Margin worries cast shadow on growth

M&M’s rising input costs and a likely increase in excise duties could have a bearing on demand and margins.

While M&M delivered results that were in line with expectations, concerns over demand, higher interest rates and falling margins have resulted in the scrip losing 17 per cent since January 24. It has underperformed both BSE Auto (-12.5 per cent) and the Sensex (-8.1 per cent). Despite the Street’s worries, analysts have a ‘buy’ rating on the stock as they believe the current price (Rs 654.40) does not represent the intrinsic value represented in the core business as well as investments in a clutch of businesses. They reckon the stock, on a sum-of-the-parts (SOTP) basis, is worth Rs 820-Rs 883 a share, with about 75-80 per cent of this value represented by the core auto business. This represents a return upwards of 25 per cent from the current levels.

Strong volumes
As was the case with other auto majors, the company recorded strong volume growth in the quarter ended December 2010. A 32 per cent jump in automotive volumes (utility and light commercial vehicles) and price increases in the quarter helped improve average realisations and resulted in automotive revenues moving up 36 per cent.
 

ROBUST REVENUES, MARGINS MAY DISAPPOINT
In Rs crore	FY10	FY11E	FY12E
Revenues	18,038	22,585	26,298
Growth y-o-y (%)	42.6	25.2	16.4
Ebitda	2,975	3,476	3,956
Growth y-o-y (%)	172.4	16.8	13.8
Ebitda Margin (%)	16.0	15.4	15.0
Change bps	770	-100	-40
Adjusted Net profit	2,018	2,559	2,864
Growth y-o-y (%)	143.0	26.8	11.9
Diluted EPS (Rs)	36.3	43.3	48.8
P/E (x)	---

15.1 13.4 E: Estimates                                                               Source: Bloomberg

Record tractor volumes at 58,600 units (up 34 per cent year-on-year; helped by a good harvest and increase in crop prices) and price rises led to revenues rising 37 per cent for the farm equipment segment (FES). The company continued its good run in tractors by reporting a 21 per cent gain in tractor volumes for January, which analysts at Kotak Securities believe bodes well for M&M’s margins. FES margins at 18 per cent are much higher than the automotive segment’s 12 per cent. The brokerage believes volumes are expected to be strong for the automotive business, given the company plans to launch six to seven new variants of light commercial vehicles, a variant of Xylo and a new SUV over the next 12-18 months.
 

SUM OF THE PARTS
	Rs/share
Tech Mahindra	63
M&M Financial Services	64
Mahindra Lifespace	19
Mahindra Holidays	42
Mahindra Ugine	2
Mahindra Forgings	2
Swaraj Engines	3
Other investments	57
Total Investments *	204
M&M core business	616
Target price	820
* Post a 20% discount Source: Edelweiss Research

The management believes its UV, three-wheeler and smaller commercial vehicle volumes are likely to grow 12-15 per cent while tractors are likely to witness 10 per cent growth in 2011-12 on a higher base.

Margins, demand
Despite gains on the volumes front, higher raw material costs led to a fall in operating profit margins at 15.1 per cent (70 basis points) on a sequential basis. While margins for the tractor division improved 15 basis points sequentially, they contracted 150 basis points for the automotive division, leading to the overall drop. Part of the pressure due to higher input prices (110 basis points higher sequentially) was eased as the company raised prices and reduced staff costs (50 bps).

While margins are expected to be under pressure in the medium term, the key worry according to analysts at Pioneer Intermediaries Research, are higher running costs for vehicles. Not only are interest rates moving up, they are accompanied by increases in product as well as fuel prices. While these could impact demand, analysts say UVs will be affected more than tractors which are less sensitive to rate changes. For now, analysts believe while volume growth is robust on the back of rising incomes, if the macro environment worsens it could reflect on demand.

Outlook
While the company has been in the news recently for buying a 38 per cent stake in micro irrigation company EPC Industrie, analysts believe the key areas among its investments to look at are Mahindra Navistar, a joint venture that manufactures medium and heavy commercial vehicles and its Korean utility vehicle subsidiary, Ssangyong.

IIFL believes the Korean company is likely to report an Ebitda of $316 million for CY12 and should add about Rs 17 a share to M&M’s EPS in 2012-13. In addition to improving performance, the acquisition is likely to help unlock synergies in sourcing, product development and marketing.

The core auto business growth is on track and the company has pricing power in the farm equipment business (40 per cent share in the domestic tractor market). That, coupled with the potential of its investments in two-wheelers and commercial vehicles, means the scope for price appreciation from these levels looks good.