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Eicher Motors Limited All successful investors have one thing in common. They are passionate in reading the annual reports of several businesses including the ones they don’t want to invest in the near future. Consider the case of Warren Buffett, who was reading the annual reports of IBM and Bank of America for 50 years before buying a single share. Why would anyone do that? I was reflecting on this question for a very long time. I got this question answered while reading the fantastic book Curious authored by Ian Leslie. Read, reread, and reflect on what Ian wrote.

Creativity starts in combination. Scottish Enlightenment philosopher David Hume pointed out that

there is nothing particularly interesting about the idea of gold or about the idea of a mountain. But a

gold mountain? Now you have something. Progressive educationalists like Robinson frame existing

knowledge as the enemy of new ideas. But at the most basic level, all of our new ideas are made up of

old ones: to imagine a winged horse, you first need to be familiar with the ideas of horses and wings;

to create a smartphone, you need to know about computers and phones. The more existing ideas you

have in your head, the more varied and richer will be your novel combinations of them, the greater

your store of reference points and analogies. A fact is a particular class of idea about the world, and it

can be put to work in a lot of different ways.

We romanticize the curiosity of children because we love their innocence. But creativity doesn’t

happen in a void. Successful innovators and artists effortfully amass vast stores of knowledge, which

they can then draw on effortlessly. Having mastered the rules of their domain, they can concentrate

on rewriting them. They mix and remix ideas and themes, making new analogies and spotting

unusual patterns, until a creative breakthrough is achieved. [Emphasis mine]

Researchers who study innovation have found that the average age at which scientists and inventors

make breakthroughs has increased over time. As knowledge accumulates across generations, it takes

longer to acquire it, and thus longer to be in a position to supersede or add to it. Even geniuses have

to accumulate knowledge of their field for years before they can produce masterpieces. Mozart, the

archetypal child prodigy, was in the twelfth year of his career when he composed his first piece of

enduring artistic value. As Steven Pinker puts it, “Geniuses are wonks.” Without knowledge, including

factual knowledge, a child is like a sculptor with no clay to work with — she is creative, but only in

theory. Here are a few examples of people whose curiosity and creativity were fed by factual

knowledge:

In an 1844 letter to his friend J. D. Hooker, Charles Darwin makes it clear that his great insight

emerged from the methodical accumulation of facts: I was so struck with distribution of Galapagos

organisms ... that I determined to collect blindly every sort of fact which could bear in any way on

what are species. I have never ceased collecting facts — At last gleams of light have come, and I am

almost convinced (quite contrary to the opinion I started with) that species are not (it is almost like

confessing a murder) immutable.

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Jacob Rabinow, a prolific inventor with more than two hundred registered patents, was interviewed

by psychologist Mihaly Csikszentmihalyi about the requirements for creative thought. Rabinow

thought the most important was “a big database” of memorized knowledge: “If you’re a musician,

you should know a lot about music. If you were born on a desert island and never heard music,

you’re not likely to be a Beethoven. You may imitate birds but you’re not going to write the Fifth

Symphony.” The earlier you start building your database, the better: “So you’re brought up in an

atmosphere where you store a lot of information. The small differences at the beginning of life

become enormous differences by the time you’ve done it for 40, 50, 80 years.” [Emphasis mine]

By reading several annual reports successful investors amass vast stores of business knowledge, which they can then draw on effortlessly to gain unique insights while analyzing a new business. Even a minion like me was able to experience it first hand when I was able to use some of the learnings I acquired while studying Bajaj Auto. Given below are a couple of things that I was able to reuse to analyze Eicher Motors, which is the subject of this post.

1. The motorcycle industry is less of a technology and more of a marketing industry. It is a game of brands. The industry is highly competitive both in domestic and export markets. The only way to create a durable competitive advantage in this industry is to specialize in a niche and create a brand out of it.

2. A motorcycle 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.

Business Eicher Motors Limited (EML) was incorporated in the year 1982. It is the flagship company of the Eicher Group and a leading player in the Indian automobile industry. The company designs, manufactures, and sells three kinds of vehicles.

1. Royal Enfield is one of the world’s oldest motorcycle brands, more than a century old, that is still in production. EML acquired the Royal Enfield (RE) motorcycles in the year 1991. RE commands 95 percent market share in mid­sized (250 ­ 750 cc) motorcycle segment.

2. It manufactures trucks and buses that are used for commercial purposes. It is a leader in the light and medium duty trucks with a 33 percent market share. In 2008 EML formed a joint venture [54.4 : 45.6] with Volvo Group to combine EML’s local market expertise with Volvo’s technological strength and bring high quality commercial vehicles to the cost conscious Indian markets.

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3. It manufactures a four wheeled multi purpose vehicle called Multix. It is a 3­in­1 vehicle which provides comfortable seating for a family of five. It can also be used for business purposes and it has a power generation capacity of 3 kilowatts. In 2012 EML formed a joint venture [50 : 50] with Polaris Industries to manufacture this vehicle.

Take a look at the shareholding pattern of the company given below. As an exercise I would encourage you to rediscover the shareholding pattern from the annual report. By doing this you will acquire a skill that can be employed while analyzing other businesses. If you don’t know how to do this then start with the standalone balance sheet Note 12.

Royal Enfield motorcycle segment generates 35 percent of its overall sales and 80 percent of its overall profits. It commands 95 percent market share in the mid­sized motorcycle segment. Around 97 percent of the REs are sold in the domestic market. And the remaining 3 percent is sold in the export markets. There are four kinds of RE motorcycles — Bullet, Classic, Thunderbird, and Continental GT. Why do you need four kinds of motorcycles? The simple answer is that everybody is different. The image given below answer this question in more detail. The engine capacity ranges from 350 to 500 cc. The price of these vehicles ranges from Rs 1.07 ­ Rs 1.95 lacs. Why would

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anyone pay close to Rs 2 lacs for a motorcycle? It is a tough question to answer when you look at it uncritically. But it would all make sense when you see it through the lens of psychology.

Customers of RE don’t view their 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. They don’t mind paying Rs 1.95 lacs for the brand. Siddhartha Lal, who is the CEO and Managing Director of EML, explained this beautifully in his latest letter to the shareholders.

Royal Enfield motorcycles are intended to bring back values that many people yearn for in the

modern sterile context – authenticity, tactility, interaction, craftsmanship, physical experience

and active pursuit. We will deliver that by firstly ensuring that the company itself is authentic

in its approach and interactions; the motorcycles we make will be timeless in sensibility and

appeal, yet approachable and relatively affordable and will encourage the owner to be

hands-on. We will serve all relevant areas around the motorcycle – products and services with

the same approach, in order to make the whole experience of motorcycling pleasurable –

thereby, delivering a ‘Pure Motorcycling’ experience. Royal Enfield brand has an extremely

rich global heritage of practical leisure motorcycling of over a hundred years. Royal Enfield is a

cult brand globally and has pioneered the leisure motorcycling culture in India. The brand’s

positioning and related marketing activities have both delighted the current customers and

opened up avenues for attracting new customers. - 2014 Annual Report

Take a look at the table given below. What do you see? From 2006 to 2010 the number of REs sold compounded at a rate of only 14 percent. Nothing much happened even though the starting

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base is very low. But from 2010 to 2014 the number of REs sold compounded at a much higher rate of 55 percent. Sales skyrocketed even though the advertising spent averaged only 0.50 percent of total sales. During the same period the domestic motorcycle industry grew only at 4.5 percent. What made the sales of RE to skyrocket when the domestic motorcycle industry was languishing?

My initial explanation was that premium motorcycle brands like Harley Davidson entered India in 2009. This made customers migrate to the premium motorcycle segment. And RE, being an established cult premium brand, benefited immensely because of this migration. My explanation was partially true, but it didn’t answer the question completely. It’s akin to telling that liquid water got vaporized because the temperature rose from 99 to 100 degree centigrade. But without the first 99 degrees the last one degree wouldn’t have mattered. In the video given below watch from 3:30 minutes to see Siddhartha Lal talk about the decade long effort, the first 99 degrees, which his team at EML undertook to unlock the RE genie from the bottle. This interview reminded me of what Jeff Bezos wrote in his 2009 letter to the shareholders, “I always tell people, if we have a good quarter it’s because of the work we did three, four, and five years ago. It’s not because we did a good job this quarter.”

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RE continuously works on strengthening its brand by providing a pure motorcycling experience through its marquee rides that are organized throughout the year. Customers and enthusiasts from all over the country take time off and participate in these rides. EML also promotes riding at the dealership levels. The company has 450 dealers and it is rapidly expanding its dealer network. EML manufactures RE from its two factories Thiruvottiyur and Oragadam which are located in Chennai. These two facilities have a combined capacity of producing around 6 lac motorcycles per annum. It’s in the process of setting up a third factory in Vallam Vadagal, Chennai to take the total capacity to 9 lac units per annum by 2018. The demand for RE outstripped supply due to production capacity constraints. Currently there is a wait time of one to four months. Human beings value things more when they are scarce. And this is helping the company to strengthen its brand further. It’s time to look at the ROIC of RE business. Take a look at the table given below. What do you see?

Let us focus on the components of ROIC — Efficiency and Profitability. RE business 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. It has a cash conversion cycle of negative 30 days. In 2014 it had an operating margin of 22.55 percent. This is better than that of any other motorcycle company in the world, and possibly the highest level compared to any automotive brand globally as well. Harley Davidson the world leader in the premium branded motorcycle generates an operating margin of around 20 percent. Over the years REs operating margin

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improved significantly by going up from 7 to 22 percent. Why did this happen? This happened because of the economies of scale. As the motorcycle volume sold skyrocketed its cost per unit declined. On top of that it introduced three new models at higher price points. May be it also helped the company to increase the margins. But I don’t know for sure as the company doesn’t reveal its operating margins for each model. The company doesn’t spend much money on advertising as RE gets free and effective advertising through word­of­mouth and social proof. Also, its virality spreads when prospective customers see their favorite actors (authority bias) riding the RE. Before moving on to the CV business refresh yourself by watching my favorite song and see how RE gets free advertising in the Indian movies.

EML manufactures trucks and buses that are used for commercial purposes. It does this under the name of the subsidiary Volvo Eicher Commercial Vehicles (VECV). VECV generates 65 percent of its overall sales and 20 percent of its overall profits. EML’s partnership with Volvo is a win­win for both as EML gets access to better technology from Volvo and in turn Volvo can use EML as a low cost manufacturing hub for exports. Also Volvo gets local expertise from EML to navigate the cost conscious Indian markets. VECV enjoys a strong franchise in the Light­to­Medium duty (LMD; 5 to 14 tonne) trucks. This was the case even before the joint venture with Volvo. It commands around 33 percent market share in the domestic market. The reason for its superiority is because of its high mileage, driving comfort, and faster turnaround time. Take a look at the chart given below. After the joint venture the LMD segment gained market share by going up from 26.7 to 32.7 percent.

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Before the joint venture Eicher’s heavy commercial vehicles (HCVs; 16+ tonne) had a market share of less than one percent. Why did the company have a very low market share in the HCV segment? This happened because of several reasons (1) low quality products (2) lack of adequate service as mechanics had trouble understanding its unfamiliar HCV technology (3) lower resale value which increased the total cost of ownership. One of the reasons for the joint venture was to fix these issues with Volvo’s superior technology. Did the issue get fixed? The chart shows that it did. Then why did the market share come down from 4.4 to 3.5 percent? It came down as the competitors discounted their HCVs very heavily. You can learn more about it here.

In the bus segment its market share went up from 5.7 to 15.4 percent. Overall the company is realizing the expected synergies by partnering with Volvo. I will not be discussing about EML’s

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Multix (four wheeler) initiative as it is yet to generate any meaningful revenues. It’s time to look at the ROIC of VECV business. Take a look at the table given below. What do you see?

CV business is a low margin business with an average operating margin of around 7 percent. The domestic CV industry is facing a lot of headwinds as the Indian economy is not doing well. This is evident when you look at the total CV sales count going down from 49,042 to 40,783. This resulted in operating margins going down from 9.14 percent to 3.71 percent as the fixed costs remained constant even though the sales volume went down. In the world of business relative performance matters more than absolute performance. How did VECV do compared to its peers?

VECV’s EBIT margin at 3.7% was the best amongst Indian CV companies in 2014; and VECV’s

lean business model gives it the distinction of being the only CV company to remain

profitable in every quarter during the longest downturn in the recent decades for the Indian

commercial vehicle industry. In both our businesses, we continue our drive to make a

breakthrough via challenging the status quo and shifting the market to a different place,

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rather than competing in the stronghold of the established players. We do this via a sharp

product-market offering and a great focus on nurturing our brands, backed by a lean and agile

business model. - 2014 Annual Report VECV follows an asset light model by outsourcing a lot and this resulted in it achieving higher asset turnover compared to its peers. Also, it doesn’t have any debt which helps EML to withstand industry headwinds better than its competitors.

Moat I haven’t done a lot of work on its VECV business. So it is not possible for me to tell if that business has a moat. For now I am going to ignore it and solely focus on its RE business. I am doing that by applying the Power Law rule as 80 percent of EML’s profits come from its RE business. The moat characteristics of Eicher Motors are similar to that of Bajaj Auto. Before reading further I would recommend you to read it as I won’t be repeating it here. The motorcycle industry is less of a technology and more of a marketing industry. So one can say that the company doesn’t have any supply side advantages. The company has economies of scale. As the RE volumes sold skyrocketed its cost per unit declined and operating margins went up from 7 to 22 percent. From the chart given below, we can see that its margins are going up further from 22.5 to 24.8 percent. Some of the increase in operating margins can be attributed to the launch of newer models that got introduced at higher price points.

Clearly the company has huge economies of scale working in its favor. But economies of scale becomes a moat only when it’s big relative to the competition. If one doesn’t consider the sub segments and instead compare RE volumes with that of any other motorcycle volumes then its

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economies of scale don’t constitute a moat. From the table given below you can see that Hero Motors is selling 14 times more motorcycles than RE.

Is that a right comparison? I don’t think so. One has to compare RE, which is in mid­size leisure motorcycling (250cc and above), with that of the other motorcycles in the same mid­size category. In the video given below watch from 4:45 to 5:45 minutes to see Siddhartha Lal talk about the scale advantages of RE.

We have got the scale. Nobody else has anything close to the scale that we do in the leisure

motorcycles (250cc and above). We have 95 percent market share. Our one single platform is

doing 30,000 motorcycles a month today. In India there is no one else is doing a 1000

motorcycles on a similar sized platform. Even though we are tiny in the world market of

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motorcycling. But in India in the mid-size motorcycling we are 30 times bigger than the

competition. I agree with Siddhartha’s point on RE’s scale advantages. But I would not classify that as a moat because the demand side is too big for anyone to take and get the scale advantages. According to me EML’s moat comes from demand side advantages. By studying Bajaj Auto we know that a motorcycle 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. RE created the mid­size leisure motorcycle segment, which never existed before and it’s reaping the benefits now. Also Royal Enfield brand is not diluted, as there is only one to protect and nourish. Royal Enfield generates mouth watering gross margins of 40 percent. I am sure competitors are seeing this and they will definitely come and try to take away the marketshare of Royal Enfield.

My hypothesis is that Royal Enfield being a leader, who created the mid­sized leisure motorcycle segment, it will be able to protect its leadership position even though its overall market share will go down. But will it be able to protect its high gross and operating margins? I don’t know for sure if it will. Royal Enfield is a premium branded product. And a rational competitor would think several times before competing on price. Why is that? Customer’s default wiring (Pavlov) makes them to assume that high price translates to high quality. Another point of comparison is that for the last ten years Harley Davidson is able to consistently maintain a decent gross and operating margin of 38 and 18 percent. What if a competitor comes up with a lifestyle motorcycle in the [150 ­ 220cc] category and downsizes the segment for Royal Enfield? From the news article given below this is what Rajiv Bajaj is trying to do. Only time will tell how this movie will unfold.

Competition is now emerging in the lifestyle biking segment as Bajaj Auto has recently

expanded the Avenger series of bikes, albeit at a lower range i.e., 150-220cc category, which

are priced ~30% below the RE products. Thus, Bajaj is attempting to downsize this segment.

The initial response to these bikes has been encouraging as the OEM has ramped up

production from under 4,000 units p.m. in 2Q to 20,000 units expected in December due to

the encouraging response from the market. - Financial Express

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Management One of the best ways to evaluate the management is to look at key numbers in four to five year increments. Numbers don’t lie and by looking at the long term trends we can learn a lot about the capabilities of the management. Take a look at the numbers for EML given below. What do you see?

During the nine year period profits compounded at 49 percent. And the share price like a slave followed it by compounding at 54 percent. Whenever you find such extraordinary results you should see if there is a person behind this. The person behind this extraordinary result is Siddhartha Lal, who is the CEO and Managing Director of EML. In order to find out what he did read this and this. In his recent blog post Prof. Sanjay Bakshi wrote about Siddhartha Lal.

I do recall that in 2008, Siddhartha Lal offered to his minority shareholders at Eicher Motors a

deal that he was not obliged to offer. As part of a JV transaction with Volvo, he sold a 13% of

his family’s stake in Eicher Motors at a price which was more than twice the prevailing stock

price. In a buyback transaction subsequent to that deal, he offered the same terms to Eicher’s

minority shareholders by initiating a stock buyback program in which Eicher gave them an

option to sell 13% of their holdings at the same price at which Siddhartha Lal had sold his

family’s shares to Volvo. He didn’t have to do this. There was no legal obligation to do it. But

he did. And that gesture went largely ignored by the media. - Prof. Sanjay Bakshi

For the year ended 31­Dec­2014 Siddhartha received a remuneration of Rs 5.37 crores. This represents 0.6 percent of total operating profits. For someone producing such phenomenal results the remuneration looks reasonable. Let us look at the capital allocation skills of the management.

1. From 2011 to 2014 the company invested Rs 683 crores as capital expenditure in the Royal Enfield business. This in turn produced an incremental operating profit of Rs 1,037 crores. In other words, every rupee invested in the RE business generated Rs 1.5 in operating profits.

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2. From 2011 to 2014 the company invested Rs 1,310 crores as capital expenditure in the VECV business. This in turn produced an incremental operating profit of Rs 277 crores. In other words, every rupee invested in the VECV business generated Rs 0.21 in profits. This doesn’t look great compared to the RE business. But we need to understand that the economics of a CV business is very different from that of a branded motorcycle business. Also the entire CV industry had a terrible time during those four years. During this period the company gained market share and made a lot of investment to improve its technology platform.

Overall the management of EML is fantastic and I don’t see any issues with them.

Valuation Let’s use the sum­of­the­parts valuation to value EML. On 30­Sep­2015 the company had 27,142,383 shares outstanding. After adjusting for all the current liabilities and debt the company has Rs 184 per share in net financial assets. In 2011 VECV business generated the highest profit after tax of Rs 414 crores. And in 2014 it generated only Rs 189 crores. We already saw that the Indian CV industry is facing a lot of headwinds. But the long term growth story of the CV industry is intact. So I am going to use the peak profits after tax to calculate the intrinsic value of VECV business. If you are expecting an after tax yield of 10 percent, then the no growth intrinsic value per share of VECV business will be Rs 1,525.

From the table shown above, we can see that 89 percent of the current price reflects the market expectations for the Royal Enfield business. In 2014 the RE business made a profit after tax of Rs 559 crores. In the last nine months PAT grew by 44 percent. If I take this as the growth rate for 2015 then we can expect RE business to generate a PAT of Rs 805 crores. On a per share basis this translates to Rs 297. This means that you will be paying almost 50 times earnings for its RE business. Is this low or high? I am going to leave that for you to decide. But here are few things to consider before paying up for its Royal Enfield business.

1. Royal Enfield exports represents only 2 percent of total sales. So there is a lot of room for growth in the international markets. But you can’t blindly assume that the company grew in India, hence it will definitely grow in the export markets. Extrapolating blindly is dangerous.

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2. In the domestic markets, sales grew at a compounded rate of 62 percent. But how sure are you that it’s going to continue for the next 5+ years? Remember, it has to do that on a higher base which is damn hard. In the last four years the demand for RE outstripped supply due to production capacity constraints. This created scarcity and helped the company to sell a lot more bikes. But scarcity is a temporary thing as the company is ramping up production. Will this slowdown sales?

3. Motorcycle is a discretionary item and its sales are subject to general economic cycles. Royal Enfield is able to defy the current industry slowdown because of the craze. Is this craze temporary or permanent?

4. Brand is a moat when it has pricing power. Royal Enfield definitely has pricing power. Moat becomes powerful when a brand is clubbed with switching costs or deep habit formation or local economies of scale. Is there one for Royal Enfield?

I don’t have answer to all these questions. But the current situation reminds me of what Charlie Munger once said — “Any damn fool can see that a horse carrying a light weight with a wonderful win rate and a good post position etc., etc. is way more likely to win than a horse with a terrible record and extra weight and so on and so on. But if you look at the odds, the bad horse pays 100 to 1, whereas the good horse pays 3 to 2. Then it's not clear which is statistically the best bet using the mathematics of Fermat and Pascal. The prices have changed in such a way that it's very hard to beat the system.” Disclaimer: As of this writing, I don’t own any shares of Eicher Motors Limited. 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 the industry. I am sharing it so that you can learn something from this. Author : Jana Vembunarayanan

Website : https://janav.wordpress.com

Twitter : @jvembuna