Description

Even though I still like US auto stocks on account of their low price, they are not as attractive as they used to be (Fiat was my application idea two and half years ago and it performed pretty well since). With the US auto market in the 8^th year of expansion it is hard to believe that the business cycle might last much longer, so an investor interested in the industry should start looking overseas. A market that comes to mind is India and the company that has the strongest presence there is Suzuki.

Suzuki Motor is a Japanese auto manufacturer that gives investors opportunity to participate in Indian car market expansion with a much higher margin of safety through its 56% Maruti Suzuki stake, given the significantly lower  price than by owning it directly.

Suzuki's story is quite different from  that of other big car manufacturers. It is not so cheap but opportunities ahead are much brighter.

 Summary

I  believe Suzuki Motor has a current intrinsic value between ¥6500  and  ¥7500 per share.

Indian assets

Maruti Suzuki was established 36 years ago in New Delhi, India as a joint venture between  Indian government and Suzuki as a minor partner. At the time, India  was a small, 35 thousand cars per year market. Car was considered a luxury product ( and taxed accordingly), manufacturing was a subject of strict licensing, expansion was restricted and protectionism existed in the form of quantitative restriction on imports and high tarrifs.

Fast forward to 2016, Indian auto market has grown to 3.3 million passenger  vehicles  per year and it is the fastest growing  market in the world. India will overtake Germany to become fourth largest market by 2017 with 3.8 million domestically sold passenger vehicles, according to IHS Markit. The same consultancy group expects that by 2020 India is going to become the third largest car market overtaking Japan, leaving only US and China ahead. With only 32 vehicles per  1000 people, the Indian market has a lot of growth potential. Considering that China, with similar population size, has  7 times larger auto market, it is expected that  the gap will be closed in the forthcoming decades thanks to   the expected strong GDP growth and emerging middle class. With more than 3/4th of the Indian market  in the two-wheelers segment, China, which has similar structure, seems  to be the best comparison. It is just a few decades ahead.

In collaboration with the Indian automotive industry, the government of India has set an ambitious goal. Its "Automotive Mission plan 2016-2026" that lays down the roadmap for the next decade, envisages "Indian automotive industry  to grow 3.5 to 4 times from its current value" and  that "by 2026, passenger vehicles likely to increase between 9.4 - 13.4 million units". Since car segment objectives from previous, AMP 2006-2016, have been achieved, this doesn’t seem unrealistic. 

Maruti Suzuki

Being in the Indian market for 36 years was essential for developing a strong brand among customers as well as unparalleled dealership and service network across the country.  Current network of 1947 outlets and 3145 service workshops across  1506 cities and towns is larger than  Hyundai, Mahindra & Mahindra, Honda, Tata, Toyota and Ford  networks combined.  The closest competitor, Hyundai has 466 dealers and 1159 service points in 276 cities. In order to preserve an edge, Maruti is adding 325 new outlets in the current fiscal year. Just last year they added more than twice as many outlets as the next  5 competitors combined. That way Maruti has presence in the most remote and rural parts of India where no alternative networks are present. Buyers always prefer providers whose workshops, parts and servicing facilities are available in their neighborhood.  Given the dealer and service penetration into the Indian market, it is no surprise that Maruti Suzuki is the undisputed market leader with 47% of market share. Five years in a row, the  company’s market share improved over the previous year and is now the highest in the last seven years. It would be even higher but with 1.5 million vehicles produced, it operates at full capacity. With the new capacity(which will be dealt below), this issue is going to be solved. The management expects that in the next fiscal year market share will be closer to 50%.

Maruti Suzuki only operates in passenger vehicle segment which combines passenger cars, utility vehicles and vans. In commercial and two/three wheelers, Maruti  is not present (Suzuki is, through wholly owned subsidiary Suzuki Motorcycles India). Hyundai hold about 16-18% of PV market followed by Mahindra with 9%, Honda with 7%, Tata with 6% and Toyota with 5%.
In passenger car segment Maruti holds 52.8% (all data from 2015) and the rest is split between Hyundai (21.2%), Honda (9.3%),  Tata Motors(5.6%) and others. In van segment Maruti holds even higher percentage – 81.8% with Tata (12.3%) and Mahindra (6%) taking second and third place. Only PV segment in which Maruti isn't  the market leader is UV segment where it holds a second place with 15% of market after Mahindra with 36.4% but that is about to change since Maruti's UV segment is fast growing.

Over time, Suzuki has increased its share in Maruti Suzuki, from initial 26% to today’s 56%, thus becoming the controlling shareholder during liberalization of the Indian economy in the early 90-ies. As of 2007 Indian government doesn't own any shares.

The company is trading on Indian two largest stock exchanges with  market cap of  1.85 tn rupees. Maruti Suzuki is richly valued by the market   as a consequence of high growth (rapid growth in the last quarters, though, were a bit extreme: 18% growth in net sales and 60% in net earnings vs. the same quarters last year. The material costs denominated in yen resulted in  the explosion of earnings) that still has a long way to go given the secular growth and low percentage of car ownership in India as well as above mentioned dealer and service network that gives Maruti a significant advantage over competitors.

Traditionally, Maruti Suzuki's sales were based on a small inexpensive models like Maruti 800 (the production of which was discontinued in 2014 after 30 years and nearly 3 million units sold)  and Maruti Alto, but in the recent quarters  we have seen a huge jump in somewhat pricier models, like new model Vitara Brezza, a SUV aimed at Indian middle class with price tag of around $8000. Just in the first half of the current  fiscal year, domestic sales of UVs rapidly increased, by 150%. Also, premium segment like Ciaz are performing well.  Increased standard of living led to the new phenomena that first-time urban buyers  are not opting for small car segments anymore. Instead, they are going for middle segments cars directly. Sales and net earnings are growing much faster than volume sales  as a result of selling more expensive models.

Dominant position in the market  and low employment costs(3.4% of the revenue)  give Maruti  one of the best operating margins in the industry. In the fiscal 2016 they were 11%( in the last few quarters even higher – 15%), towering globally much larger producers.  And that margin doesn't even include royalty fee. How sustainable margins are? Eventually, margins will drop as a result of increased competition but the whole market will be much larger as well.

Royalty fees

In addition to owning 56% stake in Maruti Suzuki,  Suzuki gets a hefty royalty fee as a technical know-how provider in accordance with the relevant license agreement. After liberalization of Indian market, royalty fees as a percentage of net sales nearly tripled to between 5.5%-6%, depending on the value of yen against the rupee.

In 2015-2016 total royalty stream  was 32.5 bn rupees. In the fiscal 2016-2017 (ending 03/31/17) it is going to be 10-20% higher, at around 35-40 bn rupees. Valuing it, is a bit trickier. Given the fact that a rupee of royalty stream is more valuable that a rupee of Maruti's earnings, should imply higher multiple for royalty stream than what market ascribes to Maruti Suzuki ( 20x LTM pre-tax earnings ).On the other hand, royalty payments are now 34% of earnings   before tax and royalties, much higher than 13% in  2005-2006. In years ahead, royalty fees are going to be reduced by 100bps (Chairman R.C. Bhargava:  "If you look four to five years in the future, definitely it would be (below 5 percent)” ) due to the increased amount of the in-house R&D. Also, future models will increasingly have element of royalty payable in rupees instead of the yen.  So, to be conservative, I used three multiples: 15x, 17x and 20x, all lower than multiple at which Maruti is trading today. Furthermore, I used the current rate reduced by 100bps.  That values royalties between ¥700bn and ¥950bn.

Suzuki is building a new $2.8 bn factory because current production at its Haryana facilities cannot meet the increased domestic demand. The capacity bottlenecks have led to delays in production and left customers waiting for months to get delivery of some of the most popular car models. Due to capacity constraints, Maruti Suzuki market share somewhat decreased over  the last 10 years. In addition to catering for the domestic Indian market, Suzuki has  big plans abroad.  Given the abundant labour pool and low labour costs, its Indian plants will serve as a export hub for  low income emerging markets. The  new factory in Gujarat state in western India will start producing in early 2017 with initial capacity of 250 thousand units and reach maximum capacity of 1.5 million by 2030.

 Initially, the  plan  for Maruti  was to set up its own factory in Gujarat, but  subsequently  the plan was changed and Suzuki was  announced as a sole investor in the project against strong opposition from Maruti minority shareholders. Minority shareholders were concerned that sourcing vehicles through the Suzuki unit would mean  not just bypassing the Maruti and taking the full control of exports by Suzuki but  also using Maruti's Indian dealership and service network  for free. It would leave Maruti's minority shareholders without, what they believed, their deserved share of profit.  As a result of minority shareholder pressures, new agreement was set. Suzuki entered into the contract manufacturing agreement with Maruti Suzuki. Under the new agreement,   the Gujarat factory owner Suzuki Motor Gujarat, which is wholly-owned  subisidiary of Suzuki Motor,  is going to sell cars to Maruti Suzuki , at a cost price (" SMG shall operate on a no-profit and no-loss principle"). Without profits, Suzuki's large investment in a new factory wouldn't make much sense and would basically be a form of subsidy to Maruti's minority shareholders.  So far, Suzuki was milking its Indian business as much as it possibly could, therefore such a generous gift to Maruti's minority shareholders, who are investing nothing and would still be gaining half of the profits, would be quite suprising and "out of character" for Suzuki Motor. Suzuki doesn't reveal much on this subject but the most likely scenario I could imagine is that royalties are going to be payed to the  parent company in Japan, either by its wholly owned subsidiary or  like it is done now, directly from Maruti Suzuki. This certainly strengthens Suzuki's position. Producing cars in a wholly owned subsidiary without any Maruti's involvement  would remove criticism regarding the rate of royalty fees. That way Suzuki would increase its control even more and use Maruti unparalleled infrastructure at a lowest possible cost.

Thus the value of Indian operations  is  between 1.45tn to 1.6tn Indian rupees or ¥2.4 tn to ¥2.7tn.

 Other assets

Indian assets  are the core of Suzuki's value but that is not all.  Two thirds of consolidated revenue and 50%  of all auto units sold come from non-Maruti business which is not as profitable as Maruti but still  has its value. Other  large markets include Japan, Europe, Pakistan, China, Indonesia.

In 2015, Suzuki's Japanese domestic sales were ¥1tn. Suzuki is firmly holding its market share but business is not as good as it used to be: Japanese market has been flat for decade or so.  Demographic decline, ageing population, slow economic growth, deflation, they all contributed to poor performance of the Japanese auto market. The past three years have been particullary ugly due to government's ill-considered introduction of consumption tax which brought about decline in revenue and sharp drop in margins.  No significant improvement is anticipated in near future, in fact in 2020 the Japanese car market is expected to be either below or at best at its current levels.

Suzuki's Japanese business relies much more on a mini segment than Indian one. Nearly 9 out of every 10 Suzuki's cars sold in Japan are minis. Such focus  makes Suzuki the leader in the mini segment, with aprox. 30% of Japanese market. Over the years Suzuki's mini market share has remained stable but decline in the domestic market, the  lack of scale and the focus on low-margin small car segment pushes management to find opportunities abroad  as well as to try to vitalize the  business through  partnerships with Volkswagen and lately, Toyota. The partnership with Volkswagen failed and it is not clear how exactly the partnership with Toyota might turn out. Without offering details, the two companies announced that they will “aim to strengthen collaboration in environment, safety and information technology”. There are speculations, however, that Toyota wants to learn from Suzuki’s exceptional Indian operations and to increase the presence in the emerging markets like India as well as in the small-car segment. Maybe even using Suzuki’s broad Indian network. In return they will share their new technologies( for example self-driving vehicles) with Suzuki which due to small size doesn’t have the required scale to compete with such companies  as Toyota, GM, Ford etc.

 How much is Japanese business worth? Well, to begin with,  it is hard to distinguish what is Japanese in it and what's not. Like Indian royalties, the royalties from other subsidiaries are included in Japanese operating income. For instance, in 2015 Suzuki's Pakistani subsidiary paid ¥1bn in royalties  to its Holding company, Suzuki Motor Corporation( at the rate of about 1%). Again, similar to Maruti's royalties: they are recurring and certain and have  much  higher growth potential. ¥1bn in royalties from Pakistan is more valuable than ¥1bn in operating income from the no-growth Japanese business. Since Suzuki has not provided any clarification of the subject, investors are left in the dark. Probably other subsidiaries pay royalties too but unlike Indian business their growth prospects are not as good. So I will  just treat this income as Japanese ( including Pakistan royalties given their small size).  Multiples? Japanese business holds domestic market share and it is in the middle of restructuring of cash burning motorcycle business.  Applying 3x-4x over the average of the last three years EBIT (which includes cars, motorcycles and marine&power,as well as exports, not just domestics sales )  seems reasonable, even conservative  and ascribes  about 150 to 200 billion yen in value.

Other markets

So what is left? European business, Chinese JVs, ASEAN businesses and Indian motorcycle business.

European Suzuki business has been recovering by recording a steady growth over the last three  years. This year  sales are  expected to increase by 17% over the 2015. Even though  232 thousand vehicles will be sold this year ( mostly produced in Suzuki's Hungarian plant with some units imported, including roughly 8 thousand Baleno cars produced by Maruti) , it still has a few years to  reach the pre-crises  levels ( not including motorcycle business which is a fraction of what it used to be, especially in Europe and it will remain so). With the expected sales of 300 thousands of cars in 2019, doubling the profitability of the European business couldn't be dismissed.

Besides India there are some other fast growing emerging markets like Pakistan where Suzuki has a strong presence. PAK Suzuki Motor  is 73% owned by Suzuki Motor and basically has the same story as Maruti Suzuki. It was founded in the early 80s as a joint venture with Pakistani government, afterward Suzuki increased  its share; similar market share etc., the only difference  being that it is a much smaller market. In 2015, 224  thousand units were sold (of which 134 thousand cars). Market value of PAK Suzuki Motor is around ¥46 billion.

Other big auto markets are China with 186 thousand units sold and Indonesia with 120 000. These are all JVs with a local partner. Chinese Changan Suzuki,  where Suzuki owns 35%, is losing money. Only a few years ago, 300 thousand units were sold in China. In Indonesian market, where Suzuki has a  90+% owned subsidiary, sales have also been dropping but only  recently  after years of strong market share gains.

Excluding the Pakistani subsidiary, none of these businesses is included in my valuation. They certainly have some value but without sufficient data I am not ready to put a number on them.

Suzuki's motorcycle business accounts for roughly 7% of the revenue. Its biggest markets are  in Asia: China, India (produced by Suzuki Motorcycle India; Maruti's factories do not produce motorcycles; Suzuki didn't even use their dealership network which may change), Philippines etc. Motorcycle business is flat to unprofitable so its small value is not of any significance and is not included in this valuation.

Net cash

As of 30th September 2016 Suzuki had ¥1tn in cash and short-term securities. Long-term securities are not included. Suzuki has ¥640bn in debt of which ¥200bn is in zero coupon convertible bonds(due 2021 and 2023) issued mostly for the funding of the Gujarat plant.

Why is the stock cheap?

There seem to be  several reasons for the low price:

1. Japanese investors see things differently than  Indian investors. They don't give the premium for the high growing Indian market, neither for strong competitive edge of Maruti Suzuki. Besides, most of them are probably unaware of royalties that are bundled up with the Japanese operating profits.
2. Currency risk. Foreign exchange rates have a strong impact on the value of Suzuki's assets. Weaker Indian rupee not only diminishes market value of Suzuki's largest holding, Maruti Suzuki, it does same thing to royalties ( which going forward will be paid in Indian rupees). Also, strong yen affects Maruti Suzuki's margin due to transfer of raw materials denominated in yen. Of course, currency risk can be hedged.
3. Litigation with Volkswagen. The long running dispute between Suzuki and Volkswagen over the breech of an alliance agreement  came to its end after 4 years and as a result Suzuki paid damages to Volkswagen. In addition to that, Suzuki repurchased 19.9% Volkswagen stake in Suzuki and sold its 1.5% stake in Volkswagen.  With settled dispute and failed partnership out of picture, investors now have more visibility and Suzuki management more room for focusing on the business and on improvement of balance sheet inefficiencies in the form of share repurchases and investments in market with high growth prospects.

Catalyst

Cancellation of treasury stocks; using excess cash for share repurchases and new investments.