Filter business is very sticky and there are 4 types of filters in an automobile. They are OEMs of many of the largest auto companies in the world, even having a 70/30 JV with Donaldon to manufacture filtration products for heavy equipment, gas turbines, industrial engines, construction equipment and automotives.
- Oil filter - Filters out dirt and particles from the oil out of the engine, highest turnover, where passenger vehicles have to change 3-4x a year (video on how it works)
- Cabin filter - Cleans the air that comes into the interior of your car through the heating and air conditioning
- Air filter - The air filter prevents any insects, dust, particles, sand or debris reaching the engine and ensures a good mixture of air and fuel to support performance
- Fuel filter - The fuel filter removes impurities like dust, rust and grit contained in the fuel
3 of them extend the life of the car (cabin filter probably extends the life of the driver) and are small ticket items compared to the cost of a new vehicle. To give a guideline, Sakura (SMSM's brand) oil filters are $7-40 on average.
Besides selling filters, SMSM also manufactures radiators and body parts. It is quite apparent that filter volumes are much more stable than radiators and body parts which are more linked to new car sales, and on average SMSM has been able to gradually raise the ASP of their products, at least in line with inflation.
Vertically integrated manufacturing = quality control, customisable and low cost
- Filters are manufactured in a single huge factory in Indonesia with a maximum capacity of 110m filters which is 70% utilisation (radiators and body makers are ~30% utilisation) in a 40 hectare industrial estate at the west of Jakarta
- Company is upfront about their strengths and weaknesses, and their main weakness is they are not innovative at all and spend nothing on R&D but they pride themselves in being able to follow engine specifications and produce anything their OEMs require
- They acquire distributors and suppliers to make themselves more flexible, even have a machinery center that allows them to build their own mould and die.
- How flexible are they? According to the IR, they can retool their production to fit new SKUs in 45 days when competitors would need 3-6 months
- While for OEMs are fine with 3-6 months due to long production cycles, the aftermarket needs a much faster lag time because automobiles are being used
- As a stamp of approval, Donaldson (leader in filters, listed in the US) chose SMSM to be its only partner in Asia since 1983, so I think they should be quite trustworthy to keep the partnership going for 37 years
- Reports indicate that SMSM's filters are priced ~30% lower than peers in OEM and on a cost basis is 40-50% cheaper to manufacture per filter
Concern 1: How will the slowdown in auto sales impact SMSM?
The honest answer is I don't know, but I would say that the impact on their topline will be much more muted that change in volume of cars sold because i) it's in the aftermarket segment and ii) 66% of their filters are sold to heavy machinery.
Since I elaborated on the relative stickiness of the aftermarket, I will just say one big data point is Indonesian auto volumes were down 50.1% from Jan-Jul 2020 while SMSM's sales were only down 17.4% in 1H20. Yes, only 35% of its sales are derived from Indonesia but I would assume a similar trend in other countries as well.
Concern 2: Will EVs kill the company's business in the long term?
Probably not what you were expecting, but my answer is another "I don't know" - perhaps someone with more experience in EVs can chime in here, but my 2 cents are:
- SMSM believes that electrification of heavy equipment is probably even further away than passenger vehicles. Management saw that the more they were exposed to PVs, the greater the risk of EV
- They started focusing on shifting product mix 8 years ago when they first heard of EVs. It was also margin accretive as heavy duty filters have a higher value so distributors have a higher incentive to sell them
- Additionally, because majority of heavy equipment they sell to are in the mining, construction and transportation industries, these equipment are owned by large corporations who will try to maximise the utility and lifespan of their equipment. This means their utilisation rate will be high + incentivised to regularly change the filters because it is a tiny cost but huge consequence if they don't
As for the other 1/3 of their business, at the risk of underestimating / trivialising the electrification trend, I would think EVs are pretty far away for many emerging markets. I am not sure of the rate that EVs are getting cheaper due to technological advances, but people in Indonesia, Thailand and Vietnam are probably not putting saving the environment very high on their list of priorities :)
Just playing around with the DCF, even if I put -1% terminal growth rate (so that would be from 2026 onwards), the potential is still 24% upside, not too bad. Of course, I may be totally wrong as it's hard to forecast a big disruption and this may end up like Sears when combustion engine vehicles fall off a cliff in 5 years...
Management and KPIs
From their annual report they sound quite different from most Indonesian companies which talk about sales and guidance. There was a whole section where they talk about what is quality to them and they describe it as:
- Quality does not end upon attaining accreditations or obtaining a system
- Quality is a state of mind which is instilled within the whole company, from management to employees with emphasis on continuous training as a management tool
- Conduct periodic examinations with both internal and external parties to improve the whole process which leads to better products, delivery, cost and service to customers
When I spoke to the IR, she said that their KPIs are mainly profitability so they are willing to let sales be flat to grow margins, thus they will not give discounts or reduce selling price.
For senior managers, 30% of the bonus is stock, and though they don't have a stock option plan, most of the managers and board have shares in the company.
Subsidiaries & Associates
One thing to note is they have a number of other companies, but the main ones are 5 subsidiaries and 3 associates.
Subsidiaries:
- PJM (Rp 888bn sales, 116bn net profit, 27% ROE): 70/30 JV with Donaldson to manufacture filters for heavy equipment.
- HP (3335bn sales, 27bn NP, 13% ROE): Assembles dump trucks, mixers and special vehicles. Owns a steel centre, tool and die, mould and machinery centre
- SSP (209bn sales, 21bn NP, 27% ROE): Manufactures rubber rings, plastics and adhesives for automobiles
- PTC (519bn sales, 56bn NP, 29% ROE): Distributor of SMSM products in Indonesian aftermarket
- Bradke (148bn sales, 13bn NP, 13% ROE): Distributor of SMSM products in Malaysia and Australia
Associates
- POSCO (122bn sales, 2bn NP, 12% ROE): Business in the steel industry
- TRSS (84bn sales, 11bn NP, 13% ROE): Manufactures radiators, JV with Tokyo Radiator Manufacturing Co
- SF Thailand (262bn sales, 17bn NP, 11% ROE): Distributor of SMSM filters in Thailand
As you can see, they have a stake in their distributors in Indonesia, Malaysia, Australia, and Thailand. The company thinks it's a good way to vertically integrate and ensure distributors sell their products, but I am not so happy as there might be a risk of financial engineering.