Equity Research: Kirloskar Oil Engines Ltd

KOEL is expected to achieve a 43% earnings CAGR over the years FY22 to FY24E. As ARKA Fincap's capital infusion nears completion, KOELs balance sheet will be further strengthened as the company continues to produce an average FCF of INR 3.4 bn per annum (FY17–22), allowing it to close the current significant value gap with its competitors in the backup power market.

Kirloskar Oil Engines Ltd. (KOEL), a significant manufacturer of diesel generator sets with a 24% volume market share, has expanded into a number of new industries, including water management, bio waste management, induction motors, and firefighting pumps. Over the following five years, it is intended to reduce reliance on diesel engines from 80% to 60%. In order to meet the demand from data centres, the company also intends to increase the range of products it offers by creating 1500KVA+ category nodes. With the end market showing signs of revival, improved earnings prospects, KOEL looks good among its peer.

Gaining market share in the UHHP area, Powergen intends to expand its range:

The real estate, construction, hospitality, and communications sectors are important end-markets for power generating. Due to strong demand in the MHP segment, where KOEL is the market leader, and the HHP segment, where it has significantly increased its market share (3% in FY21), business inquiries in this sector continue to be robust. KOEL wants to create a 1500KVA+ portfolio (now at 1000KVA) in order to close the product gap. This would enable them to penetrate the lucrative data centre market, where there is high demand.

Industrial engines will experience a rise in demand driven by infrastructure:

Following an increase in pre-purchases of industrial engines in FY21 as a result of the switch from BS IV to VI emission requirements, demand has since moderated. Industrial engines demand is expected to increase going forward as old BS IV inventory in the channel is depleted. Given the considerable uptick in building activity as the government prepares to launch a massive infrastructure investment, demand drivers are still strong. The demand for tractors is very strong.

The agribusiness portfolio of KOEL is given momentum by a number of elements:

The government's emphasis on expanding the use of farm equipment, the promotion of Make in India goods, and import restrictions all stand to greatly benefit KOEL and help it raise sales of power tiller and power weeder equipment (4% of sales contribution). Electric pumps are more in demand as a result of improved power accessibility, and the company sells them both under its own brand name and the LGM brand it bought. Additionally, a robust demand will be ensured by the government's increasing emphasis on replacing inefficient pumps with ones that use less energy.

New firefighting equipment and CPCB IV standards to support export growth: 

In order to reduce its geographic risk exposure, the corporation is attempting to better enter the market. With the help of the introduction of new goods in the power generation and agri areas, KOEL intends to increase its export contribution, which currently accounts for 9% of its sales, to the mid-teens. In the medium to long term, switching to CPCB IV criteria will not only assist KOEL significantly increase its export contribution, but it will also bring India's power generation portfolio up to pace with international emission control standards. The addition of new engines will further boost its export business. At the same time, its firefighting engines are in high demand on the international market and account for 22% of export sales.

Due to pandemic business faced sluggish demand from end user markets, KOEL's domestic sales for FY21 fell precipitously by 20% YoY. However, after the lockdown, when economic activity picked up, end markets had a significant rebound, which enabled KOEL to report 21% YoY growth in FY22. Infrastructure and the hotel industries, as well as commercial reality (IT/ITES, e-commerce, manufacturing), have begun to rise, which should support the company's goal of achieving 14% domestic growth over the period of FY22 to FY24E. Power generating sales experienced a modest 5% revenue CAGR throughout the FY14–20 period as demand from important end markets (commercial real estate, infrastructure) remained stable. Further, a substantial decline was seen in FY21 as problems caused by pandemic negatively affected the firm as a whole. After FY21, when the economy returns to normal, the power generation industry experienced a dramatic comeback, growing by 46% YoY as demand from end markets experienced a significant uptick. Momentum has continued since FY22, and KOEL reported 64% YoY growth in the power generation segment in the first quarter of FY23, helped by a weak base. We have factored in a 20% CAGR over the years FY22 to 24E, helped by a recovery in demand for real estate, hospitality, and construction, as well as the fact that pre-buying will increase in FY23 as CPCBIV norms are put into place. In order to capitalise on the data centre opportunity, which is now dominated by MNC companies, KOEL has entered the HHP category and is expanding its range to 1500 KVA. This should assist boost revenue in the power generating segment along with a pick-up in telecom capex, which saw a 70% YoY gain in FY22.

Real estate is regaining momentum:

 After a steep decrease in FY21, the commercial real estate market, which had been growing strongly in FY18 and FY19, experienced a sharp decline in FY20 due to challenges brought on by FY21. But after a dramatic decrease in the FY20, the FY21 saw a comeback, and the FY22 saw a sharp improvement as the economy returned to normal. In FY22 compared to FY21, net absorption increased by 107% while new completions climbed by 61%. Pent-up demand and a rapid rise in demand from industries including IT/ITES, manufacturing, e-commerce, and BFSI segments led to sharp growth in FY21. The demand for office space has previously been mostly driven by the IT/ITES industry in India, but recently other services have taken over, accounting for 32% of transactions, with IT/ITES accounting for 27%, followed by the co-working segment with 17% and BFSI with 15%. Given increasing completions and supplies over the past four years, vacancy, which peaked at 20% in FY12, bottomed out at 11% in FY17, and has reached 17% levels in FY22.

The commercial market has been expanding for the past four years, peaking in FY19, when net absorption reached a record high of 46.5 million square feet and new completions exceeded 50 million square feet. Future commercial real estate demand is anticipated to increase significantly as the economy returns to normal and the work-from-home culture that many commercial players have adopted as a result of pandemic gradually fades away. As the business environment returns to normal and industries like IT/ITES, e-commerce, warehousing, logistics, and manufacturing activity pick up, we think the industry will have a rebound in FY22.

Given the lack of capex activity in the infrastructure sector and also because of pandemic in FY21, KOEL's domestic sales growth through FY14-22 at 3.4% CAGR resulted in a further slowdown in infrastructure investment. As a preferred supplier to many major manufacturers of construction equipment, both locally and internationally, KOEL stands to benefit from an increase in infrastructure spending. A national infrastructure plan of INR 111 trillion is one of the core themes of the central government's strategy to resuscitate and put the Indian economy on a growth track, and the government is committed to investing money on infrastructure. Government spending on railway, metro, and road building is expected to underpin the industrial segment's modest growth of 17% CAGR over FY22–24E.

The present administration is concentrating on stimulating the economy by investing more money on infrastructure, particularly on highways, metro rail, and railroads. The government has set forth an ambitious INR 111 trillion investment plan for the National Infrastructure Pipeline (NIP) between the years FY20 to FY25E. With the Bharatmala programme, the road sector has seen significant growth in terms of contract awards, and the construction side has also experienced significant growth. The average annual awarding over FY16–22 was 11,900 km, and the average annual construction was 9,800 km. This was much greater than the average annual awarding over FY12–15, which was 6,200 km, and the average annual construction, which was 4,500 km. Moving forward, it is intended to grant 9,000 km and build 15,000 km in FY23. The government has committed to investing INR 20 trillion under NIP over the years FY20 to FY25. Road building necessitates the use of DG units in remote areas where power supply is problematic.

KOEL focuses on improving customer services:

In the industrial sector, where machine usage is high and consequent wear and tear increases the need for spares, customer support business for KOEL has been growing slowly at 3.4% CAGR. However, as broader infrastructure spend improves, we expect industrial machine sales to pick-up momentum, which in turn should lead to robust demand for spares. To guarantee the efficient availability and repair of its devices, KOEL has established 428 service facilities in India and employs 2,600 qualified service employees. Over the period of FY22–FE, we expect a 12% CAGR increase in the distribution business.

Water management initiatives are encouraged as farm mechanisation picks up steam: 

Through its product portfolio of diesel and electric engine pump sets for crop irrigation and its portfolio of power tillers and weeders for farm mechanisation, KOEL participates in the market for water management solutions. 

As a result of the shift to electric pump sets, KOEL's offering in the crop irrigation market through diesel engine pump sets started to experience a decline. As a result, this segment for KOEL has posted a muted 3.4% CAGR over FY14-22E. However, the crop irrigation market is anticipated to experience considerable growth moving forward as KOEL now offers electric pump sets through its acquired brand LGM and its own brand name. The electric pump segment experienced 39% YoY increase in FY22. Growth in this market should be fueled by the government's gradual emphasis on expanding the use of farm mechanisation equipment and restrictions on Chinese imports, which now hold a 32%+ market share. The market for water management solutions is anticipated to expand at a 16% CAGR from FY22 to FY24E.

Exports will gain momentum as demand for firefighting equipment increases, and CPCB IV requirements will further support growth:

In order to diversify regional risk, KOEL is aiming to more thoroughly penetrate the export market. Exports currently account for 9% of revenue, but KOEL anticipates that number to rise to the mid-teens with the help of the introduction of new products in the power generating and agricultural sectors. As India's power generation portfolio would be at level with the world standard in fulfilling the emission control standard with the migration to CPCB IV rules, this should assist KOEL boost its export contribution in the medium to long run. Firefighting engines are gaining significant traction on the international market and currently account for 22% of export sales. Thus, the introduction of new products for firefighting engines and the transition to CPCB IV requirements will result in a significant increase in export business. 

In order to increase exports, KOEL intends to create a new engine platform and concentrate on the Middle East and Africa. In the industrial engine and firefighting pump markets in both of these locations, KOEL has already attained a dominant position. Over the period FY22–24E, we anticipate a 15% CAGR in exports.

Diversifying Business:

By merging ARKA Fincap (100% Stake), KOEL joined the NBFC market in 2019. To date, INR 9.4 billion has been invested with the goal of meeting ARKA Fincap's capital needs up to INR 10 billion. ARKA Fincap offers corporate, MSME, and real estate financing options. AUM and loan book for ARKA are each INR 25 billion during FY22. Over the coming years, KOEL plans to inject INR 0.6 billion to boost ARKA's expansion. Given that the macro environment affects business prospects, any negative developments there could have a negative impact on the company's overall success. Going forward, it would be crucial to examine the soundness of ARKA's loan book.

Financials:

Conclusion:

Due to KOEL's historically slow sales and earnings growth trajectory, a change in senior management, and a capital allocation to its NBFC unit (ARKA Fincap) worth INR 10 billion, the firm has undergone multiple valuation derating and is currently trading at a significant discount to Cummins (trades at 30x its FY24EPS). Given that KOEL wants to decrease its reliance on diesel engines from its present 80% to 60%, we think a fast adjustment with regard to these issues would be a solid starting point. It intends to do this by forging ahead in new business sectors, which will help to increase its addressable market and foster future growth. The prospects for KOEL's core business are encouraged by the incremental resuscitation of the key end markets in the diesel genset sector and the introduction of new products in the UHHP category to capture the rapidly expanding data centre market. Numerous demand factors, such as the real estate sector's resurgence, the intention to increase the manufacturing sector's contribution from its current 15% to 25%, and changes in CPCB norms are emerging, which in our opinion will enable KOEL to achieve a 43% earnings CAGR over the years FY22 to FY24E. As ARKA Fincap's capital infusion nears completion, KOEL's balance sheet will be further strengthened as the company continues to produce an average FCF of INR 3.4 bn per annum (FY17–22), allowing it to close the current significant value gap with its competitors in the backup power market.

Source:

1. Annual Report
2. Company fillings with MCA
3. ACE Analyser
4. BSE 

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