Bajaj Auto April 29, 2016
BHIL Investment Thesis
Bajaj Auto is a stock we would not normally research but it accounts the majority of the value of Bajaj Holdings and Investments (BHIL). BHIL is a holding company trading at a discount to the current market values of its investment holdings. Its main assets are a 31.49% stake in Bajaj Auto and a 29.15% stake in Bajaj Finserv. The Bajaj Auto position accounts for roughly 56% of the company’s total value and Bajaj Finserv accounts for another 27%. The company’s remaining value is split between a large number of equity investments and fixed income investments.
At the end of March 2015, BHIL had no debt and a net cash position of INR4,514 million equal to 5.2% of its current market cap. BHIL is 54.4% owned by the Bajaj family and its associates with the remainder owned by the public. If Bajaj Auto and Bajaj Finserv’s market prices are a good approximation of fair value, there is significant upside to BHIL assuming a 30% holding company discount. Unfortunately, the market often misprices securities and if Bajaj Auto and Bajaj Finserv are overvalued then the discount BHIL is trading at relative to the underlying investments may be warranted. It seems Bajaj Auto is significantly overvalued therefore no position is taken in BHIL.
Bajaj AutoInvestment Thesis
Bajaj Auto is the second largest Indian and the fourth largest motorcycle manufacturer in the world. There seems to be brand advantages and economies of scale creating barriers to entry in the Indian two wheeler industry. The company’s management is doing a good job operationally, and strategically. There are minor corporate governance issues but nothing to eliminate Bajaj Auto as a potential investment. At the current time, valuation is a concern. The market is pricing in a very rosy picture with the company trading on a FCF yield of 3.3%. Bajaj would be an attractive opportunity below INR1,300.
Bajaj Auto is India’s second largest two wheeler manufacturer and the world’s 4th largest motorcycle manufacturer. It has been producing scooter and two wheelers since 1945. Over the last decade, the company has successfully changed its image from a scooter manufacturer to a motorcycle manufacturer. The company now exports its products to over 50 countries. In 2008, Bajaj Auto demerged into three separately listed entities, Baja Auto, Bajaj Finserv Ltd, and Bajaj Holdings and Investment Limited. These companies are all listed on the National Stock Exchange of India with an initial listing on May 26, 2008.
In November 2007, Bajaj Auto acquired 24.5% stake in KTM Power Sports AG (holding company of KTM Sportmotorcycles AG) for 98.4 million euros. KTM is known as a high performance motorcycle brand. The company is consistently Europe’s largest motorcycle brand and is a dominant maker of off road motorcycles with 260 World Championships and 15 consecutive Dakar victories. Bajaj Auto has since increased its investment by 99.7 million euros making its total investment in KTM equal to 198.1 million euros with the company’s stake increasing from 24.5% to 48%. Bajaj manufacturers all KTM bikes under 600ccs in India lowering the manufacturing cost for KTM’s bikes. Bajaj also distributes KTM bikes throughout its distribution network. Bajaj distributes its products throughout KTM network as well as received technological expertise from KTM’s motors. KTM is listed on the Vienna Stock Exchange. At current market prices, Bajaj Auto’s 198 million euro investment in KTM is now worth 595.58 million euros.
Bajaj Auto produces and exports motorcycles, three wheelers, and quadricycles. Its headquarters are in Pune, with plants in Akurdi and Chakan (Pune), Waluj (near Aurangabad) and Pantnagar. The Chakan plant produces Pulsars, Avengers, Ninjas, and KTM motorcycles and has annual production capacity of 1.2 million units. The Pantnagar plant produces CT100, Platina, and Discover and has annual product capacity of 1.8 million units. The company’s Waluj plant produces the Boxer, CT100, Platina, Discover, Pulsar, three wheelers, RE 60, and all exports. It currently has annual production capacity of 3.06 million units.
In the year ending March 2015 (FY2015), Bajaj Auto sold 3.81 million units. 2.01 million units were sold in India and the other 1.81 million units were exported. Of the 3.81 million units sold, 3.29 million units were motorcycles and 0.52 million units were three wheelers.
Since 2010, the main driver of unit growth has been export volumes, growing at 15.2% per annum, as domestic volumes have stagnated since 2010 and contracted by 10.2% since 2012.
The company sells more three wheelers in export markets with 54.9% of three wheelers sold 0.285 million units exported. In the domestic market, the company sold 0.234 million units three wheelers generating an EBITDA margin over 20% in the domestic market, holding 46% overall market share, 91% market share in the petrol and alternate fuel segment, and 62% market share in the small diesel segment.
Export markets have an EBITDA margin are greater than 20% above the company’s domestic EBITDA margin. Assuming a 20% EBITDA margin in the export market the domestic market’s EBITDA margin is roughly 16.5%. The company’s exports by regions are below with the largest two wheeler export market is Nigeria, while Sri Lanka is the company’s largest three wheeler export market.
In export markets, Bajaj Auto has a unique model. The company produces all motorcycles in India then the motorcycles are assemble locally. Hero is taking another route of producing and assembling motorcycles locally, as illustrated by Hero’s USD38 million investment in a Columbian manufacturing plant with 150,000 unit capacity. Bajaj Auto is taking advantage of the company’s existing infrastructure and ecosystem (90% of part production is outsourced in India) as well as India’s lower cost of production. KTM’s CEO puts the cost of producing a motorcycle at 30% of the cost of production in Europe. Bajaj Auto’s goal is to increase its share in the global motorcycle market from 10% to 20% through exports, primarily to developing markets.
The company’s main brands are the Pulsar, Discover, and Platina. The Pulsar brand is the company’s largest brand selling 0.881 million units in FY2015 with 0.631 million units sold in the domestic market and 0.25 million units exported. In FY 2015, the Pulsar and KTM brand had a 43% market share of the domestic sport segment with roughly a 20% EBITDA margin in the segment. The Discover brand was the company’s largest brand with 1.5 million units in FY2013. Unfortunately, the brand has not performed well and it only 429,000 units sold domestically in FY2015. 0.985 million units were sold in the domestic market and 0.191 million units were exported. The company’s third largest platform is the Platina. Platina is a motorcycle for the entry segment, where the company has a 23% market share. In FY2015, Platina and the newer CT100 brand sold 0.518 million units in the entry segment. Other motorcycle brands include the Avenger, which competes in the cruiser segment selling 44,000 units in FY2015. The KTM brand competes in the sports segment selling 23,000 units in the domestic market in FY2015.
Bajaj Auto’s marketing strategy is different than other two wheeler manufacturers. Bajaj Auto creates a motorcycle brand and uses this brand across different engine sizes and customer segments. For example, the Pulsar brand has a youthful and powerful image. The company manufactures Pulsars across many different engines sizes. Bajaj Auto also does not use the Bajaj name on motorcycles as the company sees it as very diluted. With the company’s Pulsar brand, it never advertised cheaper 135cc and 150cc models to avoid diluting the premium image of the brand even in the commuter segment. A lesson learned from the marketing mistakes made on the Discover brand. Other two wheeler manufacturers use the company’s brand name such as Hero and then a model has a specific model name such as Splendor or Passion. These model names are used on just one engine size.
Bajaj Auto believes its focus on brands over models leads to pricing power as fewer brands create less confusion among customers and creates better knowledge and intimacy with a brand. Additionally, it is more cost effective as the company only has to market a few brand platforms rather than a number of different models brand platforms.
The company’s focus on brands is what Bajaj Auto calls the front-end, which thrives on differentiation. Manufacturing is the back-end, which relies on synergies and economies of scale.
Bajaj Auto also has a marketing agreement with Kawasaki to sell motorcycles in ASEAN and South American markets. The partnership started in Philippines and has spread to Indonesia and Brazil. The companies are complimentary as Kawasaki makes motorbikes mostly with over 650-cc engines at the upper end of the spectrum, while, Bajaj Auto is a mass player with bikes ranging from 100 cc to 220 cc.
Bajaj Auto’s market share by segment in H1 FY2016 is illustrated below.
M1 is entry level mileage segment, which Bajaj serves with CT100 and Platina. The Sports segment is served by Pulsar. The Supersport segment is served by Pulsar and KTM.
Bajaj Auto- Barriers to Entry
The first step is determining whether barriers to entry exist is to examine the evidence. The evidence pointing to barriers to entry are listed below.
- The company consistently generates ROIC well above 15%. Over the past five year the company’s average ROIC is 359.2% and a FCF ROIC of 244.4%. The company has maintained its high profitability during industry downturns.
- The company has negative working capital. Negative working capital points to significant bargaining power and being the center of an ecosystem.
- The two wheeler market in an oligopoly. Hero, Honda, Bajaj Auto, and TVS are the four largest two wheeler manufacturers accounting for 90.9% of the market in FY2015. The Herfindahl index also points to significant concentration.
Bajaj Auto has seen the largest decline in domestic market share as its Discover brand sales declined significantly as the brand position was diluted confusing consumers about its position. Bajaj Auto also exited scooters, a segment of the market that has grown the most over the past few years. Additionally, the company has grown significantly in export markets. Bajaj Auto’s management is focused on profitability over market share.
- Honda’s quick market share gains while smaller players have difficulty gaining meaningful share points to a well known brand being important in a customer’s purchase decision. Until 2010, Honda had a joint venture with Hero MotoCorp allowing consumers to have experience and trust the company’s brand. Since the joint venture ended, Honda has increased its market share from 12.7% in FY2010 to 26.6% in FY2015, while smaller brands have gained share but nothing meaningful. The average annual share gain by smaller players is 0.4% per year. Eicher Motors market share increased from 0.7% in FY2010 to 2.8% in FY2015, while the other gainer outside of the top four was Yamaha, which grew its market share from 2.4% to 3.7%. Honda has had a much easier time increasing market share compared to smaller players due to its existing brand and infrastructure pointing to barriers to entry.
- Hero’s inability to gain share in the premium segment (150cc and up). Despite seven models in the segment, Hero only has a 6% share. Hero is well known for its leadership in mileage and commuter segment. Given its position as a cheaper motorcycle that gives you good mileage, it may be difficult for consumers to view it at a premium brand that they are going to spend more on illustrating the importance of a company’s brand.
- There are significant fixed costs in the form of advertising and R&D. Of the top four two wheeler makers, three are publicly traded and report full financials.
The average gross profit of three largest publicly traded two wheeler manufacturers is INR12,888 per unit in FY2015. Dividing the average fixed costs by that figure leads to a minimum efficient scale of 758,767 units or 4.1% of the market in FY2015.
4.1% is the minimum efficient scale required to compete as a generalist. A company can take niche strategy similar to Eicher Motors attacking a specificsegment and just competing in that segment. The key to winning a niche segment in the Indian motorcycle segment is to create the segment. Eicher Motor created the mid-size segment (250-750 cc) in India and holds 96% market share within the segment so smaller players can enter the market and compete but will have difficulty as a generalist. Even large international companies such as Suzuki and Yamaha that can be subsidized by profitable international parents or local automobile companies such as Mahindra that can be subsidized by the automobile companies are having difficulty garnering the 4.1% market share required to be profitable under a generalist strategy. Given the top four collectively hold 90.9% of the market and Eicher Motors hold 2.8% of the market through a profitable niche strategy, it would be difficult for many other players to be profitable with a generalist strategy.
- In the domestic market there are regulatory barriers to entry. There are high import duties with 105% import duty on new motorcycles and 100% import duty on used motorcycles. The motorcycles can only be imported through three ports. Motorcycles that are assembled in India with foreign parts have a 30% duty. The industry is fully deregulated with regard to foreign direct investment.
- Bajaj Auto outperforms its largest peers on almost all profitability measures.
Bajaj Auto has the highest ASP of its largest peers largely due to a higher focus on motorcycles and three wheelers. Adjusting for the effect of other two wheelers and three wheelers, Bajaj Auto’s ASP (INR56,690) is still higher than Hero (43,934) and TVS (49,976) due to its lack of focus on the entry level segment, 75-110cc motorcycles, which is currently dominated by Hero with a 71% market share. The next level up, the 125cc market, is also dominated by Hero with a 51% share.
Given the higher cost of producing motorcycles and three wheelers, Bajaj Auto’s cost of goods sold per unit is higher. The focus on premium products decreases the importance of price in the purchase decision. Additionally, exports are almost half of the company’s sales. Exports have higher margins than the domestic market. Both lead to a higher gross profit per unit relative to peers. The premium pricing and higher gross profit per unit potentially points to Bajaj Auto having valuable brands.
Over the five year period, Bajaj Auto has been the most efficient on operating expenses. Over both five year and during FY2015, Bajaj has used capital the most efficiently with the lowest capital requirements per unit. The company’s management is focused on efficiency and profitability over market share. Overall, Bajaj generates the highest ROIC and FCF ROIC of its largest peers.
While there is evidence pointing to barriers to entry there is also evidence pointing to no barriers to entry.
- The poor performance of the Discover brand points to a lack of brand advantage. Discover brand was introduced in 2004 reaching 1.5 million units sold in FY2013. Since 2013, Discovers sales have halved with estimated total sales of 744,000 in FY2015.
If a brand advantage existed the company’s sales would not have increased as rapidly as it did from 2004 to 2013 in the face of a strong existing competition, which would have a brand advantage. If the company was able to build a brand, its sales would not have halved in two years time.
- Bajaj Auto’s gross margin volatility points to a lack of pricing power. If the company had pricing power it would be able to transfer raw materials cost increases to customers and gross margin would be consistent or increasing.
- The decreasing concentration within the top four players consistently losing market share to smaller players. From FY2007 to FY2015, the four largest two wheeler companies lost 4.1% with four firm ratio dropping from 95.0% to 90.9%. It is still a highly concentrated market but the existence of barriers to entry should lead to the inability of players to enter the market. Eicher Motors with its Royal Enfield brand is profitable and dominating a niche segment, the mid-size segment with 96% market share. It has increased its market share to 2.8% in FY2015 from 0.7% in 2010. Yamaha has also increased its market share to 3.7% in FY2015 from 2.7% in FY2007. Suzuki has increased its market share to 2.0% in FY2015 from 0.8% in FY2007. The share increases are not dramatic and it will take some time for smaller players to break the oligopoly.
- The lack of stability in market share among the top four players. The change in market share over the eight years among the top four players is significant. If any company had a competitive advantage, market share changes would not be as drastic. The average absolute share change over the eight year period was very high at 9.94%. Honda’s market share gain should not be view as a new entrant but an existing player. Honda is a well known brand within the India market. Until 2010, it had a long standing joint venture with Hero. The prior existence of the brand in the market made it well known. The quick market share gain by Honda and small market share gains by smaller players points to how a brand can influence a customer’s purchase decision.
Overall, there is compelling evidence for and against the existence of barriers to entry in the two wheeler market. Although there is compelling evidence against barriers to entry existing, the most compelling evidence is most often a company’s ability to consistently generate excess profitability. The ability to generate excess returns with the significant concentration in the industry, the presence of fixed costs, and inability of smaller players to gain significant market share over a long period outweighs the evidence against barriers to entry.
Given the evidence points to barriers to entry existing, the next question is what are those barriers to entry? It seems the presence of fixed costs leads to economies of scale within the industry. Economies of scale should lead to greater profitability with size, which is not the case as in FY2015. Including export volumes, Bajaj Auto is just over half the size of Hero yet is much more profitable on a per unit basis and overall ROIC basis. Eicher Motors is just under a fifth of the size TVS yet much profitable. There may be economies of scale in the industry stopping entry from smaller players but it does not drive profitability differences between the four larger players.
There seems to be a brand advantage as well. A company that gets the first mover advantage by creating a new segment retains the position in consumers’ minds as the leader in the segment. Hero is a leader in the commuter segment due to a combination of price, mileage, and resale value. Despite others making motorcycles that are slightly more efficient Hero retains the position in consumers’ minds as the motorcycle that gets the most mileage. Bajaj Auto created the sport and super sport segments with the Pulsar brand launch in November 2001. Before the introduction of the Pulsar, the Indian motorcycle market trend was towards fuel efficient, small capacity motorcycles (80–125 cc class) with barely any motorcycles above the entry segment. Despite competition, Bajaj Auto continues to dominate the segment with a 44% market share. Eicher Motors created and dominates the mid-size segment (250-750 cc) with a 96% market share. Bajaj Discover’s may provide evidence of lack of brand value within the market but it was a not the leading brand and too much like the Hero Splendor. Bajaj Auto seems to have diluted the brand’s position confusing consumers.
In the export market, India has a large cost advantage over other locations and it has some of the largest motorcycle manufacturers in the world leading to an existing ecosystem. According to KTM’s CEO, it costs 1/3rd of the cost to produce motorcycles in India compared to Europe.
Other than economies of scale and brand in the domestic market and costs in the export market, there seems to be no other economies of scale.
Given the oligopolistic market structure, intensity of rivalry is also important to profitability. Prior to 2007, companies competed for market share leading to price wars and margin compression. Since those price wars, industry competitors have been more disciplined on pricing. The discipline is further shown by the invested capital growth of the three largest players. Since 2007, total invested capital increased by 10.3% per year while domestic sales volume increased by 10.2% per year.
Since Rajiv Bajaj took over as managing director, management has done well strategically and operationally. Strategically, the company narrowed its focus leaving the scooter segment focusing on motorcycles and three wheelers allowing the company to become more efficient in marketing and manufacturing. It also allowed the company to better exploit the global market through low cost manufacturing. Within the domestic market, the company’s unique marketing strategy allows it to build stronger brands and greater efficiencies in marketing. Although it has lost market share domestically, it is now a global company with almost half its revenues from global markets, primarily in developing markets.
Operationally, Bajaj Auto is the most profitable company in the two wheeler industry due to the strength of its strategy. Over the past five years, the company’s gross margin is slightly higher than it large peers due to the company’s premium products. Operating margins are well above peers due to the company’s strategic focus allowing for efficiencies in marketing and manufacturing.
The company has not made any capital allocation missteps. The company’s core operations continue to generate very strong profitability. Since 2011, total operating cash flow before working capital INR127,176 million. Working capital generated an additional INR5,773 million. The largest capital allocation decision was the decision to retain cash leading to an increase in cash by INR62,860 million. At the end of FY2010, the company had a net debt position of INR12,558 million. At the end of FY2015, the company had a net cash position of INR62,809 million. The company only spent INR17,208 million on capex over the last five years so there is more than enough cash on the company’s balance sheet and it should return cash to shareholders. At the current valuation, dividends would probably be the best option.
In November 2007, Bajaj Auto acquired 24.5% stake in KTM Power Sports AG (holding company of KTM Sportmotocycles AG) for 98.4 million euros. Bajaj Auto increased its investment by 99.7 million euros to 198.1 million euros with the company’s stake increasing from 24.5% to 48%. KTM is listed on the Vienna Stock Exchange. At current market prices, Bajaj Auto’s 198 million euro investment in KTM is now worth 595.58 million euros representing a 200% return on investment, a very shrewd investment.
In FY2014, Bajaj gave former Citi banker Nanoo Pamnani, an independent director serving on the board of four Bajaj companies, a Rs1.5 million bonus. The additional payment puts into the question the independence of the Nanoo Pamnani. Proxy advisory firm Stakeholders Empowerment Services believes the bonus payment is unfair and recommended shareholders vote against it.
The company was the principal sponsor of the Positive Health Awards run by Mukesh Batra’s the proprietor of a chain of homeopathy clinics. Mr. Batra is a good friend of Bajaj Auto’s managing director Rajiv Bajaj, who is passionate about yoga and homeopathy. The sponsorship does not seem to add much value and seems to be frivolous and not in the best interest of all shareholders.
Management does not extract too much value with directors and senior management renumeration remaining consistently around 1.0% of operating profit.
Management’s language gives you strong understanding of how they view their business and the assumptions used in the business. Below are selected quotes illustrating management’s views and assumption of its business.
FY2011 Annual Report
“In other words, there was more to Bajaj Auto’s performance than riding with the tide. It was about combining a highly focused brand-centered strategy with production efficiency, quality, costs and logistics.”
“Discover and Pulsar do not ‘buy’ market share through eventually debilitating price competition. They gain share by their brand, quality and performance – so that customers are pleased to pay more for obviously better value.”
FY2010 Annual Report
“For the last few years, your Company has been working at developing a brand-centered strategy especially of its two key brands, the Discover and the Pulsar.”
“What pleases me is that Bajaj Auto is leveraging its key brands to maximize profits. Your Company’s performance has not been about ‘buying’ market share through various pricing deals. Instead, it is about gaining share through better quality and branding – thus having the customer willing to pay higher prices for better value.”
“Your managing director often says that while products may generate market share, brands provide pricing power and create higher profits. I am increasingly tending to agree with him.”
“Management believes its ability to build very strong brands is the reason for its above industry returns on invested capital.”
“Less of technology industry and more of a marketing industry. More less all players have the same technology and quality. It is all about being first to market. Second to market with no differentiation”
“Bajaj Auto Mass manufacturer not a niche manufacturer.”
“Three wheeler segment low barriers to entry no capital requirements to develop a three wheeler, no technology requirements to manufacture, no elaborate arrangements to distribute. Absence of barriers to entry market will become commoditized.”
“At the base of all human problems lies ego. And every shareholder is human. We always have our moments when greed gets the better of us. But one must draw a line between growth and greed. Growth for the sake of growth is an ideology of a cancerous cell. This is how most companies destroy themselves. How does one grow without being greedy? We feel the best way to do that is to listen to your brands. If I want to be greedy, I can introduce a 100cc Pulsar. It will grow for 6-12 months. But over a period of three years, it will diffuse the brand. The ill-effects take time to play out. If companies look back, whenever they have line extended in some way, it has not worked. We don’t manage our brand.
Our brand manages us.”
“Of the global volume of roughly 50 million two wheelers, 30-35 million are motorcycles. This year, we will sell around 3.8 million motorcycles. We have a 10% share, so we have no business to look at something like scooters. We should go up to 20-25%. In exports, there is a lot of headroom to grow. In the past five years, we have grown six times; today, exports comprise 35% of total sales. A day should come when 20% of our sales are in India and 80% outside.”
“By end of fiscal 2016, we should enter a dozen new export markets,” said Sharma, declining to give further details. This will help the firm report a growth of 13-15% in export volumes over the next 3-4 years”
Assuming a 15% discount rate, 5.0% sales growth into perpetuity, 18.9% operating margin, and historical average capital efficiency, there is 22% downside to the company’s FY2021 intrinsic value per share of INR2,039 per share. Assuming 10% growth over the forecast period fading to a 5% perpetuity growth rate, there is 1% downside to the company’s FY2021 intrinsic value per share of INR2,595. Assuming 15% growth over the forecast period fading to a 5% perpetuity growth rate, there is 27% upside to the company’s FY2021 intrinsic value of INR3,314.
The company currently offers a 3.4% FCF yield assuming a 7% growth rate the company offers an expected return of 11.4% per year.
The ideal time to buy Bajaj Auto is when the share price is below INR1,300.
The biggest risk to an investment in Bajaj Auto is currently valuation risk as there is little to no margin of safety.
Domestically, the biggest concern is continued stagnation in demand.
Currently, the industry is undergoing a period of competitive discipline. If companies shifted its focus back to market share over profitability, it could lead to price wars and margin pressure.
Dilution of the company’s brands is a concern. While other two wheeler manufacturers have one model and engine per brand, Bajaj Auto manufacturers many different models and engine size in a brand creating the risk of diluting a brand’s position, which happened with the Discover brand.
Another concern is regulation. The company has created a quadricycle to replace three wheelers. The company has not been allowed to sell the product domestically or in Sri Lanka, the company’s largest three wheeler market outside of India, due to perceived safety issues.