Capital Goods POSITIVE Genset demand environment benign, Greaves gaining

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1 Capital Goods Genset demand environment benign, Greaves gaining market share Based on our discussions with industry experts, Greaves is poised to deliver strong revenue and EPS CAGRs over the next two years. A large 3W OEM suggested that the current volume growth in 3Ws (up 15% YoY in 1HFY15 vs 2% CAGR over FY11-14) is likely to continue in FY16 and FY17, with likely volume growth of at least 10%. This can further increase led by a pick-up in 3W replacement purchases (~30% of the overall market) given our expectations of interest rate cuts kicking off in early FY16. We expect Greaves, with a ~90% market share in 3W diesel auto engines, to report 17% revenue CAGR over FY14-17E (vs 19% CAGR in FY09-12). Further in the genset segment, an industry participant suggested that Greaves is taking market share from Kirloskar and Cummins due to its successful EGR technology. Moreover, it has hired senior personnel targeting a doubling up of genset revenues to Rs5bn by FY17. We reiterate our high-conviction BUY on Greaves (FY17 P/E 12.9x) while we stay sellers on Cummins (FY17 P/E 28.7x) in this space. Key takeaways from our discussions with a large 3W OEM Growth for 3Ws picks up to 15% YoY in 1HFY15; future outlook positive: The sales volume growth for the 3W diesel industry increased to 15% YoY vs a dismal 2% in FY As per our discussion with a large 3W OEM player, on a conservative basis it is fair to assume a volume growth of ~10% YoY for the 3W industry driven by: (a) lower penetration of 3Ws (4-5%), (b) rapid growth of urbanisation (NDA Government has highlighted development of 100 smart cities), (c) rising export demand in Latin America, Bangladesh and Africa and market share gain from China which is currently exporting 0.6mn vehicles to these countries vs India s export of 0.9mn, and (d) development of mass rapid transportation system which requires 3W for end-to-end connectivity. POSITIVE Quick Insight Analysis Meeting Note News Impact Greaves Cotton BUY Bloomberg Code: GRV IN CMP (Rs): 143 TP (Rs): 180 Mcap (Rs bn/us$ bn): 35/0.6 3M ADV (Rs mn/us$ mn): 67/0.6 Cummins SELL Bloomberg Code: KKC IN CMP (Rs): 915 TP (Rs): 470 Mcap (Rs bn/us$ bn): 253/4.1 3M ADV (Rs mn/us$ mn): 198/3.2 Share of diesel in 3Ws to increase: Within the 3W segment (total per annum market size of ~0.9mn vehicles), the share of diesel is likely to increase from the current 30% driven by: (a) higher mileage for diesel (35km per litre vs 25km for petrol), (b) higher load-bearing capacity, and (c) lower emission under the Euro III version of diesel vehicles. Note that apart from the metro cities and NCR, diesel 3W vehicles are allowed to ply without any restrictions as long as they comply with the emission requirements. Recently in Gujarat the share of diesel 3Ws has increased given the shortage of CNG (auto drivers have to wait in line for 2-3 hours to refill their tank). E-rickshaw and quadricycle not a threat to 3Ws: E-rickshaw is not a threat to 3Ws, given its limited load-bearing capacity and likely increase in cost once the regulator mandates its registration. As far as quadricycle is concerned, it will not succeed in India (currently successful in Europe) given its limited load-bearing capacity. Also, existing OEMs would not want this to cannibalise the sales of 3Ws which currently enjoy ~30% EBITDA margins. Interest rate cut is a positive driver for the 3W replacement purchases: Currently, ~30% of the 3W purchases are replacement driven (average life of the vehicle is ~7 years) where the decision to replace the old vehicle is driven by the EMIs and general cost of living. If the interest rates were to come down and the general inflation in the economy was to stabilise around 5-7%, then it would act as a positive catalyst for replacing old vehicles. With our economy team expecting a rate cut in early CY15 and a cooling off in inflation, the replacement cycle for 3Ws is likely to pick up. Analyst Bhargav Buddhadev bhargavbuddhadev@ambitcapital.com Tel: Deepesh Agarwal deepeshagarwal@ambitcapital.com Tel:

2 Key takeaways from our meeting with a participant from the genset industry Weak demand environment to persist: Despite consensus expectations of a demand recovery for gensets in 2HFY14, the demand environment remains weak. October-November volumes were down 30% YoY despite the low base effect. Industry participants do not expect a recovery in the demand environment before FY16, as enquiries remain weak and the conversion rate of enquiries into orders remain poor. All the four major segments realty, industries, government tenders and infrastructure are seeing a drop in volumes. Greaves, however, is reporting a growth (only 7% YoY decline and 30% YoY growth in 4QFY14 and 1QFY15) led by gain in market share due to improved aggression. Cummins, on the other hand, saw a decline of 29% YoY and 14% YoY in 4QFY14 and 1QFY15 respectively. However, in 2QFY15, Cummins reported 8% YoY growth due to restocking of CPCB II gensets. In 3QFY15, we expect Cummins to report a YoY decline given the persisting weak demand in the secondary market. Cummins losing market share given higher pricing for CPCB II gensets: Cummins has raised prices for CPCB II compliant gensets by 20-25% on the back of the launch of new gensets wherein the entire combustion chamber has been modified. As against this, peers like Kirloskar, Greaves and Mahindra have raised prices by 3-6%, given the adoption of the cheaper Exhaust Gas Recirculation (EGR) technology. Whilst EGR technology is inferior, it is finding acceptance given the benign demand environment, resulting in Cummins losing market share. Under the EGR technology, a portion of the engine s exhaust gases are recirculated to the combustion chamber along with the intake air. A valve is used to control the flow of gas depending upon the load. The substitution of burnt gas (which takes no further part in combustion) for oxygen-rich air reduces the proportion of the cylinder content available for combustion. This causes a correspondingly lower heat release and peak cylinder temperature, and reduces the formation of polluting gases. The presence of an inert gas in the cylinder further limits the peak temperature (more than throttling alone in a spark ignition engine). Exhibit 1: Picture of how the EGR technology works Source: Industry, Ambit Capital research In the CPCB II gensets used by Cummins, all the three major components of the engines are modified i.e. automatic voltage regulator, governor and fuel pump. Cummins has modified: (a) its Automatic Voltage Regulator (AVR) to improve its efficiency in passing the voltage load data to the Governor ; (b) its mechanical governor with the semi-automatic governor to improve the analytics of the fuel requirement in the engine, and (c) its fuel pump to combust the unburned diesel. This is a superior engine as compared to the EGR version, as the life of engine is enhanced. However, the cost increase of 3-6% under EGR is significantly lower than the cost increase of 25% in the new CPCB II gensets. Even Greaves and Kirloskar Oil Engines have started developing the new CPCB II gensets, with a launch likely in early CY15.

3 Despite the superior genset, Cummins has been losing market share, due to: Weak demand environment leading to down-trading: A combination of weak demand environment, price increase in gensets and reduction in the number of genset working hours (due to declining power deficits) has resulted in customers down-trading to relatively cheaper options. Whilst in the EGR technology, the life of the genset reduces, customers are still opting for it, given the reduced genset working hours due to reduction in power deficit. Difficulties in justifying cost increase: Unlike 2005, when the modification to genset in the CPCB I norms was visible due to the addition of a canopy, this time around the modification to the combustion chamber is internal. Consequently, justifying the price increase for the CPCB II genset has been challenging. This has allowed engine manufacturers with EGR technology to become aggressive in the market. Exhibit 2: Pictures used by Cummins OEMs partners in an effort to dissuade the adoption of EGR technology Exhibit 3: Cummins has also increased the warranty to five years from the earlier two years to retain its market share Source: Industry, Ambit Capital research Source: Industry, Ambit Capital research Greaves has been the biggest beneficiary of EGR technology given its expertise: Whilst Kirloskar has been struggling with the EGR technology (already engines have been recalled), Greaves has been doing well given its expertise and experience. Greaves had earlier successfully sold the CPCB 1 genset using the EGR technology. Even in the auto segment wherein the emission norms are relatively stricter, Greaves successfully adopted the EGR technology on several occasions. Globally, the application of EGR technology is low, as it reduces the life of the engines. Consequently, Greaves and Kirloskar have been working on the CPCB II technology wherein the combustion chamber is modified. Both these players are likely to launch the CPCB II compliant genset by early CY15. As this happens, we expect Cummins to announce price cuts for its CPCB II gensets, given the rising competitive intensity. Greaves becoming aggressive in gensets Aggressively hiring people at all levels: Greaves has aggressively hired people at the senior (from MNC players such as Cummins and Caterpillar), middle and junior management level (from domestic peers such as Kirloskar and genset OEM partners). The management, post the 2QFY15 results conference call, had mentioned about doubling its genset revenues in two years. Note that Greaves despite a better product offering reported revenues of only Rs2.2bn in FY14 vs Mahindra Powerol s revenues of ~Rs7bn. This is despite Mahindra starting the genset business as late as FY01 vs Greaves being in this business since more than four decades. Further, whilst Mahindra has been importing bulk of the genset from China, Greaves has been manufacturing it in-house. Partial abandonment of genset OEM model: Genset OEM players have been doing bulk of the business in gensets (for Cummins ~80% of the sale is done by genset OEM partners) especially in the high KVA segment, given the customisation of

4 the acoustic enclosure and the laying of the foundation for gensets. With the trend shifting towards medium and low KVA gensets, the utility of the genset OEM partners is likely to come down. Consequently, Greaves has started manufacturing gensets on its own in its factory and it has started selling the gensets to customers directly. This should allow Greaves to also enjoy the margins earned by the genset OEM partners (which make margins of 6-8%). Valuation - Attractively valued: At CMP, Greaves is trading at 12.9x FY17 P/E despite FY17E RoE of 24.1% (920bps improvement over FY14-17E), 30% EPS CAGR over FY14-17E and FCF yield of 7.1% in FY16E and 7.8% in FY17E. On comparison to its own one-year forward five-year average, it is trading at a 38% premium. However, we believe the stock would re-rate once the EPS growth revives. On comparison to Cummins, it is trading at a 55% discount on FY17E P/E (discount on FY16 P/E is 53%). We agree that Greaves will always trade at a discount to Cummins, given Cummins strong franchisee and higher liquidity; however, we expect the discount to narrow, as Greaves is a diversified engine company unlike Cummins which has a significant dependence on power gensets (~40% of FY14 revenue from gensets). Demand for gensets (especially high KVA) is likely to decline in India given falling power deficits and rising diesel prices. Greaves, on the other hand, has a stable portfolio of 3W passenger diesel vehicles wherein it has a near monopoly (market share of more than 90%). Also, as the growth picks up in the diesel small commercial vehicle business, driven by the prevalence of the hub-and-spoke model, Greaves should benefit from its near monopoly in manufacturing engines used in small commercial vehicle as well. We expect Greaves to report 30% EPS CAGR over FY14-17E (vs 14% for Cummins) and 920bps improvement in RoE over FY14-17E (24.1% in FY17E vs 14.9% in FY14) vs 130bps improvement for Cummins. Exhibit 4: Greaves is trading at a 53% and 10% discount to Cummins and KOEL on FY16 P/E Company CMP MCap P/E (x) P/B (x) EV/EBITDA (x) RoE (%) CAGR FY14-17 INR (US$mn) FY15 FY16 FY17 FY15 FY16 FY17 FY15 FY16 FY17 FY15 FY16 FY17 Revenue EPS KOEL NA NA Cummins 913 4, Greaves Average (excl. Greaves) Divergence -28% -39% -55% -35% -37% -37% -41% -47% -49% -50bps 210bps 180bps -100bps 1,610bps Source: Bloomberg, Company, Ambit Capital research; Note: Valuation as on 4 December 2014 Compared with auto ancillary companies (given 60% of Greaves revenues comes from the auto sector), Greaves is more comparable to Wabco and Gabriel. Engines for 3W are more critical than the shock absorbers made by Gabriel but equally important as the products of Wabco. Greaves has 90% share in diesel 3W engines (ex-bajaj), which implies a 23% market share in the overall 3W engine market, which is comparable to Gabriel s market share in its own product. Exhibit 5: Greaves is trading at a 36% discount to auto ancillary players on FY16 P/E Company CMP MCap P/E (x) EV/EBITDA (x) EBITDA margin (%) RoE (%) CAGR FY14-17 INR (US$mn) FY15 FY16 FY17 FY15 FY16 FY17 FY15 FY16 FY17 FY15 FY16 FY17 Revenue EPS Exide 171 2, Bharat Forge 991 3, WABCO 4,535 1, Gabriel Amara Raja 743 2, Greaves Average (excl. Greaves) Divergence -34% -36% -32% -33% -34% -30% -140bps 10bps -30bps -250bps -30bps -10bps -530bps -60bps Source: Bloomberg, Company, Ambit Capital research; Note: Valuation as on 4 December 2014 The key risks for Greaves Cotton are: (a) delay in recovery in the auto business (3W passenger vehicle and 4W small commercial vehicle); we have already assumed 20% revenue growth in FY15 vs 5% YoY decline in FY14; and (b) continuing market share losses in gensets; we have already assumed 13% YoY growth in FY16 vs 20% and 10% YoY decline in FY14 and FY15.

5 Greaves Cotton s financials Balance Sheet Networth 7,333 8,180 9,064 10,418 11,980 Loans Deferred tax liability (net) Sources of funds 7,839 8,513 9,397 10,752 12,314 Net block 3,812 3,683 3,523 3,354 3,226 Capital work-in-progress Investments 919 1,781 1,781 1,781 1,781 Net current assets 3,109 2,998 4,043 5,567 7,257 Application of funds 7,839 8,513 9,397 10,752 12,314 Income statement Revenue 19,061 17,359 19,209 22,290 26,171 EBITDA 2,406 1,877 2,593 3,522 4,214 Depreciation Interest expense Other income PBT 2,143 1,671 2,265 3,192 3,904 Provision for taxation ,206 Consolidated adj PAT 1,515 1,234 1,565 2,206 2,698 EPS diluted (Rs) Cash flow statement PBT 2,001 1,643 2,265 3,192 3,904 WC changes (780) (128) CFO 1,046 1,567 2,211 2,767 3,048 Net capex (710) (96) (300) (300) (350) Net Investments 159 (1,205) CFI (551) (1,229) (300) (300) (350) Proceeds from borrowings (178) (23) Issue of equity CFF (551) (1,229) (300) (300) (350) FCF ,911 2,467 2,698 Ratio analysis / Valuation parameter Year to March FY13 FY14 FY15E FY16E FY17E Revenue 19,061 17,359 19,209 22,290 26,171 EBITDA 2,406 1,877 2,593 3,522 4,214 Depreciation Interest expense Other income PBT 2,143 1,671 2,265 3,192 3,904 Provision for taxation ,206 PAT 1,515 1,234 1,565 2,206 2,698 EPS diluted (Rs) Source: Ambit Capital research

6 Cummins financials Balance Sheet Networth 23,867 25,652 28,220 32,127 37,376 Loans Other liabilities Sources of funds 24,195 26,117 28,685 32,593 37,842 Net block (incl. CWIP) 6,142 10,149 13,463 13,664 13,669 Net current assets 11,777 11,014 9,247 12,953 18,197 Investments 6,276 4,954 5,976 5,976 5,976 Application of funds 24,195 26,117 28,685 32,593 37,842 Income statement Revenue 45,090 39,767 44,082 53,118 62,386 EBITDA 7,545 6,967 7,274 8,977 10,481 Depreciation Interest expense Other income 3,487 1,777 1,849 1,957 2,302 PBT 10,513 8,175 8,406 10,101 11,914 Provision for taxation 2,872 2,175 2,270 2,626 3,098 Consolidated adj PAT 7,025 6,000 6,136 7,475 8,817 EPS diluted (Rs) Cash flow statement PBT 10,513 8,175 8,406 10,101 11,914 WC changes (2,531) (1,607) (195) (2,329) 2,015 Others (2,696) (2,945) (1,553) (1,794) (2,229) CFO 5,286 3,624 6,658 5,978 11,700 Net capex (2,148) (4,678) (4,000) (1,004) (843) Net Investments 302 1,516 (1,022) - - CFI (1,846) 539 (5,022) (1,004) (843) Proceeds from borrowings Issue of equity Others (3,590) (4,258) (3,598) (3,598) (3,598) CFF (3,590) (4,258) (3,598) (3,598) (3,598) FCF 3,440 4,163 1,636 4,975 10,857 Ratio analysis / Valuation parameter Year to March FY13 FY14 FY15E FY16E FY17E Revenue growth (%) 11.3 (11.8) EBITDA margin (%) 16.7% 17.5% 16.5% 16.9% 16.8% Net margin (%) 15.6% 15.1% 13.9% 14.1% 14.1% RoCE (%) RoE (%) Net debt / Equity (x) (0.1) (0.0) 0.0 (0.0) (0.2) P/E (x) P/B(x) EV/EBITDA(x) Source: Ambit Capital research

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8 Cummins India (KKC IN, SELL) - Stock price performance Dec-11 Feb-12 Apr-12 Jun-12 Aug-12 Oct-12 Dec-12 Feb-13 Apr-13 Jun-13 Aug-13 Oct-13 Dec-13 Feb-14 Apr-14 Jun-14 Aug-14 Oct-14 CUMMINS INDIA LTD SENSEX Index Source: Bloomberg, Ambit Capital research Greaves Cotton (GRV IN, BUY) - Stock price performance Dec-11 Feb-12 Apr-12 Jun-12 Aug-12 Oct-12 Dec-12 Feb-13 Apr-13 Jun-13 Aug-13 Oct-13 Dec-13 Feb-14 Apr-14 Jun-14 Aug-14 Oct-14 GREAVES COTTON LTD SENSEX Index Source: Bloomberg, Ambit Capital research