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Cummins India (CUMM.BO): Downgrade to Sell from Neutral
Attractive long-term exposure to industrial growth but current risk-reward unfavorable – expensive
valuations with developed market exposure to result in underperformance
We downgrade Cummins to Sell from Neutral on relatively expensive valuations and the company’s relative
over dependence on exports (27% of sales in FY11).
We believe in the long run Cummins is well positioned to benefit from continuing power back-up demand
(generator business) and capex recovery (engines for equipment used in transportation, construction, and
infrastructure activities).
That said, current domestic weakness in industrial capex (especially in relation to mining and construction)
combined with a slowdown in economic growth in developed markets (primarily the US), is having a twofold
negative impact on the company’s medium-term growth, in our view.
This slower growth, along with the large capex requirements for this and next year, is likely to impact the
company’s capital returns substantially, in our view – we forecast 700bp compression in ROE over the next 2
years.
EBIT Margins for the company improved by 530bp over FY08-FY11, driven by capacity expansion and cost
efficiency improvements (lower percentage of imported components).
We reduce our already below consensus EBIT margin forecasts for FY12-FY14 by a further 50bp-
100bp as we factor in a further loss in operating leverage for the company and factor in the impact of a
further increase in the cost of its key raw material, pig iron. We lower our EPS estimates for FY12-FY14 by
15%-22% as a result of the above changes.
The company’s capacity expansion plan if on track (Rs4bn-Rs4.5bn per annum for the next 2-3 years, vs.
Rs1bn planned earlier) indicates its belief in the long-term demand prospects of its products and services.
Valuation
Cummins currently trades at a 12-month forward P/E of 18X, a 10% premium to its 5-year average 12-month
forward P/E of 16.5X. These valuations are unjustified in our view – not pricing in fully the slowing demand
outlook for the company’s products and the reducing capital returns over the next 12-24 months.
We lower our 12-month target price to Rs518 (from Rs757, which implies 15% downside potential) based on
15X P/E on average FY12E and FY13E EPS (down from 18X given slower growth over the next 2 years) – 10%
below its 5-year median 12-month forward P/E, which is justified in our view given the slower growth for the
company over next two years.
Key upside risks
(1) Stronger-than-expected pick-up in domestic industrial and construction growth, and (2) improvement in
US economy increasing demand for its export products.
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