Eicher Motors Valuation: Valuing the Indian Dream

We all know the feeling.. the thrill of kick-starting a Royal Enfield motorbike and hearing the *dug dug dug* sound emerge from the rear. Over the years, Royal Enfield has almost become a household name. It's become a dream every Indian aspires towards and every family is proud to have. But what is the Value of that dream?

The Company

Before we dive in to my side of the story, let me showcase how the company has presented itself to its investors:

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The Narratives

Eicher Motors is the undisputed leader of the Indian luxury motorcycle space. It has a rich history behind its monumental success.

The company started as 'Goodearth Limited' building tractors in India. After taking over a small stake in Eicher Limited in 1990 and a further, majority stake in 1993, they rechristened themselves as 'Royal Enfield Motors Limited' and started exploring the premium motorcycle space in India. Even when the market leaders in Two Wheelers space were not ready to tap into this segment in India, Eicher Motors dared to walk a path of its own. Ever since, the company has built a loyal customer base and a household brand name for itself. Of course, we should not forget the important role the CEO, Mr. Siddhartha Lal played in developing Eicher Motors into what it is today. As Eicher Motors grows, it will face stiffening competition from the now-enlightened market leaders in the Non-premium Two Wheelers space dipping their feet in the Premium Two Wheelers segment.

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The Quality

We start by look at the company's 'Quality', broadly speaking. In my Valuation model, I have defined 'Quality' using the following parameters:

1. Moat Size

There are 4 common types of Economic Moats.

• Low Cost (1/10): A Royal Enfield motorcycle is most definitely not know for being low-cost, so this one's a no-brainer
• Switching Cost (9/10): There is a lot of thought process that goes into purchasing a motorcycle and often the customers have a very strong brand orientation. Especially after riding a luxury motorcycle, the 'normal' ones seem a bit awkward to ride. I can confirm this myself, since I own a Royal Enfield Classic 350
• Network Effect (4/10): There is a loyal fan base for Royal Enfield. However, it does not create any networking effect, the way it would with online marketplaces like Flipkart/Amazon or Food-ordering Apps like Swiggy/Zomato
• Intangible Assets (9/10): Royal Enfield is one of the most recognizable brands in India.

2. Management Standard

I use Jack Welch's 4E Leadership Model in order to gauge the Management's Standard:

• Energy (8/10): The CEO, Mr. Siddhartha Lal has been monumental in developing Eicher Motors into what it is today and continues to have the same level of passion even now
• Energize (7/10): Employees of Royal Enfield have an above-average (3.6/5) opinion of working in the company and an overwhelming majority (88%) approve of the CEO
• Edge (8/10): All of Royal Enfield's decisions, whether it's regarding introducing a new model or installing a new plant, has always been clear and well-communicated
• Execution (5/10): Royal Enfield motorcycles have had their own share of complaints. From my own experience and the experience of my friends, I know that those complains aren't addressed as much as we'd like to.

3. Customer Satisfaction

• Product Quality (9/10): Royal Enfield bikes have an above-average rating on many motorcycle websites
• Quality Perception (10/10): The owners of a Royal Enfield motorcycle (Including me) have an unflinching loyalty towards the brand 
• Customer Trust (8/10): Of course, borrowing from a link posted earlier, Royal Enfield was the 33rd most trusted brand in India last year
• Brand Image (10/10): Royal Enfield motorcycles have an aspirational quality and even today, it turns heads on the road with its iconic design

4. Industry Outlook

• Political Favor (4/10): There is no specific support extended by the government to the Premium Motorcycles segment
• Economic Favor (7/10): India's demography is slowly shifting towards the working-age population. A majority of the earlier lower-income middle class group are increasingly becoming the higher-income middle class group. This places Royal Enfield in a demographic sweet spot
• Social Favor (4/10): Luxury motorcycles does not hold any kind of importance so as to affect the social life of India's citizens
• Technology Favor (2/10): India has been a manufacturing hub for many years now. Rest assured, unless there's a breakthrough innovation, no improvement in technology is going to positively impact Royal Enfield's Sales or Margins

5. Competitive Dynamics

• Bargaining Power (10/10): Royal Enfield owners do not nearly understand the hundreds of parts that go into making the motorcycle and often rely of the wisdom of the service person. On the other side, Eicher Motors has constantly maintained a negative net working capital position (Meaning, distributors pay up front in order to get the bikes in to their showroom), which stands proof of their superior bargaining power.
• Threat of Substitutes (7/10): The big names in the non-premium motorcycles segment have entered the luxury motorcycles segment and even succeeded to some extent. Bajaj with its Avenger line of bikes is a prime example. TVS is rumored to be bringing out its 'Zepplin' line of bikes in the same segment. The other players will surely follow suit.
• Barriers to Entry (5/10): The luxury motorcycles segment does not have a high barrier to entry, so to peak. But it does need a huge initial capital outlay, so there is a minimal barrier.
• Industry Rivalry (7/10): As of today, Royal Enfield has little to no competition in the luxury motorcycles space. But going forward, it's going to face stiffening competition.

Aggregating all those scores, we get this:

The way the model works, high Quality business have a longer runway than low Quality businesses before becoming mature. The incremental periods of High Growth will augment their Value. According to the above inputs, Eicher Motors will have a High Growth period of 20 years (The maximum), before becoming mature.

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The Numbers

Most of these have come from Eicher Motors' 2017-18 Q4 Consolidated Results and a few of them (Like Company Beta, Industry Beta, Industry D/E and Indexed Returns) from simple online searches. A special note, for Minority Interest, I took the actual figure of Rs. 1742.67 and gave it a 3.5x multiplier, the average Price/Book Ratio of the Truck Industry. This is done to make sure that we don't mistakenly account for Subsidiary Income in Eicher Motors' Value.

If you would like to understand how to enter each of these inputs, I suggest you visit an earlier post of mine: Numbers and Narratives, which is a step-by-step guide on how to use the model. Since this is elementary, I'm going to go ahead and move into the exciting parts of the Valuation.

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The Capital Conversions

The ace investor Michael J. Maubossin, in his article titled "Common Errors in DCF Models", pointed to capital misappropriation as one of the biggest sins in Valuation. Accounting Policies, when taken at face value, do create problems. It becomes very important to convert wrongly allocated R&D into Capital, find out the Market Value of Debt, Lease and Equity Options in order to be consistent with real-life definitions of Assets and Liabilities. This would make the DCF model economically viable.

In the case of Eicher Motors, we make the following adjustments:

1. Research & Development

You can find disclosures related to R&D in every Annual Report of a company. Assuming a 4-year life for Eicher Motors' Research, I am capitalizing Rs. 88.50 Crores worth of R&D and adjusting Rs. 27.28 Crores worth of R&D from the current year's Profit numbers.

2. Debt

Eicher Motors has a measly Rs. 8.88 Crores of long-term financial obligations (That's a 0.01 Debt-Equity Ratio). So, it goes without saying I don't need much by way of adjustments here.

3. Operating Lease

Eicher Motors has an active Operating Lease, but it has also leased out to its JV partner, Polaris. Since the model contains the option to calculate the value of only a single Lease, I had to get a little unorthodox and combine the payments of both the leases.

Let me reiterate that this is not the way to do it. The ideal way is to evaluate both the leases separately and then combine their values. But hey, what's an Indian Company's Valution without a little jugaad.

4. Equity Options

Here's where it gets interesting. Eicher Motors has some Options outstanding and at prices much lower that the current Market Price of its Shares. That's bad news for Equity Holders, because Value dilution is a possibility. But how much Value will be lost due to a potential exercise of Options? Let's find out. The following is the information I gathered about Eicher Motors' Outstanding Equity Options (The Exercise Price for the year 2017 is assumed--the lowest Price Eicher Motors traded at for the year):

Using the above as inputs, we can calculate the potential Value that could be lost due to Option Exercise:

So in essence, Eicher Motors could potentially lose Rs. 509.23 Crores in Present Value terms during the next 5 years (Average Time to Expiry). This forms 0.61% of their Market Capitalization.

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The Assumptions

We have now arrived at the juiciest part of this whole Valuation exercise. The numbers entered here will form the crux of the Value of Eicher Motors, so due caution is necessary.

Before entering the numbers, let's take a look at how Eicher Motors has fared historically in some of the key criteria that influence the Value of a company:

I would say, great, overall. The historical performance of a company often becomes the base from which you build your story and how you determine what numbers will keep that story grounded in reality. 

This is how I complete my narrative through numbers:

To make sure that I am not influenced by any biases, I justify my assumptions as well:

But how do I make sure that my assumptions are grounded in reality and closer to economic viability?

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The Diagnostics

I check if any of my inputs are way out of line:

Looks like they're not. I can safely proceed.

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The Cash Flows

This is how Eicher Motors' Profits, Magins, Reinvestments and Cash Flows will look like, based on my inputs and assumptions:

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The Value

Discounting these Cash Flows at an appropriate Discounting Rate will allow me to calculate the Value of Equity of Eicher Motors. In our case, 10.64%, the Bottom-up Beta-based CAPM Cost of Capital, is the Discounting Rate. Then following a few kinks and adjustments, I can find out the Intrinsic Value per Share of Eicher Motors:

My narratives, numbers and assumptions assign the Value of Rs. 27,971.39 per Share of Eicher Motors. As of today, Eicher Motors trades at Rs. 30,924.18 on the exchanges. So the Price per Share of Eicher Motors is higher than the Value per Share of Eicher Motors by 9.5% or so.

But is this Value set in stone? Of course not. I could always be wrong about my assumptions of Growth and Cost of Capital in the Terminal Year (In fact, I could wrong about all my assumptions -- but the Terminal Year assumptions impact the Value more).

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The Sensitivity of Value

I simulate the Growth and Cost of Capital in the Terminal Year with incremental increases and decreases, to see how the Value changes. The Sensitivity of 12.91% is not arbitrary. It's the number at which the Standard Deviation of the simulated Values reach ~68%, which is approximately 1.00 Z-value away the Mean of Rs. 27,971 (That is to say, the simulated values are considerably relevant);

But of course, the extremes, Rs. 19,256 and Rs. 1,50,068 are incorrect. The way a Normal Distribution works, as you move closer and closer towards the center, the values become exceedingly relevant. To summarize the simulation, the Win-Loss Ratio would tell you than out of the 35 possible outcomes for Values, only 15 Values are above the current Market Price, but 20 Values are below.

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The Monte Carlo Simulation

Here, I must note that the above Sensitivity Analysis only looks at the Growth and Cost of Capital in the Terminal Year. It does not consider the fact that I could be off in my assumptions during the High Growth period as well. A Monte Carlo Simulation could be the solution to this. This is not easily done and it could get really confusing really fast. So unless you have a firm grasp on Statistics and Excel, I would suggest that you stick with the Sensitivity Analysis tool.

I'm making the simple case that all my assumptions can vary from -15% to +15% randomly. I'm going to record the outputs, plot them in a graph and see how the Value changes when randomness is accounted for:

Tidying that up with a bit of Excel showmanship and I arrive at this wholesome pictorial representation:

The correct way to interpret this graph would be as follows:

The Values at the far end of the graph are almost always wrong. As you move closer towards the center, the Values start becoming more believable. So, in a way, anywhere between Rs. 28,000 to Rs. 30,000 is the Intrinsic Value of Eicher Motors. If you require a Magin of Safety, you should consider buying at anywhere between Rs. 24,000 to Rs. 28,000. If you are very optimistic about Eicher Motors' future, you could buy anywhere between Rs. 28,000 to Rs. 34000, but there's a risk that you could be overshooting the Value.

That's all I have to say and show about Eicher Motors. I hope that made sense.

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Are you not satisfied with my story about Eicher Motors? Worry not! You can tell your own story and see what Value could be assigned to that story:

(Download Numbers and Narratives - Eicher Motors)

If your Value differs wildly from mine or if you have a different perspective on Eicher Motors, do let me know in the comments. Crowd-sourced Valuations are more fun!