PRIVATE CLIENT RESEARCH INITIATING COVERAGE NOVEMBER 25, 2014

Ruchir Khare Ltd (CUMI) [email protected] +91 22 6621 6448 PRICE: RS.174 RECOMMENDATION: BUY TARGET PRICE: RS.240 FY16E P/E: 14.5X

Stock details We initiate coverage on Carborundum Universal Ltd (CUMI) stock with BSE code : 513375 'BUY' rating and a target price of Rs 240 based on 20x FY16E earnings. We NSE code : CARBORUNIV believe that CUMI valuations can get rerated considering 1) potential case Market cap (Rs.bn) : 32.61 of turnaround in the overseas business 2) strong growth in company's es- Free float (%) : 57.9 timated consolidated PAT through FY14-16E and 3) strong positioning in 52-wk Hi/Lo (Rs) : 221/113 the domestic market. We project 54% CAGR between FY14-16 in Avg. Daily Volume BSE+NSE : 135000 consolidated profits from Rs.950 mn in FY14 to Rs 2.2 Bn in FY16E. At cur- Shares o/s (mn) : 187 rent price of Rs 174, CUMI stock is trading at 14.5 x P/E and 8.4x EV/EBITDA on FY16E earnings. Summary table (Rs mn) FY14 FY15E FY16E Key Investment Rationale Sales 21,253 23,929 26,028 Growth (%) 9.5 12.3 9.0  Leadership position in the domestic abrasives market; strong position- EBITDA 2,514 2,871 4,295 ing in global electrominerals and industrial market. CUMI is a EBITDA margin (%) 11.8 12.0 16.5 prominent player which enjoys leadership position in Indian market on PBT 1542 1750 3161 Net profit 950 1,243 2,245 back of 1) strong brand in abrasive space 2) robust distribution network offer- EPS (Rs) 5.1 6.6 12.0 ing pan India presence 3) efficient cost controls providing price advantage to Growth (%) 5.5 30.8 80.6 the end user. Moving up in the value chain, company is gaining strong hold in CEPS (Rs) 9.9 11.9 17.4 BV (Rs/share) 59.0 63.7 72.1 the electrominerals and ceramics industry. DPS (Rs) 1.3 1.7 3.0  Geographically diversified operations: Recovery expected in overseas ROE (%) 8.8 10.8 17.6 ROCE (%) 6.4 8.3 13.4 business; business uptrend across verticals. Overseas business that has Net cash (debt) (3,015) (2,917) (2,388) been under stress for several quarters in the past has stated to witness signs of NW Capital (Days) 89.7 87.4 90.9 revival. CUMI's South African business (Thukela and Foskor) has been going EV/Sales (x) 1.6 1.4 1.3 EV/EBITDA (x) 14.3 12.6 8.4 under restructuring and can further observe pick up in revenue/margin profile P/E (x) 34.3 26.2 14.5 over FY15-16. CUMI is also likely to benefit from expected favourable product P/Cash Earnings (x) 17.5 14.7 10.0 mix in Russia. P/BV (x) 2.9 2.7 2.4 Source: Company,  Sustained emphasis on research & development initiatives provides Kotak Securities - Private Client Research competitive edge to the company. CUMI pays considerable emphasis on the research and development capabilities. Company consistently deploys re- Shareholding pattern sources for adding products valuable to the end users. Recently added products contribute to over 15-18% of company's revenues.  Company to maintain high growth in revenue; recovery in operating margins likely to aid to free cash flow generation. We project growth at 54% CAGR in EPS from Rs 5.1 in FY14 to Rs 12 in FY16 on back of 1) recovery in demand for abrasives in the domestic/international market 2) pick up in in- ternational subsidiaries business and margin improvement at key subsidiaries.  Current valuations appear attractive vis-à-vis the potential growth in profits, estimated at 54% CAGR between FY14-16. At current price of Rs 174, CUMI stock is trading at 14.5 x P/E and 8.4 x EV/EBITDA on FY16E earn- Source: ACE Equity ings. We believe that company's stock can re-rate further to capture significant improvement in company's RoE going ahead. We value CUMI stock at 20x One-year performance (Rel to Sensex) FY16E (11x EV/EBITDA) earnings and arrive at a target price of Rs 240 per share. In view of adequate upside to our target price we ascribe 'BUY' rating on company's stock.

Key Concerns  Delayed recovery in global manufacturing activity.  Increased volatility in input prices.

Source: ACE Equity

Kotak Securities Limited has two independent equity research groups: Institutional Equities and Private Client Group. This report has been pre- pared 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. INITIATING COVERAGE November 25, 2014

INDUSTRY OVERVIEW

ABRASIVES The global market for abrasives, estimated at USD 12.9 Bn is characterized by a The USD 12.9 Bn global diversified customer base. Abrasives are used extensively across industries such as abrasives market is automobiles, gems & jewelry, electrical, machinery etc. The dependence on single characterized by a diversified industry is less than 15% and therefore typically, demand for abrasives gets affected customer base only during economic slowdown. However being a consumable item, demand for abrasive does loose much ground even during the slack period. Four major segments of global abrasives industry consists of:

Abrasive segments Abrasives Application Competitive intensity

Loose Abrasives Loose abrasive lapping is widely used to prepare optical glass High before its final polishing. Coated Abrasives Surface-treatment applications including grinding, blending, Low, market dominated by 3-4 dimensioning, shaping, finishing, & polishing players including CUMI, Gridwell Super Abrasives They are used to shape materials that are too hard or too fragile Low, Wendt has strong presence for conventional abrasives: glass beveling in the automotive in this segment and building sectors, as well as for high-precision grinding of crystals and components. Bonded Abrasives Presented in the form of wheels; used in automobiles, Low, high capital investment acts construction, steel, bearing etc. as an entry barrier

Source: Kotak Securities - Private Client Research, Industry

Abrasives

Coated Abrasives

Bonded Abrasives ABRASIVES Super Abrasives

Loose Abrasives

Source: Kotak Securities - Private Client Research, Industry

Indian abrasives industry is estimated at USD 0.49 Bn, out of which 75% is catered by organized players. It is highly concentrated, dominated by two main players- 75% of Indian USD 0.49 Bn CUMI and Grindwell Norton. While these players enjoy over 60% of market share, domestic abrasives market is remaining market is fragmented between remaining players. Third player-Wendt dominated by two players-CUMI enjoys just 5% market share. Some of the other prominent players are 3M India, and Grindwell Norton Bosch, Wendt, Orient Abrasives etc. There are a host of other small scale players also present in the industry. These small players normally specialize in select products and import from China, catering to low end of the market. The market, over a period of time, has become price sensitive. We believe that the key success factors are quality, cost, service and capability to provide total grinding solutions. CUMI enjoys 2% market share globally. We also, believe that the domestic abrasives Industry is evolving from two players market to a multi-player market. While many global players are setting up their manufacturing in India or expanding on their current infrastructure, cheap imports from China have also been on an increasing trend.

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Industrial Ceramics and Super Refractories Global Industrial ceramics Global Industrial ceramics market is pegged at USD 13 Bn, out of which Alumina market is pegged at USD 13 based ceramics material is around USD 5 Bn. The key user industries for Ceramics Bn, out of which Alumina business are power generation and transmission, coal washeries, grain handling, based ceramics material is ballistic protection, cement, non-ferrous metals, iron and steel industries, carbon around USD 5 Bn black, insulators, furnace building, glass, petrochemicals and construction industries.

Alumina based ceramics market (US$ mn) Market Size Cumi’s Market Share

Energy and Aerospace 250 Overall 6%n Metallized 18% Wear Resistant 1000 Overall 3%, 14% in Company’s product categories Bio Ceramics 3500 NA Defense 75 NA Cutting Tools 175 NA Total 5000 NA

Source: Company

Domestic Industrial Ceramics business is dominated by few large players including CUMI, BHEL and Jyoti Ceramics. The market is also catered by imports, mainly from China. We believe that the key requirements for success in this business are quality and cost competitiveness. Entry barriers are high by way of capital investment and technology. Refractory is a material that can withstand high temperature. Global refractories market stands at USD 30 Bn, where major demand originates from China. Indian Refractories market is estimated at Rs 45 Bn. CUMI is into High Alumina, Silicon Carbide, Zirconia based refractories which are capable to withstand very high temperature. In FY14, prices fell in the second half globally, triggered by price cut from Chinese players. In domestic industrial ceramic market, weak economic activities (mainly in power generation) and deferment of projects impacted sales of wear resistant liners which is one of the key product for the industry. Also, domestic refractories segment declined due to lower off-take of fired products. The order inflow from the projects segment, particularly glass, dropped sharply. With world economy expected to recover over the next few years, we believe that the Industry should witness growth over the previous years. Various Industry players have highlighted that the prices have now started to bottom out and are expected to recover through the second half of the current year.

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Electrominerals Electro minerals are used as basic raw material in the manufacture of abrasives and refractories. They are also increasingly being used for silicon wafer slicing in solar cell manufacture, dental care and skin therapy. Silicon carbide (one of the major Electrominerals products) also finds application in metallurgical industries. The global market size for The global market size for electro minerals is estimated at around USD 2.5 billion. electro minerals is estimated at The key success factors in this industry are cost and quality. Entry barriers are high around USD 2.5 billion. Entry capital investment, limited market and technology. Availability of alternatives and barriers are high capital product differentiation are the main challenges in this business. In India, CUMI is investment, limited market and one of the leading players in aluminum oxide grains and has established leadership technology position in Indian and Russian markets (mainly Silicon Carbide). Apart from CUMI, Grindwell Norton, Orient Abrasives and SNAM Abrasives are the others. Imports from China are also a major source of electro minerals in India.

Electrominerals industry Global Capacity Leader’s positioning CUMI’s Capacity

Fused Zirconia 75000 tons China with 40% of world’s capacity 10000 tons Silicon Carbide (SIC) 2 mn tons China with 50% of world’s capacity 1 mn ton Fused Aluminas 1.7 mn tons China with 50% of world’s capacity 1% share

Source: Company

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COMPANY OVERVIEW Incorporated in year 1954, Carborundum Universal Ltd (CUL) is a global supplier of abrasives, ceramics and electro minerals. CUMI was founded as collaboration between the , The Carborundum Co., USA and the Universal Grinding Wheel Co. Ltd., U.K. Company currently manufacturers over 20,000 different varieties of abrasives, refractory products and electro-minerals in ten locations across various parts of the country. CUMI’s focus on R&D initiatives and strategic alliances with global leaders in grinding technology ensured international recognition as a manufacturer of quality abrasives and a provider of total grinding solutions. CUMI’s products are being exported to 43 countries spread across North America, Europe, Australia, South Africa and Asia. CUMI enjoys leadership positioning in Indian abrasives industry and globally second and third position in silicon carbide and zirconia respectively.

Key Revenue Streams

Carborundum Universal (CUMI)

Abrasives Electrominerals Ceramics (40% of revenues) (35% of revenues) (25% of revenues)

Coated Bonded Super Industrial Super Anti Abrasives Abrasives Abrasives Ceramics Refractories corrosives

Source: Company, Kotak Securities - Private Client Research

Over the last five years, CUMI has grown consolidated revenues at 9% CAGR mainly boosted by electrominerals business. Company operates on 55-60% capacity utilization and major capex programs are over. With an extensive distribution network and highly qualified and motivated personnel base, CUMI aims at establishing itself as meaningful global player in its core products.

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KEY INVESTMENT ARGUMENTS

Leadership position in the domestic abrasives market; strong positioning in global electrominerals and industrial ceramics market CUMI’s business is aligned into three principal segments 1) abrasives, 2) Ceramics and 3) Electrominerals.

Abrasives CUMI is a market leader with CUMI is a market leader with 26% market share in Indian abrasive market on back 26% market share in Indian of 1) strong brand in abrasive space 2) robust distribution network offering pan India abrasive market presence 3) efficient cost controls providing price advantage to the end user. Company has been able to retain its leadership position in the Indian market despite increasing competition from Saint Gobain, Bosch and 3M. CUMI's products include bonded abrasives, coated abrasives, super abrasives, metal working fluids and power tools. Company has a strong positioning in high margin bonded abrasives segment and enjoys nearly 40% market share. Its current capacity in bonded abrasives stands at 36000 tones per annum. In Super abrasives, company is present thogh its JV with Wendt India. CUMI has thirty plants located across seven locations including India, Russia, China and Thailand. The marketing entities located in North America and Middle East support this business in getting an extended customer reach. The Company caters to customers located in over fifty countries through its network of manufacturing facilities and marketing establishments. It is one of the major players in India and Russia. The abrasives division accounts for 45% of company’s consolidated revenues and has grown at 14% CAGR between FY07-14. Indian standalone abrasives sales constitutes to nearly 74% of segment sales. We expect company to grow at 12% CAGR between FY14-16E.

Abrasives sement growth trend (Rs mn)

12% CAGR

14% CAGR

Source: Company, Kotak Securities - Private Client Research

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Ceramics CUMI is one of the major players in India (with 14% market share), Australia and Russia in specific product groups. It caters to customers located in over thirty countries through three product lines viz. Industrial Ceramics, Super Refractories and Anti-Corrosives. Unlike abrasives, ceramics business is global in nature and therefore nearly 65% of company's produce is exported. CUMI is one of the major players Industrial ceramics comprises of alumina and zirconia products that provides wear in India (with 14% market protection, thermal resistant and metallised products. The key user industries for share), Australia and Russia in Ceramics business are power generation and transmission, ballistic protection, specific product groups cement, nonferrous metals, iron and steel industries etc. The operations are carried out through twelve manufacturing / service facilities located in India, Australia, South Africa and Russia. CUMI has entered into technology agreements with Sheffield Refractiries (UK) and Anderman Ceramics (UK). Also, in FY12 company has acquired 100% stake in Thukela Refractories (TRL), South Africa to increase its footprint globally. In ceramics and refractories business, company has envisaged two point strategies for realizing growth potential 1) increase market share by addressing newer geographies and 2) move up the value chain and introduce new product offerings (current capacity at 6800 tones tiles) to increase its addressable market from current levels of USD 280 mn. For instance, in recent years company has considerably increased its focus on value added high margin products like 'Metalized cylinders' finding use in specific applications like vacuum interrupter. The Super Refractories product group supplies fired, monolithic and fibre as also Refractory design and installation services addressing the insulation and thermal resistance requirements of industries. The Refractory fibre and Refractory design and installation businesses are addressed through Murugappa Morgan Thermal Ceramics Limited and Ciria India Limited. The Anti-Corrosives product group offers acid resistant cements, polymer concrete cells and various other products addressing the anti-corrosion requirements of industries. This business is local in nature and 90% of company's sales are in domestic market. CUMI operates in Fired High CUMI operates in Fired High Alumina (38% market share in India) and Monolithics Alumina and Monolithics business (12% market share in India), present in specific high end range (mainly business and is present in high temperature). It currently has 11,000 tons of fired capacity in India, Russia and specific high end range South Africa, along with 32000 tons of monolithic capacity in India and 8700 tons in South Africa. We believe that in the ceramics division, company is well poised to benefit from recovery in domestic demand from power generation and coal washeries and also coal washeries in Australia. The ceramics & refractories division accounts for 25% of company's revenues and has grown at 16% CAGR between FY07-14. We expect company to grow at 11% CAGR between FY14-16E.

Ceramics segment growth trend (Rs mn)

11% CAGR

16% CAGR

Source: Company, Kotak Securities - Private Client Research

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Electrominerals Electrominerals segment comprises of products like fused Alumina (comprising brown and white Alumina), Silicon Carbide, Fused Zirconia, Alumina Zirconia and Zirconia Mullite. The operations are carried out through seven locations that include India, Russia and South Africa. Products are sold to customers located in over 40 countries. Key user industries for this business are Abrasives, Refractories and Steel. The business also has captive mines and a captive power plant. The operations are carried out CUMI has established a leadership position in Indian and Russian Electrominerals through seven locations that market. In fused Zirconia (Glabal capacity 75000 tons; CUMI Capacity 10000 tons)) include India, Russia and South it is world's third largest player after Saint Gobain and Imerys. Similarly in silicon Africa. Products are sold to carbide, company is present through its 97% subsidiary Volzhsky Abrasives work customers located in over 40 countries (VAW), Russia. VAW has capacity of 70000 tons and is world's second largest player after Saint Gobain. CUMI has a locational advantage in Russia by way of low power and pet coke cost (which forms nearly35% of cost) proving enormous advantage to the company. The electromineral division accounts for 30% of company's revenues and has grown at 35% CAGR between FY05-14. We expect company to grow at 13% CAGR between FY14-16E.

Electrominerals segment growth trend (Rs mn)

13% CAGR

35% CAGR

Source: Company, Kotak Securities - Private Client Research

Geographically diversified operations: Margin expansion expected in overseas business Currently CUMI derives 55% of CUMI, through its subsidiaries is present in over 55 countries including Russia, South revenues from its international Africa, USA, European region etc. Currently CUMI derives 55% of revenues from its operations international operations. In order to explore new geographies for growth, company has been expanding its presence in international markets through organic and inorganic route. Company's international business has grown at a faster pace than the domestic business in the past seven years. CUMII has made certain acquisitions in the past with an objective of achieving backward integration and establish itself as a prominent player in global abrasives market and electromineral market. Company manufactures a major portion of its products in India using raw materials from Russia and South Africa. Company primarily sells its products through its dealer network spread around globe along with front offices in select countries like Australia with an aim to gain market share.

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Table Entity % Ownership Geography Focus Area Rationale

Volzhsky 97.44 Russia SIC, Abrasives, Refractories Access to cheap power and fuel Foskor Zirconia 51 South Africa Electrominerals Access to Zirconia Sand CUMI Australia Pty. Limited’s (CAPL) 100 USA Industrial Ceramics Access to Australia Market CUMI Abrasives and Ceramics Co. Ltd 100 China Abrasives, Electrominerals Access to Chinese Market Thukela Refractories 100 South Africa Refractories Capacity enhancement in Refractories

Source: Company, Kotak Securities - Private Client Research

Over the past two years, CUMI international sales growth and profitability has got impacted by the global slowdown. However, management has stated that business would pick up and is confident of achieving improved realizations going ahead. Overseas business cam improve on back of 1) increase in volume sales and 2) favourable product mix toward high margin products, both in abrasives and ceramics 3) completion of restructuring program in the next few quarters. Management believes that this should result in improved sales and margin for the company over FY15-16.

South Africa In South Africa, Cumi operates through its subsidiaries -Thukela Refractories (with capacity of 22000 tons) and Foskor Zirconia (FZL). FZL (capacity 10000 tons) has access to Zirconia sand which is used in the manufacturing of ceramics and high end abrasives and is found only in South Africa.

Cumi subsidiary Foskor Zirconia We note that CUMI"s South African business (Thukela and Foskor) can potentially (FZL) has access to Zirconia sand observe pick up in FY16. In FY12, CUMI has commissioned tilt furnace for the which is found only in South manufacture of bubble Zirconia. Over the past few quarters, company has spent Africa time in stabilization of manufacturing process and product establishment. Management has now stated that Foskor has received various client approvals for bubble Zirconia plant and expects meaningful traction going ahead. Further, in Q2FY15, CUMI has initiated restructuring process of South Africa business. Company has halted production from its 22,000 tons capacity at Thukela. We note that the company has been operating at low utilization levels at Thukela (nearly 20%) due to global slowdown in glass refractory. To address this, company has temporarily stopped production at this unit. Company is planning to transfer its flow control business to Jabalpur (CUMI currently has production facility at Jabalpur, Madhya Pradesh). Company aims to achieve consistency in production as technical manpower is available more in India. We note that Thukela reported loss of Rs 50 mn in FY14 (substantially lower than FY13 loss of Rs 132 mn) which is expected to come down further over FY15-16. Management expects to increase capacity utilization of bubble Zirconia significantly up from 15% utilization level in FY14. We believe that the profitability at Foskor would also improve driven by operating leverage.

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Russia With acquisition of 'Volzhsky Abrasives Works' (VAW), Russia, CUMI has become world's second largest producer of Silicon Carbide (SIC). VAW has capacity of 70000 tons and is world's second largest player after Saint Gobain. CUMI has a locational advantage in Russia by way of low power and pet coke cost (which forms nearly 35% of cost) proving enormous advantage to the company. Other than internal consumption, company also exports a significant portion of its produce to Europe. With acquisition of ‘Volzhsky In FY14, Volzhsky witnessed significant SIC (Silicon Carbide) volumes pick and Abrasives Works’ (VAW), Russia, reported sales at RUB 3127 mn vis-à-vis RUB 2950 mn. Sales of abrasives and CUMI has become world’s second refractories however remained weak due to weak user market conditioned. We largest producer of Silicon believe that the changing trend is the key variable to monitor in Russia business Carbide (SIC) resulting in improved margins in future. We also believe that CUMI is also likely to benefit from expected favourable product mix in Russia operation over next few years. We note that the company has deployed considerable capacity in photo-voltaic wafering space which lost ground and resulted in severe loss accumulation for the company. However, with improving global economic scenario, management believes that the shift is coming back to high margin products like crystalline Sic from more commoditized low margin products like metallurgical Sic.

Australia Subsidiary In Australia, CUMI has established itself as one of the leading players in lined equipment and industrial ceramics industry. Management believes that the volumes have bottomed out and expect recovery through FY15-16. In FY14, Australian business sales fell by Rs 170 mn from Rs 920 mn in FY2013. EBITDA declined from Rs 220 mn in FY13 to Rs 100 mn in FY14. In our projections, we build turn around in overseas subsidiaries on back of improved global business outlook and cost efficiency measures employed by the company over the past few years. We expect South African and Russian subsidiaries to make up for sluggish performance in the past. We believe that the company would likely reduce its dependence on photovoltaic industry in electrominerals division. We build subsidiaries revenue We build subsidiaries revenue growth at 16% CAGR between FY14-16E on back of growth at 16% CAGR between potential recovery in key geographies. We also expect sharp margin improvement FY14-16E on back of potential in international business (7% OPM in FY14 to 18% in FY16) going forward on back recovery in key geographies of operating leverage and stable cost structure.

Overseas business trend Revenues (Rs bn ‐ LHS) EBITDA (% ‐ RHS) 12.0 24.0%

9.0 18.0%

6.0 12.0%

3.0 6.0%

0.0 0.0% FY10 FY11 FY12 FY13 FY14 FY15E FY16E

Source: Kotak Securities - Private Client Research

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Sustained emphasis on research & development initiatives provides competitive edge to the company CUMI pays considerable emphasis on the research and development capabilities. It constantly ventures into new initiative related to technological advancement. Company consistently deploys resources for adding products valuable to the end users. R&D activities involve development of new products and improvement of existing products. R&D expenses in FY14 stood at Rs 66.7 mn. Some of the major products introduces in FY14 are as follows.

Abrasives  High performance zirconia grains with unique B1214 bond system for grinding sensitive Hi chrome alloys.  Special fine grit rubber bonded wheels for centerless applications  Ball Lapping wheels with enhanced life and cycle time  Vitrified Thread grinding wheels and superfinishing stones with specially graded Micro-crystalline grits offering a step-jump in performance.  ‘TEZZ’ Ultra thin cutting wheels with superior life.  Ajax Sukha paper for Dry sanding applications  ‘SPEED’ Chopsaw cutting wheels with faster cycle time  New generation bonding systems for Coated Abrasives.

Ceramics  Reactive bonded silicon carbide (RBSiC) seals for thrust bearing application  CUMI Therm- Aluminum Titanate for non ferrous casting applications  Metallised devices for night vision rings  Brace products and assemblies

Refractories  Top Pour Boxes made from special alloys for the aerospace industry

Electrominerals  Specialty Alumina Zirconia grains for critical applications in abrasives and refrac- tory industries.  Variants in Alumina semi-friables  Solgel- Azuras II  Ultra Fine SiC Powders for applications in Engineered Ceramics, Diesel Particu- late Filters and the toner industry.

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Company to maintain high growth in revenue; recovery in operating margins likely to aid to free cash flow generation We project 11% CAGR between FY14-16 in consolidated revenues from Rs.21.2 Bn in FY14 to Rs 26 Bn in FY16E on back of 1) recovery in demand for abrasives in the domestic/international market and 2) pick up in international subsidiaries business.

Revenue breakup FY12 FY13 FY14 FY15E FY16E

Abrasives 8291 7462 8598 9544 10403 YoY (%) 18.0% 11.0% 11.0% 11.0% 9% Industrial Ceramics 4357 4752 4706 5319 5744 YoY (%) 31% 9.1% -0.9% 9% 8% Electro minerals 6700 6566 8099 8665 9445 YoY (%) 29.2% -2% 23.2% 9% 9%

Source: Company, Kotak PCG-Resaecrh

Revenue trend Revenues (Rs bn ‐ LHS) Asset Turnover (x ‐ RHS) 32.0 4.0

24.0 3.0

16.0 2.0

8.0 1.0

0.0 0.0 FY12 FY13 FY14 FY15E FY16E

Source: Company, Kotak Securities - Private Client Research

Within the revenue streams, we growth across all the divisions over FY14-16 and expect that the pricing would likely improve on back of global economic recovery. We believe that the company would maintain market share in India and report growth in key international markets. We expect that the company is likely to maintain its revenue mix at current levels with abrasives division contributing to nearly 40%, industrial ceramics 25% and electro minerals 30% of the revenue pie.

Revenue mix - FY13 Revenue mix - FY16E

Industrial Industrial Ceramics Ceramics 22% 22%

Electrominer Electromin als erals 38% 37%

Abrasives Abrasives 40% 41%

Source: Company, Kotak Securities - Private Client Research Source: Company, Kotak Securities - Private Client Research

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We expect abrasives division to report growth at 10% CAGR between FY14-16 from Rs 8.6 Bn in FY14 to Rs 10.4 Bn in FY16E. We believe that the growth in abrasives would be driven by global recovery in manufacturing. We also believe that ceramics and electro minerals business have bottomed out and would post recovery going ahead.

Overseas subsidiaries margins bottomed out; restructuring initi- ated-expected to post recovery going ahead We highlight that the overseas subsidiaries constitutes to nearly 50% of company’s revenue pie. We do not anticipate major shift in the revenue mix going ahead, however operating profits could substantially come in from these subsidiaries.

Domestic / Overseas mix (Rs bn) 20.0 Domestic Sales Overseas Sales

15.0

10.0

5.0

0.0 FY10 FY11 FY12 FY13 FY14 FY15E FY16E

Source: Company, Kotak Securities - Private Client Research

We build subsidiaries revenue growth at 9% CAGR between FY14-16E on back of potential recovery in key geographies and improved capacity utilization in Electrominerals division post restructuring. We also expect sharp margin improvement in international business (7% OPM in FY14 to 15% in FY16) going forward on back of successful restructuring in overseas business and operating leverage & stable cost structure.

Subsidiaries (Rs mn) FY10 FY11 FY12 FY13 FY14 FY15E FY16E

Revenues 5740 7255 8696 8705 9977 10189 10502 EBITDA 1245.59 1426.84 1696.37 843.59 721.55 1423.81 2125.91 EBITDA (%) 22.7 20.7 20.1 10.0 7.2 8.0 15.0

Source: Kotak PCG-Research

South Africa business restructuring could increase profitability in next few quarters In Q2FY15, CUMI has initiated restructuring process of South Africa business, viz. Thukela and Foskor. Company has halted production from its 22,000 tons capacity at Thukela. We note that the company has been operating at low utilization levels at Thukela due to global slowdown in glass refractory. To address this, company has temporarily stopped production at this unit.

In Q2FY15, CUMI has initiated Further company is planning to transfer its flow control business to Jabalpur (CUMI restructuring process of South currently has production facility at Jabalpur, Madhya Pradesh). Company has Africa business, viz. Thukela and booked the cost at Rs 80 mn for restructuring in Q2FY15. Management has stated Foskor that by shifting production to India, company aims to achieve consistency in production as technical manpower is available more in India. We note that the Electrominerals division can show subdued performance over the next 2-3 quarters due this restructuring initiative and would likely post recovery through FY16.

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Domestic operating margins likely to sustain over the next two years due to operating leverage We expect domestic EBITDA margins to sustain over FY15E and FY16E due to operating leverage and improved pricing. Management has been taking effective measures to control cost and passing on power (power constitutes to a major portion nearly 35% of cost structure), fuel and raw material costs to the customers to a large extent in the past.

We expect domestic EBITDA Power cost is one of the major challenges for the company. As company carries margins to sustain over FY15E manufacturing in diverse geographies, power tariffs are also different in each and FY16E due to operating location. At consolidated level, company consumes over 850 mn units each year leverage and improved pricing and therefore we note that any steep appreciation in this cost impacts portability considerably. In our projections, considering that higher volumes would mitigate the power cost, we build power cost at 13-14% of sales over the next two years.

Power cost trend

4000 18.0 Power cost Trend (Rs mn ‐ LHS) Power as % of sales (RHS) 3000 16.0

2000 14.0

1000 12.0

0 10.0 FY10 FY!1 FY12 FY13 FY14 FY15E FY16E

Source: Company, Kotak Securities - Private Client Research

Overall at consolidated level, we believe that operating margins are likely to increase substantially through FY16E on back of 1) increase in volumes driven by global recovery in manufacturing and 2) resurrection in overseas subsidiaries margin profile post restructuring. We build EBITDA margin at 12% and 16.5% in FY15E and FY16E respectively.

EBITDA trend 5.00 25.0% EBITDA (Rs mn ‐ LHS) EBITDA % (RHS) 4.00 20.0% 3.00 15.0% 2.00 10.0% 1.00

0.00 5.0% FY12 FY13 FY14 FY15E FY16E

Source: Company, Kotak Securities - Private Client Research

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Segment EBIT Abrasives (Gross) Industrial Ceramics Electrominerals 22.0%

17.0%

12.0%

7.0%

2.0% FY12 FY13 FY14 FY15E FY16E

Source: Company, Kotak Securities - Private Client Research

CUMI has a strong balance sheet with low debt and working capital requirement We opine that the working capital is likely to remain stable at current levels 25% of sales with inventory at close 70 days and creditors at 96 days over FY15-16E.

Working capital (Rs mn) FY14 FY15E FY16E

Net Working capital (non cash) 5495.99 6007.68 6798.73 Net Working capital (non cash) in days 89.67 87.37 90.90 Current Assets 9116.89 10051.24 10872.44 Inventory 4340.02 4813.14 5235.81 inventory days 70.81 70.00 70.00 Sundry Debtors 4166.50 4538.10 4936.63 Debtors days 67.98 66.00 66.00 Loans and advances 610.37 700.00 700.00 Cash 908.73 860.62 1087.32 Current liabilities 3620.90 4043.56 4073.71 Sundry creditors 2005.90 2231.72 2119.97 in days 95.55 96.00 96.00 other current liabilities 1419.00 1615.84 1757.74 in days 46.76 47.00 47.00 provisions 196.00 196.00 196.00

Source: Kotak Securities - Private Client Research

Debtors / sales

Revenues‐ (Rs Bn LHS) Debtors/Sales (% ‐ RHS) 30 22% 24 21% 18 20% 12 19% 6 18% 0 17% FY12 FY13 FY14 FY15E FY16E

Source: Company, Kotak Securities - Private Client Research

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ROE / ROCE Trend EBIT (Rs bn ‐ LHS) ROCE (% ‐ RHS) ROE (% ‐ RHS) 4.0 32.0%

3.0 24.0%

2.0 16.0%

1.0 8.0%

0.0 0.0% FY12 FY13 FY14 FY15E FY16E

Source: Company, Kotak Securities - Private Client Research

We believe that the CUMI will be able to support its future growth on back of its improving balance sheet. CUMI has undertaken major capacity expansion program over FY11-14 with an aim to move up the value chain. Its capex with respect to value added coated abrasives, SIC and bubble zirconia are now over and would potentially result in superior margins going ahead post resturcting. CUMI currently operates at nearly 55-60% of its capacity leaving enough room to scale up its operations going ahead. We estimate Capex to remain at current levels of Rs 350-400 mn over the next two years mainly related to maintenance of current capacity of the company. Company’s net debt stands at Rs 3.1 Bn at the end of FY14 implying D/E at 0.4. Stable margins and higher return on Equity at 21% are expected to result in net operating cash flow at Rs 1.9 Bn and Rs 2.6 Bn in FY15E and FY16E respectively.

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VALUATION & RECOMMENDATION

Current valuations appear attractive vis-à-vis the potential growth in revenues driven by 1) growth in domestic demand across sectors for company’s products on back of economic recovery2) reduction in losses at international subsidiaries leading to sharp recovery in EPS at Rs 12 in FY16E vis-à-vis Rs 5.1 in FY14.. At current price of Rs.174, CUMI stock is trading below its four years average P/E multiple of 16x on a one year forward basis. We believe that stock could get rerated going ahead on back of 1) improved RoE due to substantial margin improvement in international business 2) global economic recovery leading to higher demand for company's products 3) strong brand franchise in domestic market and robust distribution network in India/abroad. We initiate coverage on CUMI At current price of Rs 174, CUMI stock is trading at 14.5 x P/E and 8.4 x EV/EBITDA with a BUY rating and target on FY16E earnings. We believe that company's stock can re-rate further to capture price of Rs 240 significant improvement in company's margin profile and strong presence in Indian/ overseas market. We value CUMI stock at 20x FY16E (11x EV/EBITDA) earnings and arrive at a target price of Rs 240 per share. In view of adequate upside to our target price we ascribe 'BUY' rating on company's stock.

PE Band

Source: Ace Equity, Kotak Securities - Private Client Research

High ROE supported by potential operating margin expansion We highlight that CUMI ROE could increase substantially over the next two years to close to 18% supported by strong operating margins. With global presence and improving pricing trend along with low Capex commitment, we believe that the company would expand return on capital going ahead.

Initiate coverage on the CUMI stock with BUY rating and a target price of Rs 240 based on 20 x FY16E earnings At current price of Rs 174, CUMI stock is trading at 14.5 x P/E and 8.4 x EV/EBITDA on FY16E earnings. We believe that company's stock can re-rate further to capture significant improvement in company's margin profile and strong presence in Indian/ overseas market. We value CUMI stock at 20x FY16E (11x EV/EBITDA) earnings and arrive at a target price of Rs 240 per share. In view of adequate upside to our target price we ascribe 'BUY' rating on company's stock.

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Business review Q2FY15; revenue growth remained muted YoY due to diminished production at Thukela and FZL Company's consolidated revenues for Q2FY15 de-grew by 2.3% YoY at Rs 5.4 Bn & EBITDA stood at Rs.558 mn. EBITDA margins contracted sharply to 10.2% in the quarter against 14.2% last year. Margins declined due to initiation of restructuring process in South Africa business. EBIT margins for abrasives segment stood at 8.3% in the quarter. Ceramics segment reported margin expansion. EBIT margin expanded to 15.5% vis-à-vis 8.4% in Q2FY14. CUMI hs commenced restructuring of its operation at Thukela/FZL in Q2FY15 and part of expecses has also gone for voluntary retirement schemes. Margins in Electrominerals business will continue to observe pressure over next 2-3 quarters. Also, rapid depreciation of Ruble in Q2FY15 has led to translation losses in Russian business. Management has also stated that Russian facility (VAW) is also facing temporary pressures in exporting to Europe on account of ongoing Russia Ukraine crisis. Management has also stated that it is in the process of commencing front end offices in Europe to take care of the halted sales. Company reported tax expense at Rs 145 mn in the quarter and PAT stood at Rs 153 mn in Q2FY15 vis-à-vis Rs 289 mn in Q2FY14.

CUMI Consolidated Result for Q2FY15 (Rs mn) Q2FY15 Q2FY14 YoY (%) Q1FY15 QoQ (%)

Income from Operations 5480 5608 (2.3) 5219 5.0 Decrease/ (Increase) in stock 16 (42) (227) Material consumed 1508 1751 (13.9) 1787 (15.6) Puchase of traded goods 469 310 116 Employee expenses 734 711 3.3 718 2.2 Power & Fuel 847 872 892 Other expenses 1348 1285 4.9 1189 13.3 Total Expenses 4921 4886 0.7 4475 10.0 EBITDA 558 722 (22.6) 744 (24.9) Other income 29 20 49.5 32 (7.9) Depreciation 266 217 22.2 259 2.7 EBIT 322 524 (38.5) 517 (37.7) Finance cost 71 70 66 Exceptional Items 0 0 0 Foreign exchange dif exp 47 13 (27) PBT 298 466 (36.1) 424 (29.7) Total tax 145 177 (18.0) 135 7.2 PAT 153 289 (47.2) 289 (47.0) EBITDA (%) 10.2 12.9 14.2 Tax Rate (%) 48.7 38.0 31.9

Source: Company

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Segment Revenue (Rs mn) Q2FY15 Q2FY14 YoY (%) Q4FY14 QoQ (%)

Revenue Abrasives 2325 2254.5 3.1 2121 9.6 Ceramics 1253 1238 1.2 1149.4 9.0 Electrominerals 1966 2162 (9.1) 2021 (2.7) Segment EBIT Abrasives 194 220 (12.0) 123 57.4 Ceramics 195 148 31.8 172 13.1 Electrominerals 33 224 (85.5) 264 (87.7) Segment Margins % Abrasives 8.3 9.8 13.7 Ceramics 15.5 11.9 8.4 Electrominerals 1.7 10.4 9.4

Source: Company

KEY CONCERNS

Delayed recovery in global manufacturing activity Abrasives, ceramics, refractories and electrominerals are used by various industries in their manufacturing activity. Over the past few years, CUMI business has suffered due to languishing macro environment. Global manufacturing has started to recover through past few quarters. However we note that company business can get severely impacted if there are any delays in the recovery

Increased volatility in input prices In FY14, company has faced input cost pressure in the form of hike in power cost, fuel cost and select raw material inputs in Indian, Russian and South African operations. Company could contain these pressures by way of using alternate cost effective raw materials, improvement in raw material consumption and process improvements. We note that increased volatility in input prices could pose threat to company’s operations.

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FINANCIALS

Profit and Loss Statement Balance sheet (Rs mn) FY14 FY15E FY16E (Rs mn) FY14 FY15E FY16E

Revenues 21,253 23,929 26,028 Cash and cash equivalents 909 856 1,085 % change yoy 9.5 12.3 9.0 Accounts receivable 4,167 4,543 4,942 EBITDA 2,514 2,871 4,295 Loans & advances 610 700 700 % change yoy 6.0 14.2 49.6 Inventories 4,340 4,819 5,241 Depreciation 911 980 1,016 Misc expenditure - - 1 EBIT 1,603 1,892 3,279 Current Assets 9,117 10,062 10,883 % change yoy (3.5) 18.0 73.3 WIP 5,496 6,014 6,805 Net Interest 282 302 278 LT investments 373 373 373 Earnings Before Tax 1,488 1,750 3,161 Net fixed assets 7,863 8,163 8,463 % change yoy (2.1) 17.6 80.6 Total Assets 16,389 17,107 18,398 Tax 592 508 917 Provisions 196 196 196 as % of EBT 38.4 29.0 29.0 Current Liabilities 3,621 4,048 4,078 XO Items 0 0 0 Minority Interest 699 699 699 Recurring PAT 950 1,243 2,245 LT debt 3,924 3,773 3,473 % change yoy 5.5 30.8 80.6 Other liabilities(deferred tax) 591 591 591 Shares outstanding (m) 187.4 187.4 187.4 Equity & reserves 11,059 11,929 13,520 EPS (Rs) 5.1 6.6 12.0 Total Liabilities 16,389 17,107 18,398 DPS (Rs) 1.3 1.7 3.0 BVPS (Rs) 59 64 72 CEPS 9.9 11.9 17.4 Source: Company, Kotak Securities - Private Client Research Source: Company, Kotak Securities - Private Client Research Ratio Analysis Cash Flow Statement (Rs mn) FY14 FY15E FY16E (Rs mn) FY14 FY15E FY16E EBITDA margin (%) 11.8 12.0 16.5 Profit Before Tax 1,488 1,750 3,161 EBIT margin (%) 7.5 7.9 12.6 Depreciation 911 980 1,016 Net profit margin (%) 4.5 5.2 8.6 Current liabilities incl provisions 1 427 30 Adjusted EPS growth (%) 5.5 30.8 80.6 inc in inventory 314 479 423 Receivables (days) 68.0 66.0 66.0 inc in sundry Debtors 565 377 399 Inventory (days) 70.8 70.0 70.0 inc in advances (171) 90 - Sales / Net Fixed Assets (x) 2.8 3.0 3.1 Tax Paid 592 508 917 Interest coverage (x) 5.7 6.3 11.8 Other Adjustments - - - Debt/ equity ratio 0.4 0.3 0.3 Net cash from operations 937 1,711 2,475 ROE (%) 8.8 10.8 17.6 Purchase of fixed Assets (1,338) (1,280) (1,316) ROCE (%) 6.4 8.3 13.4 Net investments - - - EV/ Sales 1.8 1.6 1.4 Net cash from investing (967) (1,265) (1,318) EV/EBITDA 15.6 13.7 9.1 secured 346 (151) (300) Price to earnings (P/E) 37.7 28.8 15.9 unsecured - - - Price to book value (P/B) 3.2 3.0 2.6 Dividend Paid (263) (348) (628) Price to cash earnings 19.2 16.1 11.0 Net Cash from financing activities 83 (499) (928) Source: Company, Kotak Securities - Private Client Research Net Cash Flow 54 (53) 229 Cash at the end of year 909 856 1,085

Source: Company, Kotak Securities - Private Client Research

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Fundamental Research Team Dipen Shah Saday Sinha Ritwik Rai Jayesh Kumar IT Banking, NBFC, Economy FMCG, Media Economy [email protected] [email protected] [email protected] [email protected] +91 22 6621 6301 +91 22 6621 6312 +91 22 6621 6310 +91 22 6652 9172

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