• JUNE 29, 2002

M&M: Scorpio lacks sting

Though volumes might not suggest so, it has been one of the most eventful years for auto sector. The reason being, Indian automobile manufacturers, atleast a few of them, have graduated to design and manufacture of indigenously produced vehicles. One of them is Mahindra & Mahindra (M&M), a key player in tractors and utility vehicle segment. Apart from analyzing M&M as an auto manufacturer, we have dealt with in detail the valuation of Mahindra-British Telecom (MBT) in this article because of its significance at the current juncture.

M&M is engaged in the manufacturing of multi-utility vehicles (MUV’s), tractors and light commercial vehicles (LCVs). For FY01, UVs and LCVs contributed to 52% of its volume sales and tractors contributed the remaining. Consider the performance of the company in FY02. Sales declined by 8% for the full year ended March 2002 to Rs 32,731 m. The fall in sales was on account of various factors.

It has been a rough ride for tractor majors over the last two years. Like any other sector in India, this segment is plagued with over-capacity. There has been no significant improvement in the macro-economic fundamentals in the last two years and this combined with slower agricultural reforms have resulted in subdued tractor demand. Despite a fall in average capacity utilisation of the industry in reaction to a fall in demand, it could not stem the fall in realisations. Average incentive per vehicle that comprises of free services and warranty has increased notably. On the tractors front, M&M volume sales is estimated at around 58,000 units as against around 79,000 units in FY01, a fall of 26%. As a result, market share of the company stands reduced to 24% in March 2002 as compared to 29% in April 2001.

Things were not good for the UV segment as well. Farm output and income has been lacklustre in the last two years and agricultural reforms have been thrown to the back seat in the government’s agenda. Since UV demand is primarily driven by rural demand, volume growth was unimpressive. Industry volumes declined from 126,964 units in FY01 to 122,561 units in FY02, a fall of 3.5%. But M&M has managed to increase its market share by launching atleast 4 new models in this category by successfully extending its ‘Marshall’ range. This combined with the success of ‘Bolero’, which has eaten into the market share of Telco, has enabled to outperform the industry. M&M posted a marginal 1% fall in UV sales to 56,643 units in FY02. Average realisation for M&M in this segment is estimated to have increased by atleast 4%.

Apart from UVs and tractors, M&M ventured into the manufacturing of three-wheeler in 2000. The new eco-friendly electronically powered vehicle ‘Bijlee’ has received an overwhelming response. As targeted, the company has also posted improved performance at the operating level with margins increasing by 60 basis points. Margins would continue to improve in the future on account of reduction in labour force and streamlining its procurement policies.

MBT-A valuation view…
Apart from its ‘Project Scorpio’, markets seem to be enthused by the growth prospects of its software subsidiary, Mahindra-British Telecom (57% stake). This subsidiary derives a key portion of its revenues from offering solutions and systems integration services to telecom operators, telecom equipment manufacturers and telecom technology suppliers. While revenues from BT grew by 37% to Rs 4.5 bn in FY02 (86% of total revenues), income from US markets declined by 16% during the same period. MBT had entered into an agreement with BT, which provides for a minimum assured business of GBP 35 million per annum (Rs 2,345 m) to the company till March 2003. M&M has been planning to unlock value from its investment in the subsidiary by tapping the primary market for quite sometime and the markets are positive on this front as well.

But consider some facts. Globally, telecom companies are going through a rough phase, especially the European and US majors, after shelling out huge sums towards 3G licenses. British Telecom went through a major restructuring exercise in the last one year, which includes a rights issue, demerger of some of its joint ventures and sale of assets across the globe. Just to put things in perspective, as of March 2002, British Telecom’s net debt stood at US$ 20 bn (Rs 959 bn).

MBT valuation model…
Scenario – I*Scenario – II*
Based on Market Cap to Sales of 2 timesBased on P/E of 8 times
Sales (Rs m) 5,274.3 PAT (Rs m) 1,262.8
Market cap to sales (x) 2.0 No. of shares (m) 101.1
Market Capitalisation (Rs m) (A) 10,548.6 EPS (Rs) (A) 12.5
No. of shares of MBT (m) (B) 101.1 P/E (x) (B) 8.0
Price per share of MBT (Rs) (A/B) 104.4 Price (Rs) (A*B) 100.0
Value of M&M's 57% stake in MBT (Rs per share) 59.5 Value of M&M's 57% stake in MBT (Rs per share) 57.0
Value of 7% stake sale via IPO (Rs m)** 738.4   707.2
No. of shares of M&M (m) 101.5   101.5
Per share contribution from IPO to M&M (Rs) 7.3   7.0
*FY02 numbers, **assuming that M&M brings down its post-issue stake down to 50%

More recently, WorldCom has come under SEC scrutiny after misrepresentations in its balance sheet. Reportedly, MBT derives 6% of revenues from WorldCom. If this being the case, profitability as well as future revenue growth could be adversely affected consequently impacting valuations of the company if it were to tap the market. Given this backdrop, one has to exercise caution when it comes to valuing telecom software service providers.

Consider our valuations estimates for MBT. Hughes Software System, a peer telecom software service provider, trades at a P/E multiple of 13.3x FY02 earnings and market capitalisation to sales works out to 3.3 times. We have estimated per share value of M&M for a 57% stake in MBT based on two scenarios. One is by assuming a 10 times earnings multiple and another is by assuming a 2 times market capitalisation to sales. M&M’s 57% stake in MBT works out to a per share value of around Rs 57 per share. Assuming that the company dilutes 7% stake in MBT through IPO at the aforesaid price (it could be higher as well), per share contribution to M&M’s shareholder works out to Rs 7 per share. Though it looks attractive, one has to keep in mind that the revenue agreement with BT is likely to terminate in FY03 and one is not sure as to whether the support would continue in the future. If BT were to exit from this business, in line with its global strategy, what will happen to MBT?

What’s on the cards?
At last, after a two-year delay, M&M launched the much-awaited sports utility vehicle ‘Scorpio’ in June 2002. The state-of-the-art manufacturing facility and a competitive pricing strategy is expected to provide the much-needed growth impetus for M&M, which hitherto has been modifying its aged-old models.

The success of its new-project (Scorpio) is critical in light of more than Rs 6 bn investment in the project. While M&M’s new launch is promising, increasingly, product life cycle is shrinking. One has also got to keep in mind that UV segment is also stagnating. Keeping the difficult macro-environment and intense competition in mind, control over costs is important. Besides, the company has a number of subsidiaries, which has been a cause of concern for the investors. Though it has carried some restructuring in 4QFY02, it should accelerate this process to bring in transparency in its operations.

Though the near-term growth prospects of the tractor segment remain challenging considering the mechanisation levels in India currently, one is optimistic over the long-term. The company’s tractor model, ‘Arjun’, has been well received in the US as well and exports could compensate for the fall in domestic demand. Overall, a long way to go before the ‘Scorpio’ could sting.

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