Technologically Suave

A good example of a company that enjoys a technology-based moat is Cummins India Ltd. (CIL), India’s largest engine manufacturer. The company is into segments like power generation, industrial and automotive. It also caters to the growing market for gas and dual-fuel engines.

Strong parentage. CIL is a 51 per cent subsidiary of Cummins USA. The latter is the world’s largest diesel engine designer and manufacturer in the above 200 horse power (HP) categories.

Access to parent’s technology. The company draws upon the technical capabilities and technologies of Cummins Inc. This helps it develop advanced and fuel-efficient engines that are able to comply with evolving domestic and global emission regulations. Given the frequent changes in these regulations, it is access to its parent’s technologies that enables the company to get the better of its competitors.

Preferred vendor. Cummins USA is among the few MNCs that are investing in their listed subsidiary (CIL) for developing new products and technologies. The parent has identified India as a low-cost manufacturing destination. Thus the Indian arm is developing as an export hub. It acts as the preferred vendor to its parent. Exports account for 25 per cent of CIL’s revenue.

CIL’s technological superiority is reflected in its profitability ratios and margins. Over the last five years, it has notched up a strong average return on equity of 24.7 per cent and return on capital employed of 35.4 per cent. It has registered a five-year average of 16 per cent in operating profit margin .

What could cause moat to be breached
The Indian arm has access to its parent’s (Cummins USA) technologies. This moat appears difficult to breach in the short to medium term. CIL faces competition mostly in the lower HP segments. In mid- and high-HP engines, where technological superiority counts, the company is the clear leader.

Growth drivers
Given the supply-demand gap in power generation in the country, CIL’s power genset business is likely to see growth in the medium term. It has also developed gas based gensets, to augment its product offerings and diversify from diesel gensets.

Valuation
This debt-free (negligible debt) player’s stock is available at a price-earnings multiple of 18.66, a 16 per cent discount from its five-year median P/E of 22.11. The stock’s P/E has corrected 15.6 per cent over the last six months. Its Q2FY12 EPS almost halved on a quarter-on-quarter basis, following which its price fell steeply. All this has led to a contraction in its P/E multiple.

Currently its price-earnings to growth ratio is also at a more attractive level (0.7) than in June 2011, when it was trading at 0.9 times. CIL’s earnings per share (EPS) has grown at a CAGR of 27 per cent over the last five years. Price to book value ratio of 5.2 is 7.1 per cent lower compared to its five-year average of 5.6.

A high dividend yield of 2.7 per cent is the cherry on the cake. CIL has consistently paid handsome dividends in the last eight years. Its dividend pay-out ratio over this period averages around 49.8 per cent.

Buy-and-hold investors may purchase this stock at its current valuation with an investment horizon of at least three to five years.