Motherson Sumi Systems Valuation: Saving the Hippopotamus

If you've ever owned a car, you are sure to have used this company's products. With that bold opening statement, let's attempt to unravel the story and the numbers behind one of the largest Retail Automotive players in the country: Motherson Sumi Systems Limited (MSSL).

The Company

Motherson Sumi Systems Limited (MSSL) is the flagship group company of the larger Samvardhana Motherson Group (MSG). Starting from its humble roots in India as a car wiring manufacturer, MSSL has grown leaps and bounds to get to where it is today. With market leading products ranging from Electrical Distribution Systems, automotive rearview mirrors, polymer processing, lighting systems, air intake manifolds and HVAC systems. MSSL’s principal focus is the automotive industry, globally and in India. MSSL has its footprints in tens of countries via a host of more than 140 subsidiaries. This means that the company is likely to have a very long Competitive Advantage Period (CAP) and sufficient pricing power. However, the global slowdown in Auto sales is sure to play spoilsport for the company, at least in the short term. In the long term, MSSL is sure to rise back, but will perhaps not be as nimble-footed as it was once.

There is also this certain issue. The first thing you will notice if you browse through MSSL's Annual Report is that its Corporate Structure is complex, to say the least. Here's the structure at a basic level:

As you go deeper, you learn that MSSL holds an astounding amount of subsidiaries, 140 to be precise. They have done several acquisitions in the recent past and have promised to continue doing so in the future. Is this good or bad? The answer has to wait.

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The Industry

The Auto industry, which impacts all Retail Automotive players, does not need an introduction. In recent times, woes of stagnating growth have shown up:

(Source: Statista)

Several research reports, including one by McKinsey, also reinforce this. While global auto sales have begun to languish at 2-3%, India's own growth isn't very rosy either at 4-5% and change. Auto Parts / Retail Automotive suppliers will also catch the headwinds, no doubt.

Raw Material prices aren't giving the company a break, either. Here's a direct quote from MSSL's latest Annual Report:

• Key raw material for the Company’s Wiring Harness Division is copper.
• Key raw materials for the Polymer Division are polypropylenes, polycarbonates, ABS and various grades of nylons and resins.
• Key inputs for the SMR (mirror) Division are glass actuators, power folds, glass, electro-chromatic glass (“EC glass”), wiring harnesses, electronics, electrical parts, die casting, plastic parts and resins

Essentially, the major contributors to cost are Copper, Nylons and Resins. Let's take a look at how their prices have fared in the recent past:

Copper Prices

(Source: MacroTrends)

Resin prices and Nylon chips have also shown a rising trend of late. All this means, tougher time ahead for most Auto Parts / Retail Automotive players.

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The Numbers

I have taken the following financial numbers from MSSL's latest Annual Report, MSSL's Q2/H1 Report for 2018-19 and MSSL's Q4/H2 Report for 2017-18.

Of course, some of these details have been taken from elsewhere too. The Risk-free Rate from the 'World Government Bonds' website:

(Risk-free Rate: World Government Bonds)

The Company Beta and Indexed Returns have been calculated based on the data from Yahoo Finance:

Industry-related details are taken from several online sources, including Screener and Economic Times:

An important input here is the 'Minority Interests', which is basically the value of the subsidiaries that MSSL does not hold. Confused? Don't be.

As mentioned earlier, MSSL holds 140 subsidiaries and some JVs to boot. Most of these are complete subsidiaries, as in, held with a 100% stake. 10 of these subsidiaries, however, aren't completely held. Since we're going to be using the Consolidated Financials to value MSSL, we should ideally remove the value of  these 10 subsidiaries which MSSL does not hold (Because it does not accrue to MSSL's shareholders, but to someone else, who holds these remaining stakes). Here is how I have calculated the 'Minority Interest' value for MSSL (The Industry P/BV of 4.00 carries directly from the above calculations related to the Industry):

With the grunt work done, let's move ahead to more interesting levels.

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The Capital Conversions

Nothing too material to note here, but some Capital Conversions being done, to adjust for Accounting discrepancies. Here's how the Debt owed by MSSL stacks up:

My model only allows for 5 different types of Debt Maturities. So, I'm going to combine Debts with similar Maturities, in order to try and cramp them within the model:

If you are keen-eyed, however, you might have noticed something quite interesting. The Book Value of Debt for MSSL is around Rs. 14,127 Crores. However, the Market Value of Debt turns out to be Rs. 11,663. How is this possible, do you think?

If MSSL issued Debt in India, it might be able to do so at around 9%, given its strong financials, business operations and strong parentage. However, it's not. Most of MSSL's debt is in the form of foreign borrowings and papers, whose interest rates are around 3-4% and change. In fact, if you divide the Interest Expense of MSSL (Rs. 448 Crores) with MSSL's Total Debt (Rs. 14,127), you will realize that their Book Interest on Debt is just 3.17% and change. Therefore, from an Indian shareholder's point-of-view, MSSL taking these low-cost loans is actually value-accretive, compared to them issuing a 9% Debt in India. This is why the ~17% mark-down on the Book Value of Debt is justified.

The company has no outstanding ESOPs or Warrants, which is good.

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The Assumptions

This is where I attempt to narrate a story of MSSL's future in numerical terms:

Financials Cheat Sheet

Most of the numbers I have used are based on the historical numbers of MSSL itself. So, I have prepared a 'Cheat Sheet' of sorts for the same.

High Growth Period

A 20-year High Growth Period is justified, because MSSL is a massive, global player with a good history of both organic and inorganic growth. Their strong parentage also allows them to play the game for a longer period of time.

Sales Growth

As discussed earlier, I have assumed that MSSL will register a slower growth in the earlier years (7%, the lowest it has ever grown in the past), then slowly catching up to its long-term average (13.10%) and then its Self-Sustainable Growth Rate (17.03%). I have to note here that the very long-term average of MSSL is actually 36% (10-year Average). But with it being a massive player, this kind of growth is impossible without endangering its financial position further. So, I have capped the growth at the SSGR. For the Terminal Period, I have assumed that MSSL will grow at ~3%, owing to it being a big player already. Size impedes growth.

Operating Margin

Since Raw Material prices have peaked, I have assumed that Margins will drop further, to 8.61%, then slowly rise back to long-term average levels. A peek at their historical Margins will tell you about their Pricing Power, for having kept them rock-steady, with some turbulence due to excessive Raw Material prices. I have simply mimicked this reality by keeping my Operating Margins assumptions steady. In the Terminal Year, the Margins drop down to global industry levels (4.79%), as seen below:

(Source: Prof. Aswath Damodaran's 'Useful Data Sets')

Tax Rate

The Average Corporate Tax Rate (31.68%) will converge towards India's Average Corporate Tax Rate (30%) and then towards the Global Average Tax Rate (25%) in the long run. Since MSSL already pays 1.68% additional Tax over the existing rate of 30% in India, it would be rational to assume that in the long run, they might do that as well. So for the Terminal Period, the Tax Rate has actually been assumed to be 26.68% (i.e. 25% + 1.68%).

Capital Turnover

MSSL has planned to do a massive Capex in 2018-19. This will indeed take a dig at their productivity in the short run, since fresh capital, especially this large, is slow to produce returns. So, I have assumed that the company will operate at their lowest-ever productivity levels (1.85) and then slowly move back to historical levels (2.79, 3.72).

Reinvestment Rate

The Reinvestment Rate simply shows the truth we discussed earlier. It is very high in the earlier years, before slowly falling back to normal levels.

Return on Capital

The Return on Capital converges towards the Cost of Capital, as it should.

Depreciation

The Depreciation (As a percentage of Sales - 2.82%) remains fairly stable.

Cost of Capital (Industry Beta)

The Cost of Capital is determined using the Bottom-up Beta-based Capital Asset Pricing Model (CAPM). More on how this is done, if you are interested.

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The Cash Flows

Based on our above assumptions, this is how MSSL's Financials are likely to evolve:

In essence, I'm assuming that this is how MSSL's Business Life Cycle will look like:

More on Business Life Cycle, if you were wondering about it.

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The Value

In the end, this is how much I think Motherson Sumi Systems is worth:

A more interesting way of looking at this would be see how each component of Value contributes to the per-Share Value of MSSL:

I believe that Mother Sumi Systems is fairly valued at Rs. 199, which is indicative of a 21% undervaluation. A primary reason for this undervaluation could be the fact that, in the last 3 years, MSSL's Consolidated Sales have grown by 17.55% and its Net Profits by 21.04%, but its Share Price has hardly moved anywhere. A move from Rs. 130 to Rs. 153, representing a 5.60% CAGR is all the scrip has to show for the 3 years of growth:

(Source: Screener)

I understand that MSSL issued a 1:2 Bonus recently. But this should not affect our calculations, since I have already considered the number of Shares ex-Bonus (315.79 Crore Shares, to be precise). The above chart from Screener also quotes the ex-Bonus price.

Now again, if you had been attentive, you might have caught me red-handed. I have used a 20% Margin of Safety, instead of the 10% I usually use. I will explain myself towards the end of this post, so keep your eyes peeled.

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The Sensitivity of Value

The usual. The Sensitivity of Value tool showcases the different Values for MSSL for different levels of Cost of Capital and Terminal Growth Rates (This is without the Margin of Safety, mind you).

The key takeaway from this tool is that at these different levels, the Win-Loss Ratio is 1.92 i.e. MSSL is more likely to be undervalued than not.

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The Monte Carlo Simulation

Of course, we have a more definitive tool to determine the probabilistic levels of undervaluation and overvaluation in MSSL: The Monte Carlo Simulation. Some of you have been asking me to explain how I go about doing this specific section is all of my valuation. So, let me do that for MSSL. First off, I use this tool (Free to download) in excel. It's a free tool that lets you do a quick-but-cheap version of a Monte Carlo Simulation.

I'm going to simulate my assumptions in the following manner. I use the RANDBETWEEN function in excel to accomplish this (You will be able to see this for yourself, so hold on for now).

Minority Interest

As you may have noticed, I have used a simple P/BV Multiple Valuation to Value the subsidiaries. However, the larger Auto Parts industry has a P/BV of around 5. Since MSSL is engaged in both these activities, it begs the questions as to how MSSL's subsidiaries should be Valued - at 4 P/BV (Automotive Industry Average P/BV) or 4.88 P/BV (Auto Parts Industry Average P/BV). I'm simply going to simulate the 'Minority Interest' figure between Rs. 17082.38 Crores (Value at 4 P/BV) to Rs. 21,351.64 Crores (Value at 5 P/BV).

Sales Growth

• I'm leaving the Growth for the near years (Years 15) intact, since it is an inherent part of my 'story' about MSSL.
• For the next years (Years 5-10), Growth is simulated between 7.11% (Lowest ever) to 14.79% (The short term average Growth)
• For Years 10-15, the SSGR is toggled between 15.81% (Lowest ever) to 17.03% (Highest ever)
• Terminal Growth simulated between 2.67% (A third of the Risk-free Rate) to 4.01% (Half of the Risk-free Rate).

Operating Margin

• Margins are simulated from 7.83% (Long-term Average) to 9.31% (Short-term Average)
• For the Terminal Period, Margins are simulated from 4.79% (Retail Automotive Industry Margins) to 7.62% (Auto Parts Industry Margins)

Tax Rate

Tax Rates are simulated between 27.67% (Short Term Average) to 31.68% (Long Term Average) for the earlier years (Years 1-10)

Capital Turnover

• Once again, I'm leaving the Capital Turnover for Years 1-5 intact, with it being a part of my 'story' for MSSL
• For Years 11-15, I am simulating the Capital Turnover between 1.85 (Lowest ever) to 5.29 (Highest ever)
• Based on the above, all other Capital Turnover calculations will be adjusted automatically

Industry Beta

The current valuation uses a Cost of Capital of 10.99%, which is low in my opinion. The average Indian firm has a Cost of Capital of 13.50%, so I will simulate the Cost of Capital between 10.99% to 13.50%, as explained above.

Running the Simulation

When all this is said and done, I load the Add-in to Excel. I select the 'Value per Equity Share' column and then click on the 'MCSim' button from the 'Add-ins' tab. It should look something like this:

Now, I shall select the 'All RANDOM' and 'Recalculate the Entire Workbook' options and then click 'Proceed'. The output will look like this:

Given a basic understanding of statistical methods, you should be able to interpret the 'Histogram of $E$76' as below:

So, case in point, the CMP of Rs. 156.30 seems to give us a 61.73% Probability of Undervaluation. Is that enough? You should ask yourself that question and answer it honestly.

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The Model

If you disagree with my views on anything, feel free to download the model for yourself and try to change the assumptions as you wish.

(Download Numbers and Narratives - Motherson Sumi Systems)

This time around, I have included everything in the above excel - the model, all the screenshots I posted above and even the MCSim sheets.

As far as the Monte Carlo Simulation is concerned, the input is the 'Numbers&Narratives-MCSim' sheet, where the randomized (RANDBETWEEN) cells have been highlighted in blue. Look out for them to understand how I've implemented the above simulations I have explained. The 'MCSim11' sheet and the 'MCSim11-Interpretation' sheets are the output and interpretation, respectively.

If your Value differs drastically from mine, do drop a comment or two below. We can have a nice chat.

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Should the Hippopotamus be saved?

If you even had the slightest idea that the title had something to do with MSSL directly, then I must apologize. The title relates to a very interesting story from the world of Chess, a game I am quite interested in and play often. The story goes like this.

In 1964, Grandmaster and one-time World Chess Champion Michael Tal, was playing a game with Grandmaster Evgeni Vasiukov for the USSR Championship. He was genuinely stuck on a complex position on the board, which left him to decide whether he should sacrifice a Knight to get a better position in the game. Of course, if he made a wrong sacrifice, then the opponent would be a piece up for no reason. In the hands of a GM, it meant a possible defeat.

Tal tried to calculate as many moves as possible proceeding from the sacrifice, but it was too much even for him. He soon drifted off. Suddenly, he remembered a couplet from the famous Russian poet Korney Chukovsky:

Oh, what a difficult job it was.
To drag out of the marsh, the hippopotamus.

In short, Tal realized that it was a huge waste of his time to calculate all the positions leading from the possible sacrifice (Which is very much like trying to drag a hippopotamus out of a marsh). He told himself "Well, I'll let it drown." His intuition was that the sacrifice was worth it and if it didn't guarantee a win, it at least guaranteed an interesting match. So, after 'wasting' 40 minutes, he went ahead and made the Knight sacrifice. He would eventually win the game and be praised for his 'calculated' victory. Here's the game, if you're a Chess enthusiast as well.

So, how does this relate to my Valuation of MSSL? Remember how I said the complex Corporate Structure of MSSL could be a potential problem? I wanted to understand their structure entirely. I even tried to do a DCF of all of their subsidiaries. Of course, I failed miserably. I didn't have the time, nor did I have enough details to make ends meet. In reality, MSSL's Minority Interests is about 10-15% of its overall Value. Like Tal, I was wasting my time on a problem that wasn't worth solving.

The solution to my hippo problem? Margin of Safety. If I didn't understand MSSL's Corporate Structure fully and if I couldn't Value their subsidiaries separately, I might as well claim an additional amount of Margin of Safety (Here, 10%) and call it a day.

Times like these, I wish someone reminded me harshly what Benjamin Graham once said:

"The function of the Margin of Safety, in essence, is that of rendering unnecessary an accurate estimate of the future."

Company? Discounted Cash Flow. Subsidiaries? Multiples. For everything else, there's Margin of Safety.