An ace up its sleeve in a competitive industry: In a highly competitive industry such as automobiles, having an advantage that differentiates a player from the rest of the pack translates into a strong business model that can reward investors in the long run. And in the auto space, we believe that M&M fits the bill quite well. The company is a very strong player in the tractor industry enjoying a market share of 42%. Rural markets, where tractors are largely sold, are highly price sensitive but over the years M&M has established a good brand name and a robust distribution network and these have been the company's core strengths. Indeed, given that M&M's expertise in the rural market is not easily replicable, this gives the company an edge over many other players in the auto space. And we believe that this dominance should continue in the future as well. To put things into perspective, M&M's tractor sales in volume and value terms have grown at compounded rates of 20% and 27% respectively for the past 5 years and this healthy performance is expected to continue going forward. Not just tractors, but M&M has established a strong presence in the UV (utility vehicles) segment as well with strong brands such as 'Bolero', 'Scorpio' and 'Xylo'. The company has been continuously looking to launch new products and one such new product notable 'Maxximo' has established itself quite well in the highly competitive 4-wheeler cargo segment with a market share of 19%.
The auto industry in recent times has been facing many headwinds in the form of rising fuel prices and interest rates which have dampened demand and consequently led to lower sales for many players in this space. But this has not deterred M&M's performance. Besides logging in strong growth rates in FY10 and FY11 in tandem with the buoyancy in the industry, the company put up a healthy show in 1HFY12 as well with sales growing by 33% YoY. This was led by impressive growth logged in by both the automotive as well as the farm equipment businesses (both grew at 30% plus). Having said that, the company has been facing pressure on operating margins on account of rising raw material costs and we have factored this in our estimates going forward.
Valuations are also attractive and provide a good entry point to investors. After valuing the core business and taking into account M&M's investments in its subsidiaries, we arrive at a target price of Rs 1,010 from a 2-3 years perspective and hence we recommend investors to BUY this stock at the current price levels.
Strengths in the UV and tractor segments: As mentioned earlier, the core strengths of M&M are its distribution network and an established brand name in the price-sensitive rural markets. The company's commanding 61% market share in the utility vehicle (UV) segment that derives almost 60% of industry sales from rural market,is a clear vindication. The company has been able to maintain such a strong market share despite competition increasing in the UV segment. Although the company's strength lies in the rural markets, in the last few years, M&M has been concentrating on urban demand with the launch of 'Bolero', 'Scorpio' and 'Xylo' all of which have enjoyed good success. Given these inherent advantages and a strong product pipeline, we expect the company to grow more or less in line with the industry growth rate.
M&M has a commanding 42% share in the tractor industry. Given the company's strong rural network and brand equity, we expect it to command a strong market share in the future as well. The acquisition of Punjab Tractors, which was one of India's leading tractor manufacturers and a very well respected brand in the Northern markets of the country, has also bolstered the fortunes of M&M as the business was complementary to M&M's geographical spread, had a stronger bargaining power vis-�-vis vendors and also helped increase the dealer network. This helped M&M further fortify the wall around its already dominant market position.
Exports thrust: Earlier, M&M had been dependent on a single region i.e., India. This exposed it to the vagaries of monsoon, as M&M's key segments are largely rural driven. However, over the last few years, the management has been working on a strategy to increase its geographical spread. Apart from developing its base in the US and SAARC regions, the company also entered into the South African, Uruguayan, Chinese, Australian and Russian markets as a part of the strategy with others like East Europe in the fray. Having said that, while exports are not necessarily highly profitable, these will enable the company to diversify into untapped markets and benefit from economies of scale due to better capacity utilisation.
The deal with Ssangyong: 2010, M&M announced its acquisition of a controlling stake in Korean SUV (sports utility vehicle) maker Ssangyong Motor Company (SMC). SMC has a strong presence in markets outside of Korea and exports vehicles to geographies such as Europe, Russia, South America, the Middle East, Africa and Asia. It is believed that SMC has a market share of about 14% in the Korean SUV market. This acquisition gives M&M a strong leap in terms of expanding its distribution network globally. The auto sector in India is witnessing strong competition. Several international players have entered the market in recent times, thereby giving the old timers something to worry about. As such, SMC's acquisition will give the company a fillip in terms of boosting its export volumes as well as diversifying to newer geographies. Another reason for the acquisition was that M&M wanted to bridge its product gap as it did not have a presence in the premium SUV category, something that SMC manufactures. Although SMC's performance had deteriorated in recent times, one of M&M's strategies is to revive sales by launching SMC's products in emerging markets, especially India. Thus, if M&M is able to bolster the fortunes of SMC, it will be an added advantage to the former's performance in the long term.
Investment Concerns
Raw material prices remain a concern: M&M's operating margins have been quite volatile in the past. Before FY09, margins averaged at around 11% before the subprime crisis and the global economic slowdown brought these down to 7% in FY09. As India's economy recovered from the crisis, M&M also saw its operating margins expand to more than 14.5% in the last couple of years as commodity prices remained benign and demand for vehicles surged. That said, input costs have again been inching up and M&M has not been immune from the same. This is evident from its 1HFY12 results, wherein operating margins fell from 15.8% in 1HFY11 to 12.6% in 1HFY12. While we have assumed operating margins to be lower going forward, the possibility of any adverse event bringing margins down further cannot be entirely ruled out.
Too many moving parts: As of September 2011, the company had 130 subsidiaries, 6 JVs and 13 associates engaged in various activities. While it is a good thing to diversify in an attempt to suppress the cyclicality of the auto business, we believe that the company has spread itself too thin, thus making it difficult to undertake a reasonable assessment of the company's intrinsic value. Also, conglomerates are not viewed to be the most efficient corporate structure when it comes to valuations as markets almost always value them at a significant discount than what would have been the case had they all been separate companies. M&M is no exception to this trend, thus hurting the returns prospects of the shareholder of the company.
Risk Analysis
Sector:The growth of the auto industry is directly linked to the growth in per capita income levels, which in turn is a function of domestic GDP growth. Given the projected strong economic growth in the country, the auto sector is likely to witness robust growth rate in the long term. However, with the arrival of new players, the competition will only get intense from here on. Further, demand is also inherently cyclical in nature. We thus assign a medium risk rating to the stock on this parameter.
Company standing: With M&M having an industry leading market share in most of the segments that it is present in, we assign a strong rating to the company on this parameter.
Sales: M&M generated average revenues to the tune of Rs 152 bn (US$ 3 bn) in the last five years and we expect sales to grow at a CAGR of 10% between FY11 and FY14. Consequently, we assign a low risk rating of 9 to the stock.
Operating margin: Operating margin is a measurement of what proportion of a company's revenue is left over after paying for variable costs of production such as raw materials, wages, and sales and marketing costs. A healthy operating margin is required for a company to be able to pay for its fixed costs, such as interest on debt. The higher the margin, the better it is for the company as it indicates its operating efficiency. M&M's average operating margins for the past five years has been 12.4% and we expect the same to be at an average of 13.2% going forward. As such, we assign a medium risk rating of 4 to the stock on this parameter.
Long term EPS growth: We expect M&M's net profits to grow by around 3% CAGR during the period FY11-FY14 (growth of 25% during FY06-FY11). Based on a normal scenario, we consider a compounded growth of over 20% in net profits in the last 5 years as healthy for a company. As such, the rating assigned to the stock on this factor is 4.
Return on capital invested (ROIC): ROIC is an important tool to assess a company's potential to be a quality investment by determining how well the management is able to allocate capital into its operations for future growth. A ROIC of above 15% is considered decent for companies that are in an expansionary phase. Considering M&M's last five years' average ROIC of around 65%, we have assigned a low-risk rating of 10 to the stock on this parameter.
Dividend payout: A stable dividend history inspires confidence in the management's intentions of rewarding shareholders. M&M's average payout ratio was around 27% in the last five years, which is healthy. Thus, we have assigned a low risk rating of 7 to the stock on this parameter.
Promoter holding: A larger share of promoter holding indicates the confidence of the people who run it. We believe that a greater than 40% promoter holding indicates safety for retail investors. At the end of September 2011, the promoter holding in M&M stood at 25.2%, which is reasonably healthy. We have, thus, assigned a medium risk rating of 4 to the stock.
FII holding: We believe that FII holding of greater than 25% can lead to high volatility in the stock price. At the end of September 2011, FII holding in M&M stood at around 26%, which is on the higher side. Based on our parameters, the rating assigned is 3.
Liquidity: The average daily trading volumes of M&M's stock over the past 52 weeks stand at above 200,700 shares, which is reasonably higher. Hence, we assign a low risk rating of 7.
Current ratio: M&M's average current ratio during the period FY07 to FY11 has been 1.1 times, indicating the company's ability to pay up short-term obligations. A ratio under 1 suggests that the company is unable, at that point, to pay off its obligations if they came due. We assign a medium-risk rating of 4 to the stock on this parameter.
Debt to equity ratio: A highly leveraged business is the first to get hit during times of economic downturn, as companies have to consistently pay interest costs, despite lower profitability. We believe that a debt to equity ratio of greater than 1 is a high-risk proposition. Given the fact that M&M's average debt equity ratio in the last five years has been 0.5, we have assigned a medium-risk rating of 6 to the stock.
Interest coverage ratio: It is used to determine how comfortably a company is placed in terms of payment of interest on outstanding debt. The interest coverage ratio is calculated by dividing a company's earnings before interest and taxes (EBIT) by its interest expense for a given period. The lower the ratio, the greater are the risks. Since M&M's interest coverage ratio for the past five years has been 42, we have accorded a low risk rating of 10 to the stock on this parameter.
P/E Ratio: The P/E ratio (price-to-earnings ratio) of a stock is a measure of the price paid for a share relative to the per share income or profit earned by the company. This is one of the important metrics to judge the attractiveness of a stock, and thus gets the highest weightage in our risk matrix. M&M's P/E on its trailing twelve months earnings (standalone) stands at 17.2 times. As such, we have assigned a medium risk rating of 4 to the stock on this parameter.
Considering the above analysis, the total ranking assigned to the company is 72 that, on a weighted basis, stands at 5.8. This makes the stock a medium-risk investment from a long-term perspective. Valuations
The stock has fallen around 27% since then and is currently available at attractive valuations. We have used sum of the parts method to arrive at the intrinsic value of M&M from an FY14 perspective. We have valued the company's core business using an EV/EBIT multiple of 15 times. Using this multiple and after allowing for net debt, we arrive at an intrinsic value of Rs 849 per share for the core business from an FY14 perspective.
Furthermore, we have valued the company's subsidiaries at Rs 162 per share, with a contribution of Rs 59.5 from Tech Mahindra, Rs 35.8 from Mahindra Holidays and Rs 29.6 from Ssangyong Motor Company. It should be noted that we have also taken into account a margin of safety of 20% when trying to value the various subsidiaries. Thus, adding this all together, we arrive at a total value of Rs 1,010 per share on the basis of FY14 estimates. Considering the current price of Rs 748, this translates into a CAGR of around 14% from an FY14 perspective. We thus recommend a BUY on the stock.
source: Equitymaster Agora Research Private Limited
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