<b>Maruti: Goldilocks moment</b>

Low interest rates, a revival in auto financing and strong spending based on improved sentiment boosted auto sales this year so far. This sales momentum should sustain going ahead as per most market analysts and the sector has seen earnings estimate upgrades all around.

The environment has seen Maruti reinforce its leadership position (52.2% market share of passenger vehicle sales in FY09) and gain substantially from four new model launched in the last 18 months. Analysts expect Maruti to see sales growth of about 13.8% CAGR over the next two years as per an Icici Securities report.

However, the stock underperformed the BSE auto index by about 13% in the last three months and about 5% in the last month. The sense is that although demand is strong, Maruti has capacity constraints, which make it hard to ramp up supply to meet it. The current waiting period for the Swift and Dzire, manufactured at the Manesar plant, is 3 months as per an HSBC report. The Manesar production facility for Maruti is operating near peak capacity of about 350,000 units per year.

Swift sales have boosted the A2 segment market share of Maruti to 57 %( up 200bps) and Dzire (along with SX4 sales) has pushed up A3 segment market share to 31.5%. A2 segment makes up 73% of total sales while A3 contributes about 12% of total sales.

Capacity ramp-up plans

However, HSBC believes, these production constraints will be overcome. The Gurgaon plant which is functioning and aroung 83% capacity utilization offers scope for expansion. Maruti is likely to shift production of Swift petrol to Gurgaon, with the option of shifting Dzire petrol as well. This should release 5-6% of capacity (50-70,000 units) and enable it to meet immediate demand at marginally higher capex, as per HSBC research. The higher output should boost monthly sales from December 2009, a potential trigger for the stock.

A decision on possible capacity addition in the Manesar plant is expected to be made by January 2010, according to HSBC and this could expand capacity by 100-300k units (9-27%), catering to demand over the next three years.

All other parameters look extremely comfortable for the company. Domestically, rural and public sector employee spend is helping sales and have steadily grown to about 13% of sales in Q2FY10 from 4% and 8% levels end September 09. Its model launches tap all segments of high volume important 2-5 lakh market. Easy financing conditions have also boosted car sales and financed sales comprise over 70% of total sales compared to 60% in Q3FY09, according to Icici securities.

Exports were also up dramatically in Q2FY10 (570 bps y-o-y) and make up 15% of total sales. Exports to the EU zone increased partly because of the scrappage incentives offered in some EU countries. This, however, is for a limited period and therefore the growth may be capped to an extent. However, the impact to EPS will be limited, as per a BRICs report, as exports to other countries are increasing.

Healthy operations

Consolidation of platforms and shift in engine production should help save costs and allow production flexibility. Sales were up nearly 47% y-o-y to Rs 7050 crore against a sales volume growth of 30%. PAT was up 92% to Rs 570 crore with operating profits up 78% to Rs 916 crore.

While there has been a 230 bps improvement in operating margins in Q2FY10, costs pressures will come into play as inputs costs have gone up (especially steel and aluminium). Hardening Yen is another key worry as Japanese imports account for about 10% of total raw materials and nearly 8% of sales according to Icici. Additionally, 50% of royalty payment, about 3.5% of net sales, is payable in Japanese yen.

Maruti operates on negative working capital and has healthy cash flows. Icici expects that it will incur about Rs 3300 crore in capex to upgrade manufacturing facilities and in research and development expenditure. This should be financed entirely through internal accruals as the company is expected to generate cash-flows of about Rs54bn over the next year, as per Icici estimates.

The stock closed at Rs 1599.40 on 24 November 09 and was up 2.65% in the days trading. It currently trades at a P/E valuation of 16x FY11 Consensus analyst EPS estimates.