Underweight rating on Cummins India, target R386

Updated: Sep 29 2012, 08:13am hrs
We initiate coverage of Cummins India with an underweight rating and a price target of R386, implying a 23% downside. We believe the Street is overlooking headwinds for domestic generator sets and export demand, amid fragile macro conditions.

We like the strong parent, dividend yield and market leadership, but the ~67% premium to the Sensex is untenable, given the earnings risk. Slowing commercial real estate construction, a subdued capex cycle and export demand risk (parent Cummins cut its 2012 power segment revenue guidance from 10% to 0%) pose earnings risks that we believe the Street is ignoring.

On top of a weak (-9%) F12 base, we forecast muted 14%/7% y-o-y earnings growth for F13/F14, 4%/11% below consensus, rendering valuations unattractive.

Our F12-14 12% revenue and 11% earnings CAGR estimates are below the respective 16% and 17% consensus expectations. Market leadership and a strong parent are medium-term positives. We view Cummins Indias less than 50% market share in medium- and high-HP generators as a medium-term positive. Technology access via its parent positions it well against peers in launching products or capitalising on changes in emission norms.

Cummins Indias -0.3x net gearing and 2.3% dividend yield (F13e) are attractive. However, ROE and FCF are likely to remain subdued over the next 18-24 months, in our view, given Cummins Indias C2012-15 R18-billion capex plan. Cummins India trades at 22x 1-year forward EPS, close to its peak multiple. It also trades at a peak of 67% premium relative to the Sensex, 2SDs above its long-term average, while its earnings growth premium is a modest 2% (F13e). We expect multiples to contract given earnings headwinds and project a 17x 1-year forward P/E multiple.

Morgan Stanley