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Maruti Suzuki India Ltd (MSIL) has been spending a lot of time clarifying on institutional investors’ doubts over Suzuki Motor Corp’s (SMC’s) proposal to set up a fully-owned subsidiary to run a manufacturing plant in Gujarat. But the company still has a lot of explanation to provide, as some institutional investors, still not convinced with MSIL’s clarifications last Friday, say they will escalate the matter to the Securities & Exchanges Board of India (Sebi).
Some of the fund managers are even exploring legal options and planning to write to MSIL again.
They say the MSIL board decision to approve Suzuki’s plan will impact shareholder returns in the future due to a price-to-earnings ratio (PE) de-rating. Institutional investors, especially mutual funds (which own about five per cent of the Maruti Suzuki stock), say all incremental volumes of the company (after 2015-16) will be outsourced to the Gujarat entity. This will convert the company into a trading concern from a manufacturing one and lead to a significant de-rating. “Trading concerns (companies) trade at significantly lower PEs than manufacturing ones. So, such a conversion will cause a lot of shareholder wealth erosion,” says a fund manager.
“This will probably be the only instance where a car company will outsource complete manufacturing of almost the entire incremental production,” another fund manager says, adding the current plants will reach full capacity by 2015-16, given MSIL’s market share and growth prospects for the sector.
Over the past four years, Maruti Suzuki’s PE has come down from 18 times to 13 times, partly due to a slowdown and volatility in the rupee’s value.
The issue of royalty payments is another key area of concern for fund managers. According to consensus estimates, over the next three years, Maruti will have paid around Rs 8,500 crore of its Rs 22,500-crore pre-royalty operating profit to Suzuki as royalty, they say.
Over four years to 2012-13, parent SMC received Rs 7,000 crore (5.7 per cent of sales) as royalty. The pre-royalty operating profit (excluding non-operating other income) over the past four years totalled Rs 18,800 crore. This implies a royalty payment of nearly 40 per cent of operating profits. Additionally, Suzuki received Rs 550 crore as dividends.
Fund managers say, while the concept of royalty is justifiable, a big component of the value of car comprises bought items like bearing, batteries, etc. On these, vendors are either already paying royalty or incurring expenses on research & development or both. So, it is not fair to levy royalty on the total sale value of a car, as royalty should ideally be levied on the value of a car’s net of bought-out components.
Further, fund managers say, royalty should be linked to absolute sales and the percentage should come down as sales increase. Assuming a 15 per cent sales growth over the next 20 years, the estimated royalty payment of Rs 2,500 crore in 2013-14 would grow to Rs 41,900 crore. The royalty rate, at 5.7 per cent, is also one of the highest among engineering/automobile multinationals’ for their Indian subisidiaries. While Hero pays 2.5 per cent of its sales to Honda, MSIL’s supplier SKF pays 1.2 per cent. In the case of Bosch, 1.5 per cent of sales is paid as royalty.
Besides, MSIL spends Rs 515 crore on R&D, which is nearly one per cent of its sales, fund managers say. The total royalty/R&D expenditure of MSIL aggregates nearly seven per cent.
IDFC Institutional Securities’ Pramod Kumar and Jay Kale say: “We fail to see merit, given Maruti’s strong cash position, lack of advantage in SMC, rather than Maruti, running an Indian operation and uncertainty over Maruti’s profitability.”
The Maruti stock has fallen seven per cent since the deal was announced a month ago. During this period, the BSE benchmark index, Sensex, rose 1.2 per cent.
In a recent clarification, Maruti Suzuki indicated the cost of setting up the Gujarat plant by SMC would be similar to that by an existing facility. Also, since the sale price of cars from the Gujarat plant for Maruti would be less than the dealer price the company currently charged, the listed Indian entity would be able to keep the difference. SMC seeks to fund the Gujarat capital expenditure through depreciation, surplus charged over cost of production and equity infusion by the Japanese parent.
But Ambit Capital’s Ashvin Shetty and Ritu Modi say the move will have a long-term adverse impact on Maruti Suzuki’s financial performance and cash flows. Given the pricing formula (cost and surplus earned for capex needs), they believe profits will be split between the two entities and Maruti will earn lower profits than it would have if it ran the plant on its own.
The concerns are many. First, there is a lack of clarity on the mark-up, or surplus to be charged from Maruti. While the company says this will be decided by market conditions, the higher the mark-up the lower will be operational profits for the Indian company. Also, as Morgan Stanley’s Binay Singh and Yashesh Mukhi say, there should be more clarity on the potential mark-up range, as this decides the gap in future capex that Suzuki will fund (after initial investment).
The management maintains that the deal is a cheaper option and will free resources for expanding the company’s marketing network and making investments in appropriate avenues like research & development. Besides, it questions the 15 per cent volume growth assumption (of fund managers) and says the Gujarat plant is being set up with a seven-eight per cent growth target in mind. The company adds, given an uncertainty on demand (the company currently has spare capacity as a slowdown in the economy has brought down production), the initial 250,000-unit capacity by 2017-18 should suffice.
While most analysts are worried over the deal, they continue to have a ‘buy’ call on the company’s stock, as the deal will not have any impact on Maruti Suzuki’s performance over the next three years. According to Bloomberg’s consensus estimate, 42 of 65 analysts (64 per cent) have a ‘buy’, while 13 suggest a ‘hold’ and 10 give a ‘sell’ rating. Analysts have pegged a one-year target price of Rs 1,824, which means a return of 15 per cent from the current level.
