Gautam Duggad

It is a moment for nostalgia when I talk of Maruti Suzuki. As a child, not the BMW or the Mercedes-Benz, but the only car that would fascinate me was the Maruti 800 when the Indian roads were cramped with Ambassadors and Premier Padminis. A little more than three decades now, my fascination for Maruti has not ceased — as a car enthusiast and also as a research strategist. Indeed, Maruti has been making history year after year, trademarking its dynamic style along the way.

Today, Maruti is India’s largest passenger vehicle (PV) maker with over 50% market share. It probably is the only mainstream car maker in the world to enjoy such a high market share and attractive margins. A big push comes from its strong product portfolio-network, economies of scale and intent to lower the cost of ownership for customers.

Clutch, Brake, Stop!

The Indian PV industry has a huge runway for growth, considering the substantial under-penetration (around 2.5% of population) in the country. Moreover, aspirations are becoming achievable for Indian consumers, especially the millenials. However, the auto industry is cyclical and undergoing a downcycle led by a convergence of factors such as higher fuel prices, higher interest rates, insurance cost increase and the lack of new launches. The PV industry volume growth at 5.32% has nearly halved in 2018 compared with its past three-year average. The passenger car industry – including Maruti – is highly influenced by the crude cycle, not just in terms of demand but also profitability. This is the first inflationary period under the fuel price deregulation era, which has resulted in near real-time transmission of higher crude prices (up 62% from lows of Jun-17) to fuel prices (price of petrol up by 25% and of diesel by 38%), denting auto consumer sentiment.

Moreover, with anti-lock braking system, airbags, rear parking sensors and BS6 becoming standard over the coming months, customers will have to pay significantly more for vehicles. This poses a threat to the competitive positioning of original equipment manufacturers with a diesel-heavy portfolio.

Maruti has reported one of its weakest operating performances in five years in the December quarter of FY19. Much of this can be attributed to the lack of product launches last year – practically just one launch (new Swift). The new Ertiga was launched towards the end of the year on 14^th November 2018, and that too after the festive season.

Accelerate!

It is important to note that demand for PVs is being deferred and not getting destructed. Correction in fuel prices, resolution of liquidity issues and upcoming new product launches should drive a recovery in demand in the coming months. We estimate the PV industry will see a volume CAGR of 8-10% over FY19-22 on a low base of 3% CAGR.

The near-term looks more promising for Maruti with several launches lined up over the next 12-15 months — Vitara (mid-size SUV competing with Hyundai’s Creta) and a model based on the Future S Concept (micro-SUV, concept displayed at Auto Expo 2018). Moreover, WagonR and Alto would see a full platform upgrade — this augurs well amid the product fatigue in the entry-level segment. Both these models would see a substantial upgrade on safety norms (airbags, ABS and crash test).

Improved mix, lower discounts, localisation at Gujarat plant, reducing yen exposure, reducing royalty and operating leverage will all combine to stabilise margins at around 14% toward the end of next year. Meanwhile, demand improvement will be visible in another couple of quarters.

Control Unparalleled!

Despite the near-term cyclical headwinds facing the industry, Maruti’s long-term narrative remains attractive — it is a market leader in the under-penetrated aspirational category with solid and deep moats around its business. This apart, the multi-year favourable product lifecycle, the scope for further improvement in return on invested capital through margin expansion and better free cash flow conversion make Maruti a very compelling story.

As far as regulations are concerned, the company would be the least-impacted auto maker, owing to its lower cost of compliance (just 1% higher cost for the compliant new WagonR), lesser contribution from diesel vehicles (which will witness highest cost inflation under BS6) and focus on CNG and hybrids to mitigate the impact of BS6. In fact, Maruti’s competitive positioning will strengthen post the BS6 implementation from April 2020 onwards. The company’s product pipeline remains strong, with at least two new launches (including full upgrades) per annum for the next three to five years. While Ertiga has got around 55,000 bookings (a waiting period of around 28 weeks), WagonR has over 14,000 bookings as of the third quarter of the current fiscal. We expect the contribution from new models (less than two years old) and product mix to improve from the fourth quarter of FY19, as this has a high influence on discounts, which should start trending downward. There have been a number of launches by competitors since Maruti’s last launch in Feb-18 (new Swift). Key competitive launches recently, and over the next six months, include M&M’s Marazzo (launched in Sep-18), M&M’s XUV3OO (compact SUV), Hyundai’s new Santro and Hyundai’s compact SUV. Beyond these, there aren’t many that could hurt Maruti. In summary, the moat for Maruti should strengthen further, supporting a premium over long-term average valuations.

We expect volume growth to compound at 8.4% over FY19-21, translating into a revenue CAGR of around 12%. With normalisation of margins (around 150 basis points improvement in operating margin to around 11% in FY21), we estimate the earnings to see a CAGR of 20% during the same period.

The Gujarat plant arrangement with parent Suzuki, which will be incurring bulk of the investment, will make Maruti’s business asset-light, allowing the management to focus more on marketing. The company’s balance sheet is very strong and is likely to have a net cash of around Rs.440 billion (over 20% of market cap in cash) by FY21, despite having invested close to Rs.50 billion annually for strengthening its moats. At its current price, the stock trades at over 22x estimated FY20 earnings.

The writer, in his personal capacity, does not own the stock but the brokerage has a buy call on the stock