Maruti Suzuki: ‘Tough times ahead’ - Annual Report Analysis

Maruti Suzuki India Ltd (MSIL)’s FY11 annual report lays a lot of stress on its Research & Development and technological initiatives. The company is focusing on improving efficiency of existing models and developing models based on alternative fuels such as electricity and CNG. While the company is currently expanding its manufacturing capacities, the macro outlook continues to be plagued by multiple headwinds in the form of rising interest rates, higher fuel prices, slowing economic growth, etc. For MSIL, increased competition has added to the woes. We maintain our Market Performer rating with a revised 9-month price target of Rs1,165.

Focus on R&D and technology

In its FY11 annual report, MSIL has laid strong focus on its new approach, which they have termed as ‘Techno_Logical’. Under this approach, the company is focusing on delivering customer satisfaction through improving fuel efficiency and providing them options of alternative fuels. While LPG and CNG variants have already been in the markets, MSIL, through its initiatives, has been able to deliver better efficiency than the retro-fits. Going ahead, the company is studying the feasibility of electric mobility in India. R&D expenses were at 1.1% of sales in FY11 as compared to 0.6% in FY10. In absolute terms, it was higher by 140% yoy.

Poor margins hit operating performance

As compared to a revenue growth of 25.6% yoy, MSIL reported a 2.9% yoy fall in net profit. This was owing to a 300bps yoy fall in OPM from 12.9% in FY10 to 9.9% in FY11. The fall was due to a sharp jump in raw material costs and increase in royalty costs. This was partially offset by gains on lower power and fuel cost and lesser spend on advertising. Nevertheless, the fall in OPM led to 440bps yoy fall in RoE. RoCE and RoA were also lower by 720bps and 260bps yoy respectively.

Macro headwinds puts volume growth estimates at risk

For MSIL, we are currently assuming 8% yoy growth in domestic volumes and a 7% decline in export volumes. However, with increasing trend in interest rates, higher fuel prices, higher costs of vehicles (price increase on 12-18% over past one year) and increased competition, we believe these numbers carry a downside risk. While OPM might improve in comparison to FY11, it will continue to be levered to currency movements. We maintain Market Performer rating with a revised price target of Rs1,165.

Strong outlook for long term growth

MSIL believes that the long term growth story for the sector in India is intact and expects the demand for cars to double over the next five years. The company expects this rate to sustain through the rest of the decade. This, the company believes, is owing to decline in the real cost of buying cars in India which is due to the high rates of growth of the economy and consequently per capita income, and the relatively much slower increase in car prices. In the near term though, the company expects the demand growth to be slower on account of macro headwinds.

Drop in Europe sales lowers export volumes

During FY11, MSIL sales to Europe dropped substantially. The proportion of sales to non-European markets increased from about 20% in FY10 to 55% in FY11. Algeria, Chile, Netherlands, Indonesia and Sri Lanka emerged as the top export markets during the year. The company explored new markets like Hungary, Malaysia, Laos and Lebanon. During the year, the Company introduced Alto K10 in some of the export markets.

High degree of stress on technology and alternative fuels

Throughout its FY11 annual report MSIL has laid a lot of stress on satisfying consumer needs through development of technology and providing options of alternative fuel variants of its existing models. Below are few of the excerpts from management discussion & analysis, message from the chairman and directors report.

• Technology, design skills and creativity and quality have to be combined in a manner where the customer gets the best value for money. Suzuki Motor Corporation is actively helping us to achieve this goal. Our R&D facility being established in Rohtak is a major step towards this end. The R&D engineers in Japan and India are working in very close cooperation with each other and we are now a part of the integrated development of cars which was earlier all done in Japan.

• Awareness and regulation on fuel efficiency will become a big trend in India in the next few years as it helps both the economy and the environment. While working on latest technologies to enhance fuel efficiency, we are also working with the industry and policy makers to evolve mandatory fuel efficiency standards for the car industry.
  

• Globally, hybrid and electric vehicles are being explored as a solution to energy security and environment friendliness. While there are a lot of questions and challenges in this area, Maruti Suzuki is studying the feasibility of electric mobility in India along with the government and industry. In this context, use of CNG as an auto fuel is a brilliant solution that can help reduce India’s oil import and also reduce CO2 emissions drastically, while being affordable for the consumer.
  

• The Company developed in-house i-GPI (Integrated Gas Port Injection) Technology and launched factory-fitted CNG variants for five of its models: Alto, WagonR, Eeco, Estilo and SX4. This i-GPI technology delivers higher fuel efficiency compared to conventional CNG cars. Besides, the loss of power compared to gasoline engine cars, a shortcoming of conventional CNG technology, is negligible in the case of i-GPI. The Company believes that once CNG availability improves across the country, it could become a popular option owing to its low cost and environment friendliness.±  The Company has started a small research project on hybrid and electric vehicles, primarily to get some understanding of the technology involved. An electric EECO and a hybrid SX4 were built. The hybrid SX4 cars were made available for use during the Commonwealth games held in Delhi during the year.
  

• The K-series engines are now mounted on Alto, A-star, WagonR, Estilo, Swift, Ritz and Dzire. These engines are manufactured at the state-of-the-art, fully integrated manufacturing facility at the Gurgaon plant. During FY11, the Company commissioned phase-3 of the machining and casting facility for the K-series engines, taking the total manufacturing capacity for these engines to more than 780,000 per annum.

Cost cutting initiatives during the year

1) Cost of dies: In FY09, MSIL had started to design & develop dies for critical sheet metal parts and engine components. This development of in-house dies for body parts helped the company save cost (compared to imported dies). This initiative presently meets 30% requirement of sheet metal dies for new models and 100% requirement of engine parts like cylinder head. Significant cost saving, between 25%-40%, was achieved, compared to imported dies.

2) Electricity cost, water costs and emission: In the Gurgaon plant, electricity consumption per vehicle in the production process came down by 16% during the year. Similarly, CO2 emission per vehicle reduced 15%. Water consumption per vehicle was down 5% in the manufacturing process. In the Manesar Plant, electricity consumption per vehicle came down 1%, CO2 emission was lower by 13% while water consumption reduced 16% compared to the previous year.

Advertisement costs as a percentage of sales declined from 1% in FY10 to 0.8% in FY11. This reduction along with above mentioned initiatives helped the company absorb the impact of surging raw material costs and increase in royalty expenses during the year.

Cash flow remains healthy

Free cash flow was at Rs10.8bn as compared to Rs19.3bn in FY10 owing to increased capital expenditure during the year. This was on the back of ongoing capacity expansion program at Manesar to increase the capacity by 500,000 vehicles per annum. During the year, gross block increased by Rs13.3bn as compared to CWIP of Rs3.9bn at the end of FY10. CWIP at the end of FY11 was at Rs14.3bn, more than 50% of which was towards plant and machinery.

Cash balance towards the end of the year was at Rs25.1bn as compared to Rs982mn at the end of FY10. ~45% of the increase in cash balance was on account of the free cash flow generated by the company during the year. The remainder was on account of sale of investments in short-term mutual funds during the year.

RoE falls 445bps yoy on account of fall in margins

MSIL reported a fall of 445bps yoy in RoE for FY11 to 17.8% from 22.3% in FY10. The fall was primarily on account of the fall in margins for the company. EBIT margins were lower by 400bpps yoy. RoCE was down 723bps yoy, while RoA was lower by 258bps yoy.

Widening dealer network and service network

One of the key strength that has supported MSIL’s market leadership has been its nation-wide robust dealer and service network. During the year, the company strengthened it further by adding 131 new sales outlets across 113 new cities. The ratio of sales outlets/cities declined from 1.7 in FY06 to 1.4 in FY11 indicating increased presence in smaller cities and towns (where one outlet is adequate). With respect to service points, the company added 179 locations across 60 new cities. The ratio of service points/cities has increased from 1.8 in FY06 to 2.1 in FY11, indicating better service availability in existing cities.

Concern over component industry

With significant value-add in a car coming from the component industry, it plays a critical role in future growth plan for an OEM. As per the management commentary, a large section of the component industry, particularly the 2nd and 3rd tier suppliers, have to improve scalability, robustness in manufacturing and quality systems along with management bandwidth and R&D. This may require raising capital at reasonable cost. However, the biggest growth bottleneck is likely to be in the area of getting human resources, especially for R&D and technological development initiatives.

Capacity expansion at Manesar

During FY11, the company encountered an issue of capacity constraint as the domestic demand was running ahead of MSIL’s capacity, leading to waiting periods for its key models. This caused the company to embark upon a capacity expansion program. It is setting up a second line at Manesar, which would commence operations in September 2011. Furthermore, a third line is also being set up, which is scheduled to be completed by September 2012. These two lines would result in additional capacity of 500,000 units per annum at Manesar by FY13.

Macro headwinds and rising competition to restrict volume and earnings growth; Maintain Market Performer Rating

For MSIL, we are currently assuming 8% yoy growth in domestic volumes and a 7% decline in export volumes in FY12. However, with increasing trend in interest rates, higher fuel prices, higher costs of vehicles (price increase on 12-18% over past one year) and increased competition, we believe these numbers carry a downside risk. On the upside, successful launch of new models and revival in demand during the festive season could rev up volumes. While OPM might improve in comparison to FY11, it will continue to be levered to currency movements, especially Yen. The stock currently trades at 11.1x FY13E EPS of Rs97.1. We maintain Market Performer rating with a revised price 9-month price target of Rs1,165.