Maruti on top, despite rate hike

After Maruti Udyog did magic with the Swift, expectations are running high on its newly launched sedan SX4. Launched two years ago, the bold and beautiful premium hatch-back changed the perception of Maruti from being a manufacturer of staid looking last generation cars to one that is capable of producing contemporary cars with x-appeal.

Coming eight years after it launched its last sedan offering Baleno, Maruti is hoping to take on competition in the A3 (sedan) segment with its SX4.

Even though Maruti has traditionally dominated the small car market, the company has been unable to conquer the sedan segment so far. Last fiscal, Maruti sold nearly 29,700 three-box cars, less than Honda, Ford and Tata Motors, with just two models Esteem and Baleno, both of which are showing declining sales (See table below).

While the company has a stranglehold over nearly 55 per cent of the passenger car market, it has a market share of less that 15 per cent in the A3 segment at a time when car-makers such as Hyundai, Ford, GM, Honda and new entrants like Mahindra-Renault combine are launching new models or expanding their presence in the segment. Fiat and Tata Motors too will launch their new models in 2008.

Certainly, the SX4 has the potential to do well. Built on the Swift platform with an all new engine, the car is priced competitively against the Honda City which is the leader in the segment at present. In spite of a powerful engine, a fully-loaded SX4 with safety features such as ABS and airbags is priced on a par with the base model of the City. If at all, growth may be constrained by Maruti's capacity to produce enough cars.

SMALL CAR, BIG PRESENCE
	FY07	FY06	% change
M-800	79245	89223	-11.18
Omni, Versa	83091	66366	25.2
Alto, Zen, WagonR	440375	335136	31.4
Baleno, Esteem	29697	31939	-7.02
Gypsy, G Vitara	3221	4374	-26.36
Exports	39295	34787	12.96
Total	674924	561825	20.13

Maruti has plans to expand capacity by another 2,00,000 but this will not come on stream this year. Currently, its Gurgaon plant which has an installed capacity of 3,50,000 units per annum is running at nearly double its capacity.

Its Manesar plant, which produces the Swift and SX4, has an installed capacity of 1,00,000 units. Since the company is already selling around 7000 units of Swift per month (84,000 per year) in the Manesar plant, there is little scope for SX4. The capacity at Manesar plant is expected to be scaled up to 3,00,000 units only by 2010.

"We have to live with it till the new capacity comes. But if Dr Reddy has his way the demand may get softened and match supply, and my marketing people would be very happy," said Jagdish Khattar, managing director, Maruti Udyog in an analysts' conference call organised after the company announced its annual results for 2006-07.

While the man steering Maruti seems unperturbed about the adverse economic conditions, the stock markets are caught in a conundrum. So far the strong momentum in the economy and higher disposable income have been driving up car sales. Last year, passenger car sales grew 22 per cent.

However, considering that nearly 75 per cent of cars are financed, the stock market fears that rising rates would have an impact on sales sooner or later though there is not enough evidence of this happening so far. "The challenge is bring about a change in the mind-set of people who have gone into a shell and are postponing purchases," according to Khattar.

Fearful of sluggish sales due a the rising cost of finance, the Maruti stock has underperformed the market since the beginning of the year steadily losing 17 per cent even as the Sensex is where it was after the intermittent swings.

However, as the bond market calms down and the view on interest rates is stable analysts are reviewing their stance. Recently, two top foreign broking houses CLSA and Merrill Lynch recommended a 'buy' on the stock at sub-800 levels. Merill Lynch has an optimistic price target of Rs 1000 while CLSA has a 12-month price objective of Rs 865.

According to CLSA, although car loan rates have risen from nine per cent in November 2005 to 13 per cent currently, the effect on EMI (equated monthly installments) has shown a reasonable rise of seven per cent from Rs 3180 per lakh to Rs 3394 per lakh. The broking firm said, "stemming of interest rate rise is a sentiment positive" in its last report calling the stock an outperformer.

FINANCIALS
(Rs crore)	FY06	FY07	FY08e	FY09e
Sales	12287	14980	18575	22662
Sales growth	-	21.92	24	22
Operating profit	1576	2045	2331	2704
Net profit	1189	1562	1780	2066
EPS	41	54	62	71
EPS growth	-	31.71	14.81	14.52

Some car dealers too feel that the higher discounts offered by car-makers and dealers coupled with a reduction in the Central Sales Tax rate is enough to neutralize the impact of higher finance cost. Again, companies are hoping that the higher volumes will compensate for the discounts.

If on one hand car-makers have to combat the tide of rising rates, they have to fight with each other in a market where competition is getting more intense. Last year, 20-odd car models (including variants) were launched in the country and this year nearly 40 models are expected to be launched. "We are on treadmills so as long as you are running at the same speed, it is okay," says Khattar.

In the past couple of years, Maruti has launched five new models starting with Swift Petrol in May 2005. In 2006-07, the company phased out the Zen and replaced it with a brand new car the Estilo and gave WagonR a face lift. Thus, with a strong portfolio of cars in all key segments, competition may not be as much of a concern for Maruti today as it was two years ago.

While the new replacement models, with their traditional virtues of value-for-money, high fuel-efficiency and low maintenance cost, have created renewed interest in these cars helping it hold its turf, the all-new Swift is aiding it gain market share in a segment it lost out on thus far. The SX4 too will achieve the same objective.

Besides, the company is preparing for the future by investing heavily in not just new models but developing new engines. It is also doing its bit to increase its share of cheaper fuel (CNG, LPG, diesel) variants cars, although only at the margin (8000 cars a month). Maruti now has entered the diesel small car segment till now the domain of Tata Motors.

The Swift Diesel has been fairly successful with sales of around 2500 units per month although a key limitation is that Maruti will not have the option of pushing sales any higher as the Suzuki subsidiary which supplies diesel engines is committed to sell the additional capacity to other Suzuki locations.

While Maruti seems well placed to grow in the domestic market on the strength of its young model line-up, exports will provide the impetus going forward. Last fiscal, the company increased its exports 13 per cent to nearly 40,000 cars.

This year exports (entirely to non-European countries) are expected to clock 50,000. It is already working on a new model for the European market which will be ready by 2008-09. Maruti intends to export about 1,50,000 units of this model to Europe. Adding to this the 50,000 units to be exported to non-European countries, the total would top 2,00,000 by 2010.

Overall, Maruti is expected to grow at 20 per cent per annum over the next couple of years, beating competition. And if at all a slowdown happens Maruti will be hurt the least among all car-makers.

After 24 years of existence and well entrenched dealer network across the country with models that have stood for rock-solid reliability, Maruti enjoys high brand pull. According to company estimates, the company could convert over 90 per cent of the customers who sold their old Maruti cars to True Value for purchase of new Maruti cars.

The concerns for Maruti however are on the profitability. While the new launches create customer pull and also serve the company well in the long term, it is a costly affair and hence affects profitability in the short term. In the last quarter, Maruti's other expenditure which primarily constitutes advertising and promotional expenses was up 45 per cent. This year too with the launch of the SX4, ad expenses will remain high.

Besides, several manufacturers are already absorbing a part of the finance cost or giving cash discounts to attract customers to offset the impact of finance rates. Maruti, too, with its focus on the value conscious customer may not be able to escape this unless the overall economic climate changes for the better. Over the next couple of years, selling and administration expenses which stood at Rs 709 crore (Rs billion) last fiscal is expected to rise 18 per cent y-o-y, according to analysts estimates.

Not that the management does not realise this. Says Khattar, "If you spend more it will have pressure on the margin. Those people who can control cost are working overtime to do so."

But then there are pressures on the production side too. In the March 2007 quarter, even though Maruti recorded revenue growth of 35 per cent, Ebitda (earnings before interest, tax, depreciation and amortisation) margins were down from 15.9 per cent to 12.4 per cent due to losses of Rs 58 crore (Rs billion) in the Manesar plant which began operation only in the second half of last fiscal, and escalation in raw material cost.

Though Manesar losses would come down over a period of time, raw material cost is a cause for worry as commodity prices show no signs of softening. "Despite our focused cost reduction efforts, increasing commodity prices will be a cause of concern," says Khattar. Besides, Maruti is planning a capital expenditure of Rs 2,000 crore (Rs 20 billion) this year and the next which again would entail higher depreciation charges.

In the past, one of the main drivers of profitability for Maruti has been localising its components. While the older car models are already 95 per cent indigenised, the new cars are being launched with higher levels of localisation in order to price cars aggressively and ensure their success in the market, according to Khattar.

For instance, "High localisation at launch also reduces the scope for further cost reduction in the future. This is a new challenge that we will have to deal with," he adds.

Like Khattar puts it, margin can be increased in three ways -- by improving productivity, increase the price or reduce marketing. "The question is whether you are able to do it or not." Having said that he does not seem overly worried.

When asked whether he would prefer to focus on volumes or profitability, Khattar said, "As far as margins and volumes are concerned, frankly one would go a little more for the volumes because margins can always follow." In a market that is proving to be challenge for car-makers, Khattar seems to have his priority right. And that should help the company hold its fort in the stock market too.

Based on the current price of Rs 809, the stock trades at 13.5 times current year earnings and 12 times FY09 earnings. The stock looks as good as the Swift and should replicate its performance on the Street.