May 26, 2011

ELGI EQUIPMENTS LTD. (ELGI)

Initiating Coverage - BUY

Analyst Rajiv Bharati

rajiv.bharati@destimoney.com

ELGI BUY with a target upside of 20%

BUY
TARGET : `99 CMP : `82

Key Data Ticker (Bloomberg) NSE Code BSE Code Sector Industry Face Value (`) Book Value per share (`) Dividend Yield (%) 52 Week Range (`) Market Cap. (` mn.) ELEQ ELGIEQUIP 522074 Capital Goods Compressor / Pumps 1 17 1.1% 50-106.6 13,025

(In ` m n) Net Sales EBITDA EBITDA Margin EPS (`) EV/Sales EV/EBITDA P/E (x) (` 82.2) Price Performance Absolute Relative

FY10 6,770 1037 15.3% 3.7 1.7 11.3 22.5 CY08 -64.5% -12.7%

FY11 9,410 1404 14.9% 5.6 1.2 8.4 14.6 CY09 206.8% 131.0%

FY12E 10,303 1463 14.2% 6.0 1.1 8.0 13.6 CY10 114.2% 96.3%

FY13E 12,626 1856 14.7% 7.7 0.9 6.3 10.7 YTD -10.4% 1.4%

Shareholding Pattern (as on 31 Mar 2011)

Promoters 33%

240 205 170 135 100 65

May-10

Relative Stock Performance (May'10=100)

Others 3%

MF/UTI/FIs 7%

Bodies Corporate 14%

FIIs 4% Individuals 39%

Jul-10

Sep-10

Nov-10

Jan-11

Mar-11

May-11

Elgi Equipments
Source: Company, Bloomberg, Destimoney Research

NIFTY

Multi-local strategy to ride over strong domestic presence

Elgi is Indias market leader in air compressor with 26% market share. It is also one of the large pneumatic player in Asia. Strong foothold in domestic market, with limited market to address locally at present, makes Elgi a suitable case for multi-local expansion overseas. Foray in China, Brazil, Middle East and recently in France is a step towards leveraging the domestic leadership to expand footprint. Indigenization of remaining products will help improve margins for Elgi. Company is test marketing and validating its indigenously made oil-free compressors in Chinese market. The product is already available in India and is doing well. Soon it will be tested in Brazilian market as well. Management is aiming to bring high margin After-Market business in sync with the global trend. Globally After-Market contributes 40% to the topline. Elgi currently generates ~20% of its revenue from this segment. Operating margins are expected to hover in the healthy band of 14%-15% despite the expectation of some subsidiaries remaining drag on Elgis books for some more time. We initiate coverage on ELGI EQUIPMENTS LTD with a BUY rating and a target price of `99 per share.

ELGI operates in three broad segments with primary focus on air compressor manufacturing and marketing
*Ordered Pair = FY 11 (Revenue Contribution, PBIT Contribution)

Elgi Equipments Product Profile

Air Compressors (84.6%, 91.1%)*

Automotive Equipments (12.1%,10.5%)

Others (3.3%, -1.6%)

Air compressor for blast hole and drilling in mining & construction Rig compressor Water Well boring On Industrial side air supply, air for instrumentation, for operating pneumatic / hydraulic instrument. Service stations tyre inflation, spray painting. In railways air braking, pantograph lifting, water lifting for AC coaches.

Vehicle washing, vehicle lifting, lubrication, cleaning, wheel balancing, alignment, AC recovery, painting. Automotive Equipments consists of lubrication equipment, 2 wheeler and 4 wheeler hoists, paint booths, crash repair systems.,

This is primarily a spare part and after sales service segment. Being highly substitutable, management intends to maintain the business at minimalistic levels.

..which commands~26% market share in India

Air Compressors

Global Market Size = `300 bn Indian Market Size = `30 bn Elgis FY11 Air Compressor Revenue = `7.75bn

Positive Displacement

Dynamic or Turbo

Rotary Screw Air Compressors

Reciprocating Air Compressors

Centrifugal

Axial

Elgis zone of operation Elgi screw airends have been designed in collaboration with City University, London. 40% of the Screw Air Compressors are being exported to quality conscious clients in the USA, Australia, the European Union, South Africa, S.E. Asia, Middle East & Far Eastern countries. Elgi primarily manufactures rotary screw and reciprocating air compressors. For centrifugal compressors the company has a tie-up with Samsung Techwin, whose compressor Elgi markets in India. Elgi is in process of validating indegenously made oil-free compressors. Currently, Elgi sells Hitachis oil free compressors in India. 5

The company has built its technical know how by fostering strategic tie-ups across geographies

Tieup with Hitachi for Oil Free Compressors

Tieup with Samsung Techwin. Elgi markets Samsungs centrifugal compressors in India.

Tieup with MAHA Germany to make Screw Auto Lifts

Tieup with Cellette of France to sell their Crash (Collision) Repair Systems. Tieup with SP Air of Japan to offer entire range of Pneumatic tools for auto repair, industrial maintenance, ship building, fabrication, foundry. Tieup with Farrymann Diesel Gmbh of Germany for Diesel Engines

JV with J.P. Sauer & Sohn, Gmbh, Germany Tieup with Snap-On International of USA. World's largest manufacturing and marketing company in Automotive Service Equipment.
Source: Company

Revenue and Profits are highly dependent on the success of air compressor segment, which contributes ~85% of Elgis revenue and 91% of Pre-tax margins
Segment-wise Revenue Contribution
100% 75% 50% 25% 0% FY05 FY06 FY07 FY08 FY09 FY10 FY11 Others Compressor Automotive Equipments

At a consolidated level, in the last 6 years Compressor segment has grown at a CAGR of 23%, while Automotive equipments segment has grown at healthy 15% CAGR
Source: Company, Destimoney Research

Compressors Smartly growing domestically but needs to make further inroads into global market

10,000 7,500 5,000 2,500 0 2006 2007 2008 2009 2010 2011

100% 75% 50% 25% 0%

Rs. 300 bn

Sales from Compressors (Rs mn-LHS) Revenue Contribution (RHS)

Growth Rate (RHS)

Global Market Size. Market is growing at 4% annually

Indias market share=10% Elgis market share (in India) = 26%, 2nd position

Current Capacity = 32,000 units at Singanallur, Coimbatore, Tamil Nadu. Compressor segments: Bore well drilling Poor monsoon bodes well for the company. Typically a 4 year cycle observed in southern states. Industrial Side Order from Textile mills, Automobile majors Railways Govt budgetary allocation remains a big driver After-Market segment another key area of growth which is growing; currently contributing 20% of the companys revenue. High import content in oil-free screw compressor and centrifugal compressor leads to fall in margins Sharp rise in steel and casting prices is difficult to pass through to the customer.
Source: Company, Destimoney Research

After-market segment for compressors has been cushioning companies globally to provide stable cash flows

Atlas Copco Global (FY10)

Elgi Equipments (FY11)

Equipments

After Market & Rentals

Equipments

After Market & Rentals

Globally companies have 40:60 split between After market & Rental: Equipment, for Elgi the ratio is 20:80. After-market demand being relatively stable the management is working towards improving the proportion.

Source: Company, Destimoney Research

Automotive Equipments Replacement of older product suite with newer products has helped Elgi to improve the asset-turnover for this segment
Passenger vehicles have grown at 16% CAGR in last 15 years. The same is expected to reach at 5.1m n vehicles by 2015 and 9.2 mn vehicles by 2020.

1,400 1,050 700 350 0 2006 2007 2008 2009 2010 2011

45% 3600000 30% 2700000 15% 1800000 0% -15% 900000 0

Sales from Compressors (Rs mn-LHS) Revenue Contribution (RHS)

Growth Rate (RHS)

Current Capacity = 22,000 units at Kurichy, Coimbatore, Tamil Nadu. Automotive Equipments Automotive Bulk of the business comes from sale of additional equipments to existing dealers. Tyres Wheel aligner Oil Electronic tyre inflator, Integrated lube management service Projects Indigenization of products Primary driver is growth of dealership network Managing cost is a major challenge as most of the raw material is imported from Europe. It also entails considerable forex risk for the division. Undercutting by smaller players is a major issue. Elgi tries to differentiate in terms of quality of service, support and training.
Source: Company, Destimoney Research, SIAM and E&Y Study

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FY95 FY96 FY97 FY98 FY99 FY00 FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 Passenger Vehicles

Others While this business is more commoditized and contributes marginally to topline, it is maintained as a hygiene factor

Others include a host of things: This segment mainly involve manufacturing and marketing of high value and low variety components and supplying it to high cost countries. Additionally customer is very price sensitive in this segment hence not sticky. Management has indicated to keep this segment low key and to be used to complete the offering to the air-compressor segment client base. Currently, revenue from Belair France is considered as others as they primarily deal in piping systems and not compressor.

11

Company has set an ambitious plan to achieve $1 bn topline by 2016

Current Proportion

Vision 2016

Domestic

International Business

Domestic

International Business

Currently, Elgis sale is highly focused towards Indian customers, but the five fold leap in revenue the company intends to achieve is possible only through higher overseas sales. Elgi bought SA Belair, France, for 700,000. This unit primarily produces piping system. Belair is engaged in assembly, sales & service of industrial compressors, piping, fittings & accessories for more than 25 years. Elgi plans to leverage Belairs customer base to sell its compressors in Europe. With 3% market share in France, Belair contributed ~`400 mn to Elgis consolidated revenue, 31% of international business, in FY11. Losses in companys China subsidiary, Elgi Equipment Zhejiang Ltd, are reducing with rationalization of operations. Elgi is setting-up office in Brazil to garner South-American markets.

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Growth Drivers

Textile Sector: Air jet weaving looms

Drip and sprinkler irrigation systems

Railway infrastructure in passenger as well as cargo will be a pull for pneumatic systems

Development of road and infrastructure projects will require heavy drillers and rigs

Laying of optical cables to increase the penetration of internet in rural parts

Entry of newer auto makers in the country will increase the dealership footprint in the country

With the growth of Automobile sector demand for garage equipments will grow

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Growth in construction, mining and industrial segment are the key areas in equipment space for Elgi
Segment-wise revenue growth over the years
39% 26% 3% 12% 8% -8% 12% 21% 24% 37% 28%

Segment-wise PBIT margins over the years

17% 15% 15% 14% 18% 11% 4% 13% 15% 15% 12% 11%

34%

FY06

FY07

FY08

FY09

FY10

FY11 FY06 FY07 FY08 FY09 FY10 FY11

Compressors

Automotive Equipments

Compressors

Automotive Equipments

Demand for water well drilling compressors is cyclical in nature and repeats itself after every 4 - 5 years. Impact of the demand could be seen in the revenue growth of compressor segment over the years. Elgis business, excluding the water well drilling segment, is growing at a healthy rate led by Industrial segment and ably supported by Automotive and After-Market segments. Margins across the segments are close to the pre-recession levels.

Source: Company, Destimoney Research

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Though the business at large remains susceptible to steel prices

45000 42000 39000 36000 33000 30000 Aug-09 Nov-09 Jun-09 Jan-10 Apr-10 Sep-10 Jul-10 Dec-10 Mar-11 May-11

Hot Rollled Steel Prices (Rs. per tonne)

With steel prices constantly rising, margins are constantly under pressure as it is difficult to pass on the prices to customer on regular basis

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Elgi should maintain the margins at 14% - 15% levels attributing to cost rationalization measures
Q4FY11 Performance
P a rt ic u la rs ( ` mn ) Total Income Total Expenditure Operating Profit Other Income EBITDA Depreciation EBIT Interest EBT Tax PAT Extraordinary Items Net Profit (incl. Extraordinary Items) Margins(%) OPM NPM (incl. Extraordinaty Items) NPM (excl. Extraordinaty Items) 12.0% 7.5% 5.6% 13.9% 10.0% 6.0% 15.4% 10.9% 10.9% 14.9% 10.0% 9.5% Q4FY11 2,434.9 2,143.1 291.8 35.3 327.0 31.4 295.6 295.6 112.3 183.3 (47.4) 135.9 Q4FY10 2,037.9 1,754.1 283.8 20.3 304.1 25.9 278.2 (16.8) 295.0 91.1 203.9 (81.1) 122.9 10.6% 0.2% 23.4% -10.1% % Change 19.5% 22.2% 2.8% 73.3% 7.5% 21.2% 6.3% Q3FY11 2,398.1 2,029.5 368.7 30.0 398.7 25.4 373.2 373.2 112.7 260.6 260.6 -47.8% -20.8% -0.3% -29.7% % Change 1.5% 5.6% -20.9% 17.5% -18.0% 23.4% -20.8% FY11 9,410.4 8,006.6 1,403.8 113.7 1,517.5 107.1 1,410.3 1,410.3 471.5 938.8 (47.4) 891.4

2800

90%

2100

60%

1400

30%

700

0%

0 Jun-08 Jun-09 Sep-07 Sep-08 Sep-09 Jun-10 Mar-08 Mar-09 Mar-10 Sep-10 Mar-11 Dec-07 Dec-08 Dec-09 Dec-10

-30%

Net Sales (Rs. mn)

Sales Growth

EBITDA Margin

Fall in net margin in Q4FY11 is attributed to extraordinary items comprising of provision for golden jubilee celebration cost and bad debt of `16 mn. Drop in EBITDA margin is also attributed to change in product mix and encashment of leave due to manpower constraint (a one time item).
Source: Company

16

Less than 15% revenue concentration from any single sector helps Elgi diversify well

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Hence, we see Elgi rightly poised to realize its billion dollar revenue vision by 2020
16000 60% 40% 20% 6400 3200 0 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012E 2013E 0% -20%

The company is expanding its domestic facility to build stronger foundation for catering global demand. The company is developing new facility by spending `1,500 mn over the next two years. This new facility would be three times the size of the existing facility.

12800 9600

Elgis topline is expected to grow at CAGR of 21% in the following two years organically. Meanwhile the company is actively looking to acquire companies abroad to make further inroads in overseas markets.

Net Sales (Rs. mn) (LHS) EBITDA Margin (RHS)

Sales Growth (RHS)

Though the management is aiming to improve the working capital cycle by 10% in FY12, we expect securing raw material at lower price by giving favourable terms to raw material suppliers might take priority.
Source: Company, Destimoney Research

We dont forsee margin expansion organically as most capacities are already running above 80% utilization and raw material costs are climbing up

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Peer valuation

Year End Atlas Copco (India) Ltd.* Ingersoll-Rand (India) Ltd. Kirloskar Pneumatic Company Ltd. Elgi Equipments Ltd.
* delisted

TTM Revenue (in ` mn) 17,258 4,830 4,917 9,410

EBITDA Margin 15.4% 12.7% 13.0% 14.9%

TTM EV / EBITDA 22.4 8.2 6.7 8.4

TTM P/E 34.8 20.5 11.9 14.6

ROCE 25.2% 10.0% 41.2% 37.8%

ROE 19.5% 6.2% 32.9% 27.5%

200912 201003 201003 201103

Source: Ace Equity, Destimoney Research

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We initiate coverage with BUY rating and a target price of `99 per share

Organically, we expect the company to reach $1 bn by 2020 Being debt free and with `1400 mn cash on the books, we expect an acquisition abroad is around the corner which is also inline with companys vision to achieve billion dollar topline by 2015-16 i.e. 4.5 times FY11 sales. This is similar to the strategy of some of its global peers to expand into other geographies inorganically. The stock is trading at 13.6 and 10.7 times its FY12E and FY13E earnings. We initiate coverage on ELGI EQUIPMENTS LTD with a BUY rating and a target price of `99 per share.

240 205 170 135 100 65

May-10

Relative Stock Performance (May'10=100)

Jul-10

Sep-10

Nov-10

Jan-11

Mar-11

May-11

Elgi Equipments
( Fully Diluted Equity) EPS (`) CEPS (`) P/E (x) P/B (x) ROE ROCE EV/EBIDTA (x) FY10 3.7 4.8 22.5 4.9 25.1% 35.1% 11.3 FY11 5.6 6.6 14.6 3.8 27.5% 37.8% 8.4

NIFTY
FY12E 6.0 7.0 13.6 3.1 22.8% 31.0% 8.0 FY13E 7.7 8.9 10.7 2.5 23.3% 31.8% 6.3

Source: Destimoney Research, Bloomberg

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Financial Summary

(In ` m n) Net Sales Operating expense EBIDTA Depreciation EBIT Interest EBT Other Income PBT Tax PAT Margins Sales Growth % Operating Margin % Net Margin %

FY10 6,770 5,733 1,037 97 939 939 82 1,022 361 660

FY11 9,410 8,007 1,404 107 1,297 1,297 114 1,410 472 939

FY12E 10,303 8,840 1,463 159 1,304 1,304 124 1,427 471 956

FY13E 12,626 10,770 1,856 193 1,663 1,663 152 1,815 599 1,216

(In ` m n) Liabilities Equity Share Capital Reserves & Surplus Loans Deferred Tax Liability Current Liabilities (CL) Provisions Total Assets Gross Block + CWIP Accumulated Depreciation

FY10

FY11

FY12E

FY13E

78 2,553 28 17 1,366 1,131 5,173

156 3,259 17 1,882 1,506 6,821

156 4,030 17 2,061 1,648 7,913

156 5,061 17 2,525 2,020 9,780

1,767 1,038 729 143 32 4,270 5,174

2,245 1,145 1,100 143 32 5,546 6,821

2,845 1,304 1,541 143 32 6,197 7,913

3,445 1,497 1,948 143 32 7,657 9,780

22.4% 15.3% 9.8%

39.0% 14.9% 10.0%

9.5% 14.2% 9.3%

22.5% 14.7% 9.6%

Fixed Assets Investments Misc Current Assets (CA) Total

Source: Company, Destimoney Research

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Key risks

Foreign exchange fluctuation risk for the products with higher import content. Capex deferment by customers leads to severe competition for Elgi, resulting in the risk of margin erosion. Validation of equipments norms in different countries is a time consuming process, resulting in potential loss of business opportunity.

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