Meditating on Maruti

With the Auto sector in the (mostly negative) news a lot lately, I want to do a deep dive into the biggest player in this segment in India - Maruti. Maruti's stock price had hit a life-time high of around 9800 first in the go-go 2017 and then again in July 2018 right before the IL&FS crisis. Currently, the stock is at the 6000 handle. The stock is trading around its 52 week lows, while the 52 week high was about 60% higher than the current stock price.

While painting the portrait that is Maruti, a lot of the factors are well understood and advertised. Some of the ones which come right on top allude to the future of mobility itself. As the millennium generation pioneers the gig economy, we can see its manifestations in the form of Uber, Lyft, Grab and Ola. If mobility were to be compared to the retail industry, then these companies would be the Amazons and Walmarts of their space - they control the channel and hence the power. Converging with the theme of fleets and pay-per-use business models is the disruption in technology itself - from combustion engine towards electric. The benefits of electric are well known and so are its challenges for a country like India - namely charging infrastructure, range anxiety.

Global investors understand these points very well, and hence even the leaders like BMW and Mercedes are trading at low valuations of single-digit P/Es. Remember - a big part of the valuation of any stock would be terminal value. The question is - what is the terminal value of a car company these days especially one which has an expertise in internal combustion engines, when Governments are already mandating dates to phase out those very same engines. Also remember the rush and euphoria for solar panel manufacturers a few years ago - solar was the 'Sunrise' industry literally and yet so many of the solar panel manufacturers went bankrupt just because of the unit economics when competing with the likes of China. As car manufacturing takes on hues of widget manufacturing in the EV era, the players with the biggest scale and best unit economics could be expected to dominate.

Coming back to Maruti, one could argue that all these factors do not apply to this company given that almost its entire market is India - where there are just 22 cars per 1000 people. Compare this to the USA on the other end of the spectrum where there are 800+ cars per 1000 people. In other words, the terminal value of Maruti given the market it is operating in is probably more certain as opposed to even some of the luxury carmakers with bigger brands given the higher disruption that these brands could face in their developed markets.

What are Maruti's strengths? When I think of Maruti, I certainly do not see it as the tech leader or an innovation leader. Maruti is best in catering to the demand of the market at the price point that the market likes. Basic entry level cars, SUVs with the minimum level of features to keep them competitive at an attractive price, with the biggest distribution and servicing network in the country, a large base of cars with a liquid and efficient second-hand market.

Here's then a very quick and brief SWOT analysis of Maruti:

Strengths:

1. Distribution network

2. Product range, knows the pulse of the market

Weaknesses:

1. Almost entirely dependent on domestic Indian Market

2. Umbilical cord to Japanese parent

Opportunities:

1. Domestic infrastructure build out over decades, increasing per capita could increase car ownership

2. Anticipate, adapt, manage and lead technological disruption towards electric vehicle - second mover advantage

Threats:

1. Millennial attitudes towards car ownership

2. Power shift in mobility to fleet owners

3. Technological disruption

The first question that comes to mind then is, 'Is it in Maruti's DNA to be the disruptor/ technological leader'? Historically, Maruti has been dependent on its Japanese parent for its technological needs and a material portion of its revenues is paid towards royalties. So, if we push ourselves 10 years forward to 2029 and imagine the auto-world around us, we would see a lot more non-internal-combustion-engine technologies around us. Has Maruti or its parent shown leadership in the past to manage these tectonic shifts? More likely, Maruti is better at excelling at increments, optimization, operational efficiency - taking existing technologies and creating a quality product at the right price. Maruti fits more in the mould of a second mover.

What then is the terminal value of Maruti? More likely than not, Maruti will be a going concern 10 years down the line, so the least I could say is that the terminal value is > 0. When I look at valuation, I steer away from DCF precisely because of the massive assumptions that go into deciding the terminal value. How can we come up with a growth rate to perpetuity, forget about prevailing interest (and discount) rates in the future. I can only look at what history tells us and to derive what the market is attributing its valuation to.

From a business stand-point, here are the numbers for Maruti:

1. 5-Yr CAGR sales growth rate of 12%

2. 5-Yr CAGR net income growth rate of 26%

3. 5-Yr Avg ROE of 19%, 5 Yr Avg ROCE of 96% (high ROCE given -ve net Current Assets)

4. 0-Debt

5. TTM P/E of 24; Graham P/E (Price over avg of last 3 yrs earnings of 26)

6. Earnigs Power Value with 0 growth assumption = 53% of current Market Cap. 47% of current market cap is then attributed to growth

7. P/ Adj Book (Adj book where I capitalize 3 years worth of SG&A) of 2.9

8. EV/ EBITDA in the 14 handle

Historically, EV/ EBITDA has seen highs of 23 when the stock was at its highs and lows of 10 (the stock was even cheaper when the problems of Manesar were holding down valuation from 2012 through 2014). On balance though, the average EV/EBITDA since 2011 is 14, same as the current valuation. So what has the market done - the market seems to have removed the froth or excess premium that it was awarding the stock till the near term growth/ inventory/ BS-VI/ financing/ insurance cost issues are sorted out and is in a wait and watch mode.

How does Maruti handicap vs other stocks? In the last 11 years (to include the 2008 crisis year), Maruti has had sales growth of > 10% in 9 out of these 11 years and in 10 out of these 11 years, ROCE is > 15%. There are only 21 other non-financial companies which have comparable sales growth and operational histories and only 7 with equal or better valuations. That would put Maruti in an elite list of stocks to buy.

Should Maruti then be a part of core portfolios at this price? If it's stock price were to suddenly drop by say 30% (as a thought experiment) from where it is currently, then it would be easy to say that there is value on the table. At the current price, there does not seem to be too much value left. I generally refrain from entry and exit levels, as I tend to fall in the investing camp as opposed to the trading camp. Sure, if there is pre-buying of vehicles in the period before BS-VI regulations kick-in in 2020 as well as a change in consumption indicators, then the market could start adding to the premium to the stock and drive the price up, but I feel it is unlikely that the price will go back to its highs any time soon.

What we need to decide is whether the narrative trumps the numbers or otherwise. I feel in Maruti's case, despite a stellar handicap and operational numbers, the problem is more structural from a long term (10+ yrs) perspective. That said, Maruti, at the current valuation, could then definitely find a home in the satellite portion of your wealth.