announced that the investment ($500m) in the planned Gujarat plant will occur via a 100% subsidiary of Suzuki, and Maruti will only distribute and sell the vehicles. We view this as a significant strategic mis-step, as: (i) Maruti has enough cash to adequately fund the Gujarat requirements on its own; (ii) a higher share of earnings from distribution is a structural shift of the earnings profile; (iii), Marutis lack of control over the cost of production is a worry although Maruti claims that Suzuki Gujarat (SMG) will not make a profit; (iv) SMG eventually is expected to scale up to 1.5m units (as large as Maruti is today), essentially satisfying five-six years of requirements; and (v) this could set a precedent for other similar steps.
We reduce our FY14/15e EPS (earnings per share) by 1.3% and 0.5%, respectively, and believe that the risk of earnings deterioration and cash drain by Suzuki is likely to remain an overhang in the near term. We downgrade the stock to EW (equal weight) with a reduced PT (price target) of Rs 1,563 based on 6.4x FY 15 EV/Ebitda (vs 9x previously).
What are Marutis reasons for the SMG investment
(i) by investing the money through Suzuki, its cash is conserved for future requirements; (ii) it is enhancing shareholder value based on the interest income from unused funds; (iii) SMG will sell goods to Maruti on an arms-length basis, as SMGs costs will include cost plus cash requirements for future capex requirements; (iv) profitability will be unchanged.
Q3 update: Marutis Q3 earnings were operationally ahead of expectations at 12.4% Ebitda margin (vs expectations of 11.8%), despite a 3% miss in revenue terms. PAT (profit after tax) of Rs 6.8 bn (+ 36% y-o-y) was adversely impacted by a higher depreciation charge due to new capacity at Manesar. Average discounts increase to Rs 19,412/ unit (+11% q/q) in Q3.
Downgrade to EW: With the increased corporate governance headwinds, we expect the stock to trade at the lower end of its valuation band till clarity emerges. We lower our valuation multiple to 6.4x FY15 EV/Ebitda (enterprise value/earnings before interest, taxes, depreciation and amortisation).
Management call takeaways
Details of the 100% subsidiary: Maruti has allowed Suzuki to set up a 100% subsidiary in India (provisionally named Suzuki Motor Gujarat Pvt Ltd, which will set up a production facility on the land acquired by Maruti in Gujarat. Maruti will enter into a contract manufacturing agreement with SMG. The land would be leased to SMG, andt the rent would be determined on an arms length basis.
Under the contract, Suzuki will make the first round of capital investment in SMG for three to four years. Overall investment in the plant would be close to R30 bn (JPY 50 bn).
n SMG will sell vehicles to Maruti on an arms length basis, and would include only the actual cost of production incurred by the subsidiary plus just adequate cash to cover incremental capex requirements. The return on this investment for SMC (Suzuki Motor Corp) would be realised only through the growth and expansion of MSILs business.
MSIL would benefit from the interest earnings resulting from not investing its money in this project. It would also benefit
because the vehicles would be sold to MSIL by SMG without any return on capital employed.
MSIL would be able to avoid all risk inherent in any investment. MSIL would also retain the option of investing its own funds for strengthening its marketing network, product development, R&D and any other growth opportunity.
In the initial stage the capacity of SMG would be 250,000 units, scalable eventually to 1.5m units per annum.
Why do we disagree
n In our view, given Marutis healthy returns, shareholder wealth would be maximised by re-investing in the business or via a higher payout (vs choosing to conserve cash).
Secondly, given the eventual size of the SMG plant (1.5m units/p.a.), Marutis capacity requirements for the next five years would be taken care of, thus resulting in excess cash that is un-utilised. Maruti will not have control of the cost of production as incremental production moves to Gujarat.
Thirdly, while this event may remain earnings neutral, it structurally changes the earnings profile of the company (incremental shift to a distribution margin) over the longer term. Suzuki had changed Marutis royalty payments from 3% of sales to 5% sales in FY10.
Since Suzuki owns a 56% stake in Maruti, in our view a higher dividend payout or increased stake by Suzuki in Maruti would be a better use of the current surplus cash both at Maruti and at Suzuki.
Since SMG, will be an unlisted company, financials are unlikely to be shared, making it difficult for us to monitor the agreement terms.
Other key highlights
Average discounts/unit continued to increase and stood at R19,412/unit (vs R17,466/unit in Q2). Given the government focus on inflation control, the management expects further increase in discounts near term.
The company has taken a MTM (mark-to-market) reversal in Q3, on account of the current weakness in JPY/USD (MTM rate of 1.59 JPY/INR).
Exports revenue stood at Rs 9.3 bn in Q3 (vs Rs 15 bn in Q2). Export volumes have normalised after their sharp spike in Q2.
Rural demand continues to be strong, with YTD (year-to-date) growth of 18% in FY14. Rural now contributes 30% of the total domestic sales.
Investment in the R&D facility at Rohtak is expected to be Rs 14 bn, of which Rs 10 bn has already been spent. The company guided for a capital expenditure outlay of Rs 40 bn in FY14.
Depreciation cost was higher in Q3 owing to the addition of a third line of production at Manesar.
Despite adverse impact of currency, overall impact on profitability has been marginal due to: (i) employee cost normalisation post-variable pay disbursement in Q2; (ii) favourable exchange rate on royalty; and (iii) lower selling and distribution expenses due to the reduction in exports.