Maruti Suzuki Limited Indias BYD

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Maruti Suzuki Indias BYD

Introduction

Maruti Suzuki is the leading car OEM in India with 40-45% market share in the ~2.3MM car/year Indian market growing 10-15% per year. Following the divestiture of the Government of Indias stake in 2007, Suzuki Motor Corp owns 54% of the equity has majority board control and has nominated the CEO Mr. Nakanishi. True to its Suzuki heritage, ~70% of Marutis volumes are in the A1 & A2 small car segment that are typically small cars with < 1200cc engines and price tags < $9000 which segues nicely into Indias <$5k per capita income and traffic ridden roads

As the only listed Indian pure-play car OEM, with the optics of ostensibly superior Japanese management & corporate governance, 20%+ return profile, daunting market share and the luxury of $10-15MM+ daily liquidity, Maruti has been one of the blue-chip stocks and a favorite of foreign institutional investors looking to play the Indian consumption theme over the last 5 years, although the reality has been that the stock has ironically been dead money since the divestiture of the stake by the Government of India in 2007.

Through the arguments below we attempt to show why we believe that Maruti is at a critical inflection point and is a compelling contrarian selling opportunity driven by multiple short-term and long-term secular catalysts.

Secular / Long-term issues Oversupply => lower capacity utilization => lower margins & returns: Akin to the dynamics of the Chinese car industry post 2009-10, the explosion in capacity of US, European and Japanese car manufacturers extrapolating off the 20-30% growth off the troughs of 2009-10 has already resulted in excess capacity and industry utilization dipping below 70% in the current year. While Credit Suisse (which appears to be only 1 among the 60 brokers covering the stock to pay attention to demand/supply) projects a continued dribbling down of utilization of 60%, our own proprietary analysis projects an even bleaker scenario showing steeper capacity utilization collapse even at improbable 2012-15 CAGRs of 30%-35%. Given the 3 year lead time for land acquisition and 1-2 year lead time for new capacity we do not believe there is much potential for project cancellations. Based on the data below, we question if recent fixed cost absorption and discounting issues are transitory in nature or are representative of the new normal

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9,000,000 8,000,000 7,000,000 6,000,000 5,000,000 4,000,000 3,000,000 2,000,000 1,000,000 2010 2011 2012 2013 2014 2015 Industry Production capacity 2012-15 Demand @ 20% CAGR 2012-15 Demand @ 30% CAGR 2012-15 Demand @ 15% CAGR 2012-15 Demand @ 25% CAGR 2012-15 Demand @ 35% CAGR

Note: FY12/11 growth rate pegged at 4% at higher end of SIAM estimates and vs. < 0 in the first 7 months of the year

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 Hyundais Eon introduced on Oct 13th 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 Marutis 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

Dieselization of Indian car market & Marutis mix mismatch: Marutis 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 and government holding diesel subsidies relatively flat, the spread has moved to 26/litre skewing the operating benefit of owning a vehicle firmly towards 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. This trend is clearly evidenced by the monthly momentum in Jul-Oct 2011 as shown below and as per Marutis own admission on the Oct 31st 2011 analyst call that 88% of its 100k+ Swift bookings in the last 6 months have been diesel and will take 8-9 months to fulfill given supply & mix bottlenecks. In the meanwhile Toyota, Volkswagen and Nissan-Renault have exploited this and grown volumes 80-130% y/y in the last 7 months through October 2011.

Structural shift away from Marutis core < $5000 small cars towards larger $5k-15k sedans: Since road infrastructure is a bottleneck for car penetration in rural India, Cars remain an urban phenomenon unlike bikes (45%+ in rural areas). As per Maruti management ~85% of all cars sold being in the top 8-10 cities in India. As a result, as the population in these cities continues to benefit from 15% nominal wage growth and move up the proverbial J-curve, they are migrating to larger cars. Other structural issues such as the lower opex of larger cars with diesel engines (covered below) are accelerating this shift as evidenced by mix of sales in the last few months as shown below.

Structurally higher employee costs: Marutis usage of excessive temp contract labor that pushes the envelope on labor laws has resulted in employee cost / revenues of 1.9% versus a range of 4-10% for the peer auto / manufacturing groups. While it has thus far helped Maruti protect margins from the 15% wage inflation for Haryana industrial region, we think that trend is about to end. We believe that the 3 labor strikes in the last 6 months and formation of an independent union at the Manesar plant are far from transitional issues and are in fact symptomatic of this issue. We expect the situation to simmer and ultimately result in significantly higher labor costs impacting margins / returns

Yen exposure: Despite being an Indian domestic car company, Marutis 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 Marutis EBITDA margins have more than halved from FY08 to FY12 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 Marutis 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 Marutis 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 an 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. We wonder if minority shareholders are cognizant of this sneaky transfer of economics and why Maruti deserves a corporate governance premium that is accorded to it just by virtue of Suzukis control

Structurally lower returns: The increased competitive intensity, higher ad and R&D costs and higher discounts driven by overcapacity have driven down Marutis 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. We agree with Goldmans estimates and believe that a return profile in the low teens are here to stay and should be reflected in a secularly lower P/B multiple

Unproductive Growth Capex: Driven by political considerations around the labor strikes in Haryana and under pressure to show continued capacity increase in the face of competitors aggressively ramping up capacity, Maruti announced a Greenfield expansion in Mehsana, Gujarat. Over the next 3 years Maruti will acquire over 1,500 acres which will eat into materially all of the cash on the balance sheet. Furthermore with low capacity utilization in the Haryana plants and no plans to break ground for 3+ years, this represents unproductive capital allocation likely through 2017-18

Near term Catalysts 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
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Increase in fuel costs: 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

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Strikes masking the deterioration in sell-through data: We believe that the recent labor issues have been a boon to Marutis stock price! By providing a ready made excuse for all the ills, Maruti management has been able to blame the -50%+ y/y sell-through comps completely on the strike. Since management does not provide sell-through numbers we spoke to a large sample of dealers in tier 1 & 2 cities as well as industry bodies & comps to reconstruct the sell-through trends. As evidenced by the chart below we think that Marutis sellthrough in recent months including October have been -15% to -20%. We expect that to further dip in the last 5 months of the year as the full effect of fuel and rate hikes are passed through to the consumer and aided by tough comps (Maruti grew 20%+ in 2H FY11). Based on this analysis we struggle to see how the company meets our estimates leave alone consensus or their own guidance of flat y/y unit volumes for FY12

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Numbers / Assumptions (FY12, 13, 14 year ending Mar 31st) Unit volumes = 1.18MM, 1.39MM, 1.57MM vehicles Unit volumes y/y = -7% (First 7 months down -17.7%), +18%, 12% Net Sales = 350BN, 434BN, 505BN EBITDA = 31.2BN, 39.1BN, 47.3BN Net Income = 14.6BN, 19.2BN, 23.8BN EPS = 51, 66, 82

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 58-62 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 800-850 which is more than 25% below current levels
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Acknowledgement: 1. Goldman Sachs & Credit Suisse for use of charts published in their research reports