25 July 2017
Pakistan Autos Fahad Shaikh, CFA +971 4 363 4005 | [email protected]
All that glitters isn’t gold
Initiation of Coverage Automobiles Pakistan
Sell PSMC, Neutral on HCAR, but buyers of INDU Sector valuations TTM CY17 TTM TTM Pakistan auto stocks have been stellar outperformers in the past few years and while the PE (x) PE (x) DY (%) ROE (%) outlook for volumes and ST profitability is strong, we believe increasing competition is INDU 10.6 9.5 6.9 44 likely to hit margins; thus, current valuations, which are based on unsustainably high HCAR 16.3 13.2 1.9 56 profitability, are too rich, in our view. The sector has re-rated to a CY17e P/E of 11.5x PSMC 17.6 13.4 0.8 12 relative to the LT average of 10.3x, while trading at a 23% premium to the PSX (historic discount: 7%). We expect margin weakness and capacity constraints will come into play P/Es have been calendarised Source: Company data, EFG Hermes estimates, and lead to an EPS CAGR of 15% CY16-19e (down from 55% for CY13-16).
Market share (%) We have a Sell rating on PSMC (TP: PKR563, market share: 54%, TTM PE 17.6x), where we believe lower profit margins are reflective of stale products, which along with weak HCAR cash flows inhibit long-term growth prospects. We are Neutral on HCAR (TP: PKR652, 18% market share: 18%, TTM PE 16.3x) as despite impressive ST growth, its recent share price pull-back is justified given that we expect growth to slow down from FY18e. We initiate PSMC with a Buy call on INDU (TP: PKR2,104, market share: 28%), as we believe its valuation 54% INDU of 9.5x CY17e P/E is undemanding (18% discount to the sector), given its 7.1% DY, 8% 28% EPS CAGR expectations (CY16-19e), high quality business franchise and the strongest balance sheet in the sector (provides capacity addition optionality).
Source: Company data, PAMA, EFG Hermes Robust demand outlook – but profitability is unsustainable
Favourable demographics, improving security and positive wealth effects, coupled with Sector PE relative to market (x) low interest rates and resurgence of consumer financing, have been a boon for auto 1.8 manufacturers. Strong pricing power and declining input prices have also helped the 1.6 1.6 sector EBITDA margin improve to a record 13% (LT average: 8%). This has placed 1.4 1.2 industry profitability at the higher end of the range, compared to global peers, and 1.0 attracted new entrants into the space (aided by new government incentives, industry 0.8 0.6 capacity could increase 88% by 2021). While the volume outlook remains strong, we 0.4 believe increasing competition and possible PKR weakness are likely to moderate 0.2 industry EBITDA margin to more normalised levels of c10% over the medium term. - TTM INDU is our top pick – focus on quality FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16 Source: Company data, EFG Hermes estimates Given late-cycle industry profitability, quality should outperform. INDU stands out, in terms of strong brand equity, lower cyclicality than peers and an exceptional track record of ensuring that earnings are backed by cash, which provides LT expansion optionality. We believe INDU is a high-quality stock, with the best balance sheet in the sector, while it trades at significantly discounted valuations, relative to peers.
Disclosure Appendix at the back of this report contains important disclosures, analyst certifications Page 1 of 89 and the status of non-US analysts
Pakistan Autos 25 July 2017
Contents Trial Title 1 Trial Title 2
Trial Title 3 Trial Title 4
1. Executive summary and investment thesis 4
Profitability improvement is cyclical rather than structural 6
Volume story is bullish, but profitability is late-cycle 7
Buy quality when going into a tougher competitive environment 8
Peer valuations 11
Investment risks 13
2. Industry structure 16
3. Structural growth supported by cyclical tailwinds 20
Improving domestic factors have supported consumer confidence 21
Low inflation – putting more money in consumer pockets 22
Consumer demand is more sustainable than in 2006/07 23
Cyclical sweet spot to remain in play over the medium term 23
4. Profitability is not sustainable 25
ADP to usher in new competition 26
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Indus Motor Company 29
Honda Atlas Cars 51
Pak Suzuki Motor Co. 70
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1. Executive summary and investment thesis
Initiating on Pakistan auto sector
We initiate coverage on Pakistan auto manufacturers, namely, Pak Suzuki Motor Company (PSMC), Indus Motor Company (INDU) and Honda Atlas Cars (HCAR). These companies have a combined market capitalisation of USD2.7bn and, between them, they account for 100% of the domestically manufactured passenger cars and Light Commercial Vehicles (LCVs).
Figure 1: Sector overview Sales EPS Locally TTM TTM Market Sales CAGR EPS CAGR Parent Free TTM CAGR CAGR Company Brands assembled EBITDA ROE share (%) 3-yr (%) 3-yr sharehol float GP (%) (%) 3-yr (%) 3-yr brands (%) (%) (%) Historical Historical ding (%) (%) Forecast Forward INDU Toyota Corolla, Hilux, Fortuner 17.7 17.1 44 28 23 13 56 8 38 21 HCAR Honda Civic, City, BRV 14.5 13.8 56 18 16 26 75 21 51 18 Mehran, Wagon-R, PSMC Suzuki 10.0 6.7 12 54 14 18 19 20 73 27 Swift, Cultus, Bolan, Ravi
Source: Company data, EFG Hermes estimates
Despite the recent pull-back in prices, the sector has outperformed the market return by 11% YTD in USD, on the back of robust top-line growth and margin expansion leading to an EPS CAGR of 55% (CY13-16). Expectations of continued growth have resulted in the sector re-rating to a CY17e P/E of 11.5x, a 23% premium to the PSX (Pakistan Stock Exchange – KSE100 Index), relative to a historic discount of 7%. While the volume outlook is likely to remain robust, we believe that, given current valuations and late cycle profitability (sector EBITDA margin of 13% compared to LT average of 8%), quality and valuation will be the key outperformance drivers over the medium term.
Our top pick in the sector is INDU, which we believe has an entrenched competitive advantage, in terms of brand equity (reliability, durability, after-sales service, re-sale value) and superior cash generation, allowing for dividend payouts and future capex optionality. Furthermore, its modest CY17e P/E of 9.5x offers the best total return expectations, in our opinion. Given the sharp valuation differential to peers, we believe the market is offering a great opportunity to pick a long-term winner at relatively attractive valuations. On HCAR, we are initiating with a Neutral rating, as we believe the recent de-rating is justified, given an imminent slowdown in growth post FY18, as the new model euphoria erodes, capacity utilisation moves close to 100%, and profit margins normalise. PSMC is a Sell, as we believe its valuation premium does not reflect the company’s weak business franchise (reflected in lower margins relative to peers), poor quality of earnings, as highlighted by their extremely poor cash flow generation, which restricts future capex and product reinvigoration and market over-optimism on margin improvement, where we believe EPS will be 6% and 19% lower than market expectations for FY17 and FY18, respectively.
Figure 2: Sector valuations and ratings Forecast TTM TTM TTM YTD Target FY1 TTM Price Mkt Cap Upside TTM CY17 CY18 EPS EV/ FCF EBITDA perf. % Rating price Fwd ROAE (PKR) (USDbn) (%) P/E (x) P/E (x) P/E (x) CAGR EBITDA Yield margin (USD) (PKR) DY (%) (%) (%) (x) (%) (%) INDU 1,737 1.3 8 Buy 2,104 28 10.6 9.5 9.1 8 7.1 4.9 10 44 17 HCAR 671 0.9 0 Neutral 652 0 16.3 13.2 11.1 21 3.2 7.5 25 56 14 PSMC 667 0.5 9 Sell 563 (14) 17.6 13.4 12.6 20 1.5 7.9 (5) 12 7 Sector 2.7 5 10.8 13.9 11.5 10.4 15 4.7 6.3 12.0 41.7 14
Source: Company data, EFG Hermes estimates; All CY numbers have been calculated on a pro-rate basis and will differ from actual FY numbers; forecast EPS CAGR is from CY16-19e
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Robust profit growth has driven sector re-rating…
Pakistan autos’ share prices have had a stellar run, outperforming the market by 11% YTD, despite the recent pullback. Structural demand drivers like demographics, income growth and improving security conditions have received a cyclical boost from lower interest rates and increasing availability of consumer financing from banks. At the same time, increasing popularity of ride-sharing services like Uber and Careem, have also contributed to the growth in demand for automobiles. These tailwinds have resulted in volume CAGR of 14% since CY13 (13% p.a. if we exclude government incentive scheme related volumes). At the same time, sector EBITDA margin has moved up from 7% to 13%, leading to an EPS CAGR of 55% between CY13-16. On the aforementioned sector growth figures, we note that they have been market-cap weighted and calendarised on a pro-rata basis to align the different reporting periods of the three companies we initiate on.
Figure 3: Robust volume growth since CY13 (units) Figure 4: Significant improvement in sector EBITDA margin
Source: Company data, PAMA, EFG Hermes estimates, Adjusted: Excludes Source: Company data, EFG Hermes estimates government incentive scheme related volumes
On the back of this strong financial performance, the sector has re-rated materially relative to its own history and relative to the market. At a TTM P/E of 13.9x (16.9x, if we exclude INDU), we believe the sector is pricing in relatively robust earnings growth. In our opinion, sector growth will likely remain strong over the next 12 months, as structural volume drivers remain intact. However, we expect growth to normalise over the medium term, as capacity constraints come into play requiring significant capex, and profit margins also get hit as competitive forces increase. Furthermore, while the industry can absorb marginal PKR depreciation, any material currency depreciation poses a significant downside risk to our earnings estimates. Given this backdrop, we believe investors need to stick with high-quality companies, with sustainable competitive advantages and strong cash flow generation.
Figure 5: Sector trades at a 35% premium P/E relative to Figure 6: Sector P/E relative to PSX – KSE 100 (x) history (x)
20.0 1.8 1.6 18.0 1.6 16.0 13.9 1.4 14.0 1.2 12.0 1.0 10.0 8.0 0.8 6.0 0.6 4.0 0.4 2.0 0.2 0.0 0.0 TTM FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16 TTM FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16
Source: Company data, EFG Hermes estimates, based on TTM PE Source: Company data, EFG Hermes estimates, Bloomberg, based on TTM PE
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…attracting a number of new entrants to the sector
While this stellar performance has translated into significant re-rating for the listed sector, high-profit margins have also attracted new entrants into the sector. We believe competitive dynamics are likely to change materially over the next three years, as the likes of Renault, Kia and Hyundai (amongst others, whose plans have not yet been made public) start producing domestically, incentivised by government policies to attract new investment (custom duty breaks on capital machinery imports, lower import duties on imported components, etc). We estimate that, if all announced investment plans go ahead, including paint shop expansion at PSMC, industry capacity utilisation could drop off from 83% currently to between 65-70% by 2021, despite assuming demand growth at 2x GDP (historic multiplier). As these new entrants start ramping up, we believe sector EBITDA margins are likely to normalise at around 10% (vs. 13% currently). Based on a back-of-the-envelope calculation, we estimate that, given the incentives provided to new entrants, they can undercut prices by 5-7% and yet attain similar profit margins as existing incumbents (using PSMC as a benchmark and simplistic assumptions, which are discussed later on in the report).
Brand equity - a key competitive advantage
The three covered companies have invested very little in their businesses over time. Since 2010, capex has averaged between 1.5-2% of sales compared to global peers, who on average have spent around 5% of sales on capex. We believe this will translate into capacity constraints (for INDU earlier than others) if demand remains robust, resulting in new entrants gaining free market share, unless the three incumbents undertake significant investments. Furthermore, we believe INDU and HCAR have built significant brand equity over time, where INDU (Toyota) is known for its reliability and durability and HCAR (Honda Civic/City) for its aesthetics and technological superiority, while PSMC has lost brand equity over time due to a lack of innovation and model enhancements. 70% of PSMC’s volumes are driven by cars that have not had any material changes in decades, in our view (Mehran, which is 33% of total volumes, has largely existed in its current form since 1988). Consequently, as competition picks up, we believe PSMC is most at risk of eroding market share and profitability unless it spends on its business to reinvigorate its product line-up. Important to highlight is that Pakistan’s progressive customs duty structure also incentivises imports at the lower end of the market, affecting PSMC more than its peers.
Profitability improvement is cyclical rather than structural
Unlike what one would expect, strong volume growth since FY13 has not resulted in positive operational gearing. The entire profitability improvement has been driven by lower input costs and price/mix gains outpacing those costs. On a per-unit basis, PSMC’s total operating costs, excluding raw materials, have increased at a CAGR of 6.8% between FY13 and FY16. Similar analysis for HCAR highlights a 1.4% increase in per-unit cost (excluding raw material cost). INDU is the only stand-out performer in this regard, where per-unit costs (exc. RM) have declined at a CAGR of 1.0%, indicating some positive operational gearing. Based on this analysis, we believe margin improvement across the sector has been more cyclical than structural in nature.
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Figure 7: Price/mix gains have outpaced raw material trends Figure 8: Weaker JPY + lower steel price = better profitability CAGR FY13-16 (%) CAGR FY13-16 (%) – Based on respective company year ends
Source: Company data, EFG Hermes estimates Source: Company data, Bloomberg, EFG Hermes estimates
Volume story is bullish, but profitability is late-cycle
We expect auto sales growth to remain relatively robust over the forecast horizon, driven by the structural factors (discussed later in the report); however, we believe profitability is late-cycle, i.e., attracting new entrants into the space, which will dilute profitability and, in turn, growth, going forward. Current industry capacity utilization, based on operational capacity, is 83%. Factoring in i) estimated new production capacity by Kia, Hyundai, Renault and Sazgar Engineering (no details disclosed so far); ii) INDU’s paint shop de-bottlenecking, which will be online during 2018; iii) potential for PSMC to expand their paint shop; and iv) Dewan Farooque Motors Limited (DFML – not a lot of details out on it), bringing back online their 20k per annum unutilised capacity, we estimate that capacity utilisation could fall to 66% by 2021. This is despite factoring in auto demand growth of 2x GDP. Other than PSMC, where weak product innovation has led to below par profitability, both INDU and HCAR rank very highly compared to global peers, where a lot of them are even full manufacturers rather than assemblers. In our base case, we expect margins to moderate across the sector over the forecast horizon.
Figure 9: EBITDA margin (%) likely to moderate across the sector
FY14 FY15 FY16 FY17a/e FY18e FY19e FY20e FY21e
PSMC 6 11 6 8 7 6 6 6 INDU 9 14 16 18 16 15 14 12 HCAR 7 13 15 14 12 12 12 11
Source: Company data, EFG Hermes estimates, FY17a/e = HCAR is actual while PSMC and INDU are estimated numbers
Figure 10: EBITDA margin (%) comparison
Source: Company data, Bloomberg
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Buy quality when going into a tougher competitive environment
INDU’S cash generation is under-appreciated
In an environment where profitability is at a record high and increased competition is in the horizon, quality will be key to outperformance, in our view. While HCAR’s recent price correction has reduced the de-rating risk that was built into its valuations based on unsustainable growth expectations and profitability, PSMC’s weak business franchise with poor cash flows and premium valuations, still poses significant downside risk. INDU has the strongest brand equity in the country, in our view, backed by robust cash flows supporting an industry leading forward dividend yield of 7.1% and an undemanding CY17e P/E of 9.5x. A higher DY and modest P/E more than compensate for its lower growth prospects, while strong cash flows provide optionality for future capacity additions.
Figure 11: Cash generation relative to reported earnings PSMC – Where is the cash? PKR11bn mismatch relative to earnings INDU – Consistent cash generation relative to reported income
HCAR – strong cash flows post new model introduction Sector cash generation relative to reported income
Source: Company data, EFG Hermes estimates
Despite similar industry dynamics, cash generation has differed quite significantly across the three companies (charts above). There is a material divergence between reported earnings and cash flows for PSMC, driven by working capital absorption. A broader product portfolio and larger distribution network (more dealerships) are the likely reasons behind poorer inventory turnovers relative to peers, while failure to
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generate mass interest in new models reduces their ability to manage advance bookings to improve working capital management. INDU, by far, has the been the most consistent in managing working capital, with reported earnings being backed by strong cash flows, which, in our view, is the key reason behind their strong dividend payouts. In PSMC’s case, we believe the historically low dividend payout ratio has been due to cash flow constraints, as highlighted in the charts above. Strong cash flow generation is a key competitive advantage, in terms of future capex requirements, as demand conditions stay robust.
Figure 12: Inventory turnover – INDU outperforms peers Figure 13: Consistent cash flows = consistently high dividend significantly payout (% of earnings paid out in dividends since FY06)
Source: Company data, EFG Hermes estimates Source: Company data, EFG Hermes estimates
The charts above and tables below substantiate our positive view on INDU’s business franchise and competitive advantage. INDU’s brand equity has ensured that they i) have much lower cyclicality in their business relative to peers; and ii) consistently generate cash flows through the business cycle. Even during tough economic conditions (2006-10), the tables below highlight INDU’s relative outperformance. With regard to HCAR, we would note that it had a tougher time during the previous crisis because of an ill-timed expansion, which led to higher fixed costs, interest charges and depreciation in an environment where volumes were under pressure. We, therefore, do not believe the previous crisis is a fair reflection of the business franchise – cash flows have since recovered quite strongly.
Figure 14: EBITDA trends through the previous downturn Figure 15: FCF trends through the previous downturn In PKRmn In PKRmn EBITDA FY06 FY07 FY08 FY09 FY10 FCF FY06 FY07 FY08 FY09 FY10
PSMC 5,661 5,018 819 829 1,335 PSMC (1,232) (2,730) (2,719) 1,128 (587) INDU 3,904 4,052 3,540 2,290 4,870 INDU 1,556 2,065 (3,225) 5,900 7,174 HCAR 1,039 307 773 408 327 HCAR (7,574) (1,380) 1,340 (3,363) 2,213
Source: Company data, EFG Hermes estimates Source: Company data, EFG Hermes estimates. INDU generated negative FCF
for only one year during the economic crisis (FY08)
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Figure 16: Estimated net cash excluding advances from customers and deposits from dealers In PKRbn
Source: Company data, EFG Hermes estimates
From a valuation perspective, we believe high P/E ratings and unsustainably high profitability make for a poor investment case. This is particularly true when looking at Pakistan autos, where we believe EPS growth momentum will slow as profit margins normalise and capacity constraints come into play, while PKR depreciation also poses a significant risk to EPS estimates. De-rating in PSMC and HCAR could wipe away all EPS growth gains, in our view, as growth normalises. On the flip side, even though INDU is likely to underperform on earnings growth, we believe its i) higher quality franchise; ii) sustainably strong cash flows; iii) 7.1% dividend yield; and iv) better positioning to expand capacity, given the strongest balance sheet in the sector, presents a much stronger investment case.
Figure 17: Earnings and profitability scorecard TTM Exit CY17e CY18e DY+1 Forecast EPS EBITDA (%) EBITDA (%) P/E (x) P/E (x) (%) CAGR (%) PSMC 7 6 13.4 12.6 1.5 20 INDU 17 12 9.5 9.1 7.1 8 HCAR 14 11 13.2 11.1 3.2 21
Note: CY estimates are calculated using pro-rata numbers of the different company’s FY estimates, forecast EPS CAGR = 3Y Source: Company data, EFG Hermes estimates,
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Peer valuations
Pakistan auto sector valuations are relatively in line with global peers. However – these valuations are based on record high margins, which we believe are unsustainable. While some global OEMs have relatively high margins, auto assemblers in Turkey and Egypt (which are more comparable to the companies we are initiating on) have EBITDA margins of between 8-9% compared to our sector average of 14.0%. In an environment where competitive forces are likely to increase, posing risk to earnings growth, we advocate a more selective approach to investing in the sector by focusing on quality and valuation.
Figure 18: Peer valuations Pakistan auto manufacturers are trading in-line with global peers – but these valuations are based on unsustainably high profit margins Mcap Price P/E P/E + P/E + TTM DY EV/EBITDA EV/Sales Net Debt/ EPS CAGR ROE EBITDA (USDmn) (LC) (x) 1 (x) 2 (x) (%) (x) (x) EBITDA (x) (3-yr) (%) (%) (%) Pak Suzuki Motor Company 522 667 17.6 13.4 12.6 0.8 7.8 0.5 (2.4) 19.7 12 6.7 Indus Motor Company 1,297 1,737 10.6 9.5 9.1 6.9 4.8 0.8 (2.2) 7.8 44 17.1 Honda Atlas Cars 910 671 16.3 13.2 11.1 1.9 7.6 1.0 (3.5) 21.2 56 13.8 Pakistan autos average 910 N/A 13.9 11.5 10.4 4.1 6.3 0.8 (2.7) 14.5 37 14.0
Ford Otomotiv Sanayi As 4,476 45 15.4 14.6 12.8 5.1 8.1 0.9 1.1 13 35 8 Tofas Turk Otomobil Fabrika 4,300 30 15.3 13.2 11.9 2.3 11.0 1.1 1.9 11 38 9 Gb Auto 128 2 11.6 93.0 9.9 - 7.1 0.6 5.7 37 8 9 Maruti Suzuki India Ltd 35,261 7,517 30.2 27.6 23.3 1.0 17.6 3.4 (0.2) 22 23 15 Tata Motors Ltd 22,737 459 20.9 11.9 8.7 N/A 5.6 0.6 0.8 53 11 12 Mahindra & Mahindra Ltd 13,406 1,390 20.3 17.6 14.5 0.9 30.2 1.7 8.8 28 13 5 Dongfeng Motor Grp 10,759 10 5.4 5.6 5.4 2.7 16.2 0.6 (0.4) 2 15 3 Volkswagen Ag-Pref 83,713 144 11.7 6.0 5.7 1.4 1.0 0.2 (0.9) 5 7 17 Suzuki Motor Corp 23,313 5,324 14.7 13.8 12.7 0.8 4.5 0.8 (0.9) 8 15 14 Toyota Motor Corp 178,966 6,150 10.2 10.3 9.7 N/A 8.9 1.3 3.7 4 11 13 Honda Motor Co Ltd 50,063 3,099 9.1 9.3 8.5 3.1 7.8 0.8 3.7 5 9 11 Geely Auto Holdings Lt 21,150 18 27.6 17.2 13.3 0.7 6.3 2.4 (1.8) 39 23 13 Saic Motor Corp Ltd-A 54,667 32 10.9 10.1 9.2 5.2 12.5 0.6 0.8 7 16 3 Kia Motors Corp 13,130 36,450 5.7 6.4 5.4 3.0 3.6 0.3 (0.2) 1 10 8 Hyundai Motor Co 28,970 148,000 7.9 7.2 6.4 2.7 9.2 0.8 5.1 8 6 9 Nissan Motor Co Ltd 42,911 1,140 6.8 7.4 7.1 N/A 1.8 0.3 (1.0) 5 14 14 Peer average 36,747 12.5 10.8 9.6 1.4 8.2 1.0 1.7 9.6 12.3 12.0
Note: Bloomberg; averages are market-cap weighted Source: Company data, EFG Hermes estimates
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Ratings summary
Our investment ratings on the three Pakistan autos in our coverage universe are summarised as follows:
We rate INDU a Buy for the following key reasons: i) low multiples – at 9.5x FY17e P/E, coupled with a 7.1% forward DY; we believe its valuation is cheap and more than compensates for below-sector average growth rates, while not pricing in INDU’s high quality business franchise; ii) consensus earnings revisions – we expect earnings to beat market consensus by 8%, and 4% in FY17 and FY18, respectively. We do not believe consensus numbers are pricing in the ST margin uplift from the change in business mix (new model of Toyota Fortuner and higher spare part sales), while the Japanese Yen (JPY) remained weak against the PKR for INDU’s FY17 Y/E; and iii) superior cash generation – we believe the market undervalues INDU’s stronger cash generation, where they have generated FCF of 1.1x net income (FY06-TTM), which should allow the company to offset lower organic growth opportunity, with a sustainably high dividend yield and an optionality to fund future capital expenditure. This is unique to all listed auto companies in Pakistan
We rate HCAR Neutral for the following reasons: i) recent pull-back in valuation is justified – HCAR’s share price is down 23% MTD and the stock is now trading at a FY18e P/E of 12.5x, which on a CY17e calendarised basis implies a 15% premium to sector average. We believe the current valuation premium is now fair, given ST earnings momentum, where we expect EPS growth of 31% and 16% Y- o-Y in FY18e and FY19e, respectively; ii) however, premium valuations and lower growth post FY18 make HCAR unexciting – we believe FY18e will be a strong year for HCAR as they ride the growth of the new Civic model and the launch of the new Honda BRV (FY18e EPS +31%YoY). Capacity utilisation will move close to 85% in FY18e and post that, with the new model euphoria wearing off, limited room for growth, in terms of available capacity and expected margin normalisation, we expect EPS CAGR to slow down to 8% (FY18e - FY22e); iii) potential earnings miss – we believe the market is too bullish on FY18e expectations (we are 11% below consensus numbers). Consensus is likely too optimistic on margins, while not accounting for the higher imported component of new models, affecting margin negatively. Furthermore, as per our channel checks, Honda is not taking any new orders for the Honda Civic’s premium priced model (VTEC Turbo) – we believe this is likely due to technical challenges. While the recent price correction has reduced downside risk, we believe investors are better off investing in INDU, which offers better quality at much more attractive valuations.
We rate PSMC a Sell for the following reasons: i) expensive valuation & overoptimistic market expectations – CY17e P/E of 13.4x, a 17% premium to sector, which factors in unsustainable earnings growth expectations, given capacity constraints are likely to come into play by CY19e. In addition, we believe consensus expectations are too bullish on margin improvement, where we expect EPS to miss Bloomberg consensus by 6% and 19% for CY17-18e, respectively, barring any government taxi scheme related volumes; ii) weak business franchise, that has brought about subpar profitability and poor cash flow generation affecting dividend payouts and limiting future capex; furthermore, with already thin margins, any FX depreciation is likely to affect PSMC more than peers; and iii) PSMC is most vulnerable to new competition, as PSMC continues to derive 2/3rd of its sales volume from three products (Suzuki Mehran, Suzuki Bolan and Suzuki Ravi) that were launched in 1990s. We believe a lack of investment and model reinvigoration are the key weaknesses in its business model, while weak cash flows restrict its ability to turn the ship around. Plans to invest USD460mn to introduce new models and additional capacity seem unrealistic, given a market cap of USD522mn and an adjusted net cash balance of USD31mn.
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Investment risks
Upside risks:
Competition from new entrants does not materialise, allowing existing incumbents to maintain profitability at current levels. Assuming EBITDA margins stay relatively consistent over the next five years, INDU would see the biggest uplift in profits, as we have conservatively forecast that margins would moderate to 12% by FY21 compared to 18% in FY17e. In HCAR’s case, its EPS would be between 11-23% higher over the forecast horizon; which then implies a 16% upside to our target price. On a relative basis, INDU offers a much better risk/reward outcome. Figure 19: EPS sensitivity – Indus Motor Company Figure 20: EPS sensitivity – Honda Atlas Cars In PKR In PKR FY17e FY18e FY19e FY20e FY21e FY18e FY19e FY20e FY21e FY22e
Base case EPS 183 184 198 211 220 Base case EPS 54 62 67 70 73 Bull case EPS 183 201 232 265 298 Bull case EPS 60 69 77 83 90 % change 0% 9% 17% 26% 36% % change 11% 11% 14% 18% 23%
PKR/ Upside* PKR/ Upside* share % share % Base case TP 2,104 28 Base case TP 652 0 Bull case TP 2,616 58 Bull case TP 759 16 % change 24% % change 16% * Based on closing price of 20 July 2017 * Based on closing price of 20 July 2017 Source: EFG Hermes estimates Source: EFG Hermes estimates
PSMC manages to reinvigorate its products, while competitive forces remain weak. In this case, we believe PSMC could widen their below par EBITDA margin of 6.7%. Assuming PSMC was able to lift that margin to 11% through a better product offering, our target price estimate could increase 63%; all else being equal. It is important to note that the sensitivity below does not account for increased capital expenditure requirements, if PSMC wanted to have a fresh product portfolio; thus, we view this scenario as highly improbable.
Figure 21: Pak Suzuki Motor Company EPS sensitivity In PKR FY17e FY18e FY19e FY20e FY21e
Base case EPS 50 51 58 66 74 Bull Scenario 50 65 87 109 134 % change 0% 28% 49% 65% 81%
PKR/share Upside* (%) Base case TP 563 (14) Bull case TP 918 39 % change 63% *Based on closing price of 20 July 2017 Source: EFG Hermes estimates
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EPS growth for HCAR/PSMC helps maintain premium rating:
Figure 22: Pakistan autos are a lot more cyclical than the MSCI EM consumer discretionary universe Operating margin (%) through the cycle
Source: Company data, EFG Hermes estimates
Pakistan autos seem reasonably valued when put in context of growth relative to the EM Consumer Discretionary universe; however, we believe that because Pakistan autos are more cyclical than companies in this index, they should trade at a discount. Therefore, investors need to be cognizant of the premium valuations and unsustainably high profit margins in the sector. Current valuations clearly suggest that the market is pricing in a continuation of current growth trends and margins. In a scenario, where profit margins sustain, HCAR could potentially provide a 16% upside, while if we value PSMC at 15x FY18e EPS, it could provide a 19% upside relative to our base-case of 14% downside. We view this scenario as unlikely, given i) imminent growth slowdown given capacity constraints; ii) change in market dynamics towards higher competition; and iii) INDU’s current market rating gives good guidance of how the market reacts to a slowdown in earnings momentum.
Figure 23: MSCI EM consumer discretionary universe (3-YR EPS CAGR expectations vs. forward P/E) Pakistan autos are not out of line, in terms of growth, vs. P/E relative to the EM Consumer Discretionary Universe
Forward PE 50.0 45.0 40.0 35.0 30.0 25.0 PSMC 20.0 15.0 10.0 INDU 5.0 HCAR 0.0 -5% 0% 5% 10% 15% 20% 25% 30% 35% 40% EPS G (FY1-FY3)
Source: Company data, EFG Hermes estimates, Bloomberg
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The taxi scheme catalyst – The government of Pakistan is set to launch a taxi scheme for the youth to provide employment opportunities. So far, they have announced distribution of 50,000 cars against an initial announcement of providing 100,000 cars, at possibly discounted prices and through offering interest free loans. Historically, PSMC has been the key beneficiary of these schemes, given its low-cost product offerings. We estimate that this could add a one-off PKR17-35/share to PSMC earnings, depending on actual volume off-take; however, we need to keep in mind that on a TTM basis PSMC only has excess capacity of 35k units; thus, the benefit of the scheme will likely be phased out – or it will cannibalise underlying demand. We believe this to be a one-off event, but could result in ST share price outperformance
Downside risks
Depreciation of the PKR: The PKR has been relatively stable across major currencies. Based on spot rates, the PKR has appreciated 10% against the JPY since 2013, while losing only 4% against the USD. We believe this, and consistent price/mix improvement, to have been a key profitability driver for the sector. Given that an estimated 55% of raw materials is imported (based on related party purchases by the three companies under our coverage), we believe any sharp depreciation of the PKR will have an immediate impact on profitability – price increases will need to be phased, while cost increases will be immediate. The exact impact is difficult to calculate because of moving parts, which include pricing strategy. However, all else held equal, using simplistic assumptions, if we assume that 50% of raw material across all manufacturers is imported, a 5% depreciation in the PKR could affect PSMC, INDU and HCAR PBT by 36%, 12% and 14%, respectively. PSMC’s thinner margins amplify the impact of FX movement Figure 24: Sensitivity analysis In PKRmn Latest reported financial year PSMC INDU HCAR
Raw materials consumed 63,809 80,280 47,882 Assume 50% is imported 31,905 40,140 23,941 Impact of 5% PKR depreciation (incremental cost) 1,595 2,007 1,197 Profit before tax (adjusted for one-offs) 4,446 17,397 8,271 Impact as a % of PBT 36% 12% 14%
Source: EFG Hermes estimates
Higher inflation = higher interest rate: From a demand perspective, we believe robust real growth could absorb a steady pace of rate hikes as inflation moves higher. The key risk is a sharp pick-up in inflation, which leads to higher-than-anticipated increase in interest rates that would put pressure on final demand
Capex requirements: Capex-to-sales for Pakistan auto manufactures has been relatively low, compared to global peers, likely driven by i) an uncertain economic/macro scenario; and ii) lack of competition that did not necessitate significant business investments. Any significant product introductions or capacity expansions by existing players could disrupt ST profitability, even though it improves their longer-term competitiveness and growth potential
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2. Industry structure
Oligopoly – three competitors playing within their respective niches
Pakistan’s automotive industry has, to a large extent, been dominated by Pak Suzuki Motor Company (PSMC, market share: 54%), Indus Motor Company (INDU, market share: 28%) and Honda Atlas Car (HCAR, market share: 18%), which are assemblers of Suzuki, Toyota/Daihatsu and Honda, respectively. The likes of Kia and Hyundai have had limited success in the past and have largely been fair-weather friends and exited the market when economic conditions deteriorated post 2008, resulting in an oligopolistic market with three main competitors. The fourth element has been used imports from Japan, which -at their peak in 2012- accounted for 27% of the total cars market in Pakistan (estimated based on total imports from japan, which include new vehicles, but the bulk of them are used cars). Post that, the government revised the import policies to reduce the age limit on used imported cars from five to three years; thus, curbing imports down to more manageable levels, where imports now account for an estimated 19% of total units sold in the country. This policy has remained consistent in the recently-announced Auto Development Plan 2016-21 to ensure that the domestic manufacturing sector continues to attract investment and to push towards greater local manufacturing. Worth highlighting is that only expatriates are allowed to import used vehicles under the personal baggage, gift and transfer of residence scheme; however, domestic used car importers have managed to work around this regulation.
Figure 25: PSMC, INDU and HCAR have dominated the Figure 26: Used car imports are meaningful, with an domestic market estimated 19% market share Market shares % (based on locally assembled cars) Used car imports
Source: Company data, PAMA, EFG Hermes estimates Source: Company data, EFG Hermes estimates
Other than the three assemblers highlighted above, there is a decent amount of unutilised capacity, which was mothballed post the 2008 downturn due to lower demand and financial difficulties. An example of this is Ghandhara Nissan Motors, which has an unutilised production capacity of 12,000 cars (on a double shift basis). The other example is Dewan Farooque Motors, which has an unutilised capacity of 20,000 units per annum, but has not been able to produce these vehicles because of financial distress.
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Figure 27: Industry is currently operating at c83% utilisation
Production capacity TTM Utilisation Industry participants (Double-shift basis) production (%) Pak Suzuki Motor Company 150,000 114,557 76 Indus Motor Company 54,800 62,045 113 Honda Atlas Car 50,000 34,560 69 Operational capacity (double-shift) 254,800 211,162 83 Ghandhara Nissan Motors 12,000 167 1 Dewan Farooque Motors 20,000 - - Total capacity (double-shift) 286,800 211,329 74
Source: Company data, EFG Hermes estimates
As shown below, the three manufacturers have carved their respective market segments with PSMC catering more to the mass market with an average selling price 45-50% lower than the Toyota Corolla and Honda City (and 65% lower than the Honda Civic). In terms of value proposition within the passenger car segment, PSMC offers relatively lower priced car options to the mass market with low maintenance costs, INDU offers a relatively superior product (Toyota Corolla), which is known for its durability and also operates within the LCV segment with the Toyota Hilux and SUV segment with the Toyota Fortuner, while HCAR’s value proposition has always been a much more technically advanced and aesthetically superior product that allows them to charge premium pricing.
On the ground, the reality is that, given relatively poor infrastructure, Toyota’s (INDU) brand image of reliability and durability has resonated most, with consumers leading to Toyota Corolla being the highest selling car in Pakistan.
Figure 28: Competitive positioning – PSMC plays within the value space; INDU offers durability/reliability; HCAR models perceived as technically and aesthetically superior In PKRmn
3.5 Hilux Civic 3.0 Honda BRV 2.5 Corolla City 2.0 Swift Cultus 1.5 Wagon R Bolan Mehran 1.0 Ravi
0.5
0.0 0 10,000 20,000 30,000 40,000 50,000 60,000
TTM Units Sold
Source: Company data, EFG Hermes estimates
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Figure 29: Market share dynamics and growth by category PSMC dominates the market within the < 1300cc segment (%) INDU and HCAR dominate the 1300cc and above segment (%)
PSMC, 100
PSMC also dominates the LCV market, while INDU has 25% market share Volume growth (CAGR %) by category (FY02–16) relative to GDP growth
INDU PSMC Other 120
100
80
60
40
20
0 FY13 FY14 FY15 FY16 TTM
Source: Company data, EFG Hermes estimates
Used imports – Affecting some more than others
Imports are a crucial part of the market, making up an estimated 19% of all automotive sales in Pakistan (passenger cars and LCV’s), but are not recorded within the sales numbers reported by the Pakistan Automotive Manufacturers Association. The majority of these imports are used units from Japan and cater to the lower end of the market, with the <1,000cc engine displacement vehicles, making up 65% of all imported petrol vehicles. This lower end segment has also seen explosive growth with volume CAGR of 24% between 2013 and 2016 relative to only 12% p.a. in the 1,500-3,000cc segment. The average landed price post taxes for a car in the <1,000cc segment is estimated at around PKR1mn, which puts them in direct competition with PSMC’s product line-up.
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Figure 30: Volumes declined post reduction in age limit from Figure 31: Majority of imports are in the less than 1000cc five to three years in 2012 market segment Imported Units (New and Used) Imports by engine displacement
Source: UN Comtrade, EFG Hermes estimates Source: UN Comtrade, EFG Hermes estimates
Figure 32: Higher end of market has outperformed Volume CAGR (FY02 – YTD)
Source: Company data, EFG Hermes estimates
This trend is reinforced further by the progressive customs duty on imports, which results in cars with larger engine displacements being less attractive for Pakistan’s mass-market. Consequently, the duty structure itself leads to more competition for PSMC relative to INDU and HCAR. This, in our view, explains the counter-intuitive volume growth performance of the local manufacturers. Despite its broad product portfolio and exposure to the mass-market in Pakistan, PSMC has underperformed volume growth relative to INDU and HCAR. If import policies remain consistent, used imports are likely to continue dampening PSMC’s growth, in our view, unless they reinvigorate their product line-up. Mehran, the highest selling car for PSMC (1/3rd of overall volumes) has existed largely in its current form since 1988, with PSMC now likely to replace it by a 660cc Suzuki Alto.
Figure 33: Progressive duty structure makes importing smaller engine displacement cars more attractive for local market Duty structure for imported Completely Built Units (%)
Tariffs (CBU) FY17 FY18 FY19 FY20 FY21
Up to 800cc 50 40 40 50 50 801 to 1000cc 55 45 45 55 55 1001 to 1500cc 60 50 50 60 60 1501 to 1800cc 75 65 65 75 75 CBU above 1801cc 100+50%RD 100+50%RD 100+50%RD 100+50%RD 100+50%RD
Source: Auto Development Plan 2016-21; These tariff cuts had been proposed for FY18, but have yet to be implemented.
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3. Structural growth supported by cyclical tailwinds
Young population and urbanisation driving consumption demand
The automotive market in Pakistan is supported by strong structural tailwinds of urbanisation, favourable demographics and growing GDP per capita. Passenger car penetration in Pakistan has moved up from 9.2 per 1000 people in 2005 to an estimated 14 per 1000 people in 2015 – relatively in line with the experience of other countries with similar income levels. Urban population CAGR of 3.3% and working-age population CAGR of 2.5% (2010-15) have both outpaced total population growth, further lending support to consumption growth.
Figure 34: Urban population % of total Figure 35: Growth in working-age population (15-64 years) Large urbanising population… …with strong growth in working-age population (2010–15)
Source: World Bank Source: World Bank
Motorisation trends still in their infancy
Pakistan’s automotive market (passenger cars + Light Commercial Vehicles) has grown at a CAGR of 9% over the past 20 years (8% excluding Apna Rozgar scheme related volumes in FY16), significantly outpacing real GDP CAGR of 4% over the same time period, implying a real GDP multiplier of 2x. Despite this strong growth witnessed in recent years, Pakistan remains at early stages of motorisation relative to countries like India (17 cars per thousand people), Vietnam (21 cars per thousand people) or even Kenya (18 cars per thousand people). Relative to the broader ‘world’, Pakistan barely appears on the same axis, in terms of motorisation levels. While factors like availability and access to public transport do have an impact on motorisation trends between countries, it is important to understand cultural nuances, where car ownership in Pakistan is considered an important part of self-actualisation; hence, likely to be an ongoing driver of underlying demand as income levels continue to grow. As shown below, the global correlation (or R-square) between income levels and motorisation is high (0.70).
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Figure 36: Motorisation relative to the world Figure 37: Motorisation relative to emerging economies Motorization in Pakistan is in its infancy Pakistan – following a similar motorisation path as most EM economies
800 70 700 60 600 Indonesia, 50 500 R² = 0.6997 2014 40 400 30 Sri Lanka, 300 Vietnam, 2014 20 Kenya, 2014 2014 200 India, 2014 Pakistan 100 10 Pakistan Bangladesh, 0 0 2014 0 20,000 40,000 60,000 80,000 100,000 120,000 0 1,000 2,000 3,000 4,000 5,000 GDP per capita (Constant 2010 USD) GDP per capita (Constant 2010 - USD)
Source: OIC, World Bank, EFG Hermes estimates Source: OIC, World Bank, EFG Hermes estimates
Improving domestic factors have supported consumer confidence
The structural growth story has been supported further by improving domestic and macro factors leading to much higher consumer confidence levels. Fatalities in terrorism-related violence have gone down 85% since its peak in 2009, while the China-Pakistan Economic Corridor has further reinforced the government’s resolve to maintain law and order. Political stability has also been a crucial factor, where the current PML-N government will only be the second democratic government in Pakistan to complete its five-year term – including the term of the previous Pakistan’s Peoples Party government; this has been the longest stretch in Pakistan’s history, where the democratic process has continued to hold up.
Figure 38: Fatalities in terrorist violence Figure 39: Consumer confidence and expected economic conditions Improving law and order conditions... …has continued to improve consumer confidence
Source: South Asia Intelligence Review Source: SBP, IBA
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Low inflation – putting more money in consumer pockets
Consumption growth in Pakistan has benefitted from record low inflation and a relatively stable exchange rate, allowing the State Bank of Pakistan to maintain an accommodative policy stance. The reverse-repo rate has been cut from its high of 15% in 2008 (where it had significantly crunched consumption expenditure) to 6.25% currently. Assuming all consumer financing was advanced at the average disbursement rate (based on total disbursements by the banks) for the relevant period, we estimate that debt servicing cost on stock of consumer financing has dropped from 0.42% of GDP to only 0.09% of GDP currently. This implies interest savings of approximately PKR119bn just on the stock of consumer financing, i.e., a 0.4% boost to overall consumer spending.
Figure 40: Lower inflation has allowed SBP to lower interest Figure 41: Lower interest rate has saved consumers rates significantly approximately PKR119bn estimated debt servicing cost on consumer finance (% of GDP) Accommodative monetary stance Estimated debt servicing cost on consumer finance (% of GDP)
Source: State Bank of Pakistan Source: EFG Hermes estimates
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Consumer demand is more sustainable than in 2006/07
Improving macro fundamentals have also led to banks opening the gates to consumer financing. While auto financing growth has been relatively robust, car manufacturers are in agreement that only 30% of vehicles sold in the country are financed through a bank relative to almost 70% during the heydays of 2006/07. Consequently, while the opening-up of consumer financing has indeed been a driver for auto vehicle demand growth, we believe sustainable demand drivers like demographics, increasing income levels, improving security conditions and a significant boost from the wealth effect (Pakistan stock market five-year annualized total return of 28%) have also played a key role in driving demand.
Figure 42: Banks have started to grow their auto financing Figure 43: Demand is less reliant on consumer financing in book this cycle Increasing consumer financing + lower lending rates % of cars being sold on auto loans
Source: State Bank of Pakistan Source: Company management comments
Cyclical sweet spot to remain in play over the medium term
One could argue that the current cyclical view is as good as it gets, as inflation bottoms and the next move in interest rates is likely to be up. Currently real interest rates are at 1.2%, relative to their long-term average of 1.9% (excluding the abnormally negative interest rates during 2008/09 due to high inflation). As per IMF, inflation is likely to remain stable at 5% over the next few years, which is unlikely to bring about a significant monetary tightening. Even if there are some moderate rate hikes, we believe there is a long-way to go before it starts crunching final demand (current rate is only 6.25% vs. 15% in 2008). Furthermore, comparing nominal interest rates to nominal GDP growth expectations also highlights that demand conditions should remain relatively buoyant, even if interest rates move up by 1ppt (driven by robust real GDP growth).
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Figure 44: Real interest rate still implies a relatively loose Figure 45: Robust real GDP growth is likely to support monetary policy demand growth, even if interest rates increase moderately Real Interest Rate Nominal GDP growth – nominal interest rate
Source: IMF, SBP, Bloomberg, EFG Hermes estimates Source: IMF, SBP, EFG Hermes estimates
Given a very positive structural and a relatively decent cyclical outlook, we believe automobile demand in Pakistan could continue to grow at around 2x GDP – in line with its long-term growth rate. The key risk to this thesis is a sharp depreciation in the PKR, which results in higher inflation, a more rapid increase in interest rates and ultimately, lower volumes and margins due to a high proportion of imported raw material in the cost base.
Figure 46: Long-term demand has grown at 2x real GDP Figure 47: Sales growth has been strong over time, albeit cyclical Long-term automobile demand growth in Pakistan Auto sales numbers (Passenger cars + LCV’s)
Source: PAMA (Cars, LCVs, Jeeps) - Adj. for Rozgar Scheme EFG Hermes Source: Company data, PAMA, EFG Hermes estimates estimates
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4. Profitability is not sustainable
Lack of competition and favourable FX dynamics have led to strong pricing power and super profitability
All three manufacturers have benefitted from a weaker JPY and declining steel prices between 2013 and 2016. Furthermore, we believe the lack of competition has allowed price/mix improvements to outpace raw material cost growth, leading to significant improvement in margins. Notably, the improvement in profitability across the sector has not been driven by positive operational gearing, but rather a factor of input price moderation.
Figure 48: Price increases have significantly outpaced raw Figure 49: …leading to record levels of profitability material cost increases… Price CAGR vs. cost CAGR (2013 – 2016) % Sector gross margin %
Source: Company data, EFG Hermes estimates Source: Company data, EFG Hermes estimates
These companies have invested very little in their businesses over time; yet, they earn margins at the higher end of global peers, resulting in a significantly high return on equity. PSMC’s profitability is on the lower end compared to peers due to lack of innovation, in our view, where limited model changes have eroded brand equity, along with aggressive competition from used imported cars.
Figure 50: INDU/HCAR are earning super profits; PSMC lags Figure 51: Profitability has been so high despite not investing due to lack of innovation in their businesses EBITDA Margin % Capex/Sales average (2010-16)
Source: Company data, Bloomberg, EFG Hermes estimates Source: Company data, Bloomberg, EFG Hermes estimates
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Steel prices have started to move higher, with spot price of CRC steel up 7% compared to TTM results reported by the companies; however, the JPY has remained relatively weak, which we believe will lend support to short-term profitability. Assuming this raw material trend continues, we believe the bigger threat to profitability will likely be driven by increasing competitive forces in the form of new entrants.
ADP to usher in new competition
We do not believe current profitability levels are sustainable over a five-year view. While it is difficult to make a call on FX movements and global steel prices, both of which have been significant profitability tailwinds, we believe increasing competition in itself should put a dampener on profitability. The new Automotive Development Policy 2016-21 (ADP), is a game changer for the industry, in our opinion. Historically, the industry has largely operated as an oligopoly, and the strong pricing that comes along with that has been one of the key drivers behind the recent surge in profitability. However, we believe super profits, along with a more incentivised policy environment for new entrants is likely to pave way for a more competitive market; thus, normalising profit margins on a five-year view. Incentives offered as part of the ADP are in the form of (quoted from the ADP document):
1. Greenfield investments: Installation of new and independent automotive assembly and manufacturing facilities by an investor for the production of vehicles not already being assembled/manufactured in Pakistan a. Duty-free import of plant and machinery for setting up the assembly and/or manufacturing facility on a one-time basis b. Import of 100 vehicle of the same variant in CBU form at 50% of the prevailing duty for test marketing after ground breaking of the project c. Concessional rate of custom duty @10% on non-localized parts and @25% on localised parts for a period of five years for manufacturing of cars and LCVs d. Import of all parts (both localised and non-localised) at prevailing customs duty applicable to non-localised parts for the manufacturing of trucks, buses and prime-movers for a period of three years
2. Brownfield investment: Revival of an existing assembly and/or manufacturing facilities, that have been non-operational or that closed on or before 1 July 2013 and the make is not in production in Pakistan since that date and that the revival is undertaken either independently by original owners or new investors or under joint-venture agreement with foreign principal or by foreign principal independently through purchase of plant a. Import of non-localized parts @10% rate of customs duty and localised parts at 25% duty for a period of three years for the manufacturing of cars and LCVs b. Import of all parts (both localised and non-localised) at prevailing customs duty applicable to non-localised parts for the manufacturing of trucks, buses and prime-movers for a period of three years
We believe these incentives are material, especially if we put them in context of local manufacturers importing an estimated 55-60% of their raw materials. Thus, new entrants are likely to have a significant procurement competitive advantage for a period of five years. Based on already announced plans: i) Kia, Hyundai and Renault are looking to start manufacturing domestically; ii) Dewan Farooque Motors is likely to bring online its idle capacity; iii) Sazgar Engineering has also announced plans to start manufacturing passenger cars; and iv) INDU is increasing capacity by 10k units per annum, while PSMC also has room to de-bottleneck their paint-shop, in our view. If all these investments go ahead, we estimate that industry capacity utilisation could drop from 83% currently to 65-70% by 2021, even if demand conditions remain robust.
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Figure 52: Profit margin is at record high Figure 53: High profitability is attracting new entrants Sector EBITDA margin (%) Sector return on equity (%)
Source: Company data, EFG Hermes estimates Source: Company data, EFG Hermes estimates
Given this backdrop, a number of new entrants have announced intentions to set up or re-start previously mothballed manufacturing/assembly plants.
Ghandhara Nissan has forged an agreement with Renault to start producing 6,000 vehicles by 2018 with intentions to ramp that up to 16,000 initially, and then 50,000 units per annum
Dewan Farooque has indicated intentions to start manufacturing commercial vehicles in a partnership with Kolao group
Lucky Cement has forged a partnership with KIA Motors to start domestic production (capacity undisclosed)
Nishat Group has forged a partnership with Hyundai to start domestic production (capacity undisclosed)
Sazgar Engineering Works has announced its intention to start domestic passenger car production
In addition to these, INDU is in the process of increasing capacity by c10k units per annum through de- bottlenecking, while PSMC has highlighted plans to invest up to USD460mn to set up a new manufacturing plant if government offers a more even playing field between new entrants and existing incumbents (provide PSMC the same benefits they are providing the new entrants). PSMC also has the potential to further de-bottleneck their paint shop, which we estimate could potentially increase capacity by 50%. Assuming all these investments were to go through (except for the USD460mn new plant for PSMC – which, in our view, is not likely unless there is policy change), we estimate that capacity utilisation for the industry could potentially drop down to 65-70% by 2021.
Figure 54: Capacity utilisation could drop to 66%, if all Figure 55: Capacity expansion plans are vague at this point in planned investments go ahead time Estimated capacity utilisation in 2021 (%) Potential capacity additions Current operational capacity 254,800 Ghandhara/Renault - phase 1 16,000 Ghandhara/Renault - phase 2 34,000 Dewan Farooque Motors 20,000 Lucky/KIA (est.) 25,000 Nishat/Hyundai (est.) 25,000 Sazgar Engineering (est.) 20,000 Toyota additional capacity 10,200 PSMC additional capacity (est.) 75,000 2021 capacity 480,000 Source: Company data, EFG Hermes estimates Source: Company data, EFG Hermes estimates
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How meaningful are the incentives provided to new entrants?
Using PSMC as a base, and using the following assumptions:
(1) All related party purchases by PSMC are imported and incur a non-localised CKD import customs duty of 30% (2) The same purchases had instead incurred customs duty of 10% as per the incentive provided to new entrants (3) Assume the new entrants have lower localisation; hence, imported proportion of raw material is higher
All else held equal, this implies that EBITDA margin for the new entrant could be as high as 11% compared to FY16 PSMC EBITDA margin of 6%. New entrants could undercut PSMC pricing by 5% and still earn a similar EBITDA margin. While this is a very simplistic illustration, we believe it highlights the profitability pressure the industry might face if competitive forces do evolve significantly.
To conclude our sector outlook, we believe profitability will undoubtedly be under pressure over the medium term, with risks to the downside, if there is material PKR depreciation. Given this backdrop, we reaffirm our view of sticking with the high quality franchise that INDU offers, while growth prospects are slower than peers, we believe valuations more than compensate.
Figure 56: Forecast overview In PKRmn, unless otherwise stated FY13 FY14 FY15 FY16 FY17* FY18e FY19e FY20e FY21e
Revenue
PSMC 51,061 53,665 84,549 76,516 95,369 112,034 126,820 138,120 150,427 INDU 63,829 57,064 96,516 108,759 118,210 132,881 152,474 170,754 188,882 HCAR 30,275 39,153 37,764 40,086 62,803 89,765 104,836 115,710 124,339
Gross profit
PSMC 3,243 4,184 11,487 7,349 10,136 11,096 11,999 13,053 14,120 INDU 5,857 5,794 14,244 17,731 21,378 22,011 23,728 24,767 25,348 HCAR 1,447 2,857 4,773 6,047 9,122 11,628 13,423 14,423 14,974
EBITDA
PSMC 2,607 3,454 9,414 4,813 7,362 7,958 8,220 8,758 9,329 INDU 5,658 5,261 13,994 17,305 20,733 21,059 22,462 23,245 23,572 HCAR 1,626 2,916 4,722 5,841 8,639 11,058 12,692 13,559 13,993
EBITDA margin (%)
PSMC 5 6 11 6 8 7 6 6 6 INDU 9 9 14 16 18 16 15 14 12 HCAR 5 7 13 15 14 12 12 12 11
EPS (PKR)
PSMC 20 23 71 34 50 53 58 66 74 INDU 40 46 115 144 183 184 198 211 220 HCAR 3 8 23 25 41 54 62 67 70
P/E (x)
PSMC - - - - 13.4 12.6 11.5 10.1 9.0 INDU - - - - 9.5 9.4 8.8 8.2 7.9 HCAR - - - - 16.3 12.5 10.8 10.0 9.6
*FY17 is actual for HCAR and forecasted for PSMC and INDU Source: Company data, EFG Hermes estimates
Page 28 of 89 Page 28 of 89 25 July 2017
Indus Motor Company Stock Rating Buy Quality all around Target Price PKR2,104
Closing Price Initiation of Coverage
Rating: Buy Target Price PKR1,737 Automobiles. Pakistan PKR2103.71
Buy INDU on quality, undemanding valuations and future expansion optionality We initiate coverage on INDU, the sole distributor, assembler and marketer of Toyota and Daihatsu vehicles in Pakistan with a Buy rating (TP of PKR2,104, implying 28% upside). At its current price, INDU trades at a forward P/E of 9.5x, an 18% discount to peers (CY17e), while offering a sector leading DY of 7.1%. In our opinion, it enjoys the highest brand equity in the sector, based on a track record of product durability, reliability and, in turn, better resale value. This brand equity has translated into lower cyclicality than peers and superior cash flow generation, which we believe is overlooked by the market. The strong cash flows and balance sheet provide for future capex optionality, which is unique compared to peers. Furthermore, a potential Toyota Corolla face up-lift could keep investor interest elevated in the stock. Our TP is derived from our DCF valuation, a CoE of 16.0% and 6% terminal growth rate. When the going gets tough – the tough get tougher Competitive forces are set to increase in Pakistan as new entrants gain traction. Brand equity, strong management and ability to reinvest in the business will be key to sustainable returns - we believe INDU shines bright on all these metrics. Admittedly, organic growth prospects are lower than peers, based on available capacity, but we believe the market is ignoring INDU’s best in class balance sheet, which provides an invaluable optionality to fund future investments. INDU’s ability to convert 1.1x of net income to FCF since FY06 has ensured healthy dividend payouts, while still positioning it for sustainable LT growth. Its proven business franchise has shown that while INDU is not immune to PKR depreciation, it has performed better than peers in such periods. Buying quality at a significant bargain – 9.5x FY17e P/E and 7.1% dividend yield At an 18% PE discount to peers and given its better quality, this more than makes up for INDU’s lower growth prospects, in our view. Furthermore, consensus numbers will likely revise higher by 8-4% for FY17/FY18, respectively, due to ST margin uplift from the change in business mix (higher spare part sales and launch of Toyota Fortuner SUV), while the JPY has remained weak for most of INDU’s FY17 year-end. Key risk to our thesis are production disruptions, continued slippage in the PKR and new competitors targeting INDU’s pricing points specifically.
Key Financial Highlights (Jun Year End) Stock Data Closing Price PKR1737 as of 20 Jul 2017 H2,BH1,BWH1,CBH9In PKRmn, unless otherwise stated 2016a 2017e 2018e 2019e Last Div. / Ex. Date PKR30.0 / 10 Mar 2017 Revenue 108,759 118,210 132,881 152,474 Mkt. Cap / Shares (mn) PKR136,508 / 78.6 Av. Daily Liquidity (mn) PKR98.55 EBITDA 16,670 20,196 20,678 22,211 52-Week High / Low PKR2040 / PKR1122 Net income 11,302 14,388 14,464 15,585 Bloomberg / Reuters INDU PA / INDM.KA EPS (PKR) 144 183 184 198 Est. Free Float 20.7% EPS consensus (PKR) 144 170 177 187 Price to earnings 12.1x 9.5x 9.4x 8.8x Dividend yield 5.8% 7.1% 7.3% 7.8% Net debt (cash) / Equity (1.5)x (1.3)x (1.3)x (1.3)x EV / EBITDA 5.6x 4.6x 4.5x 4.2x ROAE 43.8% 46.7% 39.8% 37.5% F ahad S haikh, CF A H2,BH1,BWH1,CBH9FCF yield 8.9% 7.8% 10.9% 11.8% fshaikh@ efg-hermes.com Source: Indus Motor Company, Bloomberg and EFG Hermes estimates
Disclosure Appendix at the back of this report contains important disclosures, analyst certifications Page 29 of 89 and the status of non-US analysts
Indus Motor Company 25 July 2017 Automobiles. Pakistan
Data Miner
Investment Thesis Valuation and Risks We initiate coverage on INDU, the sole distributor, assembler Our TP estimate for INDU is PKR2,104 which values the company and marketer of Toyota and Daihatsu vehicles in Pakistan with a at a FY18e P/E of 11.4x. We derive this estimate based on our Buy rating (TP of PKR2,104, valuing the company at 11.4x FY18e DCF valuation which values the operating cash flows (excluding P/E). In our opinion, the company enjoys the highest brand interest income) and then adds the TTM net cash position to that equity within the sector, based on a track record of product valuation. The cost of equity used in our model is 16% while we durability, reliability, and, in turn, better resale value. This brand use a 6% terminal growth rate. Key downside risk is 1) a sharp equity has translated into lower cyclicality than peers and depreciation in the PKR relative to the JPY which would result in superior cash flow generation, which we believe is overlooked by significant margin contraction, 2) the new entrants being more the market. The strong cash flows and balance sheet provide for aggressive than expected within INDU’s pricing range and 3) future capex optionality, which is unique compared to peers. company undertaking a significant expansion project which Furthermore, a potential Toyota Corolla face up-lift could keep impacts production activity during the construction phase and investor interest elevated in the stock impacts FCF negatively.
Jun Year End Jun Year End
In PKRmn, unless otherwise stated 2016a 2017e 2018e 2019e In PKRmn, unless otherwise stated 2016a 2017e 2018e 2019e
Income Statement Per Share Financial Summary Revenue 108,759 118,210 132,881 152,474 EPS (PKR) 144 183 184 198 EBITDA 16,670 20,196 20,678 22,211 DPS (PKR) 100 124 126 136 Net operating profit (EBIT) 15,740 19,156 19,540 20,978 BVPS (PKR) 352 432 492 564 Taxes or zakat (5,943) (6,368) (6,806) (7,676) Valuation Metrics Minority interest 0 0 0 0 Price to earnings 12.1x 9.5x 9.4x 8.8x Net income 11,302 14,388 14,464 15,585 Price to book value 4.9x 4.0x 3.5x 3.1x Balance Sheet Price to cash flow 10.2x 10.9x 8.4x 7.8x Cash and cash equivalents 36,434 39,270 44,421 50,547 FCF yield 8.9% 7.8% 10.9% 11.8% Total assets 57,537 66,090 73,250 82,116 Dividend yield 5.8% 7.1% 7.3% 7.8% Total liabilities 29,907 32,147 34,568 37,775 EV / EBITDA 5.6x 4.6x 4.5x 4.2x Total equity 27,630 33,942 38,681 44,342 EV / Invested capital N/M N/M N/M N/M Total net debt (cash) (41,440) (44,276) (49,426) (55,553) ROAIC 61.7% 61.1% 57.4% 61.9% Cash Flow Statement ROAE 43.8% 46.7% 39.8% 37.5% Cash operating profit after taxes 11,846 15,751 15,983 17,069 KPIs Change in working capital 1,541 (3,282) 222 354 Revenue growth (Y-o-Y) 12.7% 8.7% 12.4% 14.7% CAPEX (1,292) (1,773) (1,329) (1,372) EBITDA growth (Y-o-Y) 25.8% 21.1% 2.4% 7.4% Investments 0 0 0 0 Gross profit margin 16.3% 18.1% 16.6% 15.6% Free cash flow 12,095 10,695 14,876 16,051 EBITDA margin 15.3% 17.1% 15.6% 14.6% Net financing (7,895) (7,860) (9,725) (9,925) Net operating profit (EBIT) margin 14.5% 16.2% 14.7% 13.8% Change in cash 5,015 2,835 5,151 6,126 Effective tax rate 34.2% 31.0% 32.0% 33.0% Source: Indus Motor Company, EFG Hermes estimates Net Debt (Cash) / Equity (1.5)x (1.3)x (1.3)x (1.3)x
Net Debt (Cash) / EBITDA (2.5)x (2.2)x (2.4)x (2.5)x Source: Indus Motor Company, EFG Hermes estimates
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Indus Motor Company 25 July 2017 Automobiles. Pakistan
Indus Motor Company (INDU) – The unappreciated cash machine
Investment thesis
Attractive valuation in an otherwise overvalued sector
At the current price, INDU is trading at a FY17e P/E of 9.5x, while offering a sector leading dividend yield of 7.1%. While organic EPS growth of 8% is likely to underperform sector growth of 15% (based on pro- forma calendar years CY16-19e), we believe this is more than offset by the stock trading at an 18% discounted P/E relative to peers (CY17e – calendarised based on respective year ends of each company), while being the best cash converter in the sector, in our view.
Figure 57: Estimated forward P/E (x) Figure 58: Estimated dividend yield (%) (based on respective year ends)
Source: Company data, EFG Hermes estimates Source: Company data, EFG Hermes estimates
Superior brand equity has translated into better profitability and cash flows
We believe the market overlooks the quality in INDU’s operating performance. As shown below, INDU’s profitability has been less cyclical than peers, and its earnings have also been consistently backed by strong cash flows. The higher dividend payout ratio by INDU also crystalises value, in our view. In our opinion, this quality should bode well for through-the-cycle rating of the stock and provide the optionality to fund capital expenditure to increase production capacity if need be (not factored in our estimates). We believe INDU’s financial performance is proof of its strong brand equity within the country.
Figure 59: EBITDA margin (%) Figure 60: Cumulative income, CFO and FCF (PKRmn) INDU has consistently delivered better profitability than peers INDU’s earnings have been consistently backed by strong cash flows
Source: Company data, EFG Hermes estimates Source: Company data, EFG Hermes estimates
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Indus Motor Company 25 July 2017 Automobiles. Pakistan
Recent improvements in profitability is less cyclical than peers
Profitability improvement between FY13-16 has been driven by input price moderation, while price/mix gains have outpaced. However, INDU also stands out as being more efficient, with cost per unit (excluding raw material costs) declining at a CAGR of 1% over this period (HCAR: +1%, PSMC +7%). Over the short term, PKR depreciation against the USD and a move up in CRC steel price will likely have some impact on profitability, which we have accounted for (FY19e EBITDA margin of 15.8%, down 1.7ppts Y-o-Y) – however we believe the bigger driver of margins over the longer term will be increasing competition. We expect margins to moderate to 12% over the forecast horizon, which is a key driver of our weak growth forecast.
Figure 61: CAGR 2013-16 (%) Figure 62: Spot vs. FY17YTD average (%) Moderate price/mix gains, but have still outpaced RM trends Input prices have started to move higher
Source: Company data, EFG Hermes estimates Source: Bloomberg, EFG Hermes estimates
Capacity constraints will result in earnings underperforming peers…
INDU is currently operating at 113% capacity utilisation on a double-shift basis. However, post investment in its paint-shop, name-plate capacity will increase by around 10k units to 65,000 units per annum by early 2018. Assuming demand conditions stay robust, INDU can likely continue working above nameplate capacity to produce between 73-75k units per annum. While this gives them some breathing room, we believe lower available capacity and starting off at relatively high margins will likely result in earnings underperformance, relative to peers. We expect EPS CAGR of 9% between FY16-21e.
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Indus Motor Company 25 July 2017 Automobiles. Pakistan
Figure 63: INDU capacity utilisation
Source: Company data, EFG Hermes estimates, capacity utilisation drops while volume increase due to paint-shop expansion
…however undemanding valuations and strong cash flows compensate
INDU has re-rated higher relative to history, driven by strong profit performance. However, on a relative basis, the stock still trades at a discount compared to peers. While FY16-21e EPS CAGR of 9% is lower than peers, we believe a 7.1% forward DY compensates, in terms of estimated total rate of return and a forward P/E of 9.5x presents limited de-rating risk. Based on current share price, we estimate an upside of 28%. Furthermore, INDU’s ability to consistently generate strong cash flows puts it in a strong position to fund future capital expenditure to increase capacity if the need arises – an optionality which is not built into the current share price, in our view and differentiates INDU from peers within the sector. In addition to the long-term positives, we believe INDU might get a volume catalyst in the form of a new Toyota Corolla model facelift.
Figure 64: INDU P/E relative to history (x) Figure 65: INDU P/E relative to sector (x) (MW average)
Source: Company data, EFG Hermes estimates Source: Company data, EFG Hermes estimates
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Indus Motor Company 25 July 2017 Automobiles. Pakistan
Valuation
INDU has justifiably re-rated higher, relative to history, based on a high quality track record and robust profitability growth, which has been driven by both structural and cyclical tailwinds. While profit growth is likely to slow down due to capacity constraints and margin normalisation, we believe INDU’s entrenched brand equity and superior cash flow generation allow optionality to fund future capacity expansions if the need arises, while valuations are undemanding, relative to the market and to peers.
Figure 66: EV/EBITDA relative to history (x) Figure 67: TTM dividend yield relative to history (%)
Source: Company data, EFG Hermes estimates Source: Company data, EFG Hermes estimates
We have valued INDU using a DCF-based model, cost of equity of 16% and a terminal growth rate of 6%, which results in a TP of PKR2,104. We value the operating business based on FCFE (less interest income) and then account for the cash balances by adding the TTM net cash position to our operating business valuation. NWC in FY17e is affected negatively by 100% margin requirement on imports, while we normalise customer advances cycle to get to a normalised terminal value
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Indus Motor Company 25 July 2017 Automobiles. Pakistan
Figure 68: INDU valuation In PKRmn, unless otherwise stated 2016 2017e 2018e 2019e 2020e 2021e
Net income 11,455 14,173 14,464 15,585 16,558 17,274 Add: depreciation 1,565 1,578 1,519 1,484 1,497 1,522 Capex (1,292) (1,773) (1,329) (1,372) (1,537) (1,605) NWC changes 1,541 (3,282) 222 354 (330) (57) Changes in debt ------FCFE 13,270 10,695 14,876 16,051 16,188 17,134 Less: interest income (1-t) 1,652 1,903 2,209 2,614 3,099 3,613 Operating FCFE 11,618 8,793 12,667 13,437 13,089 13,521
Risk-free rate (%) 11%
Risk premium (%) 5%
Terminal growth rate (%) 6%
Beta (x) 1.0
Cost of equity % 16.0%
NPV of five-year FCFE 49,053
NPV of terminal value 73,466
TTM net cash 42,833
Value of equity 165,351
Per share value 2,104
Source: Company data, EFG Hermes estimates
Figure 69: Sensitivity to growth rate and COE In PKRmn, unless otherwise stated Cost of equity %
15.0% 15.5% 16.0% 16.5% 17.0%
5.0% 161,269 159,638 158,043 156,483 154,957 5.5% 164,888 163,186 161,523 159,897 158,306 rate % growth
Terminal 6.0% 168,868 167,090 165,351 163,651 161,989 6.5% 173,268 171,405 169,583 167,802 166,060 7.0% 178,156 176,198 174,284 172,413 170,583
Source: Company data, EFG Hermes estimates
Figure 70: Target price per share – Sensitivity In PKRmn, unless otherwise stated Cost of equity %
15.0% 15.5% 16.0% 16.5% 17.0%
5.0% 2,100 2,031 2,011 1,991 1,971 5.5% 2,098 2,076 2,055 2,034 2,014 rate % growth
Terminal 6.0% 2,148 2,126 2,104 2,082 2,061 6.5% 2,204 2,181 2,158 2,135 2,113 7.0% 2,267 2,242 2,217 2,194 2,170
Source: Company data, EFG Hermes estimates
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Indus Motor Company 25 July 2017 Automobiles. Pakistan
Peer valuations
We believe the table below highlights INDU’s attractive valuations, relative to domestic peers, where the stock trades at an 18% discount on CY17e PE. Please note that P/E + 1 and P/E + 2 are calculated based on calendarised EPS on a pro-rata basis to allow for a comparison between the three companies under our coverage. Relative to global peers, INDU trades at a 12% lower P/E + 1, but the starker differentiation is in terms of its strong balance sheet, which provides better LT growth optionality.
Figure 71: Peer valuations Mcap Price P/E + P/E + EV/ EV/ Net Debt/ EPS CAGR ROE EBITDA P/E (x) DY (%) (USDmn) (LC) 1 (x) 2 (x) EBITDA (x) Sales (x) EBITDA (x) (3Y) (%) (%) (%) Pak Suzuki Motor Company 522 667 17.6 13.4 12.6 0.8 7.8 0.5 (2.4) 19.7 12 6.7 Indus Motor Company 1,297 1,737 10.6 9.5 9.1 6.9 4.8 0.8 (2.2) 7.8 44 17.1 Honda Atlas Cars 910 671 16.3 13.2 11.1 1.9 7.6 1.0 (3.5) 21.2 56 13.8 Pakistan autos average 910 N/A 13.9 11.5 10.4 4.1 6.3 0.8 (2.7) 14.5 37 14.0
Ford Otomotiv Sanayi As 4,476 45 15.4 14.6 12.8 5.1 8.1 0.9 1.1 13 35 8 Tofas Turk Otomobil 4,300 30 15.3 13.2 11.9 2.3 11.0 1.1 1.9 11 38 9 Gb Auto 128 2 11.6 93.0 9.9 - 7.1 0.6 5.7 37 8 9 Maruti Suzuki India Ltd 35,261 7,517 30.2 27.6 23.3 1.0 17.6 3.4 (0.2) 22 23 15 Tata Motors Ltd 22,737 459 20.9 11.9 8.7 N/A 5.6 0.6 0.8 53 11 12 Mahindra & Mahindra Ltd 13,406 1,390 20.3 17.6 14.5 0.9 30.2 1.7 8.8 28 13 5 Dongfeng Motor Grp Co Ltd 10,759 10 5.4 5.6 5.4 2.7 16.2 0.6 (0.4) 2 15 3 Volkswagen Ag-Pref 83,713 144 11.7 6.0 5.7 1.4 1.0 0.2 (0.9) 5 7 17 Suzuki Motor Corp 23,313 5,324 14.7 13.8 12.7 0.8 4.5 0.8 (0.9) 8 15 14 Toyota Motor Corp 178,966 6,150 10.2 10.3 9.7 N/A 8.9 1.3 3.7 4 11 13 Honda Motor Co Ltd 50,063 3,099 9.1 9.3 8.5 3.1 7.8 0.8 3.7 5 9 11 Geely Automobile Holdings 21,150 18 27.6 17.2 13.3 0.7 6.3 2.4 (1.8) 39 23 13 Saic Motor Corp Ltd-A 54,667 32 10.9 10.1 9.2 5.2 12.5 0.6 0.8 7 16 3 Kia Motors Corp 13,130 36,450 5.7 6.4 5.4 3.0 3.6 0.3 (0.2) 1 10 8 Hyundai Motor Co 28,970 148,000 7.9 7.2 6.4 2.7 9.2 0.8 5.1 8 6 9 Nissan Motor Co Ltd 42,911 1,140 6.8 7.4 7.1 N/A 1.8 0.3 (1.0) 5 14 14 Peer average 36,747 12.5 10.8 9.6 1.4 8.2 1.0 1.7 9.6 12.3 12.0
Source: Company data, EFG Hermes estimates, Bloomberg; averages are market-cap weighted
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Indus Motor Company 25 July 2017 Automobiles. Pakistan
Risks to thesis
Profitability deteriorates quicker than we anticipate
INDU’s EBITDA margin of 17% is significantly higher than its historic average of 10% and sector average of 13%. In our base case, we expect EBITDA margin to moderate to 12% over our forecast horizon as competitive forces increase. That said, the entire sector is at the mercy of FX movement, where we estimate that 50-60% of raw material costs are imported (purchased from related parties). On that basis, we estimate that a 5% depreciation of the PKR against the JPY affects profitability negatively by c12% (based on FY16 numbers), all else held equal, and assuming the parent company shares none of the pain. Historically, INDU has highlighted lower cyclicality than peers, in terms of profitability – thus, even in a sharp PKR depreciation scenario, INDU’s profitability should hold up better than peers.
Capacity enhancements could disrupt production or lead to higher-than-expected capex
INDU is currently in the process of de-bottlenecking their paint-shop to increase capacity by 10k units per annum at a cost of ~PKR4bn (expected to be operational early 2018). We believe key downside risks could be potential production disruptions as they bring the increased capacity online or higher-than-expected capital expenditure, if they decide to undertake a further major capacity expansion. For now, we believe INDU’s superior cash generation provides sufficient cover to fund future capital expenditure.
Change in import regulations
Current regulations allow the import of used cars with an age limit of three years. While the most recently- announced auto sector policy has indicated that this age limit will stay in place, we believe any relaxation on this policy could lead to volume growth underperforming our expectations.
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Indus Motor Company 25 July 2017 Automobiles. Pakistan
New auto policy to usher in new competition
The new Automotive Development Policy 2016-21 (ADP), is a game changer for the industry, in our opinion. Historically, the industry has largely operated as an oligopoly and the strong pricing that comes along with that has been one of the key drivers behind the recent surge in profitability. However, we believe super profits, along with a more incentivised policy environment for new entrants, are likely to pave way for a more competitive market thus normalising profit margins on a five year view. Incentives offered as part of the ADP are in the form of (quoted from the ADP document):
3. Greenfield investments: Installation of new and independent automotive assembly and manufacturing facilities by an investor for the production of vehicles of a make not already being assembled/manufactured in Pakistan a. Duty-free import of plant and machinery for setting up the assembly and/or manufacturing facility on a one-time basis b. Import of 100 vehicle of the same variant in CBU form at 50% of the prevailing duty for test marketing after ground breaking of the project c. Concessional rate of custom duty @10% on non-localised parts and @25% on localized parts for a period of five years for manufacturing of cars and LCVs d. Import of all parts (both localised and non-localised) at prevailing customs duty applicable to non-localized parts for manufacturing of trucks, buses and prime-movers for a period of three years
4. Brownfield investment: Revival of an existing assembly and/or manufacturing facilities, that is non-operational or close on or before 1 July 2013 and the make is not in production in Pakistan since that date and that the revival is undertaken either independently by original owners or new investors or under joint-venture agreement with foreign principal or by foreign principal independently through purchase of plant a. Import of non-localised parts @10% rate of customers duty and localised parts at 25% duty for a period of three years for the manufacturing of cars and LCVs b. Import of all parts (both localised and non-localised) at prevailing customs duty applicable to non-localised parts for manufacturing of trucks, buses and prime-movers for a period of three years
We believe these incentives are material, especially if we put them in context of local manufacturers importing an estimated 55-60% of their raw materials. Thus, new entrants are likely to have a significant procurement competitive advantage for a period of five years. Based on already announced plans: i) Kia, Hyundai and Renault are looking to start manufacturing domestically; ii) Dewan Farooque Motors is likely to bring online its idle capacity; iii) Sazgar Engineering has also announced plans to start manufacturing passenger cars; and iv) INDU is increasing capacity by 10k units per annum, while PSMC also has room to de-bottleneck their paint-shop, in our view. If all these investments go ahead, we estimate that industry capacity utilisation could drop from 83% currently to 65-70% by 2021, even if demand conditions remain robust.
In an environment where competitive forces are likely going to increase, while the sector is trading at a premium, relative to history and to the market, we believe buying high quality at a reasonable valuation is likely to provide the best total return. Furthermore, the company also provides future expansion optionality due to its strong balance sheet and cash flows, which is not reflected in the current price – this is the key premise for our buy call on INDU.
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Indus Motor Company 25 July 2017 Automobiles. Pakistan
INDU: Strong franchise reflected in its financials
INDU has developed strong brand equity over time, positioning the Toyota brand to stand for reliability, durability and consequently better resale value, in our view. This brand positioning is very important in Pakistan’s context, where road infrastructure is relatively poor; thus, making Toyota very popular, not just in the cities, but also in rural areas. We believe strong brand equity is reflected in INDU’s financial performance, where they have exhibited the highest volume growth over the long term, while also maintaining superior margins, relative to peers, through the business cycle.
Figure 72: Volume CAGR (2002 – YTD) Figure 73: EBITDA margin (%) INDU has outperformed industry growth over the long term INDU: Superior profitability throughout the cycle
Source: PAMA, EFG Hermes estimates Source: Company data, EFG Hermes estimates
When the going gets tough – the tough get going: Historical analysis also highlights INDU’s ability to manage their business through tough economic conditions. During the FY08-09 crisis, INDU’s profitability and cash flows held up much better than peers. We believe the market underappreciates the lower cyclicality in INDU’s business model.
Figure 74: FCF generation In PKRmn, unless otherwise stated FCF FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16 TTM
PSMC (1,232) (2,730) (2,719) 1,128 (587) (1,736) 442 752 204 13,575 (5,228) 2,088 INDU 1,556 2,065 (3,225) 5,900 7,174 (1,160) 416 (363) 1,432 29,731 12,095 11,335 HCAR (7,574) (1,380) 1,340 (3,363) 2,213 1,453 (120) 4,111 (1,630) 1,430 4,461 24,192
Source: Company data, EFG Hermes estimates
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Indus Motor Company 25 July 2017 Automobiles. Pakistan
Figure 75: EBITDA In PKRmn, unless otherwise stated EBITDA FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17
PSMC 5,661 5,018 819 829 1,335 1,905 2,135 2,607 3,454 9,414 4,813 5,358 INDU 3,904 4,052 3,540 2,290 4,870 3,899 6,402 5,658 5,261 13,994 17,305 19,412 HCAR 1,039 307 773 408 327 581 337 1,626 2,916 4,722 5,841 8,639
Source: Company data, EFG Hermes estimates
We believe INDU’s strong brand franchise has brought about high quality growth. The company has been incredibly efficient in managing its inventory, while continued consumer interest has allowed INDU to manage cash flows better than peers through advance bookings. Earnings have consistently been backed by cash flows. We believe it is on the back of its superior cash flow generation that INDU has paid out 54% of its earnings in dividends (since FY06) relative to <20% payouts for peers in the sector.
Figure 76: Inventory turnover (x) Figure 77: Earnings relative to cash flows (PKRmn) INDU: Superior inventory management Robust cash generation
Source: Company data, EFG Hermes estimates Source: Company data, EFG Hermes estimates
INDU’s ROE has significantly outperformed its COE over the long term, highlighting significant value add. Profit margin improvement has been the key driver behind the recent surge in return on equity.
Figure 78: ROE breakdown (%)
2010 2011 2012 2013 2014 2015 2016
Tax burden (%) 66 68 68 68 77 64 66 Interest burden (%) 131 130 117 107 107 112 109 EBIT margin (%) 7 5 7 7 8 13 14 Asset turnover (x) 2.5 2.3 2.8 2.4 2.2 2.5 2.0 Leverage ratio (%) 209 202 175 152 136 174 209 Adjusted ROE (%) 30 20 26 18 19 41 44
Source: Company data, EFG Hermes estimates
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Indus Motor Company 25 July 2017 Automobiles. Pakistan
High quality and undemanding valuations
We believe the market is overlooking INDU’s strong brand entrenchment due to capacity constraints. While we agree that earnings growth is likely to be slower than peers (assuming demand conditions remain robust), we believe INDU’s higher quality franchise, lower cyclicality in earnings, superior cash flow generation and undemanding valuations are being overlooked. Furthermore, we do not believe current valuations are pricing in the optionality of future capacity additions, given INDU’s strong balance sheet and cash flow generation.
Figure 79: Valuations relative to peers Forward P/E (x) Dividend yield (%)
TTM EV/EBITDA (x) INDU: P/E relative to the sector (x)
Please note that EV/EBITDA is not a very reliable indicator for the sector since it includes cash from advance bookings which have not yet converted to unencumbered cash thus understating EV Source: Company data, EFG Hermes estimates
Given attractive valuations, INDU is well-positioned to provide an ETR of 28% to our DCF-based TP of PKR2,104, in our view. Important to note is that 7.1% of that return is coming through a relatively sustainable dividend yield, given robust cash flows and a strong balance sheet. We believe that, given current ratings present limited risk of de-rating, which differentiates INDU from peers within the sector.
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Indus Motor Company 25 July 2017 Automobiles. Pakistan
Business overview
The Indus Motor Company was incorporated in 1989 as a joint venture between the House of Habib of Pakistan, Toyota Motor Corporation and Toyota Tsusho Corporation of Japan. The company manufactures and markets Toyota brand vehicles in Pakistan with their Toyota Corolla brand being the highest selling car in the country. The company also has a presence in the Light Commercial Vehicle (LCV) segment with the “Toyota Hilux” and in the SUV segment with “Toyota Fortuner”. The manufacturing facility is located in Karachi with a design capacity of 54,800 units per annum on a double-shift basis and the business is supported by 43 independent dealerships across the country.
Figure 80: Market share % (Cars, Jeeps and LCV’s) Figure 81: Market share (1300cc and above market segment)
Source: Company data, PAMA, EFG Hermes estimates Source: Company data, PAMA, EFG Hermes estimates
The company has a 28% market share of the overall domestically manufactured car, LCV and jeep market in Pakistan, but has a much more dominant market position within the 1300cc and above market segment, where they have a 56% market share (Toyota Corolla). Within the LCV segment, the Toyota Hilux commands a 25% market share, while the Toyota Fortuner controls almost 100% of the locally manufactured jeep market (Honda BRV is the new entrant in that segment, albeit at a much lower price point). The key brand image that INDU has built over time has been that of reliability and durability, which has made their flagship Toyota Corolla a booming success for Pakistan’s relatively poor road infrastructure.
From a product mix perspective, Corolla accounts for 88% of total volumes sold over a TTM basis, with Hilux contributing 10%, while Toyota Fortuner is a relatively small part of the overall product mix, albeit gaining traction since the recently-launched new model – during 3QFY17, Fortuner doubled its share in the product mix to 4%.
Figure 82: Unit sales breakdown Figure 83: Sales mix (%)
Unit sales 2012 2013 2014 2015 2016 TTM Sales mix 2012 2013 2014 2015 2016 TTM
Toyota Corolla 46,207 32,608 29,087 51,398 57,452 54,802 Toyota Corolla 85 86 86 90 90 88 Toyota Hilux 4,413 4,282 4,520 4,823 5,923 6,430 Toyota Hilux 8 11 13 8 9 10 Toyota Fortuner - 812 390 722 602 985 Toyota Fortuner - 2 1 1 1 2 Daihatsu Cuore 3,857 71 - - - - Daihatsu Cuore 7 0 - - - - Total 54,477 37,773 33,997 56,943 63,977 62,217 Total 100 100 100 100 100 100
Source: Company data, EFG Hermes estimates Source: Company data, EFG Hermes estimates
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Indus Motor Company 25 July 2017 Automobiles. Pakistan
All three manufacturers also operate a trading business, where they import new Completely Built Units (CBU’s) to sell into the local market. In INDU’s case, in addition to their manufactured product, they also import and sell Toyota Prius, Land Cruiser, Hiace and Avanza, while also providing spare parts and trading in used Toyota cars through “Toyota Sure”. This business makes a relatively small contribution to overall group revenue (5% of TTM revenue), but makes up 11% of operating profit due to a much higher profit margin.
Figure 84: INDU – Revenue split (%) Figure 85: INDU – Operating profit mix (%)
Source: Company data, EFG Hermes estimates Source: Company data, EFG Hermes estimates
As per management comments, the shift in business mix towards part sales has also had a beneficial impact on profitability within the trading business. From a group perspective, we estimate that margin improvement within the trading business has added 1ppt to group EBITDA margin between FY13 and FY16. The majority of the profitability improvement is still explained by the significant uptick in the manufacturing division’s margins.
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Indus Motor Company 25 July 2017 Automobiles. Pakistan
Figure 86: Divisional profitability In PKRmn, unless otherwise stated 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Revenue 27,601 35,237 39,061 41,424 37,865 60,093 61,703 76,963 63,829 57,064 96,516 108,759 Manufacturing 25,043 31,337 34,047 34,180 33,573 54,805 57,293 72,948 58,987 52,940 92,228 103,376 Trading 2,558 3,900 5,014 7,244 4,292 5,288 4,409 4,014 4,842 4,123 4,288 5,382
Gross profit 2,625 4,148 4,441 3,848 2,324 4,857 4,089 6,562 5,857 5,794 14,244 17,731 Manufacturing 2,114 3,441 3,621 2,769 1,708 4,185 3,443 5,885 4,860 4,708 12,978 15,895 Trading 511 707 819 1,080 616 671 646 677 997 1,086 1,267 1,836
EBIT 2,134 3,500 3,665 3,064 1,502 4,006 2,936 5,114 4,399 4,365 12,449 15,740 Manufacturing 1,657 2,861 2,939 2,112 976 3,403 2,388 4,530 3,547 3,425 11,304 14,054 Trading 477 639 727 952 526 603 548 584 852 941 1,145 1,685
GP margin (%) 10 12 11 9 6 8 7 9 9 10 15 16 Manufacturing 8 11 11 8 5 8 6 8 8 9 14 15 Trading 20 18 16 15 14 13 15 17 21 26 30 34
EBIT margin (%) 8 10 9 7 4 7 5 7 7 8 13 14 Manufacturing 7 9 9 6 3 6 4 6 6 6 12 14 Trading 19 16 14 13 12 11 12 15 18 23 27 31
Source: Company data, EFG Hermes estimates
Operational profitability drivers
Raw materials, i.e., components are the key cost driver for INDU. Raw materials make up 91% of total cost of goods manufactured, and we estimate that 56% of this is imported (related-party purchases as a percentage of total raw material purchased have been used as a proxy). It is difficult to get a further breakdown of these costs, but it is fair to assume that steel prices and the PKR exchange rate plays a key role in driving costs.
Figure 87: Raw materials make up majority of the manufacturing costs
Cost breakdown 2012 2013 2014 2015 2016
Raw materials consumed 63,650 49,364 43,256 72,294 80,280 Other cost of goods manufactured 4,677 4,114 3,587 6,818 7,693 COGM exc. stock movements 68,327 53,478 46,843 79,112 87,973
RM costs as a % of COGM 93 92 92 91 91
Related-party purchases (exc. trading) 38,974 29,303 27,060 40,150 44,739 % of RM consumed 61 59 63 56 56
Source: Company data, EFG Hermes estimates
Historically, whenever the PKR depreciated against the JPY, profitability came under significant pressure. Similarly, the JPY weakening against the PKR since 2012 has led to consistent improvement in the company’s gross margin. The company runs a relatively lean production model, whereby we believe they carry less than a month’s raw material inventory in stock. This has two important implications in our view: i) FX depreciation feeds into the costing immediately; and ii) any supply chain disruptions will affect production levels immediately. Using FY16 as base, we estimate that a 5% depreciation in the PKR affects net profit by -12%, assuming the parent company does not share the pain and holding all else equal.
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Indus Motor Company 25 July 2017 Automobiles. Pakistan
Distribution and administrative expenses form a relatively small proportion of overall costs. INDU has been the only manufacturer that has leveraged off its non-raw material costs positively since 2013 which, in our view, highlights strong cost control.
Figure 88: INDU manufacturing margin vs. PKR/JPY
Source: Company data, EFG Hermes estimates
Figure 89: Distribution & administrative expenses
2012 2013 2014 2015 2016
Distribution Expenses (PKRmn) 820 814 794 996 1,061 Administrative Expenses (PKRmn) 628 644 635 799 931
% of sales 2012 2013 2014 2015 2016 Distribution Expenses 1.1 1.3 1.4 1.0 1.0 Administrative Expenses 0.8 1.0 1.1 0.8 0.9
Source: Company data, EFG Hermes estimates
In our base case, we estimate that EBITDA margin will likely normalise to 12% (2021e), relative to 18% (2017e) expected during the current financial year, driven by an increasingly competitive market as new entrants make inroads. Assuming all related-party purchases are non-localised imported CKD components, the fact that the new players will pay a 10% import duty rather than 30% for INDU, all else held equal, we estimate that they can price 7% lower and yet earn a similar EBITDA margin as INDU. While this estimate is based on very simplistic assumptions, we believe this just highlights the materiality of the incentives that have been provided. Charts below highlight that we expect 12% revenue CAGR expectations (FY16-21e) to be diluted to 6% EBITDA CAGR, on account of margin dilution. Higher interest income on cash balances add some impetus to bottom line growth, leading to a 9% CAGR in EPS over this time period.
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Indus Motor Company 25 July 2017 Automobiles. Pakistan
Figure 90: Earnings forecasts Revenue growth to remain robust, driven by volumes and price/mix EBITDA growth to underperform revenue growth, given margin decline
EBITDA margin will likely peak in FY17e EPS (PKR) – Lower than sector, but valuations compensate
Source: Company data, EFG Hermes estimates
We have considered international benchmarks, where -on average- auto manufacturers earn an 11% EBITDA margin to arrive at what we believe is normalised profitability for Pakistan Autos. However, in the scenario where increased competition does not materialise, we believe earnings could overshoot current estimates significantly, as highlighted in the table below.
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Indus Motor Company 25 July 2017 Automobiles. Pakistan
Figure 91: EPS Sensitivity
FY17e FY18e FY19e FY20e FY21e
Base case EPS 183 184 198 211 220 Bull case EPS 183 201 232 265 298 % change 0% 9% 17% 26% 36% PKR/share Upside* %
Base case TP 2,104 28
Bull case TP 2,616 58
% change 24%
*Based on closing price as of 20 July 2017 Source: Company data, EFG Hermes estimates
Interest income is a significant contributor to profitability
INDU derives a significant proportion of its income from financial assets (cash investments). This income is cyclical in nature and is driven by the company’s ability to generate significant interest in its models to ensure that they manage cash flows through the advance booking process. However, as per new regulations, delivery time for new vehicles cannot exceed two months, and any delay beyond that limit will result in a discount of KIBOR (Karachi Inter Bank Borrowing rate) +2% prevailing at the time of delivery. This will likely result in some pressure on cash balances and consequently interest income going forward, if this policy is implemented properly.
Figure 92: Other income components In PKRmn 2012 2013 2014 2015 2016 Other income 1,776 1,038 1,113 2,907 3,164 Income from financial assets 1,303 561 505 2,395 2,510 Capital gains on financial assets 337 267 342 154 222 Agency commission 69 95 150 184 88 Freight and other charges income - - 50 147 225 Gain on sale of assets 24 17 28 16 19 FX impact 1 (2) (1) (31) 6 Other 42 100 41 41 95 Interest income as a % of PBT 21 11 10 17 14
Source: Company data, EFG Hermes estimates
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Indus Motor Company 25 July 2017 Automobiles. Pakistan
Extracting cash through better working capital management
INDU has been particularly good at managing working capital to ensure strong cash flow generation. Their inventory turnover is the best in the sector and even excluding the impact from advances and security deposits, INDU has extracted PKR4.4bn out of working capital through delaying the payable cycle (since FY13). In addition, strong consumer interest in their products has provided a significant kicker to cash flows over the past two years. Important to note is that advances and securities are cyclical and highly dependent on INDU continuing to bring exciting model uplifts to the market. Another point to keep in mind is a change in regulations, whereby banks have to keep 100% cash deposit against imports, which is likely to be a short-term negative for cash flows and has been accounted for in our forecasts.
Figure 93: Net working capital management In PKRmn 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Inventory 4,185 3,087 2,870 4,217 5,310 5,880 7,708 8,037 4,611 6,329 7,939 Trade receivables 738 666 1,333 1,737 1,613 1,356 1,460 1,383 1,737 448 1,132 Payables 2,600 2,892 2,837 3,943 5,905 5,741 6,512 6,014 4,430 9,181 10,035 NWC 2,324 861 1,366 2,011 1,018 1,495 2,655 3,406 1,918 (2,404) (965)
Advances and 6,621 4,514 942 5,927 8,076 6,520 3,824 1,399 1,546 16,193 19,127 Security deposits
Adjusted NWC (4,297) (3,654) 423 (3,916) (7,058) (5,025) (1,168) 2,007 372 (18,597) (20,092)
Source: Company data, EFG Hermes estimates
Future capacity expansion optionality is not being priced in
Throughout our report, we have emphasised INDU’s cash generation abilities. We believe this is important because it provides a key optionality of future capacity additions, relative to peers, where cash generation has not been as consistent. Over the next five years, even after factoring in average annual capital expenditure of PKR1.5bn and a 70% payout ratio, we estimate INDU will have significant balance sheet flexibility to fund expansions – a dynamic which we believe is not factored in INDU’s undemanding valuations.
Figure 94: Net cash (PKRmn) – Significant balance sheet flexibility to expand operations
Source: Company data, EFG Hermes estimates
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Indus Motor Company 25 July 2017 Automobiles. Pakistan
Board of Directors and shareholding structure
Indus Motor Company has a relatively balanced Board of Directors. Other than the current CEO Mr. Ali A. Jamali who is a company veteran, Mr. Parvez Ghias (Ex-CEO) and Mr. Farhad Zulficar (Founding Director and Ex-MD) are also on the board, which we believe brings massive local market experience to the table. There is also strong representation, as would be expected from the House of Habib, Toyota Motor Corporation and Toyota Tsusho Corporation.
Figure 95: Indus Motor Company – Board of Directors
Independen Non- Members Role Experience t executive Founding director, while also serving on the board of Thal Mr. Ali S. Habib Chairman No Yes Limited and Habib Metropolitan Bank, amongst others. Has worked for Toyota Motor Corporation for over 29 years Vice Mr. Toshiya Azuma No Yes in various roles, including AVP Purchasing Division and VP Chairman Marketing Division for Toyota Motor Philippines corp Chief Fellow of the institute of Chartered Accountants of Pakistan Mr. Ali A. Jamali Executive No No and attended the Advance Management Program at Officer Harvard. He has been with Indus Motor since 2000. Was CEO of INDU between 2005 and 2016 prior to which Mr. Parvez Ghias Director No Yes he was CFO at Engro Chemical Pakistan Limited CEO of Cherat Cement Co. Limited with 24 years of Mr. Azam Faruque Director Yes Yes experience in the cement industry Founding director of the company and was the first MD of Mr. Farhad Zulficar Director No Yes the company from 1989 to 2001 Founding director of the company and currently he is an Mr. Mohamedali R. Habib Director No Yes executive director of Habib Metropolitan Bank since 2004. Currently, he serves as President of Toyota-Astra Motor, Mr. Hiroyuki Fukui Director No Yes Toyota Motor Asia Pacific and Managing Officer of TMC Worked in Toyota Motor Corporation in various roles Mr. Masato Yamanami Director No Yes between 1981-2013 post, which he joined Toyota Tsusho Corporation in 2014 as a member of the mgmt team Senior Director Manufacturing at INDU and has been with Mr. Sadatoshi Kashihara Director No No Toyota since 1990.
Source: Company data
From a shareholding perspective, Overseas Pakistan Investors (AG) is the majority shareholder, followed by Toyota Motor Corporation and Toyota Tsusho Corporation, which collectively have a 37% shareholding. The associated companies holding mainly comprises of 4.89mn shares, which are held by Thal Limited. Free float is estimated at 21% with average daily traded value of PKR85mn.
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Indus Motor Company 25 July 2017 Automobiles. Pakistan
Financial Statements
Income Statement (Jun Year End) Cash Flow (Jun Year End) In PKRmn 2016a 2017e 2018e 2019e In PKRmn 2016a 2017e 2018e 2019e Revenue 108,759 118,210 132,881 152,474 Cash operating profit after taxes 11,846 15,751 15,983 17,069 COGS (91,027) (96,832) (110,870) (128,746) Change in working capital 1,541 (3,282) 222 354 Gross profit 17,731 21,378 22,011 23,728 Cash flow after change in WC 13,387 12,469 16,205 17,423 SG&A (1,992) (2,222) (2,471) (2,750) CAPEX (1,292) (1,773) (1,329) (1,372) Other operating inc (expense) 0 0 0 0 Investments 0 0 0 0 EBITDA 16,670 20,196 20,678 22,211 Free cash flow 12,095 10,695 14,876 16,051 Depreciation and amortisation (931) (1,040) (1,138) (1,233) Non-operating cash flow 814 0 0 0 Net operating profit (EBIT) 15,740 19,156 19,540 20,978 Cash flow before financing 12,909 10,695 14,876 16,051 Share of results from associates N/A N/A N/A N/A Net financing (7,895) (7,860) (9,725) (9,925) Net investment income (loss) 3,164 3,505 3,641 4,353 Change in cash 5,015 2,835 5,151 6,126 Net interest income (expense) (77) (380) (137) (164) Source: Indus Motor Company, EFG Hermes estimates Other non-operating inc (exp.) (1,429) (1,740) (1,774) (1,905) FX gains (loss) 0 0 0 0 Net provisions 0 0 0 0 Income before taxes or zakat 17,397 20,540 21,270 23,261 Taxes or zakat (5,943) (6,368) (6,806) (7,676) Net inc before minority interest 11,455 14,173 14,464 15,585 Minority interest 0 0 0 0 Reported net income 11,455 14,173 14,464 15,585 Adjusted net income 11,302 14,388 14,464 15,585
Source: Indus Motor Company, EFG Hermes estimates Balance Sheet (Jun Year End) In PKRmn 2016a 2017e 2018e 2019e Cash and cash equivalents 36,434 39,270 44,421 50,547 Accounts receivable (current) 1,132 1,419 1,807 2,317 Inventory 7,939 8,445 9,669 11,228 Other debit balances (current) 1,876 6,604 7,191 7,975 Total current assets 47,381 55,738 63,088 72,067
PP&E (net) 4,919 5,115 4,924 4,812 Source: Indus Motor Company, EFG Hermes estimates Goodwill & intangibles 19 19 19 19 Investments (non-current) 5,006 5,006 5,006 5,006 R ating Dis tribution Other debit balances (non-current) 212 212 212 212 R ating Coverage Universe% Total non-current assets 10,156 10,352 10,162 10,050 Buy 47% Total assets 57,537 66,090 73,250 82,116 Neutral 42% Short term debt 0 0 0 0 S ell 10% Accounts payable (current) 10,035 10,675 12,223 14,193 Not R ated 0% Other credit balances (current) 19,872 21,472 22,346 23,581 Under R eview 0% Total current liabilities 29,907 32,147 34,568 37,775 Long term debt 0 0 0 0 Other credit balances (non-current) N/A N/A N/A N/A Total non-current liabilities 0 0 0 0 Total net worth 27,630 33,942 38,681 44,342 Total equity 27,630 33,942 38,681 44,342 Total equity and liabilities 57,537 66,090 73,250 82,116
Source: Indus Motor Company, EFG Hermes estimates
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25 July 2017
Honda Atlas Cars Stock Rating Neutral Impressive ST momentum, but medium-term slowdown ahead Target Price PKR652
Closing Price Initiation of Coverage PKR671 Rating: Neutral Target Price PKR651.51 Automobiles. Pakistan
Neutral HCAR; recent de-rating deemed fair despite ST earnings momentum We initiate coverage on HCAR, the assembler and distributor of Honda cars and spare parts in Pakistan, with a Neutral rating (TP of PKR652, implying a FY18e P/E of 12.1x). With the recent launch of a new model of its flagship product, Honda Civic, and introduction of Honda BRV, earnings momentum is likely to be strong (FY18e/19e growth of 31-16% Y-o-Y). However, after a 23% MTD share price decline we believe it has reached a fair valuation - a 15% premium to the sector (CY17e calendarised basis) is justified by its strong ST earnings momentum, in our view. Longer-term we expect a slowdown in growth from FY19e, as capacity utilisation is expected to reach 95%+, and the EBITDA margin will likely normalise due to increasing competition (TTM EBITDA: 14%, LT avg: 6%), which makes HCAR an unexciting story given its valuation premium. Furthermore, market expectations for FY18e are too bullish (13% above our numbers), in our view. Our TP is derived from our DCF valuation (CoE of 16.0% and 6% terminal growth). Impressive ST momentum… New model launches are likely to drive volumes and, in turn, profit growth should remain robust over the short term. We expect volume growth of 25% Y-o-Y in FY18 and 11% in FY19, while higher interest income, on account of strong cash balances (advance bookings), should add further impetus to EPS growth. It is on the back of these forward expectations and a historic FY14-17 EPS CAGR of 71% that the market has re-rated the stock to a 15% premium to the sector and to the stock’s own history. …however, all good things come to an end (or slowdown) We expect capacity utilisation to move to 98% in FY19, and as the new model euphoria erodes, while margins start to normalise due to increasing competition, EPS CAGR will likely moderate to 8% (FY18e-22e). While growth is likely to be robust over the ST, we believe there is a likelihood of disappointing the market on margins and, in turn, bottom line, where we believe FY18e EPS will be 10% below consensus expectations. Lastly, while the balance sheet is strong, after adjusting for advances and security deposits, the net cash position drops to only PKR2.5bn – thus, while capex and capacity addition optionality exists, we believe INDU is much better-positioned, given a stronger balance sheet, while trading at a significant discount to HCAR and is thus our preferred pick in the sector.
Key Financial Highlights (Mar Year End) Stock Data Closing Price PKR671 as of 20 Jul 2017 H2,BH1,BWH1,CBH9In PKRmn, unless otherwise stated 2017a 2018e 2019e 2020e Last Div. / Ex. Date PKR13.0 / 13 Jun 2017 Revenue 62,803 89,765 104,836 115,710 Mkt. Cap / Shares (mn) PKR95,839 / 142.8 Av. Daily Liquidity (mn) PKR49.06 EBITDA 8,639 11,058 12,692 13,559 52-Week High / Low PKR920 / PKR394 Net income 5,875 7,696 8,901 9,626 Bloomberg / Reuters HCAR PA / HATC.KA EPS (PKR) 41.1 53.9 62.3 67.4 Est. Free Float 18.2%
EPS consensus (PKR) 41.1 60.7 67.0 N/A Price to earnings 16.3x 12.5x 10.8x 10.0x Dividend yield 1.9% 3.2% 3.7% 4.0% Net debt (cash) / Equity (2.3)x (2.4)x (1.9)x (1.5)x EV / EBITDA 7.6x 5.9x 5.1x 4.8x ROAE 55.9% 48.1% 40.8% 34.7% F ahad S haikh, CF A H2,BH1,BWH1,CBH9FCF yield 25.2% 18.0% 5.3% 2.5% fshaikh@ efg-hermes.com
Source: Honda Atlas Cars, Bloomberg and EFG Hermes estimates
Disclosure Appendix at the back of this report contains important disclosures, analyst certifications Page 51 of 89 and the status of non-US analysts
Honda Atlas Car 25 July 2017 Automobiles. Pakistan
Data Miner
Investment Thesis Valuation and Risks We initiate on HCAR, the assembler and distributor of Honda Our TP for HCAR is PKR652, which values the company at a cars and spare parts in Pakistan with a Neutral rating (TP of forward P/E of 12.1x. We derive this estimate based on our DCF PKR652, implying a FY18e P/E of 12.1x). With the recent launch valuation, which values the operating cash flows (excluding of a new model of their flagship product the Honda Civic and interest income) and then adds the TTM net cash position introduction of the Honda BRV, earnings momentum is likely to (adjusted for the recent dividend announcement) to that be strong (FY18e/19e growth of 31-16% Y-o-Y). However, our valuation. The cost of equity used in our model is 16.0%, while Neutral rating is based on an expected slowdown in growth we use a 6% terminal growth rate. Key risks to our thesis from FY19e, as capacity utilisation is expected to reach 95%+, emanate from lower-than-expected competitive forces, PKR and EBITDA margin will likely normalise due to increasing strength relative to JPY/USD/THB, plant de-bottlenecking leading competition (TTM EBITDA: 14%, LT Avg.: 6%) which makes to higher-than-expected volumes and elevated investor HCAR an unexciting story for us given the valuation premium. sentiment, on the back of new model launches. On the downside, sharp depreciation in the PKR could lead to a worse- than-expected margin outlook
Mar Year End Mar Year End
In PKRmn, unless otherwise stated 2017a 2018e 2019e 2020e In PKRmn, unless otherwise stated 2017a 2018e 2019e 2020e
Income Statement Per Share Financial Summary Revenue 62,803 89,765 104,836 115,710 EPS (PKR) 41.1 53.9 62.3 67.4 EBITDA 8,639 11,058 12,692 13,559 DPS (PKR) 13.0 21.6 24.9 27.0 Net operating profit (EBIT) 8,082 10,288 11,959 12,843 BVPS (PKR) 91.5 132.4 173.2 215.6 Taxes or zakat (2,501) (3,457) (4,384) (4,741) Valuation Metrics Minority interest 0 0 0 0 Price to earnings 16.3x 12.5x 10.8x 10.0x Net income 5,875 7,696 8,901 9,626 Price to book value 7.3x 5.1x 3.9x 3.1x Balance Sheet Price to cash flow 3.7x 5.3x 16.7x 31.1x Cash and cash equivalents 30,480 45,908 47,928 46,752 FCF yield 25.2% 18.0% 5.3% 2.5% Total assets 51,465 73,700 79,234 80,582 Dividend yield 1.9% 3.2% 3.7% 4.0% Total liabilities 38,401 54,796 54,507 49,789 EV / EBITDA 7.6x 5.9x 5.1x 4.8x Total equity 13,065 18,904 24,727 30,793 EV / Invested capital N/M N/M N/M N/M Total net debt (cash) (30,480) (45,908) (47,928) (46,752) ROAIC -69.2% -32.0% -31.9% -43.9% Cash Flow Statement ROAE 55.9% 48.1% 40.8% 34.7% Cash operating profit after taxes 7,415 8,465 9,634 10,342 KPIs Change in working capital 18,394 9,599 (3,907) (7,263) Revenue growth (Y-o-Y) 56.7% 42.9% 16.8% 10.4% CAPEX (1,618) (779) (629) (694) EBITDA growth (Y-o-Y) 47.9% 28.0% 14.8% 6.8% Investments 0 0 0 0 Gross profit margin 14.5% 13.0% 12.8% 12.5% Free cash flow 24,192 17,285 5,098 2,384 EBITDA margin 13.8% 12.3% 12.1% 11.7% Net financing (996) (1,856) (3,078) (3,560) Net operating profit (EBIT) margin 12.9% 11.5% 11.4% 11.1% Change in cash 18,704 15,428 2,020 (1,176) Effective tax rate 29.0% 31.0% 33.0% 33.0% Source: Honda Atlas Cars, EFG Hermes estimates Net Debt (Cash) / Equity (2.3)x (2.4)x (1.9)x (1.5)x
Net Debt (Cash) / EBITDA (3.5)x (4.2)x (3.8)x (3.4)x Source: Honda Atlas Cars, EFG Hermes estimates
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Honda Atlas Car 25 July 2017 Automobiles. Pakistan
Honda Atlas Car – Look beyond the new model euphoria
Investment thesis
New-model-launch-led overvaluation has subsided post -23% MTD performance
At its current price, HCAR is trading at a FY18e P/E of 12.5x, while offering a FY18e dividend yield of 3.2%, which we believe is fair, given expected EPS growth of 31% Y-o-Y in FY18. However, we do not expect HCAR to maintain this growth rate, as utilisation moves above 95% in FY19e, while EBITDA margin is also likely to moderate from its current level of 14% (LT average: 6%, global peer average: 11%) to c11% over the forecast horizon. We expect EPS CAGR to slow down to 8% (FY18e-22e), which along with its premium valuation makes HCAR an unexciting story for us. Furthermore, we believe FY18e growth, albeit robust, will likely disappoint market expectations on weaker margins; evidence of margin compression was visible in 4Q17 results, where gross margin was down 2ppts Y-o-Y, likely driven by new model launches, which have a higher imported raw material component. Our channel checks also suggest that the company is not taking any new orders for Civic’s premium priced variant (VTEC Turbo) – we believe this is likely due to technical challenges; hence, we see better long-term value in HCAR’s competitor, INDU, within the sector.
Figure 96: Forward P/E (x) Figure 97: Forward DY (%)
Source: Company data, EFG Hermes estimates Source: Company data, EFG Hermes estimates
Riding the sweet spot
We believe HCAR has been exceptionally well-positioned to capitalise on the improving macro tailwinds, with: i) unutilised production capacity, allowing the company to grow volumes at a CAGR of 15% over the past three years; ii) launch of a new model of its flagship product, Honda Civic; and iii) launch of a subcompact SUV, the Honda BRV, which we believe is very attractively priced at PKR2.2mn. Improving volumes, while input prices have been moderating, have allowed the company to convert the 15% volume CAGR (FY14-17) to a 71% EPS CAGR over the same time period. In FY18e, we expect earnings momentum to remain robust (EPS growth of 31% Y-o-Y), following the new product launches this year.
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Honda Atlas Car 25 July 2017 Automobiles. Pakistan
Figure 98: Production and capacity utilisation Figure 99: EBITDA margin (%) Excess capacity has been a positive; however, utilisation is catching Moderating input prices have led to significant margin expansion up quickly
Source: Company data, EFG Hermes estimates Source: Company data, EFG Hermes estimates
Above normal profitability – only sustainable over the short term
HCAR’s EBITDA margin has moved up from only 5% in FY13 to 13.8% in FY17. Much of the margin expansion could be attributed to strong price/mix gains in the wake of relatively moderate input price increases. Costs, excluding raw materials, have still increased at a CAGR of 1% on a per-unit basis over this time period despite significant volume gains. Input price inflation is likely to stay contained for now, but if the PKR continues to slip against the USD and JPY, it could lead to further downside relative to our estimates. In addition, new product launches are usually good for top line growth, but have a negative impact on profit margins due to a higher proportion of imported components. It is likely on the back of this dynamic that we saw HCAR’s 4Q17 GP margin slip to 13.3% compared to 15.3% last year and 13.9% in 3Q17. Given the ramp-up of the new Honda BRV, we do expect some EBITDA margin dilution to 12.3% in FY18e - and thus believe consensus expectations are too bullish (our FY18e EPS is 11% below Bloomberg consensus estimate).
Figure 100: CAGR FY13-FY17 (%) Figure 101: Input price trends (%) (spot rates vs. FY17 average) Price/mix gains have outpaced cost trends PKR has remained relatively strong; steel prices have moved up moderately
Source: Company data, EFG Hermes estimates Source: Company data, EFG Hermes estimates
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Honda Atlas Car 25 July 2017 Automobiles. Pakistan
Competitive forces are likely to increase = EBITDA margin has peaked, in our view
The significant margin expansion has been, to a large extent, an input-cost-driven event rather than a structural change in the business. An oligopolistic market, with limited consumer choice, has allowed the company to benefit from price/mix gains, resulting in much higher profit margins. We believe the new Auto Development Policy 2016-21 (ADP) will be a game changer for the industry through the numerous incentives provided to new entrants, which -amongst other things- allows for duty-free import of capital equipment and a preferential import duty for five years of only 10% on non-localised CKD components, compared to the 30% that existing incumbents have to incur. Based on our estimates, industry capacity utilisation could drop from 83% currently to only 65-70% by 2021, even if demand continues to grow at 2x GDP. In our base case, we believe EBITDA margin could moderate to 11% over the forecast horizon (FY17: 13.8%).
Figure 102: Industry capacity utilisation in 2021 (%) Figure 103: EBITDA margin (%) has likely peaked
Source: Company data, EFG Hermes estimates Source: Company data, EFG Hermes estimates
Capacity constraints + margin moderation = lower growth post FY18
Prior to the recent price decline, we believe the market was either overestimating HCAR’s long-term growth rate, based on its current asset base or expected margins to remain abnormally high in perpetuity. Based on feedback from industry participants, it is clear that capacity expansion is costly. PSMC has indicated that a 100k capacity plant could cost up to USD460mn, while INDU flagged that just introducing a new variant could require capital expenditure of PKR7-8bn (USD65-75mn). INDU also spent roughly PKR4bn (USD38mn) just to de-bottleneck their paint-shop to increase capacity by 10k units per annum. Thus, one needs to be mindful of factoring in capex requirements before factoring in unsustainable long-term growth rates. In our view, based on its current base and available capacity, EPS growth will slow significantly post FY18e. We estimate a FY18-22e EPS CAGR of only 8%, barring any significant FX movements.
Figure 104: Utilisation likely nears 100% in FY19e Figure 105: EPS growth (%) likely to moderate significantly
Source: Company data, EFG Hermes estimates Source: Company data, EFG Hermes estimates
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Why the neutral view despite strong earnings momentum?
We believe one only needs to look at Indus Motor Company (INDU) to understand the impact lower growth expectations have on stock ratings. INDU trades at a forward P/E of 9.5x despite its entrenched market position, strong cash flows and one of the best financial track records in the sector – with investors penalising the stock’s rating due to lower growth expectations. Furthermore, if we account for the strong growth momentum two years out, HCAR’s FY19e EV/sales is relatively in line with its LT average, which backs our thesis that current valuation premium accounts for the ST earnings momentum, while leaving little room to get excited about as growth normalises post FY18e.
Figure 106: HCAR EV/sales relative to history (x)
Source: Company data, EFG Hermes estimates
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Valuation
We have a DCF based target price of PKR652 for HCAR, after factoring in a cost of equity of 16.0% and a terminal growth rate of 6%. Important to note is that FY17 has been an exceptionally strong cash flow year due to advance bookings of the new model launches, which we expect to persist into FY18. However, post that, we have normalised the advance booking cycle to get a normalised exit terminal value.
Figure 107: HCAR Valuation In PKRmn, unless otherwise stated
Valuation 2017 2018e 2019e 2020e 2021e 2022e Net Income 6,135 7,696 8,901 9,626 9,979 10,417 Add: Depreciation 557 769 733 716 713 718 Capex (1,618) (539) (629) (694) (746) (799) NWC changes 18,394 9,599 (3,907) (7,263) (9,355) (47) Changes in debt ------FCFE 23,469 17,525 5,098 2,384 591 10,289 of which interest income 457 1,034 1,391 1,562 1,640 1,851 Operating FCFE 23,012 16,491 3,707 822 (1,049) 8,437
Risk -free rate 11%
Risk premium 5%
Terminal growth rate 6%
Beta (x) 1.0
Cost of equity % 16.0%
NPV of five-year FCFE 23,399
NPV of terminal value 41,013
TTM net cash 28,623
Value of equity 93,036
Per share value 652
Source: Company data, EFG Hermes estimates; Net cash has been adjusted for the recent ex-dividend of PKR13/sharez
Figure 108: Sensitivity to growth rate and cost of equity
Cost of equity (%)
15.00% 15.50% 16.00% 16.50% 17.00%
5.00% 90,904 89,917 88,956 88,019 87,106
5.50% 92,937 91,905 90,899 89,919 88,964 6.00% 95,174 94,091 93,036 92,008 91,007 growth rate (%) Terminal 6.50% 97,646 96,507 95,398 94,318 93,265 7.00% 100,393 99,192 98,023 96,884 95,774
Source: Company data, EFG Hermes estimates
Figure 109: Sensitivity to growth rate and cost of equity (per share) DCF sensitivity (Per share)
Cost of equity (%)
15.00% 15.50% 16.00% 16.50% 17.00%
5.00% 637 630 623 616 610
5.50% 651 644 637 630 623
rate% 6.00% 666 659 652 644 637 Growth 6.50% 684 676 668 660 653 7.00% 703 695 686 678 671
Source: Company data, EFG Hermes estimates
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Risks to our investment thesis
(1) PKR strength or weak competitive forces resulting in a better profitability outlook: HCAR imports a large component of its manufacturers with exposure to the JPY, USD and the Thai Bhat. In an environment where PKR strengthens against these currencies, while there is no downward price adjustment on the final product price could result in profit margins being higher than we expect. Furthermore, if the new entrants do not materialise, this too could result in local incumbents earning super profits. In a scenario where EBITDA margins remain stable at 14%, it would imply an 11-23% uplift to our estimates over the five-year horizon and result in a target price of PKR759/share, implying a 16% upside.
Figure 110: EPS sensitivity (PKR)
FY18e FY19e FY20e FY21e FY22e
Base case EPS 54 62 67 70 73 Bull case EPS 60 69 77 83 90 % change 11% 11% 14% 18% 23%
PKR/share Upside (%)
Base case TP 652 0 Bull case TP 759 16 % change 16%
Source: Company data, EFG Hermes estimates
(2) Plant de-bottlenecking results in volume growth beating our estimates: HCAR has recently started to operate on a double-shift basis, which results in a name-plate capacity of 50k units per annum. While there are no publicly-announced plans for further capacity expansions, if demand conditions stay robust, we could potentially see HCAR undertaking capacity expansion. While this improves growth prospects, we believe the impact on valuation will have to be evaluated post better understanding on capital outlay requirement
(3) New model launches which keep investor sentiment elevated: New models launches usually result in strong top line impetus, as we are seeing now. While we highlight this as a risk, we believe capacity constraints are likely to offset that impact, limiting overall profitability. At the same time, lower localisation on new products also has a detrimental impact on profit initially. That said, new model launches could keep investor sentiment and, in turn, stock rating elevated, given a relatively low free float of 18% and an average value traded of only PKR64mn
(4) Recently-announced tax changes: HCAR has a payout ratio of 30%, which puts it into the ambit of recent tax changes, where companies with a payout of less than 40% will likely incur an additional tax of 10% on their profits. We have accounted for this in our forecast due to the recent surge in cash flows, which should allow HCAR to boast a higher payout. This brings about a dividend yield of 3.2%, relative to only 2.5%, if the current dividend payout ratio was maintained. Another potential scenario could be a potential bonus share issue to reach the 40% threshold, resulting in a lower cash dividend payout
(5) Downside risk – The PKR: A large component of raw materials for HCAR is imported. While the impact on margin is dependent on a host of factors, including product mix and pricing strategy, we believe all else held equal, a 5% PKR depreciation affects profit by 14-17%. HCAR would need to raise prices by around 2% to offset this impact, which is not unimaginable over the short term, given weak competitive forces; however, longer-term with more competitors in the market pushing prices might get more difficult
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New auto policy to usher in new competition
The new Automotive Development Policy 2016-21 (ADP), is a game changer for the industry, in our opinion. Historically, the industry has largely operated as an oligopoly and the strong pricing that comes along with that has been one of the key drivers behind the recent surge in profitability. However, we believe super profits, along with a more incentivised policy environment for new entrants, are likely to pave way for a more competitive market; hence, normalising profit margins on a five-year view. Incentives offered as part of the ADP are in the form of (quoted from the ADP document):
5. Greenfield investments: Installation of new and independent automotive assembly and manufacturing facilities by an investor for the production of vehicles of a make not already being assembled/manufactured in Pakistan a. Duty-free import of plant and machinery for setting up the assembly and/or manufacturing facility on a one-time basis b. Import of 100 vehicle of the same variant in CBU form at 50% of the prevailing duty for test marketing after ground breaking of the project c. Concessional rate of custom duty @10% on non-localised parts and @25% on localised parts for a period of five years for manufacturing of cars and LCVs d. Import of all parts (both localised and non-localised) at prevailing customs duty applicable to non-localised parts for the manufacturing of trucks, buses and prime-movers for a period of three years
6. Brownfield investment: Revival of an existing assembly and/or manufacturing facilities, that is non-operational or close on or before July 01, 2013 and the make is not in production in Pakistan since that date and that the revival is undertaken either independently by original owners or new investors or under joint-venture agreement with foreign principal or by foreign principal independently through purchase of plant a. Import of non-localised parts @10% rate of customers duty and localised parts at 25% duty for a period of three years for the manufacturing of cars and LCVs b. Import of all parts (both localised and non-localised) at prevailing customs duty applicable to non-localised parts for the manufacturing of trucks, buses and prime-movers for a period of three years
We believe these incentives are material, especially if we put them in context of local manufacturers importing an estimated 55-60% of their raw materials. Thus, new entrants are likely to have a significant procurement competitive advantage for a period of five years. Based on the already- announced plans: i) Kia, Hyundai and Renault are looking to start manufacturing domestically; ii) Dewan Farooque Motors is likely to bring online its idle capacity; iii) Sazgar Engineering has also announced plans to start manufacturing passenger cars; and iv) INDU is increasing capacity by 10k units per annum, while PSMC also has room to de-bottleneck their paint-shop, in our view. If all these investments go ahead, we estimate that industry capacity utilisation could drop from 83% currently to 65-70% by 2021, even if demand conditions remain robust.
In an environment where competitive forces are likely going to increase, while the sector is trading at a significant premium relative to history and to market, investors need to focus on quality and valuation. In HCAR’s case, while ST earnings momentum is strong, we believe current premium valuations are already pricing this in. Recent share price decline, in our view, has been an adjustment of LT growth expectations, which we believe is fair and see no reason to get excited about the stock currently.
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Why we are convinced that earnings growth will slow
While we recognise that HCAR has built strong brand equity in Pakistan, and this has supported the strong growth in its profitability, we believe the bigger boost to HCAR’s profitability has come from the oligopolistic industry structure, where a lack of choice has allowed for significant pricing power. In the following sections, we explain this thesis further:
(1) Profitability improvement has been driven by price/mix outpacing cost trends, and not due to any structural change in the business model.
a. Between FY13 and FY16, the cost of raw materials per unit declined at a CAGR of 5%, while price/mix only declined 1% (mix shift towards the lower priced Honda City). This has been driven by a 9% annual depreciation of the JPY against the PKR and 10% annual decline in steel price in PKR
b. Incorporating the recently-announced FY17 results, between FY13 and FY17, raw material costs per unit has largely been flat vs. price/mix gains of 3% per annum
c. Other costs, which include operating expenses, have increased at a CAGR of 1% on a per- unit basis. Despite the strong uptick in volumes, per-unit operating costs have not declined, highlighting underlying cost pressure in the business
Figure 111: Price/mix and cost trends (CAGR% FY13-16) Figure 112: Prixe/Mix and cost trends (CAGR% FY13-17)
Source: Company data, EFG Hermes estimates Source: Company data, EFG Hermes estimates
(2) Historical high barriers to entry have reduced due to incentives provided to new entrants – and new entrants are keen to participate because of record high profitability a. The sector has a TTM EBITDA margin of 13% compared to its long-term average of 8% and a ROE of 33% compared to long-term average of 21%
b. Renault, Kia and Hyundai have announced plans to manufacture vehicles in Pakistan in partnership with local players, while Dewan Farooque Motors Limited (DFML) is looking to restart its idle capacity. In addition, Sazgar Engineering has announced plans to manufacture passenger vehicles, while INDU is expanding its paint-shop capacity, and PSMC has room to de-bottleneck its paint-shop also. Operational capacity could increase 88% by 2021, resulting in capacity utilisation to fall from 83% to 66%
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(3) We fail to see a sustained competitive advantage that Pakistan auto manufacturers have relative to global peers, which will allow for sustainably higher profitability.
a. Not considering the recent incentives provided to new entrants in the Automotive Development Policy 2016-21, we would have argued that high barriers to entry and entrenched capital base are a sustained competitive advantage for local companies, allowing them to earn superior margins relative to global standards. However, we believe this advantage is now likely to dilute. It is unrealistic, in our view, to factor in sustainably higher profitability in an environment, where competitive pressures are likely to increase (barring any significant appreciation of the PKR against the JPY and USD)
b. Local manufacturers rely on R&D by parent companies and leverage off that competitive advantage. From a capital expenditure perspective, Capex/Sales for HCAR has averaged at 1.6% of sales since FY05 compared to global norms of around 6-7%. This, again, in our view, highlights that the higher profitability is not driven by a sustained competitive advantage, in terms of capital infrastructure
Figure 113: Profitability in relation to global peers (EBITDA %)
Source: Company data, EFG Hermes estimates, Bloomberg
Given our view that margin improvement in the sector has been driven by input price moderation and price/mix gains, on the back of an oligopolistic market, we expect earnings growth rates to moderate significantly, post FY18e, as competitive forces increase and capacity constraints come into play.
We expect capacity utilisation to move up to 88% in FY18e and 98% in FY19e, leading to revenue CAGR of only 10% between FY18e and FY22e (down from 20% between FY13-17e). Furthermore, as new entrants gain traction, we expect EBITDA margin to normalise at 11% in FY22, which is still higher than the 8% industry average over the past ten years – we believe this accounts for HCAR’s entrenched competitive advantage and brand equity that it has built over time. We expect this lower revenue growth and margin deterioration to translate into only 8% EPS CAGR between FY18e and FY22e (down from 90% between FY13 and FY17). We believe the recent share price adjustment now accounts for this medium-term slowdown in earnings growth. Important to note is that, in our forecasts, we have assumed a relatively stable PKR exchange rate – we estimate that a 5% depreciation of the PKR affects EBIT negatively by around 14-17%, all else held equal. Thus, any sharp PKR depreciation could lead to significant downside risk to our forecast.
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Figure 114: Growth expectations Revenue growth to continue, albeit at a slower pace (PKRmn) Gross margin has likely peaked (Gross margin %)
EBITDA margin (%) expected to normalise to 11% EPS (PKR) – Resulting in a significant slow-down in growth post FY18e
Source: Company data, EFG Hermes estimates
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Business overview
Honda Atlas Cars (HCAR) was incorporated in 1992 in a joint venture with Honda Motor Co. Ltd., Japan (51% shareholding in HCAR), with the first car rolling out from the factory in 1994. Over time, the company increased its production capacity from only 5,000 units per annum (single-shift) basis to its current capacity of 50k units per annum on a double-shift basis. The principal activity of the company is assembling, progressive manufacturing and sale of Honda vehicles and spare parts. Their flagship product, the Honda Civic is an aspirational brand in Pakistan due to an entrenched image of better styling/aesthetics and technology compared to peers. The Honda City is a slightly cheaper product and plays in the same price range as some of INDU’s Toyota Corolla’s variants, while the recently-launched Honda BRV is a strong step to capture the subcompact SUV market at a reasonable price tag of PKR2.2mn – a market which, to a large extent, has been untapped by domestic players.
Figure 115: Market share (passenger cars & LCVs) % Figure 116: Market share in the 1300cc and higher segment % HCAR has an 18% market share of the overall market in Pakistan HCAR is the #2 player at the upper end of the market
Source: Company data, PAMA, EFG Hermes estimates Source: Company data, EFG Hermes estimates
HCAR has a relatively small 18% market share in the overall market for passenger cars, LCVS and jeeps in Pakistan. The company has historically played within its higher end niche, offering cars in the 1300cc+ segment, where it is the No. 2 player, with a 39% market share. The company has also recently launched the Honda BRV, which is a subcompact SUV, with a retail price of ~PKR2.2mn, which positions HCAR well in a market which has previously been untapped by local manufacturers. Most of the SUV’s being sold in Pakistan by local incumbents or through imports are at much higher price points; thus, the BRV offering seems relatively compelling. To put it into perspective, within three months of launch, they have been able to sell 2,159 units compared to only 564 Toyota Fortuner’s being sold in the same period (Toyota Fortuner carries a price tag of PKR5.2mn). In terms of brand positioning, we believe HCAR products are perceived to be technically superior, while providing better aesthetics than peers, but the general perception has been that their cars do not suit the harsher road conditions of Pakistan, as well as the Toyota Corolla.
Similar to peers, HCAR also operates a trading business, where they trade in Completely Built Units (CBU) and parts, which is much more profitable than the manufacturing business. However, in terms of overall contribution to group revenue, it remains relatively small at 3% of revenue and 7% of gross profit. It is basically the Honda CRV, Honda HRV and Honda Accord that are being sold as CBU’s with a price range of between PKR3.7mn and PKR11.2mn; thus, catering to a very niche market in Pakistan.
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Both the underlying divisions have seen significant improvement in profitability, driven by price/mix gains outpacing input price trends. On an overall group basis, the profitability improvement within the trading business between FY13-17 only accounts for 70bps of GP margin improvement – the big kicker to profitability has come through the larger manufacturing business. Going forward, we expect margin deterioration in both the manufacturing and the trading business on account of increasing competition; however just given the sheer size of it, the margin decline in the manufacturing business is the key driver to our forecast which we have explained earlier in the report.
Figure 117: Divisional profitability overview In PKRbn 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018e 2019e 2020e
Revenue 25.6 17.1 14.7 14.1 15.9 22.0 16.6 30.3 39.2 37.8 40.1 62.8 90.9 106.1 117.1 Manufacturing 24.5 16.4 14.0 13.1 15.0 21.0 15.5 29.0 37.8 36.4 38.5 60.8 88.6 103.4 114.1 Trading 1.1 0.7 0.7 1.1 0.9 1.1 1.1 1.2 1.4 1.4 1.6 2.0 2.3 2.7 3.0
Gross profit 1.2 0.2 0.6 0.2 (0.2) 0.2 (0.0) 1.4 2.9 4.8 6.0 9.1 11.8 13.6 14.6 Manufacturing 1.1 0.1 0.6 0.0 (0.4) 0.0 (0.2) 1.2 2.5 4.3 5.5 8.5 11.1 12.8 13.7 Trading 0.1 0.1 0.1 0.1 0.1 0.2 0.2 0.3 0.4 0.4 0.5 0.6 0.7 0.8 0.9
Gross margin % 5 1 4 1 (2) 1 (0) 5 7 13 15 15 13 13 12 Manufacturing 4 1 4 0 (2) 0 (2) 4 7 12 14 14 13 12 12 Trading 10 9 9 12 14 15 18 21 28 31 33 33 32 31 30
Revenue mix %
Manufacturing % 96 96 95 92 94 95 94 96 97 96 96 97 97 97 97 Trading % 4 4 5 8 6 5 6 4 3 4 4 3 3 3 3
Gross profit mix
Manufacturing 90 62 90 24 na 19 N/A 82 87 91 91 93 94 94 94 Trading 10 38 10 76 N/A 81 N/A 18 13 9 9 7 6 6 6
Source: Company data, EFG Hermes estimates
Operational profitability drivers
ROE breakdown: Operating margin has been the key driver behind the improving ROE since 2013. Historically, due to accumulated accounting losses in FY07 and FY09-12, the equity base has been diluted, resulting in a significantly high leverage ratio – but as profitability has recovered and the equity base has rebuilt, this ratio has started to normalise. Current ROE of 56% compares to a long-term average ROE of only 19%. Going forward, we expect some ROE dilution, mainly on account of lower operating margin and a lower leverage ratio as cash levels increase.
Figure 118: ROE breakdown
2013 2014 2015 2016 2017 2018e 2019e 2020e
Tax burden (%) 47 51 84 69 71 69 67 67 Interest burden (%) 95 102 98 98 102 108 111 112 EBIT margin (%) 3 6 11 13 13 12 11 11 Asset turnover (x) 2.5 2.9 2.9 2.7 1.9 1.4 1.4 1.4 Leverage ratio (%) 981 731 349 231 322 393 352 288 Adjusted ROE % 36 62 88 55 56 49 41 35
Source: Company data, EFG Hermes estimates
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Gross margin improvement: 91% of HCAR’s COGS are raw material costs, of which 62% are purchased from related parties. These related party purchases are both from offshore parties, as well as local parties – but we believe this could be used as a proxy for imported components within the raw material costs. Consequently, the PKR movement against the JPY, USD and Thai Baht play are key cost drivers, including cold rolled coil steel prices. The charts below highlight how a strong PKR and moderating steel price, combined with strong price/mix growth (highlighted in figure 5), have had a material positive impact on profitability.
Figure 119: Manufacturing margin vs. PKR/JPY Figure 120: Manufacturing margin vs. CRC steel price
Source: Company data, Bloomberg, EFG Hermes estimates Source: Company data, Bloomberg, EFG Hermes estimates
Distribution and marketing expenses (D&M) and administrative expenses have averaged between 0.9% and 0.8% of sales, respectively. These costs have been relatively well-managed – however, the interesting thing is that even though volumes have grown at a CAGR of 17% between FY13 and FY16, administrative expenses have increased from 0.7% of sales to 0.8%, highlighting no positive operational gearing.
Figure 121: Operating expenses In PKRmn 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
D&M 98 150 215 210 190 125 139 131 219 341 434 333 542 Administrative 102 135 147 139 140 136 172 159 202 287 320 352 497
Source: Company data, EFG Hermes estimates
Figure 122: Operating expenses as a % of sales
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
D&M 0.6 0.6 1.3 1.4 1.3 0.8 0.6 0.8 0.7 0.9 1.1 0.8 0.9 Administrative 0.6 0.5 0.9 0.9 1.0 0.9 0.8 1.0 0.7 0.7 0.8 0.9 0.8
Source: Company data, EFG Hermes estimates
In our base case, we expect EBITDA margin to normalise at around 11% in our terminal year. This is still relatively high compared to HCAR’s own long-term average of only 5.8% and the sector’s long-term average of 8%. We believe this accounts for HCAR’s entrenched competitive advantage in the form of established dealership network, brand equity and strong after-sales service.
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Figure 123: EBITDA margin normalisation
2013 2014 2015 2016 2017 2018e 2019e 2020e 2021e 2022e
EBITDA margin % 5.4 7.4 12.5 14.6 13.8 12.3 12.1 11.7 11.3 10.8
Source: Company data,EFG Hermes estimates
HCAR derives a significant proportion of its income from financial assets (cash investments). This income is cyclical in nature and is driven by the company’s ability to generate significant interest in its models to ensure that they manage cash flows through the advance booking process. However, as per new regulations, delivery time for new vehicles cannot exceed two months and any delay above that limit shall result in a discount of KIBOR (Karachi Inter Bank Borrowing rate +2%) prevailing at the time of delivery. This will likely result in some pressure on net interest income going forward, if this policy is implemented properly. In the immediate future, we expect profit on bank deposits to remain robust, given high cash balances.
Figure 124: Profit on cash balances is a significant contributor to profitability In PKRmn 2013 2014 2015 2016 2017
Other Income 213 271 219 310 1,115 - Profit on bank deposits 142 148 167 219 644 - Profit on loan to employees 4 4 5 4 5 - Dividend Income -
- Gains on financial assets 2 18 - 25 377 - Profit on disposal 27 2 1 - 20 - Freight income 26 22 27 40 42 - Profit on advance to suppliers 5 7 3 18 17 - Other 8 68 17 3 11
Source: Company data, EFG Hermes estimates
Cash flows and balance sheet
HCAR’s inventory turnover has historically been lower than INDU, but better than PSMC. While INDU is the most efficient company in this regard, we believe HCAR’s narrower product portfolio does allow it to post much better inventory management than PSMC. The other key point to highlight, in terms of cash flows, is the significant impact the advance booking cycle has on working capital management, as is clearly evident during FY17. This does lead to chunky cash flows and volatility, depending on model refreshes or new product launches.
Figure 125: Inventory turnover (x)
Source: Company data, EFG Hermes estimates
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Figure 126: Cash flow management and working capital (PKRmn)
2009 2010 2011 2012 2013 2014 2015 2016 2017
CFO (1,419) 2,299 1,496 267 4,484 (1,374) 2,024 5,789 25,809 Net capex (1,944) (86) (43) (387) (373) (256) (594) (1,328) (1,618) FCF (3,363) 2,213 1,453 (120) 4,111 (1,630) 1,430 4,461 24,192
Net working capital 2,724 191 (1,271) 1,148 (2,075) (394) 1,200 548 6,288 Advances from customers & dealers 2,202 2,195 1,993 4,704 5,039 2,990 2,746 3,354 28,025 Adjusted NWC 522 (2,003) (3,264) (3,556) (7,115) (3,384) (1,546) (2,806) (21,737)
Source: Company data, EFG Hermes estimates
Flexibility for large scale investment is lower than what the market believes
We believe it is important to understand the cash conversion cycle of auto makers to get a feel of underlying balance sheet strength. A large proportion of cash on balance sheet is in the form of advance payments from customers and security deposits from dealers, which, in our view, inflates the overall net cash position of the company (and understates enterprise value). Adjusting for those balances implies a true net cash position of only PKR2.5bn, indicating a very limited ability to undertake significant capital expenditure.
Figure 127: Balance sheet indicators (PKRmn)
2009 2010 2011 2012 2013 2014 2015 2016 2017
Net debt/(Cash) 3,631 1,418 (35) 84 (4,027) (2,354) (3,358) (7,113) (30,480) ND/EBITDA (x) 8.9 4.3 (0.1) 0.3 (2.5) (0.8) (0.7) (1.2) (3.5)
Advances from customers 1,137 1,129 921 3,559 3,864 1,697 1,276 1,787 26,573 Security deposits from 1,066 1,065 1,072 1,145 1,176 1,293 1,471 1,567 1,452 dealers
Adjusted net debt/(cash) 5,834 3,613 1,957 4,788 1,013 636 (612) (3,759) (2,455)
Source: Company data, EFG Hermes estimates
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Board of Directors and shareholding structure
The board is dominated largely by the parent company, which has a 56% representation and Shirazi Investments (Pvt) Limited that has a 33% representation. We believe the fact that the Chairman and CEO role is separated and represents different parties is a positive, relative to PSMC, where the entire board is dominated by the parent company. The company has an estimated free float of 18%, with an average daily traded value of PKR64mn. Other than the two major shareholders highlighted below, the other material holdings to call out would be Meezan Islamic Funds (2%) and National Investment Unit Trust (1.6%).
Figure 128: Board of Directors
Parent company has a 56% board representation – relatively in line with their shareholding Members Role Independent Non-Executive Experience Chairman of the Atlas Group, which amongst others, has JVs with Honda, GS Yuasa and Man to name a few. He has Mr. Yusuf H. Shirazi Chairman No Yes distinguished and extensive corporate and financial services experience including being the President of the Karachi Chamber of Commerce and Industry for two terms. Associated with Honda Motor Co., Japan since 1992 and has Mr. Toichi Ishiyama President/CEO No No broad experience in product business planning and operations Director & Senior President of the Atlas Group and was previously Chief Executive Mr. Aamir H. Shirazi No Yes Advisor of Atlas Honda Limited for over 11 years. Associated with the Honda Motor Co., Japan for the past 37 Mr. Kenichi Matsuo Director No No years and has experience in automobile assembly and business planning operations. Currently, he is VP production of HCAR. Associated with Honda Motor Co for the past 28 years and has Mr. Akira Murayama Director No Yes experience in financial management and business planning operations. Associated with the Atlas Group for more than 25 years in various capacities, with experience in and exposure to oil Mr. M. Naeem Khan Director No Yes marketing, food, investment banking, power and capital markets. Mr. Nadeem Arshad Extensive background in operations, general management and Director Yes Yes Elahi business development. He is amongst the co-founders of TRG. Associated with Honda Motor Co. for more than 35 years and Mr. Shigeru Yamazaki Director No Yes has experience in sales, product planning, marketing and diversified business operations. Has vast experience in the automobile industry, having worked with Honda ventures across the global including Japan, South Mr. Yasutaka Uda Director No Yes America, India and Pakistan. Currently, he is VP- Technical of Atlas Honda Limited.
Source: Company data
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Honda Atlas Car 25 July 2017 Automobiles. Pakistan
Financial Statements
Income Statement (Mar Year End) Cash Flow (Mar Year End) In PKRmn 2017a 2018e 2019e 2020e In PKRmn 2017a 2018e 2019e 2020e Revenue 62,803 89,765 104,836 115,710 Cash operating profit after taxes 7,415 8,465 9,634 10,342 COGS (53,681) (78,137) (91,413) (101,288) Change in working capital 18,394 9,599 (3,907) (7,263) Gross profit 9,122 11,628 13,423 14,423 Cash flow after change in WC 25,809 18,064 5,727 3,079 SG&A (1,040) (1,339) (1,464) (1,579) CAPEX (1,618) (779) (629) (694) Other operating inc (expense) 0 0 0 0 Investments 0 0 0 0 EBITDA 8,639 11,058 12,692 13,559 Free cash flow 24,192 17,285 5,098 2,384 Depreciation and amortisation (557) (769) (733) (716) Non-operating cash flow (4,492) 0 0 0 Net operating profit (EBIT) 8,082 10,288 11,959 12,843 Cash flow before financing 19,700 17,285 5,098 2,384 Share of results from associates 0 0 0 0 Net financing (996) (1,856) (3,078) (3,560) Net investment income (loss) 1,115 1,564 2,151 2,414 Change in cash 18,704 15,428 2,020 (1,176) Net interest income (expense) (23) (55) (76) (85) Source: Honda Atlas Cars, EFG Hermes estimates Other non-operating inc (exp.) (538) (645) (749) (805) FX gains (loss) 0 0 0 0 Net provisions 0 0 0 0 Income before taxes or zakat 8,636 11,153 13,285 14,367 Taxes or zakat (2,501) (3,457) (4,384) (4,741) Net inc before minority interest 6,135 7,696 8,901 9,626 Minority interest 0 0 0 0 Reported net income 6,135 7,696 8,901 9,626 Adjusted net income 5,875 7,696 8,901 9,626
Source: Honda Atlas Cars, EFG Hermes estimates Balance Sheet (Mar Year End) In PKRmn 2017a 2018e 2019e 2020e Cash and cash equivalents 30,480 45,908 47,928 46,752 Accounts receivable (current) 4,406 6,001 6,692 7,038 Inventory 6,793 9,976 11,775 13,161 Other debit balances (current) 4,701 6,719 7,848 8,662 Total current assets 46,380 68,605 74,243 75,612
PP&E (net) 4,402 4,611 4,507 4,485 Source:Honda Atlas Car, EFG Hermes estimates Goodwill & intangibles 373 373 373 373 Investments (non-current) 0 0 0 0 R ating Dis tribution Other debit balances (non-current) 310 111 111 111 R ating Coverage Universe% Total non-current assets 5,086 5,095 4,991 4,970 Buy 47% Total assets 51,465 73,700 79,234 80,582 Neutral 42% Short term debt 0 0 0 0 S ell 10% Accounts payable (current) 9,612 13,976 16,332 18,077 Not R ated 0% Other credit balances (current) 28,349 40,381 37,735 31,273 Under R eview 0% Total current liabilities 37,961 54,356 54,068 49,350 Long term debt 0 0 0 0 Other credit balances (non-current) N/A N/A N/A N/A Total non-current liabilities 440 440 440 440 Total net worth 13,065 18,904 24,727 30,793 Total equity 13,065 18,904 24,727 30,793 Total equity and liabilities 51,465 73,700 79,234 80,582
Source: Honda Atlas Cars, EFG Hermes estimates
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25 July 2017
Pak Suzuki Motor Co. Stock Rating Sell In need of a makeover, but lacks cash for significant capex Target Price PKR563
Closing Price Initiation of Coverage PKR667 Rating: Sell Target Price PKR562.54 Automobiles. Pakistan
Sell PSMC on valuation and lack of long-term sustainability We initiate coverage on Pak Suzuki Motor Co. (PSMC), the largest auto manufacturer in Pakistan with a Sell rating (TP of PKR563 implies 14% downside). PSMC assembles and sells Suzuki cars / light commercial vehicles, and motorcycles in Pakistan. Our negative view is based mainly on its too-high current valuation (TTM PE premium to historical of 21% and sector of 27%) and poor cash flows inhibiting LT growth. Also, despite its dominant 54% market share in passenger cars and LCVs, it has lost brand equity over time due to an over-reliance on its lower priced value offerings, which have not been significantly upgraded since the 1990s. We believe it has missed growth from a lack of innovation vs. used imported vehicles, and competition is only likely to get tougher. Furthermore, we believe weak cash flows, where only 28% of net income has converted to FCF (since FY06) and below-par profitability restricts its ability to significantly reinvest. Our TP, derived from DCF (CoE of 16.0% and 6% terminal growth), implies 14% downside and a P/E of 11.3x 2017e. Missed an opportunity to really grab the market by the horns
While PSMC has being growing, we believe its lack of innovation has meant that, whilst it remains the dominant player, its co mpetitors look like better value in the long run, as i) PSMC continues to derive two thirds of its sales volume from three cars that were la unched in the 1990s, resulting in below-par profit margins compared to peers; ii) we believe new model launches will require significant capex and because of poor cash flows, it will need to finance this externally – company is planning to invest USD460mn to introduce new models and add capacity, which seems unrealistic, given a market cap of USD522mn and an adjusted net cash balance of USD31mn (excluding security deposits & advance payments). This raises the possibility of capital raising or increasing its risk profile by takin g on debt in a cyclical industry; and iii) while organic growth prospects seem strong, there is risk to EPS estimates, as the industry becomes more competitive. We estimate FY17e/18e EPS to be 6% and 19% below consensus estimates, respectively. Frothy valuations are not supported by franchise quality
Over the short term, government-led incentives (taxi schemes) could provide an additional boost to profitability and share price performance. However, we believe below-par profitability, weak cash flow and, consequently, lower ability to reinvest compared to peers do not justify a 17% premium to the sector or a 43% premium to the market (CY17e PE of 13.4x vs. market at 9.4x).
Key Financial Highlights (Dec Year End) Stock Data Closing Price PKR667 as of 20 Jul 2017 H2,BH1,BWH1,CBH9In PKRmn, unless otherwise stated 2016a 2017e 2018e 2019e Last Div. / Ex. Date PKR5.50 / 17/04/2017 Revenue 76,516 95,369 112,034 126,820 Mkt. Cap / Shares (mn) PKR54,910 / 82.3 Av. Daily Liquidity (mn) PKR60.76 EBITDA 4,813 7,362 7,958 8,220 52-Week High / Low PKR895 / PKR402 Net income 2,792 4,087 4,373 4,794 Bloomberg / Reuters PSMC PA / PKSU.KA EPS (PKR) 33.9 49.7 53.1 58.2 Est. Free Float 26.9%
EPS consensus (PKR) 33.9 53.5 65.9 72.0 Price to earnings 19.7x 13.4x 12.6x 11.5x Dividend yield 0.8% 1.5% 1.6% 1.7% Net debt (cash) / Equity (0.3)x (0.3)x (0.3)x (0.4)x EV / EBITDA 8.7x 5.7x 5.3x 5.1x ROAE 11.0% 14.6% 13.8% 13.5% F ahad S haikh, CF A H2,BH1,BWH1,CBH9FCF yield -9.5% -0.8% 6.4% 7.5% fshaikh@ efg-hermes.com
Source: Pak Suzuki Motor Co., Bloomberg and EFG Hermes estimates
Disclosure Appendix at the back of this report contains important disclosures, analyst certifications Page 70 of 89 and the status of non-US analysts
Pak Suzuki Motor Co. 25 July 2017 Automobiles. Pakistan
Data Miner
Investment Thesis Valuation and Risks Pak Suzuki Motor Co. (PSMC) is the largest auto manufacturer in Our TP estimate for PSMC is PKR563/share which values the Pakistan with a Sell rating. PSMC assembles and sells Suzuki cars company at a CY17e and CY18e P/E of 11.3x and 10.6x, / light commercial vehicles, and motorcycles in Pakistan. Our respectively. We derive this estimate based on our DCF valuation negative view is mainly based on its too-high current valuation which values the operating cash flows (excluding interest and poor cash flows inhibiting LT growth. Also, despite its income) and then adds the TTM net cash position to that dominant 54% market share in passenger cars and LCVs, it has valuation. The cost of equity used in our model is 16.0% while lost brand equity over time due to an over-reliance on its lower we use a 6% terminal growth rate. Key upside risks include 1) priced value offerings, which have not been significantly government’s employment creation initiatives (Taxi’s for the upgraded since the 1990s. We believe it has missed growth from youth) which could potentially result in a one-off volume boost a lack of innovation vs. used imported vehicles and competition for PSMC, which we estimate could result in a one-off windfall is only likely to get tougher. Furthermore, we believe weak cash of PKR17-30/share and provide ST impetus to share price flows, where only 28% of net income has converted to FCF performance, 2) a significant turnaround in working capital (since FY06) and below-par profitability restrict its ability to management which improves FCF generation and thus impact reinvest significantly. our valuation positively and 3) sustained PKR strength against the JPY.
Dec Year End Dec Year End
In PKRmn, unless otherwise stated 2016a 2017e 2018e 2019e In PKRmn, unless otherwise stated 2016a 2017e 2018e 2019e
Income Statement Per Share Financial Summary Revenue 76,516 95,369 112,034 126,820 EPS (PKR) 33.9 49.7 53.1 58.2 EBITDA 4,813 7,362 7,958 8,220 DPS (PKR) 5.50 9.70 10.38 11.38 Net operating profit (EBIT) 3,805 5,910 6,261 6,634 BVPS (PKR) 319 363 406 454 Taxes or zakat (1,643) (2,013) (2,154) (2,361) Valuation Metrics Minority interest 0 0 0 0 Price to earnings 19.7x 13.4x 12.6x 11.5x Net income 2,792 4,087 4,373 4,794 Price to book value 2.1x 1.8x 1.6x 1.5x Balance Sheet Price to cash flow N/M 32.0x 11.9x 10.5x Cash and cash equivalents 8,548 7,666 10,365 13,614 FCF yield -9.5% -0.8% 6.4% 7.5% Total assets 37,852 45,154 51,414 57,710 Dividend yield 0.8% 1.5% 1.6% 1.7% Total liabilities 11,635 15,302 17,988 20,345 EV / EBITDA 8.7x 5.7x 5.3x 5.1x Total equity 26,217 29,851 33,426 37,365 EV / Invested capital 2.4x 1.9x 1.8x 1.8x Total net debt (cash) (8,548) (7,666) (10,365) (13,614) ROAIC 3.9% 5.1% 9.0% 10.3% Cash Flow Statement ROAE 11.0% 14.6% 13.8% 13.5% Cash operating profit after taxes 3,257 5,539 6,071 6,380 KPIs Change in working capital (5,372) (3,823) (1,452) (1,135) Revenue growth (Y-o-Y) -9.5% 24.6% 17.5% 13.2% CAPEX (3,113) (2,146) (1,120) (1,141) EBITDA growth (Y-o-Y) -48.9% 53.0% 8.1% 3.3% Investments 0 0 0 0 Gross profit margin 9.6% 10.6% 9.9% 9.5% Free cash flow (5,228) (430) 3,498 4,104 EBITDA margin 6.3% 7.7% 7.1% 6.5% Net financing (1,230) (453) (799) (855) Net operating profit (EBIT) margin 5.0% 6.2% 5.6% 5.2% Change in cash (6,458) (883) 2,699 3,249 Effective tax rate 37.2% 33.0% 33.0% 33.0% Source: Pak Suzuki Motor Co., EFG Hermes estimates Net Debt (Cash) / Equity (0.3)x (0.3)x (0.3)x (0.4)x
Net Debt (Cash) / EBITDA (1.8)x (1.0)x (1.3)x (1.7)x Source: Pak Suzuki Motor Co., EFG Hermes estimates
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Pak Suzuki Motor Co. 25 July 2017 Automobiles. Pakistan
Pak Suzuki Motor Company – In need of a serious makeover
Investment thesis
Valuation already prices in too much optimism
At its current price, PSMC trades at a TTM P/E of 17.6x (21% premium to history) and a forward P/E of 13.4x, which is a 17% premium to the sector. Although we expect PSMC’s earnings growth to be relatively robust over the forecast horizon (CY16-CY21e EPS CAGR of 17%), as it benefits from increased capacity utilisation, we believe its fair value is 14% below current levels (-16% excluding DY). While the market has priced in PSMC’s top-line growth potential, we do not believe its current valuation reflects the poor quality of its earnings or the weak business franchise.
Figure 129: PE relative to history (x) Figure 130: Forward PE relative to peers (x) PSMC trades at a 21% premium TTM P/E relative to history PSMC trades at a significant premium to peers, pricing in strong growth
Source: Company data, EFG Hermes estimates Source: Company data, EFG Hermes estimates
Weak business franchise has resulted in poor pricing and lower margins
PSMC continues to derive 2/3rd of its sales volume from three products (Suzuki Mehran, Suzuki Bolan and Suzuki Ravi) that were launched in 1990s. We believe this lack of investment, and model reinvigoration is a key weakness in their business model. This has been evident over the past two years, where unlike industry practice PSMC has moved to a uniform pricing model across the country, i.e., PSMC bears the transportation cost of its products to the customer. We estimate all else being equal, this change has eroded 1.3ppts from its EBITDA margin (margin would have been 7.6% instead of the 6.3% reported in FY16). In essence, PSMC has passed on the input price savings of a weaker JPY into better pricing for the customer which, in our view, highlights the competitive market dynamics.
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Pak Suzuki Motor Co. 25 July 2017 Automobiles. Pakistan
Figure 131: LT EBITDA margin% (average)
Source: Company data, EFG Hermes estimates
Figure 132: PSMC has passed on the benefit of lower raw material costs to its customers In PKRmn 2014 2016
Revenue 53,665 76,516 Transportation and handling charges 75 1,145 Reported EBITDA 3,454 4,813 Margin (%) 6.4 6.3
Adjusted Transportation Cost 75 106 Adjusted EBITDA 3,454 5,852 Margin (%) 6.4 7.6
Source: Company data, EFG Hermes estimates
Used imports – affecting some more than others
Pakistan allows the import of used passenger cars with an age limit of three years under the personal baggage scheme, transfer of residence scheme and the gift scheme. In 2016, around 50,560 units were imported to Pakistan (the bulk of which we believe are used cars). 65% of these imports are smaller cars with an engine displacement of less than 1,000cc, and we estimate that the average landed price of cars in this category is PKR1mn (~USD10k), positioning them in direct competition with PSMC’s product line-up. The general market perception is that used Japanese manufactured cars are much better quality and offer better technology and features compared to domestically manufactured cars in this price range. We believe these imports are the key competitor for PSMC’s product line-up and, unless there is regulatory change, better enforcement of import policies or model refreshes from PSMC, these imports will likely continue eating into PSMC’s growth.
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Pak Suzuki Motor Co. 25 July 2017 Automobiles. Pakistan
Figure 133: Mix of imported vehicles by engine displacement (%)
Source: UN Comtrade, EFG Hermes estimates
Weak cash flows, a concern for earnings quality
We are of the view that when earnings and valuations are elevated, one needs to stick with high quality companies. In PSMC’s case, the quality of its earnings is a concern for us. As shown below, PSMC’s net income has exceeded cash flows by PKR11bn since FY05 due to NWC changes. While we can understand short-term mismatches between earnings and cash flows, a through-the-cycle mismatch (FY05-16) suggests a fundamental problem. We believe this problem can be explained by lower inventory turns, relative to peers, and an inability to manage cash flows, as well as peers through the advance booking process due to limited successful model refreshes. We believe this is a key risk to future capital expenditure and, unless there is a sustained improvement, it will continue to imply a much lower dividend payout ratio than peers.
Figure 134: Cumulative cash flows vs. reported income Figure 135: Gap between cumulative income and cash flows (PKRmn) (PKRmn)
Source: Company data, EFG Hermes estimates
Source: Company data, EFG Hermes estimates
Bottom line: PSMC needs product reinvigoration to compete effectively
The Automotive Development Policy (2016-21) is likely to be a game changer for the industry, in terms of the incentives that are being offered to new entrants in this sector. We estimate that industry capacity utilisation could drop from 83% currently to 66% by FY21. Expecting a more competitive industry landscape, we believe investors need to focus on companies with the strongest brand equity. In PSMC’s case, we do not believe a cheap product offering on its own is a sustained competitive advantage and is likely to be challenged by new entrants in this space.
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Pak Suzuki Motor Co. 25 July 2017 Automobiles. Pakistan
Current valuations imply over-optimism on growth with no discount on earnings quality
PSMC is well-positioned to drive strong EPS growth due to availability of excess capacity. However, we believe current valuations are more than pricing it in, with the stock trading at a significant premium to history, to its peers and to the market (see charts below). Despite its appeal of being the largest mass- market automotive play in Pakistan, we believe the company has not lived up to these expectations. History has shown that i) PSMC’s volumes have been more cyclical than peers, as the lower end of the market has been more vulnerable to economic shocks; ii) Since FY02, PSMC’s volume CAGR of 10.8% has underperformed peers (HCAR: 11.2% and INDU: 12.2% CAGR); iii) Profitability has underperformed peers due to lack of model refreshes; and iv) cash flow generation has been poor, resulting in limited payouts for shareholders. Furthermore, we believe consensus numbers are too optimistic on margin improvement, where we expect EPS to be 7% and 19% lower than Bloomberg consensus for CY17-18e, respectively. Given this backdrop, we are comfortable with a Sell rating on the stock, despite strong earnings growth expectations.
Figure 136: Difficult to make an investment case for PSMC based on current valuations P/E relative to history (x) EV/EBITDA relative to history (x)
P/E relative to sector (x) P/E relative to market (x)
Source: Company data, EFG Hermes estimates
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Pak Suzuki Motor Co. 25 July 2017 Automobiles. Pakistan
Valuation
We have a DCF-based target price of PKR563 for PSMC, after factoring in a cost of equity of 16.0% and a terminal growth rate of 6%. Important to note is the significant cash outflow during CY17e, which is driven by 100% cash margin requirement by banks on imports, which will affect cash flows negatively. From thereon, we have been conservative in our approach and accounted for slight improvement in their cash conversion cycle, which has been relatively weak historically.
Figure 137: PSMC Valuation In PKRmn 2016 2017e 2018e 2019e 2020e 2021e
Net income 2,773 4,087 4,373 4,794 5,419 6,097 Add: depreciation 1,009 1,452 1,697 1,586 1,517 1,520 Capex (3,113) (2,146) (1,120) (1,141) (1,243) (1,531) NWC changes (5,372) (3,823) (1,452) (1,135) (638) (124) Changes in debt ------FCFE (4,704) (430) 3,498 4,104 5,056 5,962 Less: interest income 536 394 468 663 919 1,251 Operating FCFE (5,240) (824) 3,030 3,441 4,137 4,711
Risk-free rate (%) 11%
Risk premium (%) 5%
Terminal growth rate (%) 6%
Beta (x) 1.0
Cost of Equity (%) 16.0%
NPV of 5 years FCFE 9,595
NPV of Terminal Value 23,766
TTM Net cash 12,937
Value of Equity 46,297
Per Share value 563
Source: Company data, EFG Hermes estimates
Figure 138: Target price sensitivity to cost of equity and terminal growth rate (PKR/share) DCF Sensitivity
Cost of Equity
15.0% 15.5% 16.0% 16.5% 17.0%
5.0% 548 541 534 527 520
5.5% 562 555 547 540 533 6.0% 578 570 563 555 548 Rate% Growth 6.5% 595 587 579 571 564 7.0% 615 606 598 589 581
Source: Company data, EFG Hermes estimates
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Pak Suzuki Motor Co. 25 July 2017 Automobiles. Pakistan
Risks to investment thesis
Short-term price performance on the back of government fiscal measures: The Government of Pakistan has recently announced a plan to facilitate sale of 50k auto vehicles to boost youth employment (taxi scheme). This is against an earlier announcement of 100k vehicles. Based on initial news flow, total reimbursement amount has been set at PKR35bn for 50k vehicles, implying a per-vehicle price of PKR700,000. Given this price tag, PSMC is likely to be the key beneficiary, given their lower priced product line-up. We estimate that this one-off event could add ~PKR17/share to PSMC’s EPS and potentially twice that amount based on 100k units. Although we view this as a one-off event, it could potentially result in ST price performance based on the boost to earnings.
Product revival leading to better pricing and profitability: PSMC’s EBITDA margin of 7% relative to 14% for HCAR and 17% for INDU, implies significant room for improvement. However, we are not convinced that PSMC can play catch-up, unless there are significant changes to the product portfolio, which will require substantial capital expenditure. All else held equal, if PSMC were to improve EBITDA margin from 7% to around 11%, it would imply an EPS uplift of between 23-81% over our forecast horizon, as highlighted below. However, we would note that the cost of this margin uplift through the introduction of new products could be material (PKR7-8bn assuming it is for one product and an investment in its current plant and not a new greenfield), and this cost is not reflected in our DCF calculation below. The PKR7-8bn estimate is based on management comments from INDU regarding the cost of introducing a new product to the line-up.
Figure 139: Sensitivity analysis
FY17e FY18e FY19e FY20e FY21e
Base case EPS 50 53 58 66 74 Bull case EPS 50 65 87 109 134 % change 0% 23% 49% 65% 81%
PKR/share Upside* %
Base case TP 563 (14)
Bull case TP 918 39
% change 63%
*Based on closing price of 20th July 2017 Source: Company data, EFG Hermes estimates,
Competitive forces do not materialise as expected: As would be expected, there is a significant push by local incumbents to push back on the incentives provided to new entrants or to at least get access to the same incentives. We believe that, given current profitability levels, local manufacturers will find it difficult to justify why the market should not be more competitive, especially if we account for the long period local incumbents have had to establish local supply chains and entrench their brands. That said, policy outlook is always volatile and, if competitive forces do not increase in Pakistan, we believe profitability could evolve better than we expect.
Import regulation changes: As discussed under the investment thesis section, we believe used imported cars have eaten into PSMC’s growth prospects. While this policy is likely to remain consistent, any changes that restrict the import of used cars will be highly beneficial for the entire sector, but more so for PSMC, which bears the brunt of this competition.
Recently-announced tax changes: PSMC has a payout ratio of 16% (17% over the long term), which puts it into the ambit of recent tax changes, where companies with a payout of less than 40% will likely incur an additional tax of 10% on their profits. This could potentially result in PSMC raising its payout ratio, but we view this as unlikely, given our analysis of their cash flow conversion. A more likely scenario is PSMC paying out bonus shares to achieve the 40% payout threshold, which might be a short-term positive for sentiment, but has no implication on the investment case.
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Pak Suzuki Motor Co. 25 July 2017 Automobiles. Pakistan
New auto policy to usher in new competition
The new Automotive Development Policy 2016-21 (ADP), is a game changer for the industry, in our opinion. Historically, the industry has largely operated as an oligopoly and the strong pricing that comes along with that has been one of the key drivers behind the recent surge in profitability. However, we believe super profits, along with a more incentivised policy environment for new entrants are likely to pave way for a more competitive market thus normalising profit margins on a five-year view. Incentives offered as part of the ADP are in the form of (quoted from the ADP document):
1. Greenfield investments: Installation of new and independent automotive assembly and manufacturing facilities by an investor for the production of vehicles of a make not already being assembled/manufactured in Pakistan a. Duty-free import of plant and machinery for setting up the assembly and/or manufacturing facility on a one-time basis b. Import of 100 vehicle of the same variant in CBU form at 50% of the prevailing duty for test marketing after ground breaking of the project c. Concessional rate of custom duty @10% on non-localised parts and @25% on localised parts for a period of five years for manufacturing of cars and LCVs d. Import of all parts (both localised and non-localised) at prevailing customs duty applicable to non-localised parts for manufacturing of trucks, buses and prime-movers for a period of three years
2. Brownfield investment: Revival of an existing assembly and/or manufacturing facilities, that is non-operational or close on or before 1 July 2013 and the make is not in production in Pakistan since that date and that the revival is undertaken either independently by original owners or new investors or under joint-venture agreement with foreign principal or by foreign principal independently through purchase of plant a. Import of non-localized parts @10% rate of customers duty and localized parts at 25% duty for a period of three years for the manufacturing of cars and LCVs b. Import of all parts (both localized and non-localized) at prevailing customs duty applicable to non-localized parts for manufacturing of trucks, buses and prime-movers for a period of three years
We believe these incentives are material, especially if we put them in context of local manufacturers importing an estimated 55-60% of their raw materials (estimated based on related party purchases as a % of total raw material purchases). Thus, new entrants are likely to have a significant procurement competitive advantage for a period of five years. Based on already announced plans: i) Kia, Hyundai and Renault are looking to start manufacturing domestically; ii) Dewan Farooque Motors is likely to bring online its idle capacity; iii) Sazgar Engineering has also announced plans to start manufacturing passenger cars; and iv) INDU is increasing capacity by 10k units per annum, while PSMC also has room to de- bottleneck their paint-shop, in our view. If all these investments go ahead, we estimate that industry capacity utilisation could drop from 83% currently to 65-70% by 2021, even if demand conditions remain robust.
In an environment where competitive forces are likely going to increase, while the sector is trading at a significant premium, relative to history and to the market, we believe buying PSMC is likely to expose investors to downside risk, given its premium valuations, coupled with an unexciting product portfolio and weak cash flow generation, which restricts ability to invest meaningfully.
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Pak Suzuki Motor Co. 25 July 2017 Automobiles. Pakistan
Cash flow and expansion challenge explained
A key issue we want to flag is PSMC’s weak cash flow generation in absolute terms – but also relative to peers, which indicates to us that it is a company-specific issue rather than a business model/industry issue.
Since FY05, PSMC has generated net profit of PKR25bn
Adding back cumulative D&A implies cash net profit of PKR37bn
This compares to cash flow from operations of only PKR26bn
Implies a PKR11bn cash flow shortfall relative to reported earnings (FY05-1Q17)
Figure 140: Cash generation relative to reported earnings (PKRmn)
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 YTD
CFO 4,716 101 (897) (1,460) 2,399 282 (908) 959 2,351 1,219 14,265 (2,115) 5,541 Net Capex (1,762) (1,333) (1,834) (1,259) (1,271) (869) (828) (517) (1,599) (1,014) (690) (3,113) (1,032) FCF 2,954 (1,232) (2,730) (2,719) 1,128 (587) (1,736) 442 752 204 13,575 (5,228) 4,509
Net Income + D&A 2,880 4,361 3,970 1,667 1,224 1,376 1,829 1,985 2,733 3,040 6,945 3,781 1,574
CFO less NI + D&A 1,836 (4,260) (4,867) (3,127) 1,175 (1,094) (2,738) (1,025) (382) (1,822) 7,319 (5,896) 3,966 Cumulative cash mismatch 1,836 (2,424) (7,291) (10,418) (9,243) (10,338) (13,075) (14,101) (14,483) (16,305) (8,985) (14,881) (10,915)
Source: Company data, EFG Hermes estimates
Key reasons behind the cash shortfall were: 1) Slight deterioration in the inventory turnover, but performance is significantly below peers
Figure 141: Inventory turnover (x) 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 TTM
PSMC 6 6 5 5 3 5 5 5 4 4 5 5 5 INDU 8 8 10 13 10 12 10 10 7 8 15 13 11 HCAR 5 7 5 6 6 6 7 5 8 9 7 7 10
Source: Company data, EFG Hermes estimates
2) Deterioration in the advance booking cycle
Figure 142: Advances from customers 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 TTM
PKRmn 7,344 6,187 2,409 372 442 327 3,065 1,144 629 2,159 4,226 1,625 4,590 % of sales 21 13 5 1 2 1 6 2 1 4 5 2 6
Source: Company data, EFG Hermes estimates
3) Sales tax and excise duty adjustables (receivables) have increased by PKR3.2bn over this time period
Overall, while some of these may be timing differences, we believe the stark difference in cash generation, relative to peers within the same sector, which have the same business model, is indeed a cause for concern, in our opinion.
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Pak Suzuki Motor Co. 25 July 2017 Automobiles. Pakistan
Figure 143: PSMC cash generation (PKRmn) Figure 144: INDU cash generation (PKRmn)
Source: Company data, EFG Hermes estimates Source: Company data, EFG Hermes estimates
Our emphasis on cash generation is increasingly important in an environment where PSMC needs to spend on their business to either reinvigorate their product line-up or even to benefit from longer-term growth in the Pakistan market. As per media comments, PSMC is willing to invest up to USD460mn, i.e., PKR48bn to set up a new manufacturing facility to introduce four new models to the Pakistan market if the new auto policy is revised to ensure that existing incumbents get the same incentives as new entrants.
To put this potential investment into perspective, we would first note that PSMC has a net cash position of PKR12.9bn and around PKR9.6bn of this cash is customer advances and security deposits from dealers. Therefore, if PSMC had to undertake significant capital expenditure today, it technically would only be in a position to spend around PKR3.3bn, which is significantly less than the PKR48bn needed to build a new plant and introduce new products to the market.
Figure 145: Balance sheet indicators In PKRmn 2009 2010 2011 2012 2013 2014 2015 2016 TTM
Net Debt/(Cash) (3,466) (2,867) (1,064) (1,417) (1,964) (1,841) (15,006) (8,548) (12,937) Customer Advances 442 327 3,065 1,144 629 2,159 4,226 1,625 4,590 Security Deposits 810 1,157 1,518 1,571 1,703 1,917 2,068 3,673 5,035 Adjusted Net Debt/(Cash) (2,214) (1,384) 3,519 1,297 368 2,236 (8,711) (3,250) (3,312)
Source: Company data, EFG Hermes estimates
While we cannot rule out a significant capital expenditure programme, we believe a USD460mn programme will likely require funding through a rights issue. With regard to debt funding, we doubt that PSMC would aggressively leverage its balance sheet as it has historically been very averse to debt because of the cyclical nature of the auto industry in Pakistan.
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Pak Suzuki Motor Co. 25 July 2017 Automobiles. Pakistan
Business overview
Pak Suzuki Motor Company (PSMC) was formed in 1983 as a joint venture between Pakistan Automobile Corporation Limited (representing Government of Pakistan) and Suzuki Motor Corporation (SMC) Japan with the primary objective of progressive manufacturing, assembling and marketing of cars, pick-ups, vans and 4x4 vehicles in Pakistan. The company was then privatised in 1992 with the Suzuki Motor Corporation increasing its shareholding to 73.1%. In 2007, the company then had an amalgamation with Suzuki Motorcycle Pakistan limited (SMPL), which was completed through a share swap scheme. The entire production of the motor business and the motorcycle business takes place at Bin Qasim in Karachi. The company has a broad product line-up (which we suspect might be the reason behind weaker NWC management relative to peers), but plays largely at the lower end of the market with an average product price of just under PKR1mn. In addition to its domestically manufactured auto vehicle portfolio, the company also has a trading business (3% of group revenue), which imports and sells the Suzuki Vitara, Ciaz, APV and Jimny.
Figure 146: Domestically manufactured product line-up
CKD Products Engine capacity Average price (PKR '000)
Suzuki Ravi 796cc 672 Suzuki Bolan 796cc 730 Suzuki Mehran 796cc 741 Suzuki Wagon-R 998cc 1074 Suzuki Cultus 998cc 1,321 Suzuki Swift 1328cc 1,419
Source: Company data, EFG Hermes estimates
The company has a leading 54% market share within the car, LCVs and jeep market in Pakistan and mostly controls 100% of the small car domestically manufactured market (less than 1300cc segment). They also have a strong presence within the LCV segment with Suzuki Ravi which commands a market share of 75% (with INDU having the other 25%).
Figure 147: Market share (passenger cars and LCVs) Figure 148: PSMC dominates the <1300cc market (market share %)
Source: Company data, EFG Hermes estimates Source: Company data, EFG Hermes estimates
The motorcycle manufacturing business of PSMC is relatively immaterial in the bigger scheme of things. The motorcycle business has a capacity of 44,000 units per annum and on TTM basis only 42% of that is being utilised. They have a small 1% market share in the overall market for two- and three-wheelers with the market mainly being dominated by Atlas Honda (different entity than Honda Atlas Car), which has a 59% market share.
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Unlike its automobile business, which plays at the lower end of the market, the motorcycle products are pitched at higher price points (63% higher than Honda based on average revenue per unit). As per management comments, the automobile business remains the core focus area for the group, while it is unlikely that the motorcycle business sees any significant growth investments. In our opinion, this makes sense, given an already unutilised production capacity.
Figure 149: Group revenue mix
Revenue mix % 2009 2010 2011 2012 2013 2014 2015 2016 TTM Automobile 97 97 97 98 96 96 98 97 97 Motorcycle 3 3 3 2 4 4 2 3 3
Source: Company data, EFG Hermes estimates
The automobile business is the key profitability driver. Due to lack of scale and relatively pricier product, the motorcycle business is a marginal drag on profitability. By comparison, the market leader Atlas Honda makes an operating margin of 6-7% on its motorcycle business. Assuming PSMC were to earn the same margin, it would imply a meagre PKR98mn uplift to profitability – thus, this is unlikely to be a game changer for the company. The table below also highlights that only 4% of group assets are allocated to the motorcycle business, while capital expenditure has been very moderate (marginally higher than depreciation since 2009).
Figure 150: Divisional profitability metrics In PKRmn 2009 2010 2011 2012 2013 2014 2015 2016 TTM
Revenue
Automobile 25,364 41,497 51,374 57,130 49,251 51,536 82,508 74,468 78,250 Motorcycle 870 1,145 1,345 1,401 1,810 2,129 2,041 2,048 2,164
EBIT
Automobile 68 548 1,257 1,627 2,225 2,819 8,645 4,043 4,388 Motorcycle (208) (378) (387) (499) (502) (484) (335) (238) (6)
EBIT margin (%)
Automobile 0 1 2 3 5 5 10 5 6 Motorcycle (24) (33) (29) (36) (28) (23) (16) (12) (0)
Segment assets
Automobile 12,046 13,223 17,070 14,578 15,767 19,894 17,618 22,330 28,074 Motorcycle 1,016 1,192 1,555 1,527 2,103 2,662 2,486 1,944 1,772
Return on assets (%) Automobile 1 4 8 10 15 16 46 20 17 Motorcycle (21) (34) (28) (32) (28) (20) (13) (11) (0)
Capex
Automobile 1,042 380 547 426 1,881 773 614 3,023 2,900 Motorcycle 33 150 370 55 62 108 118 100 104
Source: Company data, EFG Hermes estimates
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Pak Suzuki Motor Co. 25 July 2017 Automobiles. Pakistan
Operating profitability drivers
From an ROE perspective, PSMC stands out relative to peers, where ROE has not moved up to the same extent as it has for peers in the sector. As discussed earlier, PSMC seems to have passed on the raw material savings on to its customers; thus, operating margin has remained relatively low. While this implies more sustainable profitability for PSMC, we believe it reinforces our view about the weaker product portfolio leading to lower pricing power.
Figure 151: ROE breakdown
2010 2011 2012 2013 2014 2015 2016 TTM
Tax burden (%) 32 58 65 79 73 67 63 64 Interest burden (%) 399 150 127 121 109 105 117 112 EBIT margin (%) 0 2 2 3 4 10 5 5 Asset turnover (x) 2.3 2.5 2.6 2.3 2.1 2.6 2.0 1.9 Leverage ratio (%) 128 143 144 135 141 150 148 159 Adjusted ROE (%) 1 5 6 10 10 27 11 12
Source: Company data, EFG Hermes estimates
From a gross margin perspective, the company has benefitted from price/mix gains outpacing raw material trends, similar to peers in the industry. However, in PSMC’s case, other costs have increased substantially due to a change in business model, whereby they incur the transportation and handling costs relative to peers who make customers pay for delivery charges, depending on the city that they live in (it is worth mentioning that PSMC has one plant that is located in the south of the country in Karachi). We estimate that this move alone has cost the company 1.3ppts of EBITDA margin.
Figure 152: CAGR 2013-16 (%)
Source: Company data, EFG Hermes estimates
Going forward, we have taken a more cautious view on EBITDA margin, despite the fact that PSMC’s profitability is below industry and global averages. We believe the fact that PSMC was unable to lift margins during the heydays that exist right now is evidence of the impact old models are having on profitability. Given a backdrop where competitive forces are likely to increase, we believe PSMC will continue to underperform peers on profitability metrics.
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Pak Suzuki Motor Co. 25 July 2017 Automobiles. Pakistan
Figure 153: Profit margins (%)
2010 2011 2012 2013 2014 2015 2016 2017e 2018e 2019e 2020e 2021e
Gross margin % 2.4 3.5 4.0 6.4 7.8 13.6 9.6 10.6 9.9 9.5 9.5 9.4 Distribution cost % 0.5 0.5 0.6 1.1 1.4 2.3 2.6 2.6 2.6 2.6 2.6 2.6 Administrative % 1.5 1.4 1.5 1.9 2.1 1.5 2.0 1.8 1.7 1.6 1.6 1.6 EBITDA % 3.1 3.6 3.6 5.1 6.4 11.1 6.3 7.7 7.1 6.5 6.3 6.2
Source: Company data, EFG Hermes estimates
Over the forecast horizon, we expect revenue CAGR of 14%, driven by a volume CAGR of 7%. We expect EBITDA CAGR of 14% over the same time period, as we expect their profitability will continue to underperform peers and have thus not factored in any reversion towards sector average. In addition, tax rate normalisation from 37% in CY16 to a normalised level of 33% (we have continued to factor in the super tax across our forecast horizon), adds another 2ppts to our growth forecast, leading to our EPS CAGR expectations of 17% between CY16-21e. It is worth highlighting that the spike in 2015 profitability was driven by a one-off government taxi scheme, which resulted in a strong volume uptick and, in turn, a significant improvement in profitability – we do not see that level of profitability sustainable under normal circumstances.
Figure 154: Robust revenue growth over the forecast period… Figure 155:…driven by continued volume growth Revenue (PKRmn) Unit sales
160,000 180,000
140,000 160,000 140,000 120,000 120,000 100,000 100,000 80,000 80,000 60,000 60,000 40,000 40,000
20,000 20,000
- -
Source: Company data, EFG Hermes estimates Source: Company data, EFG Hermes estimates
Figure 156: EBITDA margin (%) unlikely to provide impetus Figure 157: Expect EPS CAGR of 17% over the next five years EBITDA margin (%) EPS (PKR)
12.0 80
70 10.0 60 8.0 50
6.0 40
30 4.0 20 2.0 10
- - 2012 2013 2014 2015 2016 2017e2018e2019e2020e2021e 2012 2013 2014 2015 2016 2017e2018e2019e2020e2021e
Source: Company data, EFG Hermes estimates Source: Company data, EFG Hermes estimates
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Pak Suzuki Motor Co. 25 July 2017 Automobiles. Pakistan
Board of Directors and shareholding structure
Pak Suzuki Motor Company is 73% owned by its parent, Suzuki Motor Corporation, Japan. This ownership structure is reflected in its BoD, where 86% of the directors (six out of seven) are connected to the parent company, including the Chairman, CEO and Deputy Managing Director. There is only one independent director on the board, i.e., Mr Shahid Ghaffar who is a nominee director of National investment Trust Limited (NIT) and has significant experience in fund management, risk management, market monitoring and surveillance in capital market and formulation and regulatory function of capital markets.
Figure 158: Pak Suzuki Motor Company Board of Directors Independen Non- Members Role Experience t executive Associated with the Suzuki Group since 1981 and has worked Mr. Kinji Saito Chairman No Yes in numerous capacities with Suzuki Motor Corporation, Japan (SMC) and its overseas subsidiaries Mr. Hirofumi Associated with the Suzuki Group since 1978 and has CEO No No Nagao previously been MD of PSMC between 1994 and 2000. Deputy Associated with the Suzuki Group since 1982 and has worked Mr. Tetsuya Fujioka Managing No No in numerous capacities across the group including the position Director of Chief Engineer for Suzuki's JV in Canada Mr. Toshihiro Associated with the Suzuki Group since 1994 and has been Director No Yes Suzuki appointed CEO of SMC since 2016 Associated with the Suzuki Group since 1983 and is currently a Mr. Minoru Amano Director No Yes Divisional General Manager of Asia Automobile Division in SMC Mr. Kazuyuki Associated with the Suzuki Group since 1987 and is currently a Director No Yes Yamashita Group Manager of Asian Automobile Group 1 in SMC Nominee Director of National Investment Trust Limited (NIT). He is currently MD of NIT since 2014 and has significant Mr. Shahid Ghaffar Director Yes Yes experience in fund management, risk management and in formulation and regulatory function of capital markets.
Source: Company data, EFG Hermes estimates
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Pak Suzuki Motor Co. 25 July 2017 Automobiles. Pakistan
Financial Statements
Income Statement (Dec Year End) Cash Flow (Dec Year End) In PKRmn 2016a 2017e 2018e 2019e In PKRmn 2016a 2017e 2018e 2019e Revenue 76,516 95,369 112,034 126,820 Cash operating profit after taxes 3,257 5,539 6,071 6,380 COGS (69,167) (85,233) (100,937) (114,822) Change in working capital (5,372) (3,823) (1,452) (1,135) Gross profit 7,349 10,136 11,096 11,999 Cash flow after change in WC (2,115) 1,716 4,618 5,245 SG&A (3,544) (4,226) (4,835) (5,365) CAPEX (3,113) (2,146) (1,120) (1,141) Other operating inc (expense) 0 0 0 0 Investments 0 0 0 0 EBITDA 4,813 7,362 7,958 8,220 Free cash flow (5,228) (430) 3,498 4,104 Depreciation and amortisation (1,009) (1,452) (1,697) (1,586) Non-operating cash flow 0 0 0 0 Net operating profit (EBIT) 3,805 5,910 6,261 6,634 Cash flow before financing (5,228) (430) 3,498 4,104 Share of results from associates 0 0 0 0 Net financing (1,230) (453) (799) (855) Net investment income (loss) 0 0 0 0 Change in cash (6,458) (883) 2,699 3,249 Net interest income (expense) 896 629 736 1,024 Source: Pak Suzuki Motor Co., EFG Hermes estimates Other non-operating inc (exp.) (285) (439) (470) (503) FX gains (loss) 0 0 0 0 Net provisions 0 0 0 0 Income before taxes or zakat 4,415 6,100 6,527 7,155 Taxes or zakat (1,643) (2,013) (2,154) (2,361) Net inc before minority interest 2,773 4,087 4,373 4,794 Minority interest 0 0 0 0 Reported net income 2,773 4,087 4,373 4,794 Adjusted net income 2,792 4,087 4,373 4,794
Source: Pak Suzuki Motor Co., EFG Hermes estimates Balance Sheet (Dec Year End) In PKRmn 2016a 2017e 2018e 2019e Cash and cash equivalents 8,548 7,666 10,365 13,614 Accounts receivable (current) 1,205 1,425 1,584 1,691 Inventory 16,400 19,849 23,160 25,953 Other debit balances (current) 4,365 8,186 8,854 9,446 Total current assets 30,518 37,126 43,963 50,704
PP&E (net) 6,672 7,366 6,789 6,344 Source: Pak Suzuki Motor Co., EFG Hermes estimates Goodwill & intangibles 73 73 73 73 Investments (non-current) 0 0 0 0 R ating Dis tribution Other debit balances (non-current) 589 589 589 589 R ating Coverage Universe% Total non-current assets 7,334 8,027 7,451 7,006 Buy 47% Total assets 37,852 45,154 51,414 57,710 Neutral 42% Short term debt 0 0 0 0 S ell 10% Accounts payable (current) 6,300 7,763 9,194 10,459 Not R ated 0% Other credit balances (current) 5,335 7,539 8,794 9,886 Under R eview 0% Total current liabilities 11,635 15,302 17,988 20,345 Long term debt 0 0 0 0 Other credit balances (non-current) 0 0 0 0 Total non-current liabilities 0 0 0 0 Total net worth 26,217 29,851 33,426 37,365 Total equity 26,217 29,851 33,426 37,365 Total equity and liabilities 37,852 45,154 51,414 57,710
Source: Pak Suzuki Motor Co., EFG Hermes estimates
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Pakistan Autos 25 July 2017 Automobiles Pakistan
Disclaimer
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I, Fahad Shaikh, CFA, hereby certify that the views expressed in this document accurately reflect my personal views about the securities and companies that are the subject of this report. I also certify that neither I nor my spouse(s) or dependents (if relevant) hold a beneficial interest in the securities that are subject of this report. I also certify that no part of my respective compensation, was, is, or will be directly or indirectly related to the specific ratings or view expressed in this research report.
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