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KPIT Cummins Infosystems Ltd. review and analysis by Keynote Capitals

By Keynote Capitals

 

Based out of Pune, KPIT Cummins Infosystems Ltd (KPIT) is an industry leader in embedded logic and industrial automation, with a rich industrial network catering to 144 clients including 7/10 largest auto OEMs worldwide and 30 Tier-I auto suppliers and, enjoys the privilege of premium membership in AUTOSAR and JASPAR.

The company is actively evolving around its niche focus in instrumentation and control systems, specifically in the manufacturing sector (auto segment) and is further strengthening its presence though cutting-edge R&D and strategic acquisitions. Recently it acquired Sparta, an American SAP accelerator with significant footprint in the utilities sector and a German diagnostics company. On the R&D front, KPIT has filed for 27 international patents as of date and, has introduced a unique plug- in parallel hybrid solution, to be manufactured in a JV with Bharat Forge Ltd (BFL) demonstrating the marketability of its patents.

 

Investment rationale

Unique play –Well positioned to exploit global manufacturing sector growth

The global manufacturing industry’s turnaround has been fully captured by ISM PMI data, returning to pre-crisis levels, reflecting improved traction in the sector. With increasing contribution of electronics in automobiles and elevated activity related to implementation of lean manufacturing systems, KPIT is poised to cash in growth prospects by leveraging its core expertise through a profound industrial network.

JV with Bharat Forge Ltd., Impact Automotive Solutions Ltd. (IASL)

With growing environmental concerns, markets have opened up for hybrid solutions. KPIT has pioneered a unique parallel plug-in hybrid product -“Revolo”, substantially cheaper than most globally available solutions, to be manufactured in a JV with BFL, estimated to clock 300-500Cr revenues by FY12. Financed through 50Cr in equity, KPIT will receive continuous license income (~6% of JV’s topline) alongwith 50% stake in the JV.

Looking to leverage expertise in Defense and Energy verticals

KPIT has comfortably leveraged the Sparta acquisition and, its expertise in embedded logic and analytics to enter the energy space, while growing at an annualised rate of ~350% during 2009-10. Going forward, KPIT has tremendous opportunity to grow with investments in smartgrids, estimated to grow at a CAGR of ~38% during 2009-13.

 

 

KPIT also stands to benefit from massive investments in modernisation of Indian forces. To this effect, the company is already working with the defense labs of DRDO.

Marketable R&D practice

As of date, KPIT has filed for 27 international patents. The company is actively looking to build IP through AUTOSAR contributions, accounting for ~2.5% of total revenues. Going forward, non-linear component is set to improve on account of license income from the JV and KPIT’s latest acquisition of a German auto-diagnostics company.

Active acquisition strategy for fueling growth in the long-run KPIT actively seeks to build competencies through the inorganic route, while striving to become a complete end-to-end one stop provider of most manufacturing solutions.  The company has a robust track record of successful acquisitions, fulfilling, both, financial and strategic imperatives.

Sustainable business growth

KPIT faces enormous business cycle risks as a virtue of its manufacturing focus, demonstrated by its dismal topline performance during FY10. However, with reducing customer concentration and proposed diversification in Energy & Defense verticals, KPIT looks more robust to weather the impact of future business cycles.

Continual efforts aimed at improving efficiency

The company has orchestrated impeccable control over various margin levers, effectively improving EBITDA margins by ~10pps to ~23% during the testing periods of FY09. With increasing contribution of fixed price contracts in the revenue mix, the management is confident of margin improvements, going forward.

Valuation

At CMP of 166 the stock is trading at 10.4x FY12E earnings. We initiate coverage on KPIT with fair value of 208.

 

 

Key business takeaways

KPIT is a manufacturing focused IT firm providing a wide portfolio of services spanning across embedded solutions, semicon solutions, SAP/ERP, analytics and engineering design catering to manufacturing, energy and BFSI verticals. The management has reaffirmed its manufacturing focus by recently realigning businesses to address core manufacturing problems while, gradually exiting from the BFSI sector. Going forward, the company plans to grow through energy and defense verticals

 

 

 

Customer profile

Earlier, KPIT was over-reliant on revenues from Cummins, its largest anchor client, peaking at ~50% during Q3FY06.  As of Q1FY11, KPIT has reduced its exposure to Cummins by more than 25pps, effectively decoupling its business from Cummins and, thus, diversifying the client portfolio. Moreover, KPIT has also been successful in reducing business sensitivity w.r.t. star-customers, bottoming at ~60% as of Q1FY11.

 

 

 

 

KPIT’s acquisition track record

KPIT actively seeks to build competencies through the inorganic route, while striving to become a complete end-to-end one stop provider of most manufacturing solutions. The company has a robust track record of successful acquisitions, fulfilling, both, financial and strategic imperatives

 

 

 

Efficiency levers

The company has orchestrated impeccable control over various levers like fixed price revenues, off-shoring, operational efficiency and customer satisfaction, effectively improving EBITDA margins by ~850bps from 12.3% in FY08 to 20.8% in 2009-10. Going forward, the margins are set to improve on higher IP realization, fresher hiring among other factors

 

 

R&D program

KPIT pursues an active R&D program funded by the CREST, aimed at building a substantial manufacturing focused niche-IP portfolio, going forward .  KPIT has the highest R&D intensity among peers, estimated at ~2.5%, translating into 27 patents till date. The marketability of its patents has been proved beyond doubt by "Revolo", an innovative solution to be manufactured in a JV with BFL. Accordingly, we consider KPIT to be an intelligent firm looking to create opportunities through investments in R&D.

 

Geographical breakup of revenues

US and Europe account for a major chunk (60%, 30% respectively) of KPIT’s income giving it the distinction of being one of the very few Indian IT companies to have significant exposure to the European economy/markets

 

 

KPIT is also well-prepared to exploit trends in demand shifts from developed to emerging markets by levaraging its India presence, translating into ~50% growth in emerging markets business, going forward.

 

Growth drivers

With retreating recession-blues, the stage has been set for KPIT's growth on the back of robust global manufacturing sector performance. Previously, in 2008-09 the manufacturing sector, particularly automobile manufacturers were plagued by declining orders, increasing inventories and mounting financial distress. However, the situation has changed of late and the confidence in the manufacturing sector has been restored to pre-2008 crisis levels At the same time, the recession has deeply impacted corporate policies, resulting in increased focus on sustainability, intelligence and frugality. Organisations have restructured business units and realigned processes towards achieving a higher degree of customer- centric-ness while, adopting a demand driven agile approach. Consequently, for the manufacturing sector this translates into higher investments in technology enabled lean systems. Correspondingly, we see greater spending in the areas of process automation and optimisation tools, which will significantly increase the demand for instrumentation, control logic and system integration.

 

 

Manufacturing outlook

Auto industry

Given the concentrated monopolistic structure and pervasive vertical disintegration in auto industry, KPIT is well positioned  to exploit emerging trends related to environmental consciousness, rigorous safety standards, demand shifts from developed to emerging economies and increased customer centric-ness, by leveraging its expertise in embedded logic through a vast industrial nexus.

 

Driven by elevated concerns over global warming and energy security, industrial communities across the globe are under tremendous pressure to systematically reduce dependence on traditional fossil fuels.  As a result, considerable development has transpired in the form of hybrid cars to achieve increased fuel efficiency.

Further, auto electronics solution providers have immense potential to exploit the strengthening economies of standards due to increased modularisation and, going forward, the industry might witness a gradual shift from selling to licensing while locking-in existing customers, thus, ensuring divergent growth paths.

Infotainment systems are becoming an integral part of the car microcosm, with auto-majors treating them as key differentiating factors for increasing market share. Beyond, obvious entertainment value these systems are being increasingly used for functional purposes, like productivity enhancement while achieving highly disciplined coordination.

Going forward, with increasing contribution of electronics in auto architecture, the scope for auto diagnostics and preventive maintenance has become relevant. Presently, the market for vehicle diagnostics is relatively undeveloped and lacking standards, while KPIT is positioned to enjoy first mover advantage fueled by its recent acquisition.

Industrial solutions

The shift towards frugality is evident post financial crisis. The commercial applicability of information technology which was initially restricted to productivity enhancement and ROI has been expanded to include cost –saving objectives, resulting in concentrated demand for control systems and operations management tools.

At the fore-front has been the recent spurt in Product Lifecycle Management (PLM) and Manufacturing Execution Systems (MES) tools, followed by a conscientious approach towards analytics by meaningful practice and implementation of ERP and SCM systems. Going forward, we expect this to extend from intelligent querying to process modeling and factory simulation for empowering and automating critical decisions at the enterprise level.

Sizing estimates suggest doubling of MES revenue during 2006-12, with Frost & Sullivan predicting ~$6bn tied into MES and PLM set to achieve $20bn while registering 9% CAGR during 2007-12.

We also expect KPIT’s semicon business to register more than comparable growth due to its broader focus and rich network incl. tie-ups with worldclass foundries like TSMC, Global Foundries etc.

Energy and Utilities outlook

With a view to protect the environment from emissions and enhance energy security, most countries are improving electricity transmission efficiencies through the adoption of smartgrids, with the US Govt allocating ~$5bn for selective implementation. India too, has launched a smartgid task force under the leadership of technocrat Sam Pitroda. Expected to grow at a whopping 38% CAGR during 2009-13, smartgrids require substantial investment in instrumentation and control systems and, need to be empowered by analytics and optimisation tools.

Broadly speaking, KPIT is set to leverage its embedded logic and SAP expertise to enter the fields of Distribution Automation (DA), Advanced Metering Infrastructure (AMI) and Substation Automation (SA). On the AMI front, KPIT has comfortably leveraged Sparta’s system integration expertise and consulting related acceleration abilities to grow at an annualised rate of ~350% during 2009-10.

On the DA and SA fronts, KPIT is looking to provide instrumentation & control systems including Intelligent Electronic Devices (IEDs), Supervisory Control and Data Acquisition (SCADA) products and analytics solutions aimed at designing tariff plans, identifying exceptional events (thefts, grid failures etc.) and realtime execution.

 

Revenue forecasts

 

Manufacturing

Auto business

For tractable analysis, the auto electronics market can be divided into four segments: powertrain, vehicle controls, driver assistance and infotainment, each accounting for comparable market shares.

 

 

 

 

A  market sizing report by Databeans suggests ~10% CAGR for KPIT's key strength areas, powertrain and infotainment during 2010-13

Based on KPIT's thrust in these areas and recovery of business from key clients like Cummins, coupled with relatively smooth competitive landscape we expect CAGR of ~15- 20% during 2010-13 for its auto embedded business.

 

 

On the back of double-digit growth in PC, smartphone, memory, military, industrial, automotive (see chart 11) applications, semiconductor revenues are expected to grow from $274bn in 2010 to $344bn in 2014, with Asia- Pacific accounting for 45% revenue share by 2014 (Source: IDC Research). Correspondingly, there will be increased activity in the addressable semiconductor market and, we expect KPIT's semicon solutions to grow by a CAGR of ~13-23%, tightly correlated with movements in its embedded solutions vertical, over the next three years.

 

 

Auto manufacturers are incorporating fuel efficiency through electronic control systems, primarily comprising of powertrain and hybrid technologies, ushering the era of "greener" cars. It is likely that these green cars will represent up to a third of total global sales in developed auto markets and up to 20% in urban areas of emerging auto markets by 2020 (Source: Zacks). Some of the green cars like Ford Focus, GM Volt, Nissan Leaf, Toyota Prius and Daimler AG's Smart fortwo micro EV have already generated a stellar market response. Going forward, global hybrid-vehicle sales are expected to reach 2.3mn units by 2015, with ~4% or 92k light-vehicle units

 

 

 

 

KPIT is at the cusp of recent advancements in this direction with the launch of a parallel, plug-in hybrid solution "Revolo" and, has ample maneuvering room attributable to its expertise in powertrain control systems. The solution aims at increasing fuel efficiency by atleast 60% while reducing emissions and cost of travel by 35%.

Compared to competitors, Revolo is much cheaper and will be available in the 65k-150k range to, both, OEMs and end-consumers. Assuming an addressable market of less than 2% of expected total demand and capacity of ~50k units p.a., we expect the JV to clock 300Cr in FY12 and grow at a CAGR of ~15-20% over next three years.

Industrial solutions

KPIT has delivered superior performance across all supply chain components for many manufacturing organisations incl. some of the largest auto OEMs and Tier-I suppliers globally (see chart 13) . The company has unmatched expertise in assembly line control systems for discrete manufacturing processes.

 

 

Given its global footprint, KPIT is well positioned to exploit the expected growth in manufacturing related IT solutions by leveraging its SAP practice and niche expertise in the manufacturing space. Accordingly, we estimate ~12-20% three year forward CAGR in enterprise solutions for KPIT.

Utilities business

As of 2009, ~$10bn is tied into smartgrids globally, with US accounting for ~$5bn. Going forward, with policy thrust towards greener technology global smartgrid investments are expected to peak up to ~$36 by 2013 while aggregating a capital stock of ~$200bn by 2015. Among KPIT’s smartgrid focus areas, DA will account for a substantially larger share of growth at ~57% CAGR followed by AMI and SA at CAGRs of ~26% and 19% respectively during 2009-13

 

 

 

KPIT has already launched two specialized SAP frameworks, a solution delivery framework and an analytical solution for smartgrids, pertaining to the utilities vertical. Going forward, we expect KPIT's utilities activity to grow at CAGR of ~35% during 2010-13, incorporating KPIT's potential to successfully foray in the fields of DA and SA by leveraging its R&D capabilities in embedded logic and analytics.

 

Valuation

We used SOTP approach to compute the fair value of KPIT's share, with KPIT consol. accounting for 164 per share at 14.1% cost of capital and, IASL contributing 42 per share at 12.4% cost of capital. Accordingly, we value KPIT's common stock at 206 or, at 13.5x 11.4x TTMQ1FY12E and TTMQ1FY13E earnings resp.

 

 

Risks & Concerns

Business cycle risks

Due to increased focus on manufacturing sector, KPIT has enormous exposure to business cycles. However, going forward, we expect the manufacturing industry to switch to JIT and other agile systems aimed at reducing inventory buildup in the entire supply chain, thus, effectively diluting the impact of economic cycles. Also, KPIT has improved business robustness by diversifying its client portfolio, as reflected by its reduced exposure to Cummins’ business

Attrition rates

KPIT’s recruitment pool is restricted to engineers with scarce skill-sets. KPIT’s ability to sustain future growth acutely depends on its ability to develop, retain and recruit human capital. With an employee strength of ~5300, attrition rates stood at ~23% during Q1FY11 and, going forward, with the recession easing off, we view talent retention as a major challenge.

Exchange rate risks

With ~70%, 15%, 5% of its income in USD, EUR and GBP respectively and majority costs borne in INR, exchange rate impact on EBITDA margins is tremendous, with sensitivities estimated at ~70bps, 10bps, 3bps respectively (computed as partial derivative of EBITDA margin w.r.t. exchange rates).

Protectionist measures by developed economies

Recently, with the introduction of the Border Security Fund (BSF), US has signaled its willingness to stifle free-economic trade for controlling domestic unemployment rate. With ~40% on-site revenues KPIT has significant risks related to such unexpected regulatory changes.