Bajaj Auto Limited Few days back, I was watching the famous 1989 “Hamara Bajaj” advertisement on YouTube. The input from a forty second advertisement was more than enough for my brain to bring back all the pleasant memories from my childhood days. At a subconscious level my brain has created an association with the advertisement and all the pleasant childhood memories. This experience made me realize that the human brain is the most complex structure in the universe.

Business Bajaj Auto started off in the year 1944 by selling imported two and three wheelers in India. In 1959 it obtained a license from the Government of India to manufacture two and three wheelers. In 1970, after spending more than a decade since getting the license, Bajaj Auto rolled out its 100,000th vehicle. Do you know how many vehicles it sold in the last fiscal year? In FY2015, it sold 3,811,201 vehicles in India and 62 other countries. The company designs, manufactures, and sells three kinds of vehicles (1) Two wheelers; Motorcycle a two­wheeled vehicle that is powered by a motor and has no pedals. (2) Three wheelers; RE a three­wheeled vehicle used for commercial purposes and it is the most widely used last mile public transportation solution in India. (3) Four wheelers; RE60 an intra­city multipurpose vehicle which could be used as a taxi or a self­drive rental and it is positioned

between the autorickshaw and the four wheeler taxi. RE60 is fuel efficient and environmentally friendly. The company classifies the motorcycle industry into three different segments — Mileage, Sports, and Premium. Within each segment there are few subsegments. The company manufactures motorcycles in all three segments. Why do you need three kinds of motorcycles? The simple answer to this question is that everyone is different. In the table given below I have summarized all the motorcycles it manufactures across different segments.

Segment Motorcycle Notes

Mileage Boxer, CT100, Platina, and Discover

Price range from Rs 0.4 to 0.6 lacs. The engine capacity ranges from 100 to 150 cc. It can travel up to 89.5 kilometers per litre.

Sports Pulsar, Avenger, and KTM Price range from Rs 0.6 to 2.5 lacs. The engine capacity ranges from 150 to 500 cc. It can travel up to 65 kilometers per litre.

Premium Kawasaki Ninja Price range from Rs 2.5 lacs and above. The engine capacity ranges from 250 to 500 cc. It can travel up to 30 kilometers per litre.

Long back, I used to own a motorcycle in India. I viewed the motorcycle purely as a utility and its only purpose is to take me from point A to B. There are a couple of things that I expected from the motorcycle (1) High Mileage; the number of kilometers it can travel for a litre of petrol (2) Low Price; the motorcycle should not only touch my mind but also my purse. Customers like me buy motorcycles from the Mileage segment. Some customers don’t view the motorcycle purely as a mode of transportation. They view it as a luxury good where they are used mostly for recreation, as a lifestyle accessory or a symbol of personal identity. These customers don’t care much about the mileage or price of the bike. And they pay up for quality by buying motorcycles from Sports and Premium segment. These bikes accelerate faster than the ones in the mileage segment because of the higher energy or thrust provided by the engines. The thrust produced by the engine is measured in cubic centimeters (CC). Higher CC engines provide more thrust and this results in faster acceleration and lesser mileage. In India the minimum age to apply for a permanent license to drive a motorcycle over 50cc is 18 years. Bajaj Auto’s motorcycle customers include anyone who is 18 years or older. Most of its customers are males as females prefer driving scooters instead of motorcycles. And Bajaj Auto exited the scooter segment completely in 2009 as it decided to focus only on motorcycles. The company has a Pan­India dealer network and authorized service centers. This reduces the search costs and enables customers to buy and maintain their motorcycles in quick time.

In FY2015, around 54 percent of its motorcycles were sold in India. And the remaining 46 percent was sold in the International markets. Africa represents 45 percent of its international market. Take a look at the table given below which shows the motorcycle market share of the company in domestic and export markets. What do you see?

The company has a healthy market share of 67.6 percent in the export markets and its share went up over the years. But in India it is losing market share and in the last five years, it lost over 10 percent share. Losing market share is not a joke and gaining it back is damn hard. Why is Bajaj Auto losing market share in India? Hold on to this question and we will come back to it later in the document. Bajaj Auto three wheelers, marketed under the brand name RE, are used for carrying passengers and it is the most widely used last mile public transportation solution in India. The company classifies its three wheelers into two different segments — Big and Small. Around 60 percent of RE it manufactures are small and the company maintains a leading market share of 80 percent. The remaining 40 percent of RE it manufactures are big and the company maintains only 18 percent market share. In order to drive a three wheeler in India one needs to apply for a permit from the state government. So RE sales are a function of new permits issued. This is what the company wrote in their latest annual report about the permits — “Maharashtra has issued fresh three­wheeler permits for around 80,000 units. The Company expects other large states such as Delhi and Andhra Pradesh to follow suit.”. Take a look at the table given below which shows the three wheeler market share of the company in domestic and export markets. What do you see? Over the years the company gained market share in India by increasing it from 39 to 44 percent. In the export markets, maintaining a market share of close to 70 percent is decent.

Finally, the company is ready to launch its four wheeler, marketed under the brand name RE60, an intra­city multipurpose vehicle which could be used as a taxi or a self­drive rental. But the company couldn’t launch it as there are multiple petitions filed against this new vehicle category in the Indian Supreme Court. While there is still uncertainty about the launch of RE60 in India, the company has announced its plans to export it.

As regards our quadricycle RE60, the product is ready for launch. However, RE 60 launch was mired in legal tangles created by vested interests filing multiple petitions in various High Courts, questioning the Government process in creation of this new category. Some of the High courts had, pending detailed hearings, ordered stay of the Government notification in the interim; while some others admitted the petitions, but did not find merit to grant a stay. In the face of stay orders, ARAI­ the testing agency, kept the approval and related processes in suspended abeyance. ­ Annual Report

In the table shown above you can see the break up of production capacity for each of its plant­product type. Bajaj Auto manufactures its two, three, and four wheelers in three plants located in India. Two of them are located at Waluj and Chakan in the state of Maharashtra and

one plant at Pantnagar in the state of Uttranchal. Three factories put together has a production capacity of 6,060,000 vehicles. Compared to FY2015 sales the company has an excess production capacity of 37 percent. The company generates 56 percent of its revenue from India. And the remaining 44 percent is made in the international markets. The table given below shows the sales breakup between domestic and export markets. In the last four years sales from the international markets grew at the rate of 21 percent compared to the domestic market which didn’t grow at all.

One of the major reasons for the no growth situation in the domestic markets is because of its Discover bike which is losing market share in the mileage­mid­level segment. The company explained this well in the latest annual report.

However, there has been an overall fall in the volume of motorcycles. This has been mainly on account of Discover, which occupies the middle segment, between entry­level motorcycles on the one hand and the premium segment sport or supersport bikes on the other. Given the weight of this segment in the overall domestic market, the fall in sales of Discover has dragged down the otherwise excellent performance of your Company in the two­wheeler front. Consequently, Bajaj Auto’s motorcycles have lost domestic market share — from 24.4% two years ago to 20% last year, and then to 16.5% in FY2015. ­ Annual Report

The company doesn’t give the sales breakup between its two and three wheelers. Assuming the average cost of an RE (three wheeler) to be Rs 1.5 lacs the sales split between two and three wheelers comes to 65 and 35 percent. Its RE60 (four wheeler) didn’t generate any revenue in FY2015. The manufacturing process of two, three, and four wheelers basically involves metal cutting and metal forming (re­shaping metals without adding or removing material). The basic raw materials used in vehicle manufacturing are steel and aluminum. Take a look at the table below. In the last five years the company on average spent 74 percent of its sales on the cost of goods sold. The company has 9,183 employees in its payroll. On average the company spent 3.25 percent of its sales on the employee's payroll. The remaining 5 percent is spent on SG&A, depreciation, and Miscellaneous expenses. In the last five years the

average operating profit generated by Bajaj Auto comes to around 18 percent. Is pretax operating margin of 18 percent, low or high?

In order to answer my earlier question we need to compare Bajaj Auto’s operating margin with other companies in the vehicle manufacturing industry. From the chart shown below, we can see that Bajaj Auto’s operating margin is 7.3 percent higher than Hero Motors which has the second highest operating margin. From this we can conclude that it has a very high operating margin.

We can’t take these numbers at face value as the vehicle category mix for every company is very different. Also operating margin only tell you half the story and the other half is revealed by looking at the asset turnover. But the above chart begs us to ask a question — Why is Bajaj Auto able to generate such high operating margins? If have to answer this question in a single word then it will be — Brands. Rahul Bajaj, who is the Chairman of the company explained this beautifully in the 2010 Annual Report.

Bajaj Auto’s superior performance suggests that it has been more than just leveraging market growth. What was it? For the last few years, your Company has been working at developing a brand­centred strategy especially of its two key brands, the Discover and the Pulsar. I believe that 2009­10 saw a near perfect alignment between the power of the brands – the front­end – and production efficiency, quality, costs and logistics, or the back­end. I agree with the managing director and his team that it is this alignment which has resulted in your Company growing faster than the market and earning the highest profit rate in the industry. What pleases me is that Bajaj Auto is leveraging its key brands to maximise 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. ­ Annual Report

It’s time to take a look at return on invested capital (ROIC) for Bajaj Auto. The company has an asset light business model which enables it to turnover its fixed and working capital at very high rates. And this resulted in generating ROIC greater than 200 percent. It has a negative working capital because of its high bargaining power with vendors and distributors. In the last five years, it had an average cash conversion cycle of negative 23 days.

It has negligible debt in the balance sheet. The debt­to­equity ratio is 0.01. On average, 93 percent of its operating profits get converted into operating cash flows. This conveys to me a couple of things (1) majority of its sales are quickly converted to cash. It has only 10 days of sales outstanding (2) accounting profits are not overstated as they agree with the operating cash flows. Let’s look at the challenges that the company is currently facing in India. Take a look at the motorcycles year­over­year growth rate for the entire motorcycle industry and Bajaj Auto. What do you see? The motorcycle industry as a whole is growing very slowly in the last 3 years. Why did this happen? One reason is that Indian economy didn’t do that well during this period. But that doesn’t explain the negative growth experienced by Bajaj Auto. Clearly the problem is company specific.

Take a look at the table given below showing the scooter market share in two wheelers over the last five years. What do you see? In the last five years the scooters market share went up from 17 to 28 percent. Remember that the company exited the scooter segment completely in 2009. The company didn’t get benefited from the increase in demand for scooters. Click here to read more about this.

Staying out of the scooter segment was a strategic move from Rajiv Bajaj, who is the Managing Director of the company. In one interview he said — “We are not making scooters. For that, we need to earn the right to make them and for that I need to be No. 1 in motorcycles”. Click here to read more about this. The increase in demand for scooters doesn’t explain why the company lost market share in motorcycles. In order to find out the root cause of the problem we need to know that the motorcycle industry is divided into segments and subsegments. The Mileage segment is divided into M1, M2, and M3 subsegments. Together they control 82 percent of the industry motorcycle volumes. The Sports segment is divided into S1, S2, and S3 subsegments. Together they control close to 18 percent of the industry motorcycle volumes. The Premium segment is not broken down into any subsegment and it controls around 0.08 percent of the motorcycle volumes. Spend some time to understand the table given below which shows the industry volumes across subsegments.

Bajaj Auto is the market leader in S3 (KTM) and S1 (Pulsar) subsegments. Profit margins are much higher in S1 and S3 subsegments. But S3 is too small compared to the overall industry volumes and it is not moving the needle much for Bajaj Auto. S1 (Pulsar) has been doing wonders for Bajaj Auto well over a decade. The troublemaker for Bajaj Auto is M2 and M3 (Discover) subsegments which commands 61 percent of industry motorcycle volumes. In one year [2014 to 2015] its market share from M2 and M3 came down from 14 to 10 percent. The next question that one should ask is that why Bajaj Auto is a leader in Pulsar and not in Discover. Is this random or is there a reason behind the leadership? Hold on to this question and I will address it in the next section.

Take a look at the chart shown above. What do you see? The domestic two wheeler market is extremely competitive. The second biggest player Honda is fighting to gain market share in the M1 segment from Hero Motors. Honda is successful in achieving this by increasing its overall market share from 13 to 27 percent. But it gained this market share by sacrificing profit margins. This is not good for all the players, including Honda Motors, in the industry. Click here to read more about this. Bajaj Auto is playing the game sensibly by moving away from entry level [100 to 110 CC] to [150 CC] motorcycle segment.

Moat Sir Arthur Conan Doyle was the author and creator of Sherlock Holmes; the most rational and intelligent detective of all time. In one of the books he wrote — “Once you eliminate the impossible, whatever remains, no matter how improbable, must be the truth”. I am going to use the same technique to identify if Bajaj Auto has any moat. I will try to prove that the company doesn’t have a moat. If the absence of a moat is impossible to prove then I will conclude that the company has a moat. Let us start with supply side advantage, one of the three sources of moats. Is there any proprietary technology involved in the manufacturing of two, three, and four wheelers that is protected by patents or know­how? There is none. In the video given below watch from 36:25 to 37:30 minutes to see Rajiv Bajaj explain about the technology saturation that happened in the motorcycle industry long back.

Motorcycle business which we must humbly accept that the technology has saturated long time back. If you read the auto magazines, we would look very foolish because if you make commuter bikes we are competing on the last 1.3 kilometers mileage. And if you make sports bike then you need four stop watches to find out who is one third of a second faster than whom. In other words everybody’s product is like everybody else’s. And it can point to a very commoditized industry. ­ Rajiv Bajaj

Let us move on to the local economies of scale, the next source of a moat. If a company can produce 3,811,201 vehicles in three factories, then it will get benefited from economies of scale. But that doesn’t mean that it becomes a moat for the company. Why is that? This is because the total market for two and three wheelers is very big. In FY2015 the total two and three wheeler sold in both domestic and export markets add up to 19,402,062 [SIAM]. Bajaj Auto’s sales represent only 19 percent of the total industry sales. The market is too big for other players to produce enough vehicles and achieve economies of scale. Clearly this is not a moat for the company. From the table given below you can see that top four players control 90 percent [Autocarpro] of the domestic market sales in October 2015. If everyone has scale advantages then it doesn’t constitute a moat for the company.

When you’re thinking about cost advantages that stem from scale, remember one thing: The absolute size of a company matters much less than its size relative to rivals. Two massive firms that dominate an industry—for example, Boeing and Airbus—are unlikely to have meaningful scale­based cost advantages relative to each other. ­ Pat Dorsey A simple example should help explain why small markets are more hospitable than large ones for attaining competitive advantages. Consider the case of an isolated town in Nebraska with a population of fifty thousand or less. A town of this size can support only one large discount store. A determined retailer who develops such a store should expect to enjoy an unchallenged monopoly. If a second store were to enter the town, neither would have enough customer traffic to be profitable. Other things being equal, the second entrant could not expect to drive out the first, so its best choice would be to stay

away, leaving the monopoly intact. At the other extreme from our Nebraska town is downtown New York City. This large market can support many essentially similar stores. The ability of even a powerful, well financed incumbent to prevent entry by a newcomer will be limited. It cannot, in other words, establish effective barriers to entry based on economies of scale relative to its competitors. ­ Bruce Greenwald

Let us move on to the demand side advantages, the last source of a moat. A lot of investors assume that if the company has a high operating margins, then it has demand side advantages. But that’s not true as high operating margins without a moat can be an ephemeral thing. For having demand side advantages a company should have captive customers. We already saw that everybody’s motorcycle is like everybody else’s (commoditized). Is there a customer captivity in the motorcycle industry? Take a look at the image below. In the Sports segment (S1) Bajaj Pulsar is the leader, which controls 44 percent market share. There is competition in every segment including, this sub segment. Pulsar brand was introduced in 2001. How can a commodity product enjoy high market share which has been profitable for more than 14 years?

This is because Bajaj Auto created this subsegment (S1) which didn’t exist back then. A company which creates a new subsegment by introducing a branded product gets rewarded by customers with a very high market share, which is profitable and it lasts for a very long time. This is what Hero Honda’s Splendor did in the 90s by creating a new segment. It sells more

than one million Splendors every year. Recently this happened to Royal Enfield, owned by Eicher Motors, which is the leader in the S2 subsegment with more than 90 percent market share. The motorcycle industry is less of a technology and more of a marketing industry. It is a game of brands. In the video given below watch from 9:10 to 16:20 minutes to see Rajiv Bajaj explain why the leader who creates a new segment gets to dominate the market for a very long time. In it, he answers my earlier question — “Why Bajaj Auto is a leader in Pulsar and not in Discover?”

From this we can conclude that some of the subsegments like S1 and S3 have demand side advantages. We have to wait and see how the company is repositioning its Discover brand in the domestic markets to regain the lost market share. The motorcycle industry is highly competitive both in domestic and export markets. But by specializing and branding the company is able to create demand side advantages. Hence I am assigning a narrow moat for Bajaj Auto.

Management Take a look at the table given below. What do you see? From [2005 to 2015] sales went up by 3.5 times. Operating profit went up by almost 5 times and exports contribution to overall sales went up from less than 10 percent to 44 percent. How did this happen? This happened because of the strategy created by Rajiv Bajaj, who is the Managing Director of the company. I would

urge you to read the Forbes article The Comeback Kid which tells the entire story about how Rajiv Bajaj transitioned a domestic scooter company to a world class branded motorcycle company.

Here are few things that I learnt about him by reading the annual reports and listening to his talks.

1. Rajiv Bajaj understands the essence of strategy. According to Michael Porter the essence of strategy is choosing what not to do. He set himself to become a world class manufacturer of motorcycles. The only way to achieve that goal is to focus solely on motorcycles. So he exited the scooter segment and specialized in motorcycle manufacturing.

2. Growing the market share is very important. But it should not come at the expense of profits. The only way to create profitable market share is to establish brands. A brand is something unique that is positioned in the mind of the customer and he is willing to pay up for the product. Brands get diffused and loses pricing power if you try to create too many of them. They key is to have few core brands [KTM, Pulsars, Discover, Boxers] and not stray away from the core.

3. Capitalism guarantees that competitors will emerge like bees to honey and will try to take away your market share. After creating a brand you need to adopt a strategy to defend your profit share. Here are a few strategies that he uses to grow sales and defend profits in the export markets.

Sno Export Markets Strategy

1 Sri Lanka, Bangladesh, and countries similar to India.

For countries that are similar to India sell the brands like Pulsar and Discover that are successful in India. And hope to achieve the same success there.

2 Philippines and other ASEAN countries

The markets are more competitive than Sri Lanka and Bangladesh. The entry strategy is to partner with a player like Kawasaki who has a fabulous distribution network. And push brands like Pulsar into the existing network.

3 Brazil Markets like Brazil are mature and much evolved. It is

hard to sell brands like Pulsar and Discover in these markets. In these markets the company sell well known Western brands like KTM. It has a subsidiary named Bajaj Auto International Holdings which is a JV between Bajaj and KTM with a share of 48:52. KTM an Austrian company is the 2nd largest motorcycle manufacturer in the Europe. The company is based in Austria.

4 Africa It is a cost conscious market. Chinese player dominate the market by selling cheap motorcycles. The strategy here is to do the opposite of what the Chinese are doing. If he is [slow then be fast], [cheap then be expensive], [fuel efficient then be powerful]. The company sells Boxer motorcycles which sells at 50 percent premium of Chinese motorcycles.

The company has 28.94 crores shares outstanding. And they haven’t issued any new shares in the last five years. Take a look at the table given below. From [2009 to 2015] Bajaj Auto generated Rs 15,612 crores in operating cash flows. Around 48 percent was returned back as dividends to the shareholders.

It invested Rs 1,109 crores back into the business. This in turn generated an additional pre tax operating profit of Rs 16,000 crores. This tells me a couple of things (1) it doesn’t need a lot of capex [asset light] to grow its sales and profits (2) excess cash generated by the business can’t be reinvested back into the business at high rates of return. As of 30­Sep­2015 the company has close to Rs 10,000 crores sitting on treasury assets. With negligible debt in the balance sheet I am not sure why the company needs to keep so much in treasury assets. Overall, I don’t see any issues with the management. And I have become a big fan of Rajiv Bajaj. If there is one risk with the management it’s a key man risk.

Valuation As of 30­Sep­2015 the company had Rs 83 in net operating assets per share and Rs 350 in net financing assets per share. So the total book value per share comes to Rs 433. The last few years have been really challenging for the domestic motorcycle industry. On top of this the company is facing issues with its Discover brand. Let’s assume that the industry will turn around and Bajaj Auto will clock 15 percent increase in sales for one more year. With this assumption it will have a net sales of around Rs 25,000 crores. Assuming that the company will be a going concern with an earning power to generate 18 percent pretax operating margin. It will generate Rs 3,150 crores after tax (30 percent tax rate). On a per share basis this translates to Rs 109. If you are expecting an after tax yield between 7 to 10 percent, then the intrinsic value (no growth) of Bajaj Auto will be between Rs 1,440 to Rs 1,906. fter tax operating EPS s 109A = R

[Multiply by 14.28 for 7 percent yield]t 10 percent yield operating assets will be worth s 109 10A = R *

t 10 percent yield operating assets will be worth s 1, 90A = R 0 ntrinsic value per share (10 percent yield) s 1, 90 Net financing assets per shareI = R 0 + ntrinsic value per share (10 percent yield) s 1, 90 Rs 350I = R 0 + ntrinsic value per share (10 percent yield) s 1, 40I = R 4 The auto industry is extremely competitive. And the moat of Bajaj Auto is very narrow. So I wouldn’t pay anything for growth. The current share price of Bajaj Auto is Rs 2,412. Even if I consider the higher band of intrinsic value the current price has 20 percent growth in it. When I calculated the intrinsic value without growth we assumed that the company will maintain a pre tax operating margin of 18 percent. If competition forces the company to reduce the margins, then it will result in permanent loss of capital. Disclaimer: I have a small position in Bajaj Auto. This is not a recommendation to Buy, Sell, or Hold. I am not a SEBI registered analyst. I wrote this document to organize my thoughts and deepen my understanding about the company and industry. I am sharing it so that you can learn something from this. Author : Jana Vembunarayanan

Website : https://janav.wordpress.com

Twitter : @jvembuna