY2011 formanufacturing diesel engines in the range of 610-2,560 KW to cater Commercial Marine segment. KOEL seeing high growth in itsCustomer Support segment (spares & service) is widening its service dealership network.KOEL offers value for money in its segment with a focus on delivering high quality diverse mix of environment friendly, efficient productsand reliable services. Managements strategy to provide diverse range of products and increase operational efficiency will ensure economicvalue addition.
KIRLOSKAR OIL ENGINES BUSINESS REVENUE MODELSource: Company, IndiaNivesh ResearchPower Generation (PG) segment accounted for 37% of FY2012 revenues. KOEL focuses on manufacturing airand water cooled engines, Diesel Gen-sets across industries with power output ranging 5-750kVA. Alsocompany focuses on 2100-6300kVA range for both standby & continuous duty DG Sets.Power Gen Revenue Mix: Cellular business (upto 40kVA) accounts for 4%, 40-320kVA product mix accounts for80% of the revenue and >321kVA accounts for about 16% of the revenues.Industrial and Off-Highway Segment accounted for 21% of FY12 revenues. In this sub-segment KOEL caterto Construction Equipment Sector with a market share of 55%. KOEL supplies products to 35 OEMs (Escorts,GC, Hyundai, Ingersoll Rand, L&T, Volvo). Major setback for KOEL recently was losing JCB, one of its maincustomer with ~35% sub-segment revenue, possibility of losing GC.Customer Support Segment accounted for 17% of FY12 revenues; Revenue Ratio (Spares:Service) is 80:20.KOEL have over 100 service dealers for Power Gen & Industrial segment, have 237 service dealers for Agrisegment. KOEL in this segment has seen high growth and successfully increased its revenues/service dealer.Agriculture Segment accounted for 15% of FY12 revenues. KOEL offers products like Diesel Gen-sets andpump sets in wide range of 3-130 HP and has 20%+ (by value) Agri engines market share. Agri segment Q1FY2013 at Rs. 83 Cr represents 30% yoy increase.Large Engines Segment accounted for 7% of FY12 revenues. KOEL caters to Nuclear Power Plant, and Navalvessel frigates in wide range of 2,400-11,000 HP.Automobiles (Bearings) Business has been hived off since Sep 30, 2011 with a profit of Rs. 47.71 Cr.Exports contributes 7% of FY12 revenues and company is focusing to increase its exports to importantmarkets like Africa, South Asia and Middle East.
KOELS CLIENTS & EXPORTSSource: Company, IndiaNivesh ResearchExports are growing at 8.4% CAGRSource: Company
KOELS FINANCIAL HIGHLIGHTS AND FEATURESSource: Company● Revenue (2011-12): Rs. 2,276 Cr; Operating Expenditure: Rs. 2011 Cr● EBITDA: Rs. 304 Cr; Reported Net Profit: 192 Cr● Return on Capital Employed (ROCE): 23%● Sales of the company is growing at a CAGR of 7%+ and profit margins are stable● Earnings have been on consistent continuous rise & future growth is expected to rise● D/E of 0.08 represent KOEL to be a debt free company and very stable capital structure● Owners Earnings (FCF) is growing at 23% CAGR● ECB due in June 2013, to be paid of by excess free cash flow● Dividend Yield of 2.6% is attractive given low valuations of the company● Lower effective tax rate due to tax incentives to be received for the Kagal Plant● Inventory & Receivables (Days) reduced to 25 & 41 in Q1FY13 from 31 & 53 in FY12 Respectively● Depreciation & Amortization Expense for FY2012 was Rs. 91 Cr (SL Method)● Profit on sale of Bearings business resulted in Exceptional item (Income) of Rs. 47.7 Cr● CAPEX plans for FY13E: Rs. 120 CrSource: Company
KOELS BALANCE SHEET FOR LAST 3 YEARSSource: Money Control● Networth of thecompany grew at23.2% CAGR.● Total Liabilities grewat 8.5% CAGR.● Net Block grewmarginally at 2%CAGR.● Total Assets in last3 years grew at8.5% CAGR.● Book Value of thecompany increasedfrom Rs. 46.7 Cr toRs. 70.9 Cr, CAGR24%.
KOELS P&L FOR LAST 3 YEARSSource: Money Control● Revenues are stableand marginallygrowing at 2.2%CAGR.● Total Expenses grewat 5% CAGR.● Reported Net profitof KOEL hasincreased from Rs.164 Cr in FY2010 toRs. 191.8 Cr with ahealthy CAGR of8%.● EPS in last 3 yearsgrew at 8.3%CAGR.
KOELS FINANCIAL RATIOS FOR LAST 3 YEARSSource: Money Control● Operating Profit Margin Ratioshow a marginally downwardtrend but Net Profit MarginRatio shows slightimprovement, this is mainlyaided by value engineeringbenefits.● Gross Profit Margin hascome down from 11.54% inFY10 to 8.32% in FY12averaging down at 15%/year.● ROCE, RONW both showsmarginal downward trendwhereas ROA have improvedfrom 46.72% in FY2010 to70.91% in FY2012.● D/E Ratio has shownfavorable trend, company issoon planning to be debtfree.
KOELS FINANCIAL RATIOS FOR LAST 3 YEARSSource: Money Control● Inventory Turnover Ratiohas improved from 18.11to 20.35.● Asset Turnover Ratioshows a marginaldownward trend.● Material Cost Compositionand Selling DistributionCost Composition isconsistent for last 3 years.● Expenses as Compositionof Total Sales Ratio showsa marginal increase mainlydue to companysrelocation plans which willeventually help companyreduce costs.● Dividend Payout Ratio(Ref: Net Profit) decreasedfrom 41.41 in FY2010 to35.29 in FY2012, mainly ascompany is focusing onreducing debt andexpanding its capacity.
KOEL HAS 21% MARKET SHARE AND UNDERVALUED RELATIVE TO ITS PEERSSource: Company, Emkay ResearchSource: MoneyControl
KEY MARKET PLAYERS IN ENGINES AND GENSET SEGMENTSource: Emkay ResearchThe market for Gen-sets is approximately 135,000 units annually and growing at 13%/year and to growsteadily for the next 10 years. Players like Mahindra, KOEL and Greaves Cotton are extremely strong in 15-200kVA range, KOEL and Volvo Penta are extremely competitive in the <600 kVA range.Few niches - MTU (subsidiary of Diamler Chrysler) is recognized in the 1000 kVA machines and Volvo Penta ispopular in the 500 kVA machines.Players like Cummins and KOEL have manufacturing facilities in India; Rest all import and sell in India.Cummins has by-far the highest distribution touch points (spares) at 400, followed by KOEL at 338.Caterpillar and Cummins sell their products at a premium, Perkins and Volvo Penta are in mid range and KOELand Greaves Cotton sell its product with 25% to 30% price differential. Chinese products are sold 30-40%lower than KOEL & GC and 10-20% lower than local players.Perkins (subsidiary of Caterpillar) is investing USD 150 mn for a manufacturing set-up at Shendra IndustrialEstate, Aurangabad, India. The facility will have capacity to produce 3000 engines per year, scaleable upto5000 engines per year. The facility is expected to commence operations in June 2013.
COMPARISON OF FY2012 FINANCIALS WITH KEY COMPETITORSSource: Money ControlKOEL trades at lower multiples relative to itscompetitors reason to which is two folds,competitors like Cummins India has higherprofitability and ahead in terms of size,growth, product mix, and global brandrecognition etc. Exports is another reason dueto which competitors like Cummins trade atbetter valuation than KOEL. KOEL nowfocusing on increasing its exports will help thecompany to get re-rated. On an average peersdo better in terms of financial and operationalefficiency but KOEL has also successfullyimplemented its value addition multi-prongstrategy and soon it will trade at bettermultiples. KOELs debt came down from Rs.269.6 Cr in FY2010 to Rs. 86.6 Cr in FY2012,presently almost a debt free company as itspeers. This trend shows that company isgearing up its resources and in years aheadsavings from cost cutting will be going toimprove the margins.KOELs R&D Expenses/Sales has consistentlygrown from 0.4 in FY10 & 0.9 in FY11 to 2.1 inFY2012, inline with companys new productdevelopment. For FY11 Cummins India hasR&D Expenses/Sales at 0.9 and GreavesCotton at 1.0
CUMMINS INDIA HISTORICAL FINANCIAL RATIOSSource: Money ControlCummins India trades at P/E of22.4 and P/B of 6.52 (vs.KOELs P/E of 12.3 and P/B of2.24) which reflects two things,one that market is willing to paymore for better performingplayers in this segment andsecondly if Cummins India is notable to maintain its highperformance level, there arechances of downgrades.
CUMMINS INDIA HISTORICAL FINANCIAL RATIOSSource: Money Control
GREAVES COTTON HISTORICAL FINANCIAL RATIOSSource: Money ControlGreaves Cotton trades at P/Eof 9.24 and P/B of 2.61 (vs.KOELs P/E of 12.3 and P/B of2.24). Greaves Cotton hasslightly better performance inall of the metrics except ROAwhere KOEL has exceptionalreturns of 70.91% in FY2012compared to Greaves CottonsROA at 26.42% in FY2012 andis in declining trend for last 2years.
GREAVES COTTON HISTORICAL FINANCIAL RATIOSSource: Money Control
INDIAN ECONOMY GROWTH SCENARIO AND ENGINES & GENSET MARKET OUTLOOKAs per companys surveys on engines and gen-sets segment, the market is estimated to grow at 10% CAGRfor the next 5 years and more. In terms of GDP (PPP), India has surpassed Japan in 2011 to become theworlds third largest economy. As per numerous surveys, India is going to be one of the important markets forengines and gen-sets. Indian Government is investing heavily in the infrastructure, agriculture and powerrelated industries which will help companies offering products and services to grow constructively. India’sthrust on achieving higher economic growth rate has intensified construction activities all across the country.This has also created huge demand for power supply. According to market research findings, there is ademand-supply gap of about 15% in power generation. This has created huge market opportunities forcompanies providing power backup. The power backup market in India is growing at 15-20% CAGR, varyingwithin the three different segments – Generators, UPS and inverters. Major players like Kirloskar Oil EnginesLtd (KOEL), Mahindra-Powerol, Cummins India, Greaves Cotton, Ashok Leyland, Eicher, Caterpillar, MTU andfew other imported brands are seeing huge market potential to grow. (Source: Company)Engines & Genset segment has Above average but fading returns. Companies in this kind of competitive lifecycles have above average reinvestment rates & economic returns (earn their COC on average). Engines &Genset segment is a stable & mature industry, where top players are more conducive to sustainable valuecreation & add value by Product refinement, Investment in service quality & Process innovation. Industry has ahigh concentration ratio & leads to more opportunity for coordination. As the Demand variability is limited inthis segment, so companies can coordinate their internal activities & with competitors. Overall Industry has lotof growth opportunities so companies can create shareholder value without undermining their competitors.Industry doesnt display any Disruption & Disintegration trend. There is a steady demand of products from thissegment, despite minor threats from Alternative energy options. Trade-off between higher earning curveadvantages and lower future cost advantages leans in favor to the incumbent and deters new entrant in thisdeclining process costs industry. Barriers to entry are large as it is very tough for a new entrant to put theupfront capital commitment to replicate the required infrastructure, technical know-how and gain marketshare. Also asset specificity, the level of the min. efficient production scale, excess capacity, & incumbentreputation deters the entry to this market. There are some disorganized players in the market but they dontcreate a dent in the existing market leaders beneficially. Industry has interactive networks & work on positivefeedback from existing customers. Switching costs for those customers rise as the network becomes moresignificant. The final source of added value is external, or govt. related. Issues here include subsidies, importduties, tariffs, quotas, & both competitive & environmental regulation. Historically stringent emission norms fordiesel engines have helped technological leaders increase their market shares and profit margins.
KOELS ECONOMIC MOAT IS INCREASINGKOEL business does well on our criteria on creation of sustainable value by earning economic profit (cash flowreturn on investment - cost of capital) and earning excess returns over a period of time. For this reason weanticipate revisions in expectations for financial performance that enable them to earn returns above theiropportunity cost of capital.KOEL qualifies on all the three broad sources of added value: production advantages, consumer advantages,and external advantages (Government subsidies etc.). Competitors in this segment are fiercely trying to gainmarket share based on quality, service, customer satisfaction, operational efficiency. Some of them arecomplementary but overall the competition is tough among the Top 4 players.KOEL has aggressively worked to increase operational efficiency, negotiate with its suppliers and pass on itsadvantage to its customers. KOEL provides differentiated products to a diverse buyer base.KOEL achieve competitive advantage by being a low to medium cost producer (production advantage) andproduct differentiation (consumer advantage).KOELs strategy to pass on the value added advantage to its customers and keeping the price low has paid offin increasing its market share. As the sole competition is not just based on pricing, growth is constructive.KOEL has several Incumbent advantages like precommitment contracts, licenses and patents, learning curvebenefits and network effects.KOEL operates in a complex processes businesses which require more technical know-how & coordinationcapabilities and is a source of advantage.KOEL coming from The Kirloskar Group has a good brand name in the market and adds value as the customersare willing to pay atleast a small premium compared to other low cost producers.KOELs management seek to understand the industry and competitive landscape so as to make decisions andallocate resources in a way that maximizes long-term economic profits.
KOEL HAS EFFECTIVE MANAGEMENTMr. Atul C. Kirloskar, an engineer from WIT, USA and with 34 years of experience is the Executive Chairman ofKOEL. He is well known in the industry as a Master Strategist and major force behind KOELs growth. Mr.Gautam A. Kulkarni has over 34 years of experience is the Executive Vice Chairman. Mr. Nihal G. Kulkarni,Brown University Grad. and 10 years of experience is the MD of KOEL. Mr. Rahul C. Kirloskar (brother of Mr.Atul C. Kirloskar) is a Mechanical Engineer from USA with 27 years of experience and serves as the NonExecutive Director of KOEL. Mr. Sanjay D. Parande is the CFO of Company and has over 30 years ofexperience.KOEL is run by highly entrepreneurial, experienced and technically qualified industry leaders. Management isvery dynamic and work relentlessly towards providing customers superior products and services. Professionalculture and good academic background of its managers and over decades of experience has helped KOEL facedthe recent downturn effectively. Managements low dividend payout policy is suitable seeing the higher futuregrowth prospects and current expansions. Management is focused on transparency while operating and keepinvestors interest first. KOELs Management is very particular about being the best in their league and makingthe company state of art operations.KOELs Management skill entails both fashioning the strategy and execution of the strategy. KOEL does well onall the 3 core of execution processes: the people process (good relations with the Union), the strategy process(moving up in the value chain by increasing product mix), and the operations process (possess valueengineering advantage to keep cost low). KOELs Executives chose and promote people in light of the strategicand operational realities. KOELs management given the medium size of operations is able to execute itsstrategies well. Hence KOELs Managers are able to link operations to strategic goals and human capacity.Some of KOELs competitors being very large companies have a particular challenge because of the significantcomplexity of managing a large employee base.KOELs management has developed an organizational structures that allow them sufficient flexibility in a fast-changing world which is reflected during smooth shift of operations from Khadki to Kagal facility.Due to higher promoter stakes in the company, management incentives are aligned with outside investors.KOELs management strive to create sustainable value by a constant balancing act between delivering currentresults and allocating the appropriate resources to assure a vibrant and value-creating business in the future.
KOEL HAS GOOD CORPORATE GOVERNANCESource: CompanyPromoters Remuneration isconsistently in line with the profits theyare able to generate for the company.Last 3 years average forremuneration/pre-tax profits stands at5.19% and remuneration/post-tax profitsat 7.69%Related Party Transactions:During the past 3 years under review,there were no materially significantrelated party transactions made bythe Company with its Promoters,Directors, Management or Subsidiariesthat may have potential conflict withthe interests of the Company at large.Loans and Advances to PromoterGroup: For past 3 years, there are noloans and advances in the nature of loansto firms/companies in which Directors areinterested. There are no investments inthe firms/companies in which Directorsare interested.No Suspicious Nature Transaction
KOEL & ENGINES-GENSET INDUSTRY DOES WELL ON THE PORTERS MODEL (OF POTENTIAL FOR VALUE CREATION)AVERAGE SCORE: 4.03 (ON A SCALE OF 1 TO 5; 1: MOST UNFAVORABLE & 5: MOST FAVORABLE TO A INDUSTRY & INCUMBENTS)Five Forces○ How much leverage do suppliers have?3(suppliers have choices to supply their products to several competitors in the mkt.)○ Can companies pass supplier increases to customers? 5 (quality & specifications keeps customer to pay marginally more)○ Are there substitute products available? 3 (main competitors and local players offer similar products)○ Are there switching costs? 3 (ease of switching is medium unless a customer has created a huge setup on few products)○ How much leverage do buyers have? 4 (quality & product differentiation from the incumbents creates leverage in its favor)○ How informed are the buyers? 4 (products are for tech & specific uses, so buyers are well informed and know value to price)Barriers to Entry○ What are the entry and exit rates like in the industry? 4 (high setup cost, tech know-how deters new entrants)○ What are the anticipated reactions of incumbents to new entrants? 4 (to come up with better products at lower cost)○ What is the reputation of incumbents? 5 (top leaders enjoys good market share due to brand recognition)○ What is the level of asset specificity?3(products can be manufactured & imported from another country & sold in India)○ What is the minimum efficient production scale? 4 (favors incumbents due to high setup costs, medium level margins)○ Is there excess capacity in the industry?4(due to innovation & tech specifications, products evolve, medium capacity)○ Is there a way to differentiate the product? 5 (better quality, efficiency due to innovation, norms requirement helps in this)○ What is the anticipated payoff for a new entrant?4(new entrants face significant headwinds to take incumbents mkt. share)○ Do incumbents have precommitment contracts? 5 (present customers are satisfied and stay, govt. gives new contracts)○ Do incumbents have licenses or patents? 5 (technical expertise is a key and lots of tech. and operations licenses & patents)○ Are there learning curve benefits in the industry? 5 (entrants are deterred by the tech. & network level of incumbents)Rivalry Among Existing Firms○ Is there pricing coordination?3(pricing is not the sole criteria, product range differs, low margins, low scope forcoordination)○ What is the industry concentration? 4 (top 4 incumbents has 60% of the market share by value, so highly concentrated)○ What is the size distribution of firms? 4 (top 4 has majority market share by volume, so less fragmented)○ How similar are the firms in terms of incentives, corporate philosophy, ownership structure? 3 (similar so rivalry is intense)○ Is there demand variability? 3 (due to high fixed costs and capacity utilization during economic cycles changes)○ Are there high fixed costs? 4 (companies need one time fixed investments, later on its innovation driven)○ Is the industry growing? 5 (growing at 10%+ CAGR due to rapid industrialization of India)Disruption/Disintegration○ Is the industry vulnerable to disruptive technology? 5 (some threats from alternative energy but more or less stable)○ Do new technologies foster product improvements? 5 (in favor of incumbents, increases learning curve for new entrants)○ Is the technology progressing faster than the markets needs? 4 (changes are there but not to make incumbents obsolete)○ Have established players passed the performance threshold? 3 (incumbents are established players, so margins aremedium)○ Is the industry organized vertically, or has there been a shift to horizontal markets? 4 (product range creates horizontalshift)
KOEL QUALIFIES ON MOST OF THE ECONOMIC VALUE ADDITION CHECKLISTAVERAGE SCORE: 3.9 (ON A SCALE OF 1 TO 5; 1: MOST UNFAVORABLE & 5: MOST FAVORABLE TO THE COMPANY)○ Does the firm have production advantages? 4 (high fixed cost, unit costs decline as output rises but to certain extent)○ Is there instability in the business structure? 4 (overall stable business, economic cycles though affects business)○ Is there complexity requiring know-how or coordination capabilities? 5 (tech adds complexities, deterrent to entrants)○ How quickly are the process costs changing? 5 (value engineering, lean operations, ability to pass on costs to customers)○ Does the firm have any patents, copyrights, trademarks, etc.? 5 (technical know-how and patent driven company)○ Are there economies of scale? 4 (company is growing both at local level and globally by focusing on exports)○ What does the firms distribution scale look like? 4 (local, regional, national and growing exports ensure global presence)○ Are assets and revenue clustered geographically? 3 (revenues: 93% India, 7% outside India, assets primarily in India)○ Are there purchasing advantages with size? 3 (key input material is pig iron, price depends upon economic cycles)○ Are there economies of scope? 4 (value engineering, lean, R&D spillover from one dept. to another helps in reducing cost)○ Are there diverse research profiles? 4 (works towards increasing fuel efficiency, quality etc. of its product-mix)○ Are there consumer advantages? 4 (main consumers are who cant afford expensive products but need to maintain quality)○ Is there habit or horizontal differentiation? 4 (due to service network of business customers stay with the company)○ Do people prefer the product to competing products? 4 (customers cautious about price to value stays with the company)○ Are there lots of product attributes that customers weigh? 4 (efficiency, low noise, durability, diverse product-mix etc.)○ Can customers only assess the product through trial? 4 (experience goods, company enjoys product differentiation by spec.)○ Is there customer lock-in? Are there high switching costs? 3 (switching cost declines as product ages)○ Is the network radial or interactive? 4 (positive feedback based interactive network where winner takes most business)○ What is the source and longevity of added value? 3 (innovation, value engineering helps in lowering cost but marginsmedium)○ Are there external sources of added value (subsidies, tariffs, & competitive/environmental regulations)? 4 (Govt. & Norms)○ Firm Interaction—Competition and Coordination 3 (competition, leads to medium sustainable value creation)○ Are there complementors to the industry? 3 (products have single operation use, service though complements it)○ Is the added value growing due to other companies? Or, do entrants take share from a fixed-value pie? 5 (growth 10%CAGR)○ Does the brand increase willingness to pay? 4 (good brand name of KOEL in the market helps to distinguish from locals)○ Do customers have an emotional connection to the brand? 4 (long history of company, its group with large network)○ Do customers trust the product because of the name? 4 (company known for engineering prowess, assurance, values)○ Does the brand imply social status? 4 (better than most of the Indian competitors and locals & China imports)○ Can company reduce supplier operating cost with its name? 4 (have leverage to a certain extent, driven by economiccycles)
CPCB II NORMS AND ITS IMPACT ON THE INDUSTRYThe Central Pollution Control Board, CPCB II norms are applicable from June 2013 onward. KOEL has strongtechnical expertise to comply with the upcoming CPCB II norms. This new norm will eventually help thecompany in increasing its prices and chances are there will be 5% additional growth for companys products.This could now generate pre-buying in anticipation of application of CPCB II norms. The upcoming CPCB IInorms are applicable for engines below 800 kVA range. Engines above 800 kVA are already emission normcompliant.Competitors like Cummins India who have strong parent technology support will also benefit from these newnorms. Historically companies with strong emission technical know-how benefits in terms of revenues andprofit margins. The real challenge in designing cleaner diesel engines is to reduce NOx and PM emissions whilemaintaining performance. The emission norms in India are being continuously updated to match those in theEuropean Union. So the major suppliers of Diesel Gen-sets will be facing some competition from the renewableenergy sources like the Solar PV or CSP wherin this industry the price of materials and thus cost of energy isdecreasing on an year by year basis. As Alternative Energy is still far from being economically viable at a largescale, it doesnt create any immediate threat to the conventional energy sources.Source: CPCB, Avendus Research
COMPANY OWNERSHIP INFORMATIONPromoters have maintained their stake at 67.17% & not sold shares in the recent past. Promoters stake wentup from 62.37% in 2011 to 67.17% in 2012, an increase of 8%.None of KOELs shares are pledged which helps in increasing the free float and shows little reliance on debt tooperate.KOEL has announced for shares buy-back (Rs. 73.62 Cr) anytime before Jan 2013, so the insiders stake isgoing to increase and will benefit the existing shareholders and increase potential investor confidence to investin KOEL. So far company has not announced buying any shares under this program.As of June 2012, 7 Institutions holds 17.82% of KOEL. These Institutions have been consistently holding thestock over a period of time.Source: Company, Money Control
KIRLOSKAR OIL ENGINES LTD. VALUATION● For this study, 2-Stage aggregate free cash flow model has been used, which is growing well over 23%,even if we take a conservative growth rate of 5% for the next 5 years and 2.5% for the 5 yearsthereafter, our intrinsic value calculation of Rs. 256 shows a MOS of 66% from the present day price ofRs. 154.● Taking a range gives us a valuation of Rs. 211 to Rs. 264 market value for earnings multiple of 16X and20X respectively. The revised multiples used are reasonable given the excellent growth rate the companyexemplifies and lower than its peers.● DCF Model approach value of Rs. 256 lies in between this Earnings Multiple range of Rs. 211 - Rs. 264.● The main reason for the low valuation of Kirloskar Oil Engines Ltd. is due to the economic slowdown inthe country along with concerns on new emission norms being imposed from June 2013. Short terminterest are not very keen on this segment but for long term investors with few years investmenthorizon, Kirloskar Oil Engines is attractive at these low valuations.● Comparing the present P/E and P/B ratio to it’s historic average and its competitors figures, tells us thatthe company is trading at a lower multiple.● Debt to equity = 0.08 (very stable capital structure). Company is virtually debt free and can focus ondiverting its free cash flows towards CAPEX requirements to build new and better products.● Credit Rating and Information Services of India Limited (CRISIL) has provided good rating to KOEL.Source: CRISIL
VALUATION METHODMethod used here is 2 Stage Discount cash flow valuation with an aim to find the intrinsic value of Kirloskar OilEngine Ltd. based on the present cash flow, growth and risk. Assuming the life of the assets, here 20 years, toestimate Free cash flows, and Discount rate (r) to apply to get the present value.Free cash flow = Cash from operating activities – Capital ExpenditureFuture Free cash flow growth based on past revenue growth rate of KOEL from 2010-11 (Rs. 233 Cr) to 2011-12 (Rs. 287 Cr) ~ 23%.Taking a very conservative approach due to slowdown in economy and expecting a modest free cash flowgrowth of: Year 1- 5, growth rate - 5%, Year 6-10, Growth Rate - 2.5%.Perpetuity value (Year 11 to 20) = FCFn+1/(r-gn), FCFn+1 = FCFn * (1+ gn )/(r- gn),where n = 10 years, Perpetuity Growth (gn) = growth of Indian economy in future (Historic Avg. of Indianeconomy last decade: 6%), Cost of Equity (COE) = r = Risk free rate + Beta* Risk premiumKOEL has good credit rating from CRISIL, so enjoys lower credit cost.Risk free rate = 7.5 % (Average Indian Government Bond Yield for 10 Year Notes Rate)Beta = 0.75 for KOEL ; Risk premium = 7.5% (Average Indian Historic implied equity risk premium)Therefore COE (r) = 7.5% + 0.75 *7.5% ~ 13%Free cash flow (year 1-20) = Free cash flow (year 1- 5) at 5% + Free cash flow (year 6- 10) at 2.5% +Perpetuity value (Year 11- 20). All the three values are discounted at COE.Net value = DCF Estimate (Rs. 260) + Present (Cash-Debt) (- Rs. 4)Using the above values and steps KOELs Per share value is coming out to be Rs. 256This value is based on Discounted Free Cash Flow Analysis.Present value of Rs. 154 (As of Aug 23rd, 2012) shows a Margin of Safety of 66%.Disclaimer: This Report is for information purpose only and express our views about the company, not an offer to buy or sell. Risks involved in investing is not suitable for all kinds ofinvestors. Seek professional advice if this research is suitable for you.