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Kirloskar Oil Engines – Providing backup to India’s capex revival


Company Name – Kirloskar Oil Engines Limited (KOEL)


Current Share Price – INR 381 (March 22, 2023)


Market Cap – INR 5,511 cr


 

1. What is interesting about the stock?


The Indian government's USD 122 billion allocation towards capital expenditure in the union budget 2023, which is aimed at making India a USD 5 trillion economy by FY25, is expected to spur economic activity across various sectors such as manufacturing, construction, telecom, real estate, and defence. This is excellent news for Kirloskar Oil Engines Limited, the 135-year-old Kirloskar Group's flagship company. KOEL is a leading manufacturer of diesel engines, gensets, and pump sets in India. After a 7-year period of sluggish performance where the standalone revenues grew only at a CAGR of 1.5% (FY14 – FY21), KOEL appears re-energized under a new leadership team to use the macroeconomic and policy tailwinds to its advantage.


KOEL, which was established in 1946, has classified its wide-ranging product portfolio into three segments:

  • B2B Segment - This segment encompasses two main businesses: Internal Combustion Engines (ICE) and Institutional and Project Solutions (IPS). The company produces power gensets and industrial engines within this segment. The B2B segment accounts for 70% of the company's consolidated revenues.

  • B2C Segment - KOEL's Water Management Solutions (WMS), Farm Mechanization Solutions (FMS), and other agriculture-related businesses are classified under this segment. KOEL has also acquired a 100% stake in La-Gajjar Machineries (LGM) which is a leading submersible pump manufacturer with established brands like “Varuna” and “Raindrop”.

  • NBFC Segment – KOEL owns a fully-fledged non-banking financial company (NBFC) called Arka Fincap Limited, in which it plans to invest INR 1,000 crores. The focus of this segment is to provide structured term financing solutions to corporates and real estate companies, as well as offer loans to micro, small, and medium enterprise (MSME) borrowers.

The Company has 5 manufacturing plants for its standalone business, with the two biggest facilities located in Kagal and Nashik in Maharashtra. KOEL exports its products to over 30 countries and serves a wide range of industries, including manufacturing, real estate, defense, commercial marine, fisheries, and agriculture.


Product Portfolio of KOEL and understanding the sectoral tailwinds


A) Power Genset Segment (B2B segment)


KOEL is the market leader in India's low and medium HP genset segments. Its products are sold under KOEL 'Chhota Chilli' and KOEL 'i-Green' brands. The Company specializes in manufacturing air-cooled and liquid-cooled diesel engines and generating sets ranging from 2 kVA to 5200 kVA for industrial, residential, and commercial establishments, and special applications like telecom. KOEL also provides turnkey power backup solutions, including gensets for businesses of all sizes, addressing specific requirements like variable loading, synchronized generators, and exhaust piping for continuous, efficient, and reliable power supply.


Sector Outlook


The growth of the power genset industry is tied to key end-user industries like real estate, manufacturing, telecom, and construction. The Indian diesel genset market is projected to grow at a CAGR of 7.6% from USD 900 million in 2022 to USD 1,380 million in 2028, driven by demand from these sectors undergoing a multi-year capex cycle. The demand for gensets is primarily driven by higher capacity building and capex in the economy, which in turn creates a need for backup power. As with developed economies, India is also experiencing a shift in the demand for gensets towards backup power, with approximately 85-90% of genset usage currently being for backup power.

  • Telecom industry is set to undergo USD 37 billion capex over the next 3-4 years to enable 5G Rollout across India.

  • The Indian real estate market is expected to grow at a CAGR of 5.5% from 2020 to 2025, reaching a market size of INR 12,854.2 billion (~USD 174.5 billion) by 2025.

  • India's office market witnessed a net absorption of 38.25 million sq ft in 2022, up by 18% compared to 2021. The demand for office space is expected to remain strong in 2023, with an estimated net absorption of 35-40 million sq ft, driven by the technology, e-commerce, and pharma sectors.

  • The Indian data center (DC) market is growing due to increased demand from large hyper-scalers like Amazon Web Services, Google, and Microsoft, who outsource their storage needs to third-party DC providers. It is expected that the next five years will see an addition of 3,900-4,100 MW of capacity involving investments of INR 1.05-1.20 lakh crore.

B) Industrial Engines Business (B2B Segment)


KOEL's operations in this segment are designed to meet the specific power requirements of customers worldwide who require industrial engines ranging from 20 hp to 750 hp. KOEL produces a diverse range of reliable diesel engines that power over 85 industrial applications across six sectors, including earth-moving, construction equipment, material handling, fire-fighting and other pump sets, agriculture, and specialized applications like defence and marine segment. It is a market leader in construction engines with a 98% market share in India. KOEL has recently developed electric motors for industrial machines and electric fire pumps for the export market.


Sector Outlook


The demand for construction and earth-moving engines is expected to rise due to the expansion of the roads sector, which is projected to account for 18% of capital expenditure and involve the construction of USD 200 billion worth of roads in the next two years, including 23 new highways and economic corridors planned by March 2025. The government's USD 1.2 trillion Gati Shakti Plan is also contributing to the demand for construction equipment.


C) Agriculture and allied business (B2C)


KOEL has two segments within its division: Water Management Solutions (WMS) and Farm Mechanization Solutions (FMS). WMS produces diesel and electric pumps, while FMS manufactures power tillers, power weeders, and rotary tillers. In the Q3FY23 earnings call, the company reported a YoY growth of 45% in the FMS category and 27% in the WMS category. Additionally, the company's wholly-owned subsidiary, LGM, also contributed around INR 100 cr of revenue to KOEL's Q3FY23 topline.


However, the EBITDA margins for this division are subject to fluctuation due to the seasonal nature of agricultural demand. Moreover, the profitability margins have been impacted in recent quarters by commodity inflation, which limits price flexibility in the B2C segment. The Company is focused on introducing new products and increasing its product range to cater to the diverse needs of farmers in India. The Company has also been expanding its distribution network in rural areas through partnerships and collaborations. KOEL is also focused on increasing the share of exports in this segment to achieve its target of a double-digit EBITDA margin in the long run.


Sector Outlook:


The agriculture equipment market in India is expected to reach USD 19.6 billion by 2025, growing at a CAGR of 8.6% between 2020 and 2025. This growth is being driven by factors such as increasing mechanization of farming practices, rising demand for high-yield crops, and the adoption of precision farming techniques.


Another trigger for this sector could be the government’s focus on energy-efficient pumps which would gradually boost the demand for electric pumps. The Indian electric pump market is expected to grow at a CAGR of 11% from 2021-2026.


Key Investment Thesis

  • R&D and continuous development of new products – In FY22, KOEL and its subsidiaries invested more than INR 100 cr in research and development activities. The Company has a dedicated team of 177 personnel working on innovative projects at its in-house R&D centre. KOEL has successfully launched new engines and products, which highlights its R&D capabilities. Some recent examples of its innovative products include the Organic Waste Decomposer, Dual Fuel-kit engine, and Gas and Ethanol-based gensets. Furthermore, KOEL has signed a memorandum of understanding (MoU) with RITES for developing products in the fields of export of railway rolling stock, infrastructure, and urban transport for both domestic and overseas markets.

  • CPCB IV+ Emission Norms to be commissioned in 2023 – Starting July 1, the Ministry of Environment, Forest and Climate Change (MoEF&CC) has made it mandatory for power gen-sets assembled, manufactured, and imported to India to comply with new emission standards (CPCB IV+). As per these norms, mechanical fuel systems in generators must be replaced with electronic ones. This move is expected to cause industry consolidation, with smaller players finding it difficult to comply with the norms. KOEL anticipates a shift towards higher-capacity engines, which it is well-positioned to benefit from. This will also bring in a price hike of 25-40% across the genset product range. Moreover, the company's new generation of products that comply with the CPCB IV+ norms will help expand its export market to meet emission standards in developed countries worldwide.

  • Management Focus on 2X3Y Strategy – KOEL aims to achieve a turnover of INR 6,500 crs by FY25 through its '2X3Y Strategy' in its standalone business. The company's management is strongly focused on increasing its export revenues, expanding its aftermarket sales in the B2B segment, and widening its sales channels in the B2C segment. The company aims to increase its share of exports from 13% to 30% of its overall sales by FY25. To improve its brand reputation and customer loyalty, KOEL has expanded its service network to 425 dedicated service centers and 6000+ service engineers.

2. Key Historical Financials

  • KOEL operates in a deeply cyclical industry as it has witnessed poor sales and profit growth till 2021. The problem was further accentuated by the pandemic which mowed down the economic growth of the country. However, the Company appears to be undergoing a turnaround in the last 2-3 quarters along with the revival in capex in the country and a focused approach by its management and its 9MFY23 revenue stand at INR 3,639 Cr. Revenue grew 22% in FY23 and 20% in Q3FY23 on a YoY basis

  • EBITDA margin has expanded from 10% in FY22 to ~15% in 9MFY23

  • Revenue contribution from LGM and Arka stood at INR 350 cr. in Q3FY23. KOEL is incubating various new business lines under its subsidiaries which can create a drag on its standalone EBITDA in the near term.

  • Consolidation of Arka has impacted the EBITDA margins and CFO/EBITDA ratio

  • Company had weak ROE of 9% in FY22 which is set to improve in FY23

3. What is my view on Company valuation?

  • The company is trading at a TTM PE of 17X against its 5-year median PE of 13X. This is on the back of a stellar 160% runup in the share price over the last year. Investors should wait for some pullback in the price to its median PE levels before entering for long-term investment purposes.

  • Cummins India, a listed peer in the genset segment trades at a premium valuation of 46X TTM PE. KOEL is trading at a significant discount primarily due to its exposure to the agriculture segment (B2C). However, considering the aggressive growth plans in place for FY25, increasing penetration of export sales, “Make-in-India” theme and capex revival in the economy, KOEL could undergo a valuation re-rating in the near term.

4. What are the risks to the investment analysis?


Risks to the analysis are:

  • The demand for the company's products is largely contingent upon the state of the economy and the amount of infrastructure spending authorized by government authorities. Any downturn in economic growth or reduction in infrastructure spending could potentially have a negative effect on the company's revenue.

  • Investment in unrelated NBFC business is a key monitorable for the investors of KOEL. Any deterioration in the asset quality of Arka Fincap can affect the market sentiments of this company.

  • The feud between the Kirloskar brothers, Atul and Sanjay, could have significant implications for their respective companies, KOEL and Kirloskar Brothers (KBL). The ongoing dispute has created uncertainty and has adversely affected the valuation of KOEL in the markets.

 

About the Author


I am an MBA grad from the Indian Institute of Management, Bangalore, and currently working as a corporate finance specialist in a technology-based startup. I have cleared all 3 levels of CFA, US. I am an avid reader of businesses and like to analyze emerging trends in various sectors and macro economy.


Disclosure


I have had no stock, option, or similar derivative position in any of the companies mentioned for the last 30 days, and shall not initiate any such positions within the next 5 days. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from SocInvest). I have no business relationship with any company whose stock is mentioned in this article.


I am not a SEBI registered advisor. This article is purely for educational purposes and is not to be construed as investment advice. Please consult your financial advisor before acting on it.


I have used publicly available information while writing this article.

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