Maruti: Gujarat plant concerns remain and may lead to de-rating

While the company's management says that investor concerns are overdone and high growth assumptions are exaggerated, institutional investors and analysts are not convinced

One month after the Maruti Suzuki board approved a Suzuki Motor Corp (SMC) proposal to set up a manufacturing plant at Gujarat and a recent clarification, investors are still not convinced. The clarification did little to stop the stock from sliding 4.5% on Friday and given lingering doubts it is likely to be under pressure going ahead.

Institutional investors as well as analysts tracking the stock continue to ask questions related to bypassing of Maruti Suzuki India (MSIL) to set up the Gujarat unit, the surplus to be charged and capacity split between the two Suzuki subsidiaries. Ashvin Shetty and Ritu Modi of Ambit Capital who have a negative view on SMC's decision to form a wholly-owned subsidiary question the rationale for such a move as well as long-term adverse impact on MSIL's financial performance and cash flows. Given the pricing formula (cost and surplus earned for capex needs), they believe that profits will be split between the two entities and MSIL will earn lower profits than it would have had it made the plant on its own.

MSIL in its recent clarification has indicated that the cost of setting up the Gujarat plant by SMC will be similar to that of the Haryana plant. Further, the sale price of the cars from the Gujarat plant to MSIL will be less than the dealer price that MSIL currently charges, helping the listed Indian entity to pocket the difference. SMC seeks to fund the Gujarat capex through depreciation, surplus charged over the cost of production and equity infusion by the Japanese parent.

There are, however, a couple of concerns for investors. First is the lack of clarity on the mark-up or surplus to be charged to MSIL. While the company says that the same will be decided by market conditions, higher the mark-up lower the operational profits for MSIL. Also, as Morgan Stanley's Binay Singh and Yashesh Mukhi say that there should be more clarity on the potential mark-up range as this decides the gap in future capex that Suzuki will fund. SMC is expected to incur a cost of about Rs 3,000 crore for the initial capacity of 2.5 lakh vehicles per annum and this is expected to come on stream from FY17/FY18. Funding beyond this capacity is expected to come from the operating profit from SMC's Gujarat subsidiary and equity funding if required. Secondly, the production split between the two companies, the models to be produced at the respective plants and the utilisation levels of the same. MSIL management has indicated that there is no mark-up in the first phase as Suzuki will bring in equity investment and that some investors are assuming a higher mark-up than is the case.

Joseph George and Kevin Mehta of IIFL Institutional Equities say that when the Gujarat subsidiary's capex is high, Maruti will make negligible margins but the loss of potential Ebidta would be partly offset by lower depreciation and higher other income on higher cash balance. Beyond the capacity expansion phase FY25 onwards, Maruti, according to them will not lose out and will see positive impact on savings from depreciation and higher other income.

Most analysts continue to have a 'Buy' call on the company as the deal will not have any impact on MSIL's performance over the next three to four years. According to Bloomberg consensus estimates, out of 65 analysts 42 (64%) have a 'Buy', with 13 having a 'Hold' while 10 have a 'Sell' rating. Analysts have pegged a one year target price of Rs 1,824, which is a return of 15% from the current levels.

Taking the subsidiary route

While there are many concerns and there is no clarity on the final terms of the deal, the core question continues to be the rationale for Suzuki setting up a100 per cent subsidiary to expand its capacities in India. Pramod Kumar and Jay Kale of IDFC Institutional Securities, say, "We fail to see merit given MSIL's strong cash position, lack of any advantage for SMC over MSIL in running an Indian operation and uncertainty over Maruti's profitability." Institutional investors, especially the Indian mutual funds which own about 4% of the MSIL stock, have communicated their concerns to the Maruti management in a letter dated February 13. Given the steady market share of MSIL and the growth prospects of the sector, the current plants will reach full capacity by FY16. Fund managers, however, feel that all incremental volumes of MSIL (post FY16) will be outsourced to the Gujarat entity which will convert the company to a trading concern from a manufacturing one leading to a significant de-rating. "Trading concerns (companies) trade at a significantly lower P/E compared to manufacturing ones and this will lead to significant erosion of shareholder wealth," say the fund managers in the February 13 letter. Experts, thus, believe that even as the industry and MSIL will continue to grow, the gains for shareholders may get impacted (due to de-rating) in the long-run.

The Maruti management, however, continues to maintain that the deal is a cheaper option and would free resources for expanding its marketing network and making investments in appropriate avenues like R&D. Further, they question the volume growth assumptions of 15% and state that the Gujarat plant is being set up with the 7-8% growth target in mind. The company says that given the uncertainty in demand (with economy slowing the company currently has spare capacity), the initial 250,000 unit capacity by 2017-18 should suffice.