Investment Idea : Bajaj Auto to be the next outperformer

(BSE: 500490 | NSE: BAJAJAUTO | ISIN: INE118A01012)

Bajaj Auto (BAL) is set to return to its winning ways with a refreshing new strategy, which is more focused towards high-end high-margin two- wheelers. Substantial opportunity of value creation in the high-growth insurance business could give a further fillip to its valuations. We initiate coverage on the company with an OUTPERFORMER rating.

Company Background Bajaj Auto Ltd (BAL), the flagship of the Bajaj group, manufactures and markets Bajaj scooters, motorcycles, three- wheelers and spare parts. The company was incorporated in 1945 as a private limited company and went public in 1960. Currently, the company has four plants at Akurdi, Waluj, Chakan and Uttranchal with a combined installed capacity to produce 4,180,000 units of two and three-wheelers. With the opening of the insurance sector in the 90s, the company entered into joint venture agreements with Allianz AG of Germany to set up two separate companies – Bajaj Allianz General Insurance Company and Allianz Bajaj Life Insurance Company. Bajaj Auto and Allianz have signed two separate joint venture agreements for these two businesses and respectively committed 74% and 26% of the initial share capital of Rs 110 crore in case of the general insurance venture and Rs 150 crore in case of the life insurance venture. The company has undertaken a capex of various projects of about Rs1,520 crore to increase the total capacity from 3.2 millions units in FY06 to 5.5 millions units by FY09. It includes expanding existing facility at Akurdi, and Chakan, a green-field project at Pantnagar in Uttaranchal (commenced operations in May 2007), and another green-field project at Chakan tomanufacture a new range of 3-wheeler and 4- wheeler goods carrier. The company is planning to increase its presence in overseas and plans to set up manufacturing facilities in Indonesia and Nigeria.

Investment Rationale : A) Automobile sector geared for robust growth : BAL’s success in the motorcycle space can be attributed to its ability to create new product segments and differentiate its existing products. In a highly competitive market, BAL’s strategy of modifying its product mix towards higher end motorcycles, thrust on profitable exports and focus on the high-margin three-wheeler segment is aimed at becoming a leading player.

(1) Change in product mix towards high-end motorcycles One of the key strategies of the company is to move up the value chain and create a niche on high-end value and premium segments, which would generate more revenues. These segments are more profitable than the lower range entry segments, where competition is fierce.

BAL is leveraging its research and development (R&D) and technological :capabilities to move more customers up in the value chain by offering high-end vehicles at extremely competitive prices, expanding the market using innovative distribution models and penetrating rural market. In motorcycles, it introduced Pulsar in the high-end segment of 200 cc and 220 cc segments after creating a successful super premium 180 cc premium segments. This innovative move would help company to garner higher sales revenues, and protecting EBITDA margins at 15% .

(2) Thrust on profitable exports :As part of its future growth strategy, BAL is focusing on the profitable exports to expand its bottom line. Two-wheelers with engine capacities of less than 250cc constitute over 90% of the global market and BAL, with various vehicle models in different engine size is well positioned to leverage the opportunity of rising demand. The company is using a combination of direct exports out of India, and also setting up assembly operations in Indonesia and Nigeria to service demand. During FY06, the company reported a 27.2% growth in overall exports and in FY07 it reported a 75.7% rise in exports. Some of its models are market leaders in overseas countries. Further, with ramp-up in production at its Indonesian and Nigerian plant, the company is expected to report further jump in export numbers. The Indonesian market is of the size of 5 million vehicles and BAL entered this market by forming a joint venture company and has set up manufacturing facility for 2 and 3- wheelers. The company is likely to sell around 35,000 vehicles next year, and numbers will increase gradually, garnering higher market share in that market.The size of Nigerian market for 2-wheelers is about 1 million units and the company is targeting sales of around 35,000 two-wheelers and around 5,000 three-wheelers in FY08. The company is also planning to enter Iran, which has 2-wheeler market of the size of 5 million units, and currently dominated by Chinese models. However, with the change in emission norms, the Chinese players are losing strength, opening up wide opportunity for BAL.

Is rupee appreciation a threat to the topline? : Rupee is appreciating against dollar in past few weeks and with the strong GDP growth, the rupee should maintain a steady appreciation trend impacting revenue growth for export-oriented companies. We believe BAL’s export revenues may not be impacted as its exports are mainly to following countries.

Focus on high margin three wheelers segment :The company is focusing on 3-wheeler production and is planning to start 4 wheeler production. It plans to increase production from 300,000 units in FY06 to 480,000 in FY09 by setting new capacity at Chakan. Demand for 3- wheelers – both passenger and goods carrier – is increasing with sales rising at a CAGR of 21% (FY02-07). Sales of passenger 3- wheeler vehicles grew 17.8% and the same for goods’ carriers has grown by 32.3% during the same period. In addition to that, margin on this product segment is comparatively high at around 25-30% BAL is the leading producer of 3-wheeler passenger and goods carrier vehicles. As of March 2007, it was the market leader in the passenger carrier segment with a 73.6% market share, while in goods carrier, it is second after Piaggio Vehicles Private Ltd.

Capex and capacity expansion : The company is planning to ramp up production capacities in both 2 and 3-wheelers at a capex of Rs 1,520 crore taking total capacity to 5.5 million in FY09 from 4.2 million in FY07. This capex would be used for capacity building, research and development of new models, pro-biking showrooms (company’s high-end retail initiative) across the country and to open a new learning center at Akurdi. These projects will be funded through internal accruals. The capex also includes setting up a greenfield project at Pantnagar in Uttaranchal with a capacity of one million motorcycles.

Sales initiatives to push volumes The planned capex also includes investing on pro-biking showroom. BAL currently
has around 6 pro-biking showrooms, which it plans to increase to 50 in the coming period by spending around Rs 150 crore. Pro-biking is a high-end retail initiative to push sales of 180 cc + motorcycles where margins are nearly double as compared
with sale of 100 cc motorcycle. The company is likely to spend around Rs 150 crore on this project. Secondly, the company also has rural initiatives to garner greater market share in low-end motorcycle segment. The strategy of the company is upgrade the semi urban and urban population to high end motorcycles (125 cc+) and garner competitor’s market share in the rural segment by selling CT100 and platina. To compete on pricing, the company has already passed on the benefits of tax saving from Uttaranchal plant to customers by cutting down Platina prices.

Operational efficiency to protect EBITDA margins at 15% To protect fall in the margins in the face of rising input costs, the company is improving its labour productivity by modern and automated technologies, which has brought about a remarkable improvement in the output per employee. Output per employee increased from 100 vehicles per employee per year in 2002 to 257 vehicles per employee per year in 2007. (Though output per employee is improving, it is much lower than that of Hero Honda of about approximately 412 vehicles) Further, the thrust on R&D has further helped company to improve productivity. Staff cost-to-sales ratio has declined drastically from about 7% in FY03 to 3.7% in FY06.Further, the company is consolidating its vendor base and the count has declined from about 1,000 vendors to 200 vendors in FY07. It has concept of ‘Cluster layout’ according to which, the vendors’ (Suprajit Engineering, Endurance Group, Verroc, Mindas, LG Balakrishana, etc.) plants are situated close to BAL’s plant. This has helped the company cut down transportation costs as well as stock holding requirements, improving cost structure. It has also reduced warranty cost of motorcycles from Rs 700 per vehicle to around Rs 50 per vehicle, resulting into lower sales expenses.The strategy of shifting from high-volume low-margin entry level segment to higher end high margin vehicles and profitable export market would further play its role in protecting margins; expanding bottomline. All these efforts would help company to lower down the impact of higher raw material costs, protecting EBITDA margins at about 15%. With good investment portfolio, the company would continue to earn good investment income, strengthening bottomline growth. We expect the company to report CAGR (FY07 09E) of 9.5% in net profit.

Insurance sector – Immense potential for growth (1) Life insurance business :Bajaj Allianz is the number 3 player among total 16 players and excluding LIC, it enjoys number 2 position after ICICI prudential. It collected premium of Rs 4,269.8 crore in April – March 2007 as against Rs 2,715.6 crore in FY06. We on the conservative basis have assumed 35% and 20% growth in non-single premium and 20% and 15% for single premium for FY08 and FY09 respectively. We have valued the life insurance business on new business achieved profit (NBAP), considering a margin of 20% and multiple of 13. We arrive at value of Rs 656.3 per share for Bajaj Auto on the basis of FY09E NBAP. General Insurance business In the general insurance business, the company holds 6th position among 12 players, and among private players it is number 2 with a market share of 20.1%. Rising GDP and surge in the capital formation and auto industry are key growth drivers of non life insurance industry. Till March 2007, the company collected gross written premium of Rs 1,804.6 crore, registering growth of 40.5%. We on the conservative basis have assumed 30% and 20% growth in FY08 and FY09 respectively. We have valued general insurance business at 1.3x its FY09E book value, to arrive at value of Rs 34.8 per share for Bajaj Auto.

Key relevant regulations in insurance sector

  • 1) Life insurance companies should seek an IPO within 10 years of formation
  • 2) Indian insurance industry still await of freeing up of FDI investment limit from current 26% to 49% by the IRDA (the regulator). Due to this FDI limit, most foreign participants are not able to achieve a 50% ownership in the JV.
  • 3) Effective from June 30, 2006, unit linked product has a three-year lock-in, a term of atleast 5 years and higher sum assured. As per the new rules, if all the due premiums have not been paid for atleast 3 consecutive years from inception, the
    insurance coverage under the Unit Linked Life Insurance contracts shall cease immediately. Further, the insurers will also have to publish the portfolio of investments under their various ULIPs, which enhances the transparency of the product so that a buyer can make an informed decision. As a result of this change the proportion of single premium product has reduced in the overall sales mix.

Demerger To Help Focus On Key Businesses

The company declared a much-awaited demerger plans along with the financial numbers for Q4FY07 and FY07. The key elements of demerger plans are:

  • 1. The restructuring will create 3 separate entities
  • 2. The auto company to focus auto manufacturing
  • 3. The wind power and financial services company to focus financial, insurance, wind power business and also to explore new initiatives in the financial services segment
  • 4. Primary investment company to focus on new business opportunities

The demerger will be done in two stages

Stage I: The auto business will be transferred to Bajaj Holding and Investment Ltd (BHIL), plus Rs 1,500 crore in cash and cash equivalents

Stage I:

  • a) Other financial, insurance and wind power business will be transferred to “Bajaj Finserv Ltd” (BFL) plus Rs 800 crore in cash and cash equivalents
  • b) Existing Bajaj Auto to shall own 4.35 crore shares of Rs 10 each i.e. Rs 43.5 crore in BHIL and 4.35 crore shares of Rs 5 each i.e Rs 21.8 crore

Stage II:

  • a) BHIL would be renamed as new “Bajaj Auto” (BAL) to reflect the nature of business
  • b) The old BAL would be renamed as “Bajaj Holding & Investment Ltd”(BHIL) and would be investment company

Share swap ratio

Each shareholder of existing Bajaj Auto shall receive

  • – 1 share of Rs 10 of BHIL – holding company for investments
  • – 1 share of Rs 10 of new BAL
  • – 1 share of Rs 5 of BFL

Thus BHIL would have 30% stake each in new BAL and BFL while existing shareholders would own 70% stake in the company. In addition to the restructuring plans, Bajaj Auto’s management disclosed the call options available to its foreign partner – Allianz SE that is as under

  • • Allianz hold 26% stake in both life insurance and general insurance business from the date of the initial capitalization of the company in 2001
  • • In case of Bajaj Allianz Life Insurance, Allianz can exercise call option to increase its holding to 74% on following terms
  • a. Till July 31, 2016 at a price of Rs 5.42 per share plus interest at 16% per annum compound annually from July 31, 2001 to July 30, 2016

b. After July 30, 2016, the highest of

  • 1. Market price if it is listed entity by that time
  • 2. Rs 5.42 plus interest @ 16%pa compounded annually
  • from July 31, 2001 – July 30, 2016

3. Fair value mutually agreed by two entities

• In case of Bajaj Allianz General Insurance, Allianz can exercise call option to increase its stake to 50% on following terms

a. Till April 22, 2016. at a price of Rs10 per share plus interest at 16% pa compounded annually from April 23, 2001 to April 22, 2016

b. After April 22, 2016, the highest of

  • 1. Market price if it is listed entity by that time
  • 2. Rs 10 plus interest of 16% pa compounded annually from
    April 23, 2001- April 22, 2016
  • 3. Fair value mutually agreed by two

If Allianz exercises the call option…

  • 1. It can increase its stake to 74% in life insurance business and 50% in general insurance business at very low price as compared to the price based on its respective valuation methods
  • 2. Bajaj group’s voting power shall dilute to 50%
  • 3. Decline in the value of insurance business embedded in the share price of existing Bajaj Auto

… is it simple for Allianz to opt for their call option?

Indian insurance industry still await of freeing up of FDI investment limit from current 26% to 49% by the IRDA (the regulator). Exercising the call option by Allianz is strictly restricted by Indian regulatory authority. However, 9 years is too long period.

Risks and Concerns Could rising interest rates impact demand for 2- wheelers? In past few months, there is continuous rise in the interest rates making borrowing dearer. The rise in the interest rates has lead to an increase in EMIs and likely to slow down the growth in demand for vehicle loans. But can it really dampen the demand for 2- wheeler loans? We have done a sensitivity analysis for rate hike and its impact on EMI, which states that with every 50 bps increase in interest rate, the rise in EMI is just about Rs 8-15 per month. With rising per capita income, this pinch is too low to decelerate the demand for 2 wheeler loans. However, if interest rates continue to head north as a measure to control inflation, and rise beyond 14%, it may impact the 2-wheeler loan demand.

Do rising fuel prices pose threat to vehicle demand?

Crude prices touched high of $78 per barrel and from they corrected to hit a low of $55 per barrel. It is currently trading at $79.6 per barrel. Rising crude prices result into higher petrol and diesel prices. But the automobile industry continues to grow at a robust rate of 13.5% during FY07. The passenger car segment grew 22%, commercial vehicles (33.3%), while 2-wheelers registered 11.4% growth and 3 wheelers 12.2% during April – March 2007. We have done a sensitivity analysis considering different petrol prices and the likely additional payment due to such hike. The exercise resulted into additional charges of Rs11-18 per 1,000 km, which we believe to have minimal impact on the demand for 2 wheelers. The rise in interest rate and fuel cost beyond our expectation may taper demand for 2-wheelers. Shift in high end vehiclesThe company has decided to shift focus from lower cc vehicle segment to higher cc vehicle segment, which is comparatively expensive. The rise in interest cost making EMI dearer can continue to support demand for lower CC vehicles, impacting our projected numbers. Tata Motors’ Rs 1 lakh carThe launch of Tata’ Motors’ Rs 1 lakh car is mainly to shift the two-wheeler population to 4-wheeler vehicle segment and its successful launch may slowdown 2-wheeler demand. This is a major threat to 2-wheeler industry in general and BAL in particular as the latter is likely to focus on premium segment going forward. However, it does not pose immediate threat to demand slowdown as its launch is delayed. Further, the cost of fuel and maintenance of 4-wheelers is comparatively higher than that of 2- wheelers. Rise in raw material costs Rising in raw material cost beyond our expectation poses threat to our bottomline growth and earnings estimates.

Industry Dynamics The size of the Indian automobile industry is estimated at US$30.6 billion. Two wheelers constitute 28% and 3- wheeler constitutes 2%. The 2-wheeler industry has a major portion of the pie, accounting for a 76% share in terms of volume. The 2 wheeler industry has grown at a CAGR of 14.7% over FY02-07. In FY07, overall automobile industry registered growth 13.5%, while 2-wheelers sales grew 11.4% and that of 3-wheelers was at 12.2%. Two-wheeler exports grew 20.7%, while 3 wheeler exports grew 87.2% in the same period.

Growth linked to economy The buoyancy in automobile sector is expected to continue in near future. The growth in automobile sector is linked to the economic growth of the country and it has been further observed from historic data that for every 1 % rise in GDP there is a corresponding 1.8 – 2.5 % increase in road traffic. Since GDP is expected to be at around 9% for FY08, the growth in automobile sector is expected to be around 13-14 % for FY2008.Going forward, we expect the industry to grow at around CAGR of (FY07-10E) 8% but let us not forget that it is on high base of FY07 despite having concerns like increasing oil prices, rising interest rates and a likely shift in demand for 4- wheelers. Some of the demand drivers are as follows:

Rising per capita income New sectors such as business process outsourcing (BPO) and knowledge process outsourcing (KPO) are creating new and better paying jobs. The average per capita income is also rising at higher rate as illustrated in following table. The rising income level, the main demand driver, would support the demand for 2- wheelers sales as well as the pinch due to rising interest rate and oil would be lower. Further, the replacement demand is rising and out of total demand now 45% of the demand is from replacement as against 65% in few years back. The rising aspiration for the new launches is another demand driver.

Financials On a stand-alone basis, BAL reported net sales of Rs 9,415 crore, registering a growth of 24.3% for the year ended March 31, 2007 . EBITDA grew by 4.7%., however, EBITDA margins declined 260 basis points to 14.2%. Net profit grew 10.1% to Rs 1,237.1 crore. On a consolidated basis, it reported net sales of Rs 10,118.7 crore and net profit of Rs1,249.4crore.

Quarterly Performance For Q1FY08, BAL reported 4.2% decline in net sales mainly impacted by 11.7% de growth in volumes. The volume de-growth was mainly impacted by lower sales of 100cc motorcycles however, the fall in net sales has been restricted to 4.2% mainly due to increased contribution from high end motorcycles. BAL reported net sales of Rs 2109.1 crore as against Rs2,202.7 crore in the corresponding period. Average realization per unit improved 8.9% to Rs36,930 per unit however, EBITDA per unit declined 13.2% to Rs 4,821. Raw material costs declined by 1.8% however as percentage to net sales increased 180 bps to 72.4%. Further, the commencement of Uttaranchal plant resulted into higher staff costs; cost to sales ratio increased to 4.7% (3.9%) and other expenses ratio to sales increased by 70 bps, bringing down EBITDA margins 330 bps to 13.1%. EBITDA declined 23.7% to Rs 275.4 crore. Higher non operating income mainly from treasury helped bottonline fall to restrict at 14.9%, reporting net profit of Rs 226.5 crore as against Rs 266 crore. On consolidated basis, net sales down 3.8% to Rs 2,206.4 crore and net profit declined 24.4% to Rs 201.2 crore. EBITDA margins declined 340 bps to 16.3%.

Other developments in the quarter

  • • BAL launched 2 motorcycles during the quarter – Discover 135 DTS -i and Pulsar220 DTS – Fi at competitive price points
  • • It earned net premium for general insurance increased 47.4% to Rs 280 crore. It reported net profit of Rs21.9 crore as against Rs18.6 crore in Q1FY07, up 18%
  • • In case of life insurance, gross written premium reported growth of 45% to Rs 1,060 crore as against Rs 730 crore. It reported profit of Rs 30.6 crore in the quarter as against loss of Rs 19.1 crore
  • • Bajaj Auto Finance reported net profit of Rs 4.1 crore as against Rs 3.4 crore in Q1FY07. Total disbursal increased 30% to Rs740 crore
  • • BAL investment portfolio increased to Rs 6,589.2 crore and its valued at Rs9,077.7 crore as on June 30, 2007

 

Going forward, we expect the company on standalone basis to grow at CAGR of17.4% in net sales and 5.8% in net profit over FY07-09 and report net sales of Rs 12,973.7 crore and net profit of Rs1,384.8 crore in FY09 .

Valuation Attractive valuation – sum of parts basis We believe, BAL’s strategy to move towards high end bikes and thrust on more profitable exports and 3-wheeler business to yield good returns in coming years. At CMP of Rs 2,260, the stock trades at 17.5x and 16.5x its FY08E and FY09E EPS respectively and at 8.5x and 7.8x its core FY08E and FY09E EPS respectively. We have valued the stock on the sum of the parts (SOTP) basis to project our target price of Rs 2,725 as detailed in the table below (considering 50% stake in insurance business). At existing stake of 74% in both insurance businesses, the valuation would be as illustrated in following table

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Investment in equity shares has its own risks. Sincere efforts have been made to present the right investment perspective.The information contained herein is based on analysis and up on sources that we consider reliable. I, however, do not vouch for the accuracy or the completeness thereof. This material is for personal information and I am not responsible for any loss incurred based upon it.& take no responsibility whatsoever for any financial profits or loss which may arise from the recommendations given in this blog.

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