Citigroup has maintained buy rating on Mahindra & Mahindra with target price of Rs 945. The current stock price implies that the core business is trading at 6.8x on core FY08E EPS.

Recurring PAT +15% yoy

Recurring PAT at Rs 1.92 billion (+14.8% yoy) was 8% below expectations, mainly on account of higher "other expenses". PAT growth is based on last year's recurring PAT of Rs 1.67 billion, which is adjusted for the one-time special dividend of Rs 250 million of Tech Mahindra.

Margins impacted by other expenses

Margin at 10.6% declined 70 bps yoy, 50bps lower than our expectations. Higher staff costs and other expenses offset the impact of lower material costs (down 120bps yoy), which we view as the key positive in these results. We await clarifications from management on the surge in other expenses. We surmise there is an element of forex losses in both other expenses.

Segmental profitability

EBIT margin in the tractor business (13.4%) was down 20bps yoy – commendable, given the lack of volume growth over the quarter. Margins in the auto business were down 110bps yoy to 8.8%, reflecting higher input costs, aggressive promotional spends. Capital employed in the tractor business rose Rs 2.44 billion over the quarter; we await further clarifications from management on this aspect.

Maintain Buy/Low Risk

The current stock price implies that the core business is trading at 6.8x on core FY08E EPS. The risk-reward ratio looks attractive at these levels. Await further details in tomorrow's conference call. Key downside risks: 1) lower than forecast volume growth; and 2) continued margin pressure due to escalating input costs.

Investment thesis

We rate M&M shares Buy/Low Risk (1L) with a target price of Rs 945. Tractor sales are benefiting from relatively low penetration levels and the government’s emphasis on increasing credit to the agriculture sector. Apart from dominance of the lower end of the market, where competition has been limited, M&M’s utility vehicle business is also benefiting from product initiatives, particularly the launch of the Scorpio and Bolero models and variants of these, which have enabled M&M to tap into the urban markets for passenger vehicles. Moreover, we also recognize management's efforts to retain market share within segments like three-wheelers, given the stiff competition in this segment. We remain positive on management’s efforts to de-risk from the local market by pursuing sales in select international markets. The target is to raise international sales from around 10% at present to 20% over the next three years. Their efforts have met with substantial success particularly in the tractor segment, wherein they are currently ranked No. 4 (in terms of unit sales) globally. The substantial value of the company’s real estate and investment holdings (particularly in the information technology business through Tech Mahindra and in the financial services business through M&M Financial Services) should provide downside support (especially with increasing dividends from key subsidiaries). Given recent initiatives to unlock value in subsidiaries – MMFSL and Tech Mahindra being the primary examples – we incorporate the value of key subsidiaries within our sum–of-parts valuation.

Valuation

Our target price of Rs 945 is based on a sum-of-parts methodology. We value M&M's core business at Rs 468 (9x FY09E core CEPS). We also incorporate value for M&M's listed subsidiaries (Rs 378 per share), its auto component business (Rs 57 per share) and M&M's investments in other subsidiaries (including Mahindra Holidays at Rs 41 per share). Our core multiple of 9x is supported by an 11% CAGR in core cash earnings (excluding dividends from group companies) for M&M over FY07E-09E. We value the key subsidiaries / associates / auto component initiatives at Rs 477 per share. At our core target price (of Rs 468) the stock would trade at around 10.2x FY08E core EPS (excluding dividends from subsidiaries) and should be supported by 11% CAGR in earnings over FY07E- 09E. We have chosen to use P/CEPS as our primary valuation metric to ensure proper comparison with historical trading bands — the company is undertaking a significant product development and capital expenditure program, and also undertook a restructuring of the balance sheet in FY02. We believe valuations will also be supported by: a) management’s continued efforts to unleash value from investments in group concerns (we believe that the listing of the group's hotel / resorts venture is next on the anvil); and b) new initiatives announced in the passenger cars, commercial vehicles and auto components segments, which should fructify over the next 2-3 years.