Automobile Manufacturing Sector

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1 1Jan13 1Feb13 1Mar13 1Apr13 1May13 1Jun13 1Jul13 1Aug13 1Sep13 1Oct13 1Nov13 1Dec13 1Jan14 1Feb14 1Mar14 1Apr14 1May14 1Jun14 1Jul14 1Aug14 1Sep14 1Oct14 1Nov14 1Dec14 Index = 100 Automobile Manufacturing Sector Initiation Report 21 st January, 2015 Positives overplayed; Initiate with Underperform Recommendation Indus Motors Limited (INDU,PA) Pak Suzuki Motors Ltd (PSMC,PA) Honda Car Limited (HCAR, PA) Companies Featured Indus Motors Limited (INDU,PA) 2014A 2015E 2016E P/E (x) PBV (x) EPS Div yield (%) Pak Suzuki Motors Ltd (PSMC,PA) 2013A 2014E 2015E P/E (x) PBV (x) EPS Div yield (%) Honda Atlas Cars (HCAR, PA) 2014A 2015E 2016E P/E (x) PBV (x) EPS Div yield (%) Initiate with Underperform We initiate coverage on the Auto sector with an UnderWeight stance, and a rating on INDU (TP of PRs 614), HCAR (TP of PRs 137) and PSMC (TP of PRs316). Our TP s imply significant downside from current levels for all 3 stocks. Investment Case Stock prices have rallied considerably, with INDU, PSMC and HCAR clocking in total returns of 378%, 445%, and 1082% respectively in the last 24 months due to increasing margins and volumetric sales growth. We feel the rally has run ahead of improved fundamentals; our sensitivity indicates that even if gross margins sustain at 10 year highs, current prices are not justified. Downside risks, in the form of a recovery in steel prices and JPY appreciation (both expected by the forward markets) can create a downward pressure on margins. We believe Novelty factor of new 11 th generation Corolla and the oneoff Punjab Rozgar Scheme are priced in. Catalysts Given the volatile nature of valuations in the sector, any price cut by manufacturers to pass on the impact of lower costs, or appreciation in the JPY can have significant negative impact on stock prices. With these stocks priced for perfection at the moment, any negative news can have a disproportionate impact on prices. Valuation We have valued the Auto Sector stocks using DCF methodology. In the case of HCAR, we have assumed the launch of new Honda City by the beginning of next calendar year, whilst we have forecast substantial growth in sales of PSMC and INDU in Our risk free rate is 9.5%, and equity risk premium is 6%. All three scripts look unattractive based on DCF valuations, P/E multiples, and dividend yields. Figure 1 Price performance of the Auto sector over the last two years has been excessive Source: KSE KSE 100 INDU PSMC HCAR Table 1: Gross Margin Sensitivity indicates overvaluation INDU Valuation Avg. 5yr Forward Gross Margin PKR 690/share 12.0% PKR 750/share 12.5% (current) PKR 815/share 13.0% Table 2: Gross Margin Sensitivity indicates overvaluation PSMC Valuation Avg. 5yr Forward Gross Margin PKR 270/share 8.0% PKR 340/share 9.0% (current) PKR 430/share 1 Next Research Ext 113 research@nextcapital.com.pk Table 3: Gross Margin Sensitivity indicates overvaluation HCAR Valuation Avg. 5yr Forward Gross Margin PKR 160/share 12.0% PKR 185/share 13.0% (current) PKR 215/share 14.0%

2 F 2016F 2017F 2018F 2019F Industry Outlook Normalized growth & margins post new model launches and government schemes After the launch of the new Corolla model in July, 2014 INDU has sold on average 4,000 cars per month and is currently operating at full capacity. This is expected to continue till the end of the fiscal year as orders placed today are to be delivered by June Launch of the new City model by HCAR is expected by 1QCY16, which in our opinion will normalize Corolla sales as some demand will switch from Corolla to the new City. PSMC will benefit under the Rozgar Scheme with delivery of 25,000 units of the Bolan and 25,000 units of the Ravi expected during CY15 and early CY16. Thereafter, sales and margins are expected to normalize as such schemes are not expected to continue on an annual basis. Overall, sales are expected to witness a sizable increase in FY15 and FY16, and then normalize going forward. Figure 2 FY15 & FY16 will see an increase in demand due to new Corolla Model and launch of Rozgar Scheme; thereafter sales growth will normalize (No.of Cars) 200, , ,000 50,000 Source: PAMA, Next Research FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15FFY16FFY17F A quick look at the companywise gross margins reveals that INDU enjoys higher margins compared to both PSMC and HCAR. PSMC has lower margins due to the price sensitive nature of its customers whilst HCAR, though catering to consumers in the premium segment, has operated at capacity utilization levels of below 50% as INDU continues to retain a higher market share in the 1300cc segment. Going forward (post CY15), we expect margins to come down as forward curves highlight that steel prices are expected to gradually increase and the JPY is expected to appreciate as well. Figure 3 Gross margins will increase in the near term but taper off going forward.. Figure 4..as JPY is expected to appreciate and steel prices ($/ton) are expected to increase % 1 5.0% CY15 CY16 CY17 CY18 CY19 USD:JPY 5.0% INDU PSMC HCAR CY15 CY16 CY17 Source: Company Financials, Next Research, Bloomberg Hot Rolled Coil A discount rate cut in the next few months will bode well for automobile sales, especially PSMC which caters to a price sensitive consumer. Decline in prices of petrol also reduce the cost of automobile usage, thereby creating demand. However, loans are not expected to reach levels seen in the golden years between FY05FY08 as banking policies on auto loans have become more stringent. Nevertheless, we have forecasted an increase in Mehran volumes in CY15CY16 as car financing rates decline with discount rate cuts. Table 4: Comparison of Car Loan Variables Particulars FY07 FY14 Upfront Payment 10% 20% Spread 3% 5% Documentation Simple Detailed 2

3 FY03 FY04 FY05 FY06 FY07 FY07 FY09 FY10 FY11 FY12 FY13 FY14 Indus Motors Limited Current volumes will not sustain One time factor Novelty value of the 11 th generation Corolla With 6MFY15 INDU sales at 22.8K (+50.8 YoY), we expect INDU s unit sales to clock in at 50.7K for FY15E (+47.7%). As is evident from Figure 8, sustainability of sales is quite dependent upon launch of new models by HCAR, a direct competitor of INDU in the premium car segment in Pakistan. In recent history, with the launch of the new civic model in 2012, INDU sales were significantly affected as consumers switched to the new civic. Figure 5 INDU and HCAR have traded market shares with new model launches in a low volume growth premium car segment market (No.of Cars) 70,000 60,000 50,000 New Corolla 40,000 30,000 10,000 New Civic model Source: PAMA, Company Financials Total Cars INDU Sales HCAR Sales Lack of Pricing Power Inability to pass on impact of adverse JPY movements, even over the long term Despite its dominant position in the premium car market segment, INDU is unable to entirely pass on cost increases (due to an appreciation in JPY) to consumers. As illustrated in Figure 6, Primary Margins (Net Sales per Car minus Raw Material Cost per Car) have fallen from 19% in FY03 to 13% in FY11 and raw materials as a % of sales has risen from 81% in FY03 to 87% in FY11. Primary margins have risen to 15.9% in FY14, however, this is not due to any substantial increase in prices, but largely due to a change in the product mix i.e. selling more higher margin vehicles (as shown in Figure 7) such as the Hilux and Fortuner, and a depreciation in the JPY of about 12% during FY13 and FY14 (as shown in Figure 6). Therefore, any appreciation of the JPY going forward will put cost pressure on INDU which will likely reduce margins and profitability. Figure 6 Margin decline between FY03FY11 as JPY appreciated against PKR Figure 7 Change in product mix to higher margin automobiles largely help margins (FY12FY14) % 12.0 % FY % FY14 1.1% % 85.6 % Primary Margin Raw materials as a % of sales JPY:PKR (RHS) Source: Company Financials, PAMA, Bloomberg Corolla Hilux Coure Corolla Hilux Fortuner 3

4 INDU unlikely to sustain gross margin and recent volumetric growth Due to sharp depreciation in JPY and rising Corolla sales, gross margins are expected to be around 12.5% in FY15, a 11 year high for INDU. However, given that steel prices are expected to rise, and the JPY is expected to gradually appreciate, INDU s inability to entirely pass on cost hikes to the consumer will cause primary and gross margins to decline going forward. Also, Corolla volumes are likely to decline with the launch of new City model by HCAR in FY16FY17. Figure 8 Margins and volumes to taper off due to competition from HCAR and cost pressures from an appreciating JPY and increase in steel prices (No.of Cars) 20.00% 15.00% 10.00% 5.00% 0.00% FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15F FY16F FY17F FY18F FY19F 60,000 50,000 40,000 30,000 10,000 Total Sales GP Margin Primary Margin Source: Company Financials, Next Research Even assuming high sustained gross margins, INDU is overvalued We conducted a sensitivity analysis of gross margins vs fair value to whether current price levels are justified in a best case scenario. Table below indicates that even with high sustained margins in the long run, which are unlikely, current price levels are unjustified. Table 5: Gross Margin Sensitivity indicates overvaluation Valuation Avg. 5yr Forward Gross Margin PKR 690/share 12.0% PKR 750/share 12.5% (current) PKR 815/share 13.0% 4

5 Pak Suzuki Motors Rozgar Scheme to benefit; product challenges remain Lack of Pricing Power Inability to pass on impact of adverse JPY movements Despite PSMC being the dominant player in the lower price segment of the automobile industry in Pakistan, the Company is unable to pass on cost increases to the consumer. Its pricing power appears to be less than INDU (See Figure 1 in Industry Section), most likely due to its target market, where it caters to price sensitive consumers. As shown in the graph below (Figure 6), as the JPY appreciated against the PKR, raw material costs as a % of sales increased from 82% in CY06 to 90% in CY12 and primary margins fell from 15.8% in CY06 to 10.2% in CY12. Both are indicative of PSMC s inability to pass on cost increases to the consumer, even over a longer period. However in CY13 raw material as a % of sales decreased due to deprecation in JPY, translating into higher primary margins. However, the upside from depreciation in the JPY tends to be limited as dealers of imported cars, which directly compete with PSMC are quicker to pass on the cost reduction impact to consumers. Please see next section for further analysis. Figure 9 PSMC unable to pass on raw material price increases during periods of JPY appreciation % 88.6% 90.4% 89.7% 89.8% 87.2% 81.8% 83.9% 15.8% 16.1% 9.6% 11.4% 9.6% 10.3% 10.2% 12.8% CY06 CY07 CY08 CY09 CY10 CY11 CY12 CY Primary Margin Raw materials as a % of sales JPY:PKR (RHS) Source: Company Financials, PAMA Competitive pressures from imported Cars as price differential reduces PSMC directly competes with reconditioned imported cars of a similar price range. In recent months, imported car dealers have passed on cost reductions to the consumers, thereby reducing the differential between models such as the Vitz & Swift and Passo & Cultus. This reduction in price differential is expected to exert competitive pressures on PSMC, who have recently reduced prices on their products such as the WagonR by about 10% and their other range by 34%. Figure 10 Decrease in prices of imported cars in 1000cc segment.. (PKR in mn) Figure 11..leads to a decrease in competitiveness for PSMC local range (PKR in mn) Vitz Passo Mira (0.10) (0.20) Price of Swift minus price of Vitz Price of Cultus minus price of Passo Price of WagonR minus price of Mira Price in June Price in Dec Price differntial in June Price differntial in Dec Source: Conversations with Car Dealers 5

6 Product range issues have yet to be addressed After the discontinuation of Alto in 2012, a gap has been created in PSMC s product offering which we believe is being partially filled by imported reconditioned cars of the same category. If this issue is not addressed, not only will it dilute brand equity of the Company, but will also hinder volumetric growth going forward. Note that after the discontinuation of Alto in 2012 PSMC total sales fell by 17.6% in 2013 YoY. Figure 12 After discontinuation of Alto, a gap in product offering continues to exist, which is diluting brand equity and hindering volumetric growth Product mix in 2012 Product mix in 2014 Premium High Medium Low Premium High Medium Low Expect Normalized Volumetric Growth and Margins postrozgar Scheme Margins are expected to improve in CY15 with increase in sales due to Rozgar Scheme and the recent depreciation of the JPY. However CY16 onwards, with an expected appreciation of the JPY as well as steel prices, the Company will face downward pressure on margins given that the Company is unable to pass on cost increases, continues to compete with imported cars and has yet to address its product offering issue. Figure 13 Margins to taper off due to competition from imported cars, an appreciating JPY and increase in global steel prices (No.of Cars) 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% CY08 CY09 CY10 CY11 CY12 CY13 CY14FCY15FCY16FCY17FCY18FCY19F 1 100,000 80,000 60,000 40,000 Source: Company Financials, Next Research Even assuming high sustained gross margins, PSMC is overvalued We conducted a sensitivity analysis of gross margins vs fair value to whether current price levels are justified in a best case scenario. Table below indicates that even with high sustained margins in the long run, which are unlikely, current price levels are unjustified. Table 6: Gross Margin Sensitivity indicates overvaluation Valuation Avg. 5yr Forward Gross Margin PKR 270/share 8.0% PKR 340/share Sales (cars) GP Margin Primary Margin 9.0% (current) PKR 430/share 1 6

7 Honda Atlas Car Low utilization hitting profits Better pricing power than Peers, but margins lower due to low capacity utilization HCAR seems to have better pricing power than its peers, evident from the 10 year data below which illustrates stable primary margins and a decline in raw materials as % of sales, during Figure 14 HCAR has maintained primary margins during times of an appreciating JPY 120% 100% 80% 60% 40% 20% 0% 95% 87% 87% 88% 83% 84% 87% 88% 86% 85% 84% 13% 14% 18% 5% 9% 12% 16% 12% 16% 13% 16% Primary Margin Raw materials as a % of sales JPY:PKR (RHS) Source: Company Financials, Next Research, Bloomberg Despite the ability to pass on cost pressures to the consumers, HCAR has seen limited profitability due to low levels of capacity utilization. In recent years however, these margins have increased with increased utilization levels, following the launch of the new Civic model in Figure 15 Profitability has remained low as capacity utilization has remained below 50% due to competition from Corolla 50% 40% 30% 20% 10% 0% % 6.0% 4.0% 2.0% 2.0% Source: Company Financials Capacity Utilization Gross Margins (RHS) New Corolla Model to keep Utilization levels between subdued at 40% in We believe HCAR is likely to underperform in CY15 given consumers preference for the new Corolla. As shown in the graph below, (Figure 17) HCAR sales declines with the launch of new Corolla models. After the launch of the new Corolla in 1HFY15, HCAR sales are down YoY by 10%. Therefore we expect utilization levels to remain subdued atleast uptill the launch of the new City model in CY16. Figure 16 INDU and HCAR have traded market shares with new model launches in a low volume growth premium car segment market (No.of Cars) 70,000 60,000 50,000 40,000 30,000 10,000 New Corolla New Civic model Source: PAMA, Company Financials Total Cars INDU Sales HCAR Sales 7

8 Volumes to remain under pressure in the near term, until launch of City & Civic models In the near term we expect the City and Civic volumes to remain under pressure due to the launch of the new Corolla. However, in CY16 and CY17 we expect an increase in volumes with the launch of the new City and Civic respectively. Margins however will continue to show a gradual decline as cost pressures from steel prices and JPY are expected in the near to medium term. Figure 17 Sales to pick up in HCAR financial year 2017 (CY16) and then normalize. Margins to gradually decline over the long term due to cost pressures from JPY and steel (No.of Cars) 25.0% % 1 5.0% 5.0% F 2016F 2017F 2018F 2019F 25,000 15,000 10,000 5,000 Source: Company Financials, Next Research Even assuming high sustained gross margins, HCAR is overvalued We conducted a sensitivity analysis of gross margins vs fair value to whether current price levels are justified in a best case scenario. Table below indicates that even with high sustained margins in the long run, which are unlikely, current price levels are unjustified. Table 7: Gross Margin Sensitivity indicates overvaluation Valuation Avg. 5yr Forward Gross Margin PKR 160/share 12.0% PKR 185/share 13.0% (current) PKR 215/share 14.0% Total Sales GP Margin Primary Margin 8

9 APPENDIX 1 Analyst Certification: All of the views expressed in this report accurately reflect the personal views of the responsible analyst(s) about any and all of the subject securities or issuers. No part of the compensation of the responsible analyst(s) named herein is, or will be, directly or indirectly, related to the specific recommendations or views expressed by the responsible analyst(s) in this report. Disclaimer This information and opinion contained in this report have been complied by our research department from sources believed by it to be reliable and in good faith, but no representation or warranty, express or implied, is made as to their accuracy, completeness or correctness. All opinions and estimates contained in the document constitute the department s judgment as of the date of this document and are subject to change without notice and are provided in good faith but without legal responsibility. This report is not, and should not be construed as, an offer to sell or a solicitation of an offer to buy any securities. Next Capital Limited (the company) or persons connected with it may from time to time have an investment banking or other relationship, including but not limited to, the participation or investment in commercial banking transactions (including loans) with some or all of the issuers mentioned therein, either for their own account or the ac count of their customers. Persons connected with the company may provide or have provided corporate finance and other services to the issuer of the securities mentioned herein, including the issuance of options on securities mentioned herein or any related investment and may make a purchase and/or sale, or offer to make a purchase and/or sale of the securities or any related investment from time to time in the open market or otherwise, in each case either as principal or agent. This report may contain forward looking statements which are often but not always identified by the use of words such as anticipate, believe, estimate, intend, plan, expect, forecast, predict and project and statements that an event or result may, will, can, should, could or might occur or be achieved and other similar expressions. Such forward looking statements are based on assumptions made and information currently available to us and are subject to certain risks and uncertainties that could cause the actual results to differ materially from those expressed in any forward looking statements. Readers are cautioned not to place undue relevance on these forward looking statements. NCEL expressly disclaims any obligation to update or revise any such forward looking statements to reflect new information, events or circumstances after the date of this publication or to reflect the occurrence of unanticipated events. Exchange rate fluctuations may affect the return to investors. Neither the company or any of its affiliates, nor any other person, accepts any liability whatsoever for any direct or consequential loss arising from any use of this report or the information contained therein. Next Capital Limited, its respective affiliate companies, associates, directors and/or employees may have investments in securities or derivatives of securities of companies mentioned in this report, and may make investment decisions that are inconsistent with the views expressed in this report. 9