Mahindra & Mahindra Limited - At its complicated best! - Antique

M&M's subsidiary structure has always been too complicated for our liking and the new Systech-CIE deal has complicated it even further (even while they might have intended otherwise). While all the small Systech group companies now being a part of a single entity is a positive, we aren't happy about the fact that M&M has ceded majority stake in the business (very unlike them). To our mind, this is a sign of them not finding the forging business lucrative enough after having had a reasonably fair shot at it.

Leaving that aside, the deal is a synergistic win-win in terms of untapped segments/markets - Systech gets exposure to the car segment/American, Chinese market, while CIE gets exposure to the CV segment/Indian market. From a cashflow standpoint, M&M would see an outflow of ~INR4bn - INR630m (diff between share purchase and sale, at current INR-EUR rate of 76.5) + INR3.4bn {purchase of MUSCO's stake in steel JV (INR2.14bn) + surplus land (INR1.26bn, both not required by Mahindra CIE}. From a valuation standpoint, this deal is marginally positive for M&M (as the combined entity should be more valuable than the sum of its parts), but given that it has no bearing on our view on the core Auto business, we maintain HOLD.

Key takeaways of the deal and highlights from the call:

3-step deal:

1. CIE's 75% subsidiary - Autometal (listed on the Sao Paolo stock exchange) will buy a stake in the listed/unlisted Systech group companies (for INR6.73bn) through a holding company.

2. M&M will buy a 13.5% stake in CIE (making it the 2nd largest shareholder) for EUR96.24m (INR7.36bn at current exchange rate of 76.5, hence a net cash-outflow of INR630m).

3. All Systech companies along with a CIE's Forging unit in Spain and Lithuania will be merged into Mahindra Forging, which would be re-christened Mahindra CIE.

The open offer closes in October 2013, and the deal will be finalized by April 2014 after CCI/ATA/SEBI/High Court approvals. Of all Systech businesses, Aerospace, Engineering, and Steel (through JV with Sanyo and Mitsui) are not a part of this transaction.

What would Mahindra CIE look like?

Mahindra CIE would have revenues of ~INR50bn (40bn Systech cos + 10bn CIE Forging), with forging accounting for >80% (balance from stampings, castings, gears, composites). Mahindra CIE will have outstanding shares of 325.8m (vs. Mahindra Forging's 92m). CIE would hold 45-51% (depending on the acceptance of the open offer) and M&M would hold 20.2% directly {+ additional ~5% indirectly (13.5% of CIE's ~75% in Autometal's ~50% of Mahindra CIE)}.

Mahindra CIE will have a debt of EUR230m (CIE Forgings' debt of EUR60m + Systech group companies' debt of EUR170m). CIE Forgings has a EUR150m top-line and an EBITDA of EUR21m (margins have increased to 15%, through some cost-cutting initiatives).

Synergies:

With Mahindra's strong in India and the truck market in Europe coupled with CIE's strong presence in passenger car market of Europe, Brazil, Mexico and other markets like America/China, the merged entity will have a wide geographic/segment presence.

Furthermore, While Systech's forging business has a capacity utilisation of 70%. CIE's forging has a capacity utilisation of 80%, suggesting that further utilisation will be shifted towards India. Mahindra CIE could therefore be the outsourcing hub for CIE's exports to Europe/Thailand and other Asian markets for products like gears, forgings, castings, etc.

That said, while one of the core rationales of the deal is to increase M&M's exposure to the American market, the management stated that exports to America are unlikely for now, as Mexico is more cost-competitive, simply from a logistics point of view.

Mahindra Ugine Steel (MUSCO) an unusually high beneficiary:

The share swap ratio for Mahindra Ugine Steel (MUSCO) shareholders is very favourable. Based on advice from the valuers providing the Swap ratios, Musco shareholders will get 284 shares of Mahindra Forging for every 100 shares held in Musco, even while both shares are at roughly the same price before the deal was announced (~INR65/sh).

Furthermore, as Musco's Steel division is not a part of the deal, M&M is buying Musco's 51% stake in its Steel JV with Sanyo & Mitsui for INR2.14bn and also buying 76 acres of surplus land (not required by Mahindra CIE) for INR1.26bn. Hence, the total outflow from M&M to Musco is INR3.4bn.

M&M has a 55.5% stake in Musco, with Institutional investors accounting for <5% of the balance.

How does our SOTP change?

Till the deal goes through completely, we are unable to arrive at an exact value for Mahindra CIE and hence, we are not changing our SOTP at the moment. But clearly, M&M's 25% stake (direct + indirect) in Mahindra CIE would be worth more than the value we are giving Mahindra Forgings (the only Systech company we are valuing currently - at INR4/share, after a 20% hold co discount), and hence our SOTP will increase marginally after the deal goes through.

On a consolidated basis, M&M will no longer consolidate Systech companies' revenues (given its minority stake in Mahindra CIE), nor will it consolidate Systech's debt (INR12bn). It will only account for M&M's share of profits and hence consolidated numbers will look more profitable.

Outlook on core business remains bitter-sweet... Maintain HOLD!

Leaving the deal aside, given our positive view on the tractor division and negative view on the UV division, our outlook on the core Auto business is sort of bitter-sweet. The tractor volume upgrade cycle is playing out as expected, with the management increasing their tractor volume guidance steadily over the past couple of quarters (they see upside risk to their industry growth guidance of 6-8%). Monsoons have progressed very well thus far and unless things go dry from here, we expect the ensuing up-cycle in the industry to kick-in in 2HFY14. Moreover, we expect M&M to outperform the industry should the lagging South-India market recover. We forecast a 10%/15% YoY tractor volume growth for FY14/15, which also has a positive bearing on margins.

Conversely, we remain circumspect on the so-far resilient Auto business. In our view, M&M is where Maruti was 3-4 years back, i.e. when heavy competition was just upon it. While Maruti proceeded to withstand competitive pressures extremely well, the stock was under pressure till they proved their mettle. While only time will where M&M's UV market share stabilises, till all OEMs of reasonable repute have had their fair shot at the relatively untapped UV space, we'd remain cautious on the company's Auto division. Furthermore, a narrowing petrol-diesel disparity is another headwind for the UV industry overall. Hence, despite our positive view on the tractor business, we maintain our HOLD reco with a target price of INR1,048.

Source : Equity Bulls

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