Description

I believe Maruti Suzuki is overvalued given the short and medium term threats it is facing.  I know several VIC members don’t invest much (or at all) in India, in part due to restrictions on retail investing by non-Indians, but hopefully this will be helpful for funds that do invest there, as there are only a limited liquid shortable names in India.  Disclaimer: We are short MSIL (through futures). 

Description 

Maruti Suzuki India, a 54%-owned subsidiary of Suzuki, has been the largest car manufacturer in India for over two decades and has historically had a dominant (>50%) share in the passenger car market. 

Near term issues

• Increase in interest rates: 350bps of rate hikes in the last 12 months have impacted volumes resulting in negative growth rates for the industry in the first 6 months of FY12 and -20%+ for Maruti in the most recent quarter since 80%+ of all cars sold are financed. Admittedly rate hikes appear to be over and swap rates indicate a 100bps cut in CY 2012 subject to easing inflation. However given the 3 month lag in loan pricing suggests another 100bps loan yield impact in next 3-6 months
• Increase in fuel: With petrol costs up 30% in metros such as Mumbai, operating expenses have shot up significantly. We think that besides the short term impact this resets the bar for car buyers to a higher per capita income level to offset the incremental $100/year fuel costs which in the context of a $2000/year per capita GDP seems steep

Secular / Long-term issues

• Competitive Intensity: The sell-side loves to point out that despite the entry of 10+ US/European/Japanese car manufacturers to India in the last 5 years, Maruti has defended its market share losing only 400bps to go from 52% to 48%. However that disregards the start-up time required for those companies to establish distribution channels and engineer cars relevant to local needs such as a high chassis clearance for the potholed roads, trading off acceleration & speed for 20km/l+ fuel efficiency etc. We think that inflection point is now as evidenced by the raft of < $7,000 car introductions by GM, Hyundai, Nissan-Renault etc starting Oct-11. Considering that 70%+ of cars sold in India are < $7,000 we think that is significant. Specifically Hyundai’s Eon introduced on Oct 13^th priced at $5,200 and benefiting from distribution / service hubs / second-hand value close to Maruti represents a clear threat with volumes of 10k+ month likely to hit Maruti’s flagship Alto small car and take away 5% share of the overall market. We expect the Volkswagen Up and Renault Pulse introductions at the Auto show in January to sustain that competitive pressure
• Structurally lower returns: The increased competitive intensity, higher ad and R&D costs and higher discounts driven by overcapacity have driven down Maruti’s ROE from 20-25% in 2004-05 to low teens at present (excluding 1-off items). However valuations especially on a P/B do not appear to have reset with bulls clinging to historic multiple ranges
• Structurally higher employee costs: Maruti’s usage of excessive temp contract labor that pushes the envelope on labor laws has resulted in employee cost / revenues of 1.9% versus a median 6% for other Indian auto & auto parts companies, 3% for Japanese & Korean car companies, 6.5% for Indian cement / steel companies and 7.5% for Indian consumer companies. It has also helped Maruti remain immune from the 15% wage inflation for Haryana industrial region wage hikes. We believe that the 3 labor strikes and formation of an independent union are far from transitional and are symptomatic of this issue and will ultimately result in significantly higher labor costs thereby impacting margins & returns
• Supply / demand and mix mismatch: Maruti’s sales of Diesel/non-diesel vehicles have historically held around 22/78 while the spread in price / litre between the 2 which is a proxy for car operating costs stayed in the 13-17 range. However with Brent > $100/bbl, the spread has moved to 26/litre skewing the operating benefit of owning  a vehicle firmly towards diesel. This is reflected in Maruti’s admission on the Oct 31^st call that 88% of its 100k+ Swift bookings in the last 6 months have been diesel. As one of the few auto companies without vertical integration and material capacity of sourced diesel engines Maruti stands to lose and grow slower than peers. The mooted outsourcing agreement with Fiat would increase the supply to 30-35% which still falls significantly short of the demand for cars with diesel engines
• Yen exposure: Despite being an Indian domestic car company, Maruti’s fundamentals effectively behave a Japanese exporter primarily because Suzuki has stipulated all intra-company transfer of raw material and royalties in JPY thereby shifting the burden on currency fluctuations firmly on the 46% minority shareholders. Hence Maruti has costs equating to 28% of revenues exposed to fluctuations in JPY/INR. As the JPY/INR has moved a stunning 77% from 0.35 in Jan-08 to 0.62 Maruti’s EBITDA margins have more than halved from FY08 to FY12 (and will continue to get worse over the next 6 months if the yen remains at spot rates 0f ~78 vs an average of ~80 for FY H1)

           o   A common argument on the part of the bulls is that Maruti will eventually localize components reducing the JPYINR exposure over time. The reality is that such a trigger appears to be perennially “3 years away”. Despite multiple assurances of localization in the last 4 years, the exposure has actually risen from low 20s 4 years ago to 27-28% at present

           o   Another anomaly is that some 8% of the 27-28% exposure appears to be from commodity products such as galvanized steel sourced from Nippon Steel (plus landing costs and freight). The inability of Maruti to localize even this brings up questions of what other dynamics drive such transactions

• Royalty rates: Since 2006-07 when the government deregulated royalty rates payable by subsidiaries of international companies Suzuki has tweaked the weighted average rate from ~2.6% to 6% in the most recent quarter. Ostensibly this is supposed to offset internal R&D. However the math does not add-up since Maruti’s current R&D burden of ~7-7.5% (5.5-6% royalties + 1-1.5% internal local R&D) is well in excess of every other Japanese, Korean and German car manufacturers who average 4.5% of sales. Considering that Maruti has had < 5 new model introductions in the last 7 years (excluding renaming of prior models and slight variations), the return on R&D appears dismal. In contrast Hyundai recently developed a completely new model (Eon) at $180MM completely through its Indian R&D center
• Value destruction for minority shareholders: In the 3 years from FY 08 to FY 11 Maruti’s volumes sold grew 66% driving a 51% growth in operating profit pre-royalties. Curiously that splits out into a 77% growth in economics to Suzuki and only a 11% growth (not CAGR) to minority Maruti shareholders. The reason for this is the aforementioned increase in royalty rates and dumping of 100% of JPYINR exposure on minority Maruti shareholders. Like frogs being slowly boiled in hot water, incumbent shareholders appear to be oblivious to this transfer of economics and persist in identifying Maruti as a “blue-chip with best of breed corporate governance”

Numbers / Assumptions (FY12, 13, 14 – year ending Mar 31^st)

• Unit volumes = 1.18MM, 1.39MM, 1.57MM vehicles
• Unit volumes y/y = -7% (First 7 months down -17.7%), +17%, 12%
• Net Sales = 350BN, 424BN, 505BN
• EBITDA = 31.0BN, 38.0BN, 47.3BN

Valuation

• Adjusting for realistic rate of growth (-6.5% in FY12 and +15% in FY13) and spot JPYINR rates, we believe that EPS will come in at 56-60 for FY12 and 70-75 for FY13. That represents a 30% discount to current consensus estimates which have already pulled in 20% in the last 6 months
• Considering the new realities discussed above, we apply a 12x FY13 P/E which is the long-term average multiple yielding a price target of 850-900 which is more than 20% below current levels

Risks

The biggest risks are falling commodity costs, falling interest rates, and strengthening rupee against the Yen.  All these are easily monitored.  Monthly market share data is also available. 

Catalyst

Catalysts

Though I have to admit I have been very surprised by MSIL’s share price resilience in the face of a massive FY2Q  miss this past weekend (Oct 30^th), followed by a horrible October monthly volume number put out yesterday (Nov 1^st) – I believe investors/sell-side are continuing to give MSIL the benefit of the doubt (putting more of the blame of the miss on the labor strikes rather than on pricing pressure and share loss due to competition).  Over time, I expect the shares to de-rate as investors lose confidence in growth/margins getting back to historical levels. Continued competitive intensity (new competitor launches) and demand slowdown (lagged impact of rate hikes, high fuel prices) are the most important catalysts over the next 6 months.