Merrill Lynch has recommended buy rating on Bajaj Auto with the price objective of Rs 2871. The PO of Rs 2,871 is based on sum-of-the-parts valuation approach. The research firm value core business at 8.5x FY09E EV/ EBITDA, marginally higher than the two wheeler sector (which is at 7.5x).

Upgrade on 21% upside potential

Bajaj Auto has been one of the worst-performing auto stocks over the past year (13% decline vs 5% for Hero Honda and 2% for four wheelers), on the back of worsening earnings trajectory. We now upgrade Bajaj Auto to Buy from Sell, following our upward revision of EPS by 10.8% in FY08E and 15% in FY09E. We expect the stock to re-rate, as contribution from the new bike kicks in.

New product should earn much more than anticipated

We believe that Bajaj Auto's new bike Exceed, with its superior economic proposition is insulated from possible pricing action of low-priced competitive models e.g. Hero Honda’s Splendor. Also, its low cost of manufacturing implies EBITDA margins of 15%, compared to earlier expectations of 6%.

Operational recovery in Q2, YoY growth from H2

We expect margin profile to improve from Q2, with 23% QoQ in EBITDA. Improved volumes and low base effect will likely drive 21% YoY EBITDA growth in H2 (after 15.5% decline in H2). We expect high-teens EBITDA growth in FY09.

Sum of parts value Rs 2,871

We have raised our sum-of-the-parts valuation by 30% to Rs 2,871, which represents 21% potential upside. We are mainly reversing our stance on the core auto business, and marginally raising value from the insurance subsidiaries.

Upside risk to fair value

We believe our assumptions are conservative, with respect to (1) new bike sales estimates - a 10% increase would raise auto EPS by 2.5%, (2) imputed life insurance stake of 26%, with a 100bps change adding Rs 30 per share.

New bike: Driver of stronger margins, profits

We expect new bike to replace 100c models

Bajaj Auto's new 125cc bike, Exceed, is being positioned to wean away customers from 100cc models - which have seen trended decline, from recent peak of 76% of aggregate bike sold, to 65% presently. We believe lack of product innovation is pulling customers away from 100cc motorcycles. However, as exhibited in chart below, demand for premium end products continues to remain robust. Exceed is positioned to create further excitement through innovation.

A superior value proposition

Exceed will hit the road in September. The difference to the company's earlier launches (which did not deliver) is the engine performance, which is expected to deliver the highest fuel efficiency within the premium end (109kmpl compared to sub-80kmpl for competition), without sacrificing power output (9.3BHP compared to 7.7BHP for nearest, and largest competitive model). Also, although the bike is yet to be showcased, external design is also expected to be appealing, a departure from standardized motorcycles in the similar price point.

Engine performance the key to success

R&D efforts have ensured that the cost of manufacture will be lower than any product conceptualized and developed in-house by the company. For instance, engine weight has been cut 10%, which has a direct bearing on material cost. Such examples are evident in the Indian auto industry e.g M&M Scorpio, Tata Motors' Ace, which have enjoyed huge successes over competition through aggressive pricing, without sacrificing overall profitability. We believe that Exceed will fall under such genre of products.

Competitive action will not impact Exceed

The overriding concern is the possibility of Hero Honda (dominant competitor) cutting prices of CD-Deluxe (anyway a lower segment) or Splendor (lower category, but strong franchise). We do not believe that such an eventuality will hurt Bajaj Auto's Exceed, given the niche segment the product will be positioned i.e at high end with a superior economic proposition, compared to low-priced competitive bikes. In the past Bajaj Auto attempted to create a new segment for customers wanting to upgrade on features such as power, but forego fuel efficiency e.g. Discover 125. The new bike actually betters all earlier cost propositions with the upgraded features.

We therefore believe it will be margin accretive

We estimate Bajaj Auto's two wheeler margins at 12.2% in FY07, which declined 300bps YoY (blended margins were higher at 14.7%, due to three wheelers). This was largely a function of declining profitability in 100cc entry level bikes. We believe margins to expand hereon (mainly in FY08E, as illustrated in table below), despite the continuing squeeze on 100cc models, as:

Exceed is expected to operate at significantly higher margins, given the lower production cost, and being relatively insulated to competition;

Entry level bikes as a proportion of overall volumes, is expected to decline;

Shift in mix within the 150cc Pulsar series (to high end models) will enable maintain high margins, despite rising competition;

Moving up the value chain with 135cc Discover (from the 125cc base model) will do likewise;

Upside risk to our estimates

Our existing forecasts already factor cannibalization (50%) of its existing range of 100cc and 125cc models. We have not altered this assumption. We believe that there is upside risk to our estimates, if Exceed is able to deliver on capturing higher share from competition rather than just its own existing products.

Q2 will mark recovery in operating performance

We expect Q2 EBITDA to rise 23% QoQ, despite marginal changes on aggregate volumes. The upside will come from higher margins, driven by: 1. Stronger than expected product mix toward premium priced bikes (Pulsar series which has successfully moved the value chain); 2. Additional export benefits notified from Q2; 3. Lower percentage of salary expenses, as the earlier quarter saw an annual aberration; and 4. Price hikes of 2% from July 2007.

We expect YoY growth from H2 FY08

Stable volumes, stronger margins, and low comparable base of last fiscal will be key reasons why we expect Bajaj Auto to reverse declining operational trends. In H2, we estimate 11% increase in sales (on 13% YoY volume growth), 21% growth in EBITDA and 12% rise in net profit. This will compare favourably to the preceding quarters.

Valuation: 21% upside potential

Core business revival deserves higher rating

We have re-rated core auto business at 8.5x FY09E EV/EBITDA (earlier 7x), based on our revised expectation of stronger growth (11% EBITDA CAGR compared to 2% earlier). This is equivalent to 13.7x FY09E EPS.

Surplus cash will raise value on deployment

Bajaj Auto’s surplus position outside the auto business is being presently valued at book (earlier we valued the cash held in holding company at a 20% discount). We believe that at some stage, the company will leverage this to build its finance businesses i.e retail. This has not been captured in our valuations.

Sum-of–the-parts valuation raised by 30%

Our revised SOTP value of Rs 2,871 (earlier Rs 2,211), is derived as much from the core business, as from the stronger performance of insurance subsidiaries. We have raised total value of insurance subsidiaries to USD 8.1 billion. We have also removed the imputed 20% discount on cash and equivalents of the holding company.

Price Objective and Basis Risk

Our PO of Rs 2,871 is based on sum-of-the-parts valuation approach. We value core business at 8.5x FY09E EV/ EBITDA, marginally higher than the two wheeler sector (which is at 7.5x). We justify this multiple by our expectations of strong growth, ahead of the industry. With respect to insurance subsidiaries, we value Life Insurance at 21x FY09E NBAP, which is in-line with the multiple assigned to its peers like ICICI Prudential, HDFC Standard Life and Reliance Capital. We value General Insurance at 1x NWP, which is also in sync with our benchmark valuations assigned to the other general insurance players. Also, it works out to 20x P/E (assuming normalized earnings at 5% of NWP), which is justified given high growth trajectory relative to players in the region. With respect to cash and equivalents, we value listed entities such as ICICI Bank at current market value, and the remaining investments at book value. Risks are higher input prices and competitor action on product launches and pricing.