Revenues flat QoQ; in line with guidance

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1 RESULT UPDATE Dipen Shah KPIT CUMMINS PRICE: RS.115 RECOMMENDATION: BUY TARGET PRICE: RS.139 FY14E P/E: 9.3X KPIT's 3QFY13 results were marginally lower than estimates on the operational front. While USD revenues remained flat in line with expectations, EBIDTA margins were marginally lower. The results contained one-off provisions of about Rs.95mn, which impacted PAT growth. Management commentary echoes the optimism sounded by other leading peers about the continuing traction in automotive, manufacturing and hitech verticals, the mainstay of KPIT. However, we note that, the company has faced constraints with some clients and we will be watchful of this trend. We fine-tune FY13E EPS to Rs.10.6 and FY14E EPS to Rs We have incorporated the proposed equity dilution of about 7.3%. Our FY14E-based TP stands at Rs.139 (Rs.146 earlier). At our TP, the stock will be valued at about 11.2x FY14E earnings. This is a suitable discount to larger peers. Looking at the 20% upside, we maintain BUY. We remain positive on the long term prospects of KPIT. Summary table (Rs mn) FY12 FY13E FY14E Sales 15,000 22,303 23,801 Growth (%) EBITDA 2,181 3,499 3,691 EBITDA margin (%) PBT 1,786 2,860 3,250 Net profit 1,453 2,027 2,362 EPS (Rs) Growth (%) CEPS (Rs) BV (Rs/share) Dividend / share (Rs) ROE (%) ROCE (%) Net cash (debt) ,013 NW Capital (Days) P/E (x) P/BV (x) EV/Sales (x) EV/EBITDA (x) Source: Company, Kotak Securities - Private Client Research 3QFY13 results (Rs mn) 3QFY13* 2QFY13* % chg 3QFY12 % chg Turnover Expenditure EBDITA Depreciation EBIT Interest Other Income PBT Tax PAT Minority Int XO Item Adjusted PAT EPS (Rs) ^ Margins OPM (%) GPM (%) NPM (%) Source : Company; ^ FY13 equity capital After considering preferential allotment in 3QFY13; * includes Systime financials on a line-by-line basis, excludes SSG hardware revenues Revenues flat QoQ; in line with guidance Revenues were almost flat in USD terms. They matched expectations. Revenues were largely in line with what the company had guided. KPIT had indicated that, 3Q revenues would be challenged by the lower number of working days and constraints in a few accounts. Average realizations were flat QoQ. Prior to 3Q, realisations had improved in 5 out of the previous 6 quarters, which is encouraging. Kotak Securities Limited has two independent equity research groups: Institutional Equities and Private Client Group. This report has been prepared by the Private Client Group. The views and opinions expressed in this document may or may not match or may be contrary with the views, estimates, rating, target price of the Institutional Equities Research Group of Kotak Securities Limited. Kotak Securities - Private Client Research Please see the disclaimer on the last page For Private Circulation 5

2 Focus verticals seeing continued spends According to the management, the focus verticals are seeing continued spends though cost rationalization is also a theme for most customers. Larger industry peers have also indicated continued order traction from verticals like automotive and hi-tech. KPIT derives a substantial part of revenues from these industries. The automotive industry is investing in developing technologies that address emerging trends such as alternate mobility concepts of hybrid or electric vehicles and the software requirements for in-car 'value added services'. Automakers are spending good amount of their R&D budgets on improving fuel efficiency of their vehicles through focus on areas of powertrain technology, battery management systems and light weight body materials. They are also looking at the concept of connected vehicles to build intelligent transportation systems. In terms of demand, KPIT is seeing higher momentum in areas of Autosar, In- Vehicle Networks, Infotainment and powertrain. Manufacturing companies are looking at agility in operations, seamless integration of business processes, efficient design and development of new products, coupled with reduction in time-to-market. This segment is also seeing high demand for engineering services, a view echoed by companies like Geometric. Auto / Transport vertical and Engineering vertical reported a 3% and 4% QoQ revenue growth, respectively. Utilities sector is undergoing modernization, driven by state and federal mandates for smart meters, smart grids and other technological requirements that combines traditional IT with advanced applications to develop operational and consumer related technology solutions. Environmental concerns are also driving investments in newer infrastructure and sustainable energy sources. Cummins - soft Revenues from Cummins fell by 4% QoQ after growing marginally in 2Q. Cummins sees some growth challenges in 1HCY13 and it has already indicated some cuts in spends in some of the areas of operations. This may entail cuts in spends IT in these areas also. Cummins has been driving in operational efficiencies through internal cost control measures but is also continuing with the on-going projects KPIT is looking at more options to penetrate the account further. On the IT business front, Cummins is likely to roll out global programs to meet its global business needs and on the engineering side it is expected to continue investing in products to stay ahead of the competition. Thus, KPIT has avenues to grow business with Cummins. However, 1HCY13 may witness soft trends in demand from Cummins Geographies - Europe revenues grow strongly Within geographies, Europe revenues rose by 14% QoQ after falling about 13% in 2Q (largely due to cross currency fluctuations). The sentiments in Europe continue to be weak, though the company is seeing traction in areas like EDGE applications, etc. We need to watch the developments in Europe closely, due to the still weak macros. However, the company continued to see good traction in US across all the SBUs, which, we feel, is encouraging. In APAC, SAP vertical saw good order wins from China and India. Kotak Securities - Private Client Research Please see the disclaimer on the last page For Private Circulation 6

3 Services The revenue growth in 3QFY13 came largely due to revenues from IES, which reported a 5% QoQ growth. KPIT has developed proprietary solutions in areas like upgrade assessments, which will help it win more deals in this space. KPIT has been focusing hard on emerging areas of Big Data, Analytics, mobility, cloud and social media and has won several deals in the mobility space over last few months. The inter-practice cross-selling has started gaining momentum as KPIT has won deals along with CPG and SYSTIME teams. Efforts are on to extend this to the JDE customers also. Systime registered a revenue growth of 7.15% QoQ to reach USD 18.2mn. Post consolidation, this was the third consistent quarter of strong revenue growth in SYSTIME and we expect revenues to grow at a fast pace, going forward. The A&E practice is benefiting from increasing spends on infotainment, Powertrain and AUTOSAR. KPIT has established a dedicated team to market its non-linear solutions, with a view to promote IP and new product development. In SAP SBU, KPIT has seen traction in automotive and utilities vertical and also in practices like Mobility, Analytics, Customer Relationship Management (CRM) and SuccesFactors (SF). KPIT's SAP practice had suffered over the recent past as SAP implemented a technology reset with SAP HCM being replaced by SAP SuccessFactors (SF). KPIT has become the consulting partner for SF and has already won its first SF assignment. The pipeline in SAP SBU is pretty strong for KPIT, and we view this positively. The company has already increased the number of SAP certified solutions to 6 in US and 5 in India. It has started seeing traction for these non-linear offerings. KPIT has added a consulting layer above its services portfolio, which has allowed it to enter the customers relatively early. The company continues to make investments in the Business Transformation Unit. Non-linear revenues is the focus The company has been focusing on non-linear initiatives. As part of its efforts in this direction, the company had entered into an engagement with a Japanese Tier I for AUTOSAR license sale for their new vehicle program. In FY13, KPIT has launched its latest LINUX based platform for Rapid Prototyping and emulation of AUTOSAR based applications, developed jointly with a German OEM. Two of the company's patents (both in automotive areas of which, one was in hybrid area) were registered, which we see as a positive. The company has filed more than 40 patents already. Currently, about 5% of overall revenues (mostly from auto electronics) currently accrue from non-linear initiatives. KPIT plans to have 25% of revenues from these initiatives in 3 years' time. We believe this is an important lever to protect and sustain margins. Kotak Securities - Private Client Research Please see the disclaimer on the last page For Private Circulation 7

4 SYSTIME Systime reported a 7.5% QoQ growth (15.7% in 2Q) in revenues during the quarter to $18mn. The focus of the combined operation is now on medium size deals ($3 - $5 mn). We note that, with the SYSTIME acquisition, KPIT has a strong Oracle and JD Edwards practice. Systime had achieved 15% EBITDA margins for 2Q. We understand that, they were in this range in 3Q also. Within Systime, the company is experiencing new growth drivers in form of a major version launch by JD Edwards, which is expected to provide migration and integration revenues over the next 5-6 quarters. KPIT won a major order in US for a JDU upgrade. KPIT is also looking at increasing the productivity of the sales and delivery teams. SYSTIME's margins were targeted to be at the KPIT overall levels in FY13 and the same are very near to this target, we understand. KPIT now has 76% stake in Systime. Financials are being consolidated on a lineby-line basis WEF 1Q. We see the acquisition of a majority stake in SYSTIME (to buy remaining stake over a 3-year period) as a good strategic fit for KPIT. REVOLO - commercial production may start in FY14 KPIT is holding a major trial of Revolo. 40 vehicles are currently running on roads for testing. The company is looking to have some support from the regulatory side. We understand that, the launch will happen only after it gets the regulatory support. We expect the commercial production to start sometime in the next fiscal. We have not assumed any revenues from this JV in our estimates. Employee strength up KPIT added 175 employees on a net basis in 3Q. The total employee strength of KPIT stood at 8286 (8111) as at the quarter end. Capacity utilization was down by about 200bps, both off-shore and on-site. EBITDA Margins lower EBIDTA margins were lower QoQ and also v/s expectations. In 2Q, they had sprung a positive surprise by rising 164bps over 1Q. Margins fell by about 100bps on the back of lower number of billing days and also due rupee appreciation. Lower utilization rates also impacted margins QoQ. The company initiated cost control initiatives, which helped restrict some impact. Systime margins were likely around the 15% mark. We believe that, the company has a few levers which will allow it to improve margins going ahead. The potential improvement in Systime's margins is an important lever. It is also looking at a higher off-shore proportion to sustain and improve margins. Currently, about 45% of revenues come from off-shore services. KPIT is also looking at non-linear revenues (more than 40 patents filed) to improve profitability. Going forward, if billing rates improve, they may provide further cushion to margins. The management has also indicated that it will rationalize low-margin, nonfocus projects with a view to improve profitability. KPIT had made a strategic investment by buying about 20% stake in a company few years back. Kotak Securities - Private Client Research Please see the disclaimer on the last page For Private Circulation 8

5 While the company has derived the desired strategic benefit out of the same (client relationships), the financials of the target company have turned for the worse. Hence, KPIT has written off the investment of Rs.95mn towards the same. Further benefit from this investment, if any, will be a positive for the company. Preferential allotment of shares; ECBs KPIT has issued 12.96mn equity shares on preferential basis to Van Dyck, CX Partners Fund 1 Limited and AAJV Investment Trust, leading to a dilution of about 7.3%. The shares have been issued at Rs.125 per share, bringing in nearly Rs.1.62bn. The amount is expected to be utilized for M&A as well as acquiring the additional stake in Systime. KPIT had also raised debt of $20mn in 3Q. A similar amount of debt is coming up for repayment in 4Q. We have assumed a yield of 6% on these additional funds and expect this preferential issue to have a marginal impact on FY14E earnings. KPIT has raised about $20mn through an ECB to fund earn-outs of past acquisitions ($20mn for Systime in 1QFY14 and $3mn for CPG in 3QFY14) and for fresh acquisitions. Total LT borrowings are at about Rs.1.7bn. The company also has working capital loans of about Rs.1.6bn. The average cost of LT and DT borrowings is about 4.5% and 5.5%, respectively. Earnings estimates tweaked We have tweaked our FY13 and FY14 earnings estimates. For FY13, we expect revenues to grow by 49%, largely on the back of rupee depreciation and higher volumes. Part of this is due to Systime's consolidation. SYSTIME revenues will be for the full 12 months as against 3 months in FY12. For FY14, we expect volumes to rise by 12%. Rupee is expected to average 54.3/USD in FY13 and 52.5/USD in FY14. Margins are expected to moderate on the back of expected rupee appreciation and also salary increments. PAT is expected to grow to Rs.2.36bn in FY14E, resulting in an EPS of Rs We maintain BUY on KPIT Cummins with a price target of Rs.139 Valuations and recommendation The stock has been range-bound in the past few weeks in the backdrop of an uncertain macro. We have accorded KPIT valuations higher than comparable peers, based on its positioning on the value-chain, relatively higher revenue growth and potential upsides to margins. The valuations are at a suitable discount to larger peers, though. Our PT is at Rs.139. At our target price, KPIT's FY14E earnings will be discounted 11.2x. We maintain our positive bias on the stock. Looking at the potential upside, we upgrade the stock to BUY. Risks and concerns Slower-than-expected recovery in demand from major user economies and a sharper-than-expected appreciation in rupee remain the key risks for earnings. Revolo earnings can provide significant upsides, if successful. Kotak Securities - Private Client Research Please see the disclaimer on the last page For Private Circulation 9