Credit outlook for domestic construction equipment sector: Healthy financial profile and demand mitigate impact of intensifying competition

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1 CRISIL Insights March 2011 Credit outlook for domestic construction equipment sector: Healthy financial profile and demand mitigate impact of intensifying competition Anuj Sethi Head - Corporate and Government Ratings Tel: , ansethi@crisil.com Analytical contacts: Pradeep K Manager - Corporate and Government Ratings Tel: , pradeepk@crisil.com Indian construction equipment industry will benefit from healthy demand, driven by infrastructure spending. The profitability of the domestic players will be susceptible to rising raw material costs and pricing pressure due to intense competition. However, healthy growth prospects, and strong financial risk profiles will mitigate the impact of pressure on profitability, helping CRISIL-rated construction equipment manufacturers sustain the credit quality over the medium term. Healthy demand to drive growth in revenues India s construction equipment industry has regained momentum since the second half of (refers to financial year, April 1 to March 31) following the recent economic slowdown, with off-take growing at a steady pace. The Eleventh Five Year Plan period ( ) entails an investment of about USD492 billion on infrastructure projects. This is likely to result in significant construction expenditure, driving growth in the industry. The demand has led to healthy revenue growth for the domestic construction equipment players (refer to Chart 1); CRISIL believes that the players will maintain the healthy revenue growth trends over the medium term. Rising input costs, intensifying competition, and diminishing technological edge impact profitability The profitability of construction equipment players is a function of volatility in their cost of inputs, mainly steel and aluminum, and their coverage for fixed costs and unfavourable movements in the value of foreign exchange (forex). While the operating margins of players recovered slightly in (refer to Chart 1), in keeping with improved capacity utilisation, and cost reduction initiatives, the margins remained below the levels reported in and earlier. In , the operating margins declined once again, due to rising input costs (refer to Chart 2), increasing competition, and focus on higher volumes to utilise augmented capacities. Also, in recent years, most players have had to face a reduction in their pricing power on account of the diminishing technological edge. A Knowledge Sharing Endeavour from CRISIL

2 Chart 1: Trend in revenues & profitability for CRISIL rated portfolio Chart 2: Trend in raw material prices- Steel & Aluminium Source: CRISIL Research New global players competing for market share: The healthy demand prospects on account of increasing impetus to develop infrastructure in the country have attracted the global players to the Indian markets, leading to intense competition and fragmentation over the past 4-5 years. The industry is dominated by established players such as TELCO Construction Equipment Co Ltd, L&T Komatsu Ltd (L&T Komatsu) and others. Though the top four players contribute to more than 60 per cent of the market, their combined market share has been impacted by 5-10 per cent over the past three years, following the advent of new players such as Schwing Stetter (India) Pvt Ltd, Hyundai Construction Equipment India Pvt Ltd (Hyundai), and Volvo Construction Equipment. The new players have aggressively grown their volumes in the domestic market; for instance, Hyundai has increased its market share by nearly 5 per cent in the market for earthmoving equipment between and , eating into the pie of its dominant peers. Existing players have augmented capacity: The construction equipment players have invested significantly in India s infrastructure growth story. Many existing players have augmented their capacities in expectation of growth in demand. Others have brought in new capacities pertaining to construction equipment to diversify revenue stream; L&T Komatsu doubled its capacity in earth-moving equipment in ; L&T Case Equipment Private Ltd (L&T Case) has increased its capacity in earth-moving equipment by more than 2.5 times since ; Eimco Elecon (India) Ltd (Eimco Elecon) has added capacity to manufacture loaders used in construction since These players have scaled up their capacities in expectation of growth in demand, and will, therefore, need to focus on increasing volumes to cover fixed costs. Diminishing pricing power due to dilution in technology edge: Technology used to be a key factor in helping players maintain market share and ensure pricing power in the construction equipment industry. In recent times, however, the players pricing power has diminished owing to ease of availability of technology. Access to technology has not been a hindrance, as domestic players have tied up with international technology providers. Also, the multinational corporations in the CRISIL-rated portfolio are supported by the strong product and design capabilities of their parents. For instance, players like Atlas Copco (India) Ltd and Sandvik Asia Pvt Ltd are backed by the product base of their parents. Also, products sourced from abroad are customised to the domestic requirements; the products of L&T Komatsu and L&T Case are backed by joint venture partners Komatsu Inc and CNH Global, respectively, who have a strong product base and are large global players. Hence, the competitive edge that technology provided to players till recently, is no longer a differentiator, and has led to reduced pricing power.

3 Healthy financial profiles to help sustain credit risk profile Though the profitability of CRISIL-rated construction equipment players has been impacted, the conservative capital structures (refer to Chart 6) with which CRISIL-rated companies operate is helping mitigate the impact, leading to stable overall credit profiles. The capital structure has also facilitated healthy debt protection measures; for instance, the ratio of net cash accruals to total debt (NCATD) remained at more than 0.2 times even during , when the industry was faced with a slowdown in off-take. The credit profiles of some financially weaker players are also buoyed by the financial support they derive from their strong parents. The industry is moderately capital intensive, as indicated by its asset turnover ratio of just over 3 times. Most players had enhanced capacity by the end of (refer to Chart 3) in expectation of growing demand, only to face challenged relating to unused capacities. They are expected to undergo incremental and marginal capex, which will be largely funded from accruals. The players have also sought to prune their working capital requirements by rationalising inventory and debtors (refer to Charts 4 and 5). In the absence of large, debtfunded capex, and with control over working capital requirements, the CRISIL-rated portfolio of construction equipment players are expected to maintain their conservative capital structure and healthy debt protection metrics; CRISIL expects the gearing of players in its rated portfolio to improve to about 0.48 times at March 31, 2011 (refer to Chart 6) from 0.52 times as on March 31, 2010, while the ratio of net cash accrual to total debt (NCATD) is expected to improve to 0.43 times in from 0.29 times in Chart 3: Trend in Capex and Asset Turnover for CRISIL rated portfolio Chart 4: Trend in Inventory for CRISIL rated portfolio Chart 5: Trend in Debtor for CRISIL rated portfolio Chart 6: Impact of reducing debt on CRISIL rated portfolio

4 The ratings on the debt instruments of most CRISIL-rated players are in the high rating category (refer to Annexure 2) and have remained largely stable since The players healthy financial risk profiles have helped them survive the business impact of the economic slowdown. While the rating outlook of one of the players was revised to Positive on the back of improving business prospects, the ratings of three players in the portfolio was downgraded for reasons, not entirely related to their current business operations. CRISIL believes that its rated portfolio of construction equipment suppliers will maintain strong financial risk profiles over the medium term, despite pressures on profitability, and benefit from the healthy demand prospects driven by higher infrastructure spending by the government. CRISIL, therefore, expects these players to maintain stable credit risk profiles over the medium term. Annexure 1: Portfolio of CRISIL-rated players and their products: CRISIL rated Entity Product Action Construction Equipment Ltd Material Handling Equipment - Cranes, Forklifts Atlas Copco (India) Ltd Eimco Elecon (India) Ltd Underground Mining Equipment, Loaders Gujarat Apollo Industries Ltd Construction Equipment Hyundai Construction Equipment India Pvt Ltd Hydraulic Excavator L&T Case Equipment Private Ltd. Earth Moving Equipments- Loaders & Vibratory L&T Komatsu Ltd Hydraulic Excavators Revathi Equipment Ltd Sandvik Asia Pvt Ltd Schwing Stetter (India) Pvt Ltd Construction Equipment WMI Cranes Ltd Cranes

5 Annexure 2: Rating trends in CRISIL s portfolio of construction equipment players Dec 2010 Dec 2009 Dec 2008 Dec 2007 Action Construction Equipment Ltd. A+/Stable/P1 A+/Stable/P1 A+/Stable/P1 - Atlas Copco (India) Ltd. AA+/Stable/P1+ AA+/Stable/P1+ AA+/Stable/P1+ P1+ Eimco Elecon (India) Ltd. AA-/Stable/P1+ AA-/Stable/P1+ AA-/Stable/P1+ AA-/Stable/P1+ Gujarat Apollo Industries Ltd. A+/Positive/P1 A+/Stable/P1 - - Hyundai Construction Equipment India Pvt Ltd A/Stable A/Stable - - L&T Case Equipment Private Ltd. AA-/Stable/P1+ AA-/Stable/P1+ AA-/Stable/P1+ - L&T-Komatsu Ltd. AA-/Stable AA-/Stable - - Revathi Equipment Limited. A+/Stable/P1 A+/Stable/P1+ P1+ P1+ Sandvik Asia Pvt Ltd. AA-/Stable/P1+ AA-/Stable/P1+ AA/Stable/P1+ - Schwing Stetter (India) Pvt. Ltd. A+/Stable/P1 AA-/Stable/P1+ AA-/Stable/P1+ - Disclaimer CRISIL has taken due care and caution in preparing this report. Information has been obtained by CRISIL from sources which it considers reliable. However, CRISIL does not guarantee the accuracy, adequacy or completeness of any information and is not responsible for any errors in transmission and especially states that it has no financial liability whatsoever to the subscribers/ users/ transmitters/ distributors of this report. No part of this report may be reproduced in any form or any means without permission of the publisher. Contents may be used by news media with due credit to CRISIL. CRISIL. All Rights Reserved. Head Office: CRISIL House, Central Avenue Road, Hiranandani Business Park, Powai, Mumbai Tel: Fax: