Heat and light on Suzuki's plan

Shares of Maruti Suzuki (MSIL) tanked by 4.75% on Friday last week when analysts and investors rejected the clarification issued by the company elaborating its reasons for accepting parent Suzuki Moto

Shares of Maruti Suzuki India Ltd (MSIL) fell 4.75 per cent to hit a monthly low of Rs 1,582.80 on Friday last week, when analysts and investors rejected the clarification it issued on the reasons for accepting parent Suzuki Motor Company’s (SMC) proposal for a 100 per cent subsidiary to implement the Gujarat projects. Business Standard looks at the key concerns flagged by seven mutual funds (MFs) – Axis, DSP BlackRock, HDFC MF, Prudential ICICI, Reliance MF, SBI MF and UTI MF - in a seven-page letter dated February 13 to MSIL Chairman R C Bhargava and his response to the issues raised.

MFs: Given the low penetration, investors have assumed at a compounded annual growth rate (CAGR) of 15 per cent, the Gujarat plant would reach full capacity of 1.5 million units by FY21. Since the cash flows would be utilised to fund the incremental capital expenditure (capex) requirement of around Rs 12,000 crore, the internal rate of return (IRR) on Suzuki’s phase-I investment of Rs 3,000 crore is 30 per cent. This is much higher than the cost of capital of both MSIL and SMC itself.

R C Bhargava: The calculations are flawed, due to their wrong assumption of growth. The implication of a CAGR of 15 per cent is without basis. In 30 years, we reached one million (vehicles); now, analysts claim in five years, we will climb to three million. To grow at 15 per cent annually, the economy should do so at nine per cent; unlikely, with the present five per cent. Suzuki has said that unit will be commissioned with an initial capacity of 100,000 units. Expansion after that will depend on market demand. Each assembly line will cost us about Rs 3,000 crore. Our capacity utilisation in Haryana is currently 1.17 million units; we have with us idle capacity of 330,000 units. The implied assumption in starting the Gujarat plant is that sales will grow a CAGR of seven to eight per cent. Whether it will or not, I do not know. But if this is our expectation over the next three years, then how can you double our capacity requirement in five years (2017-2021)?

We are expecting sales of 100,000 units every year over our present volumes. Even if I include exports, the growth rate would come to around eight per cent. To grow from 1.2 mn units to 1.8 mn will mean growing our volumes by 50 per cent. At a CAGR of eight per cent, we will take five years to reach that number, nine years to double to 2.4 mn. It still is not three mn units. And, that would take me to 2023.

MFs: Investors have said the deal is being portrayed in a manner which suggests Suzuki is being generous to MSIL and its minority shareholders by not earning any returns on the investments. But since the plant is depreciated over seven years (14 per cent annually), much shorter than its economic life, even ignoring the cash flows to meet incremental capex, the depreciation charge itself amounts to a respectable return.

Bhargava: A plant is usually depreciated over eight years, at around 12 per cent per annum. If the first plant starts in 2017, with initial capacity of 100,000 units, it will be fully utilised (at 250,000 units) by 2018-19. We will need fresh capacity only in mid-2019 or early 2020. Depreciation funds would add up over three years, over 2017-19, and the amount would be about Rs 240 crore every year. So, that brings us Rs 720 crore. If we need, say, Rs 2000 crore for the second assembly line, we will need an additional Rs 1,200-1,300 crore. This will come from two sources, the mark-up on cars produced and fresh equity brought in by Suzuki to the extent required. What this extent would be will be decided jointly by Suzuki and Maruti Suzuki. We have clarified Suzuki will bring in fresh equity to the extent necessary. Analysts are assuming fresh equity will be brought in “if” necessary. They are assuming Suzuki will not bring in equity but only mark-up the price of the cars.

MFs: Investors have also said that after FY16, all incremental volumes of MSIL will be outsourced, steadily transitioning MSIL to a trading concern from a manufacturing one, thereby leading to significant de-rating of the price to earnings (P/E) ratio.

Bhargava:  With a capacity of 1.5 mn in the Gurgaon and Manesar plants, even when the Gujarat unit eventually reaches full capacity, only 50 per cent of the cars will come from the subsidiary and that is a long way off. Also, we are increasingly going to concentrate our attention on research & developement (R&D) and marketing. That is not unusual -- Apple Inc does not manufacture a single phone but invest on R&D and marketing, and make a lot of money.

Also, in the first phase of investment, there will be no mark-up as that will be financed through equity capital brought in by Suzuki. The mark-up will become lesser and lesser with new assembly lines, providing us with a larger depreciation fund and also the mark-up would also be spread across a larger number of cars, of around 600,000 for the third plant. The mark-up will be highest when the second plant comes up and come down after that. Analysts are assuming the second plant will come up in the next year after the first and they are assuming mark-up will fully support capex needs. Both assumptions are wrong. More important, the capex will end after nine or 10 years. After that, Maruti Suzuki will get cars at the cost price; there will be no mark-up.


MFs: The high cash percentage on Maruti Suzuki’s balance sheet is lowering the return on capital employed (RoCE) and this, with factors like slowdown and the rupee’s volatility, has brought down P/E in the company over the past four years. As on September 2013, Maruti had net cash of a little over Rs 7,000 crore and, further, the company should generate Rs 5,000-6,000 crore of operating cash flows for each of the next three years. Thus, overall, the company would have a little over Rs 25,000 crore to invest by FY16.

After this, MSIL should on a very conservative basis make upwards of Rs 7,500 crore cash profit every year from FY17, and growing. Against this, only Rs 3,000 crore is needed to be invested by FY17 in the proposed Gujarat facilities. The cash MSIL has earns pre-tax returns of eight to nine per cent, much below the cost of equity capital; this should, therefore, be invested in good projects to earn higher returns. The Gujarat project appears to be one such ideal opportunity for Maruti because the IRR of this project is significantly higher than current returns on cash.

Bhargava: Assuming return on capital of 15 per cent, Maruti Suzuki would expect to earn Rs 450 crore from an investment of Rs 3,000 crore. So, if I am making 300,000 cars, it means a mark-up of Rs 15,000 a car. This would not be required, as the car will be made in the Gujarat plant. Even if one assumes the mark-up of the Gujarat car is Rs 11,000, I am still better off by Rs 4,000. When capex is not required, I am better off by Rs 15,000. Also, I would have available with me all the money I would have otherwise had to invest in Gujarat. I will get an interest return of over Rs 1,500 crore annually, which will go to my bottom line. We would have also lost money in interest earnings, around Rs 250 crore on an investment of Rs 3,000 crore.


MFs: Investors have said it is ironical that manufacturing plants in India are being invested in by Suzuki and plants outside India are likely to be set up by MSIL.

Bhargava: Suzuki has transferred to us these markets – Africa, Middle East, neighbouring countries. We cannot have contract manufacturing systems there. We are responsible now for developing these markets and growing these.


MFs: There are concerns over royalty payments being made by the company to Suzuki. In the past four years to FY13, it received a total of Rs 7,000 crore as royalty (5.7 per cent). The pre-royalty operating profit (excluding non-operating other income) over the past four years totalled Rs 18,800 crore, Over the next three years, royalty payments would total approximately Rs 8,500 crore of the total pre-royalty operating profit of Rs 22,500 crore. The royalty rates at 5.7 per cent are also among the highest that engineering/ automobile multinational corporations charge their Indian subsidiaries. Hero MotoCorp pays to Honda 2.5 per cent of sales, SKF pays royalty of 1.2 per cent, Bosch pays 1.5 per cent of sales as royalty.

Bhargava: The royalty payments are no different from those in any other car Japanese car company. It is around five per cent for all Japanese companies; whether it becomes 5.7 or 5.8 per cent depends on exchange rate fluctuations. The yen has devalued in the past few years, due to which the royalty has gone up. But, despite these payments going up, how have we performed in terms of market share/growth/volumes/profit as compared to the industry? Comparing the royalty paid by Bosch is ridiculous. How can you compare the royalty payouts of an automobile components company with a passenger car company?


MFs: This is not the first time such issues have been perceived to be not fair to MSIL shareholders. In 2004, Suzuki announced an independent investment for a car assembly plant, later reversed. Second, formation of Suzuki Powertrain India Ltd to manufacture diesel engines (70 per cent owned by SMC and 30 per cent by MSIL) in 2007, merged in MSIL in June 2012, led to a two per cent increase in the stake of SMC in MSIL. Third, the changed royalty payment terms in July 2010 has led to a little over 150 basis points impact on MSIL’s margins.

Bhargava: The government was okay with 70 per cent Maruti and 30 per cent Suzuki. They objected when a wrong report came in that they were looking at a 100 per cent subsidiary to manufacture cars in Manesar. They were okay with a joint venture but we gave it up because of various transfer pricing and tax issues. We have got over those largely by this contract manufacturing arrangement. However, there could still be issues on transfer pricing, which Suzuki is looking into.