News flow over the past few months suggests the government may be taking earnest steps to shrink the deficit over time and ease certain supply-side constraints. The global economic sentiment also appears to be improving: tail risk in Europe is receding, while the promise of low interest rates for the next few years, combined with sustained quantitative easing, is helping improve sentiment in the US.
With India’s economy potentially moving back towards capacity creation, investment strategies might change in favour of cyclical companies, which could provide investors with high absolute returns. However, simply rotating into beaten-down cyclical businesses could be dangerous. While there is a definite improvement in sentiment, no major supply-side reforms have actually happened. This is why many power and infrastructure projects have stalled. With elections due in little over a year, companies in these sectors will continue to face slow decision-making from the government and, hence, meaningful upward earnings revisions in the coming year will be rare.
The most successful theme in the Indian equities over the past four years has been to invest in companies with strong profitability. Such companies tend to have a focused approach to their operations, strong domain knowledge, and strong free cash flow generation. For the medium term, investors are best placed staying with quality businesses where already-strong earnings will only improve in a stronger domestic and external growth environment.
Smooth rider
India’s two-wheeler industry has increasingly become a two-horse race between Bajaj Auto and Honda. Bajaj’s success in this highly competitive industry highlights its superior understanding of the market and strong research and development capabilities, while its premium positioning has been crucial in helping the company become one of the most profitable automotive manufacturers in the world. Bajaj’s brand strength extends into other emerging markets, with exports regularly contributing about 30% of its ₹20,000 crore revenues.
Bajaj also owns just under 50% of Austrian sports bike maker KTM, which recently pipped BMW as the largest two-wheeler company in Europe. Part of Bajaj’s strategy is to expand in the higher margin sports segments in India and abroad with a series of new products using its own and KTM’s sport brands, with the added benefit of operating leverage as products for both are being developed and built at the same facilities in India. It has also deployed capital with extraordinary efficiency to develop an all-new four-wheeled successor (the RE60) to its decades-old autorickshaw, which will be used exclusively as a taxi in domestic and export markets but also has obvious applications in personal transport.
Bajaj’s profits are driven by its focus on the higher end of the market and the premium positioning has had a positive effect on its entry-level products as well. For example, it will release a new premium model in early 2013 in the high volume 100cc segment that will be priced higher than rivals although it has lower market share in this class. Despite a weak demand environment over the last calendar year, Bajaj Auto’s stock price year-to-date has climbed 24%, excluding dividend return. Bajaj’s share of profits in the auto sector should continue next year as its entire range of products will benefit significantly in an expanding economy, especially with the likelihood of rate cuts, growing consumer preferences for premium products, and increasing finance penetration for two-wheelers and light commercial vehicles.
Besides, the company expects exports to double by 2016, that is 20% compounded growth in sales over four years. However, risks in the export segment remain in certain key markets such as Sri Lanka, where volumes have continued to stay weak over the last year. Bajaj also risks deeper competition domestically from Honda, which so far has been gaining market share at Hero’s expense.
Based on last year’s earnings of ₹109 per share, Bajaj trades at an earnings multiple of 17 times — a 15% premium to Hero MotoCorp. The market’s consensus is that Bajaj’s earnings will grow at 12% compounded annually for the next three years — which does not price in gains from the four or five all-new products likely to be rolled out over that period.
Bajaj has increased its dividend payout in the past four years by 45%, compounded annually. With high free cash flow yields of 5-7% expected to continue, investors can expect additional gains through strong dividend yields, which will grow significantly from the current 2.5%. We expect a one-year target price of ₹2,300 on Bajaj, an 10.56% upside from the current price, before dividend gains. With about 10% of the market capitalisation in cash, the stock remains an attractive bet given its relative visibility and quality of earnings.
IndAsia and its clients may have a position in the above mentioned stock
