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Maruti Suzuki India Ltd’s long-term earnings outlook has substantially improved after the company announced changes to its deal structure for the proposed Gujarat plant.
First, the capital expenditure will not be funded by Maruti’s after-tax profits but through depreciation and equity brought in by Suzuki (the parent). The company, in a call with analysts, has conveyed that Suzuki Gujarat will make zero earnings before interest and taxes (Ebit) margins. Suzuki will also fund future capital expenditure needs, to expand the powertrain and engine capacities. Thus, Maruti will not forgo its profit margins for expansion at the Gujarat plant, as was proposed earlier, says Nomura.
The agreement, under which Suzuki will invest in the new plant, will be for 15 years. At the end of this period, the Gujarat subsidiary would be transferred to Maruti at book value. Even in case of a termination of the contract, the subsidiary would be transferred at book value. Analysts say this would remove uncertainty around the merger ratio at the end of 15 years. The market has welcomed the move, as the key concern on the use of Maruti’s surplus cash and parallel capacity outside of the company was addressed with the changed deal structure.
Aashiesh Agarwaal and Siddhartha Bera of Edelweiss Securities believe the new arrangement implies earnings before interest and taxes (Ebit) margins for MSIL at pre-deal levels and other income at levels higher than before, beside zero return on capital employed for Suzuki (implying considerably higher return on equity for Maruti Suzuki India).
The company intends to proceed with the changed deal structure only after this has the blessings of minority shareholders. There are several takeaways from this development. First, by seeking the approval of minority shareholders, the company has met higher corporate governance standards. Second, the gains to shareholders of Maruti are expected to be significant after the deal has been re-engineered. With lower capex requirements, Maruti’s free cash flow generation will improve.
For Suzuki, the return on its Gujarat investment would be only through Maruti and not in the form of direct profits. For now, the initial investment by Suzuki would be treated as endowment to MSIL and this would add another Rs 100 a share to the existing stock price. This brings back the market's fair valuation of 15 times for the stock.
