Six factors to consider before investing in Hyundai’s IPO

India is all set to get its largest-ever IPO (initial public offering). Hyundai Motor India (HMIL), the country’s second-largest carmaker, filed a draft red herring prospectus (DRHP) with markets regulator Sebi on June 15. While the IPO pricing will be announced later, media reports pegged the size of the listing at ₹25,000 crore. Till now, the ₹21,008 crore public issue of LIC, launched in May 2022, is India’s largest IPO.The Hyundai Motor India IPO will be an offer for sale (OFS) of up to 142mn shares, or a 17.5% stake, by its South Korean parent Hyundai Motor Company.So, what can investors expect from the IPO? And what are the pros and cons?What’s under the hood?Hyundai will give investors an opportunity to invest in a highly profitable passenger vehicle manufacturer amidst a massive outperformance of auto companies on the bourses. The Nifty Auto index went up 224% in the past five years compared with the 100% rise in the Nifty 50 index.What may surprise many is the fact that volume growth (both domestic sales and exports) at Hyundai was only 2.4% CAGR (compound annual growth rate) over FY14-24. Its domestic sales grew 4.9% CAGR, while exports declined 3.5% CAGR during this period. Hyundai has underperformed Maruti Suzuki in this period in volume growth and to a lesser extent in revenue growth.Continuing with the FY22-24 trend, Hyundai may grow slower than Maruti Suzuki in FY25. Hyundai’s monthly sales have been range-bound since July 2023, when its small SUV Exter was launched. The next product launch, the Creta EV, is planned in the last quarter of FY25. medium111250394Hyundai now gets 66% of its domestic volume coming from SUVs, which is higher than the industry average.This rising share of higher-priced, more profitable SUVs has pushed operating profit margins higher, from an average 7% over FY16-23 to 9.5% in FY24 (nine months). However, a 100-basis point (bps) hit from royalty increase could mean earnings per share (EPS) could be flat over FY24-25.We estimate that for both the years, Hyundai’s EPS will be around ₹75, which is very close to the annualised EPS of ₹72 per share in the nine-month FY24 period.If Hyundai was to be valued at the same forward multiple as Maruti Suzuki — 26x FY25 EPS — it should imply a valuation of around ₹1,950. However, given the superior free cash flows at Hyundai compared to Maruti Suzuki, investors may want to value it at a slight premium to India’s No. 1 carmaker.If the 142mn share sale by Hyundai is priced at ₹2,000 per share, it will mean the IPO could raise as much as ₹28,000 crore, much higher than the ₹21,000 crore of the LIC IPO. medium nocaptionhttps://youtu.be/4Lbe6kceeZM?si=n2wDAJUQ-Ll3MrRJHyundai is not contemplating a pre-IPO placement, according to the DRHP.Anchor investors may be allocated up to 30% of the issue on a discretionary basis.Retail individual investors would be allocated not less than 35% of the issue or 4.97 crore shares. This will imply that around 7mn demat accounts could get allotment, likely a record number.Hyundai will still own 82.5% of the company after the listing.While all eyes will be on how Hyundai and investment bankers price the IPO, here are six factors from the DRHP that investors should study closely.Factor #1: A cash-generating machineCar manufacturing needs heavy investments. That is why automakers’ free cash flows are significantly lower than their profits. Hyundai breaks from that norm.Hyundai’s capital expenditure (capex) between FY23 and FY24 (nine months) was ₹4,996 crore. This includes the acquisition of General Motors’ Talegaon plant in Maharashtra for ₹787 crore. That was only 4.4% of Hyundai’s revenue over the said period. In contrast, Maruti Suzuki spent 6.6% of its revenue over FY23-24 in capex. Even over a longer period of FY21-24 (nine months), capex was 4.4% of revenue at Hyundai.The lower capex, combined with negative working capital investments, results in superior free cash-flow generation.Hyundai had negative working capital in FY23 and a negative working capital cycle of 26.5 days, compared to Maruti Suzuki’s 22.5 days. Hyundai takes around two months to pay its creditors (suppliers), while holding approximately 26 days’ worth of inventory and receiving payment from its customers (dealers) within 18 days. medium111250452At Hyundai, free cash flows were 93% of its profit after tax (PAT) between FY21 and FY24 (nine months). After excluding the effects of the more volatile working-capital changes, its free cash flow was 72% of its PAT, which is outstanding.The low investment requirement translates into return on capital employed (ROCE), excluding cash and investments, rising to a staggering 140-150% in FY23-24, which is well above its competitors. Its net fixed asset turnover at 8.7 times in FY24 is roughly double that of its peers, according to analysts at IIFL Securities.That kind of free cash-flow generation and return ratios are seen more in FMCG (fast-moving consumer goods) and IT services industries than in car manufacturing.Factor #2: Increased royalty payout to parentHyundai and its parent have signed a new royalty agreement on June 10, effective retroactively from April 1. This will increase Hyundai’s royalty payout by an estimated 100bps to 3.5% of revenue from the sale of passenger vehicles or parts in domestic and export markets.This will bring Hyundai’s royalty rate closer to that of Maruti Suzuki’s, which hovers around 3.5% to 4%. It was 3.5% at Maruti Suzuki in the second half of FY24. medium111250475“The royalty agreement may be terminated in accordance with its terms, including by our promoter in the event HMIL is prevented from remitting to our promoter in the Republic of Korea or any other country designated by our promoter,” the DRHP reads.This agreement is an improvement from the product-by-product royalty agreement that was in place earlier. Having a long-term agreement in place for royalty before the IPO will provide investors a much-needed clarity on a contentious issue. However, investors need to factor in the profitability hit coming from the 100bps increase in costs.Factor #3: Capacity additionsHyundai increased the annual production capacity at its Chennai plant to 824,000 by the end of March. The company says that the Chennai plant will remain the key hub for making SUVs and EVs.The newly acquired Talegaon plant is scheduled to add 170,000 units to its production capacity in the first phase. Hyundai plans to start production at the plant in the second half of FY26. So, the overall production capacity will increase to 994,000 units by FY27. medium111250509If the company operates at 90% capacity utilisation, it will imply sales volume will increase 4.7% CAGR over FY24-27. If it operates at 94% capacity utilisation, sales volume can increase 6.2% CAGR.Factor #4: Growth of used cars, networkHyundai’s pre-owned car sales have jumped 79% over FY21-24, compared with 30% growth in new car sales in the same period. Now, for every four new cars sold in India, one pre-owned car is rolling off Hyundai’s dealerships. The company now has 586 used-car outlets spread over 349 cities and towns.Also, Hyundai is getting its dealers to expand their footprint. The company now has 17% more sales outlets and 19% more service outlets than it had in FY21. The company’s throughput of new passenger vehicles per outlet was 450, 11% lower than Maruti Suzuki’s 506.Factor #5: Supplier and related-party risksHyundai has a relatively high concentration of few suppliers for its parts and materials. Although the company has 194 tier-1 suppliers, the top five provide 44% and top 10 a staggering 58% of the parts and materials by value. medium111250529Hyundai primarily sources key parts — engine components, engine and transmission assembly, moulds and dies — from its South Korean parent or other companies within the Hyundai Motor Group. That is why three out of top five, and four out of top 10 suppliers were from related parties namely Hyundai Mobis India, the parent company in South Korea, Kia Motors India, etc. The value of parts sourced from the related parties was 39% in FY24 (nine months), up from 34-35% in FY22-23.Factor #6: Govt incentives and almost zero currency riskHyundai receives big incentives through various central and state government schemes. This accounted for a sizeable 14% of its operating profit in FY24 (nine months). With the PLI (production-linked incentive) scheme and additional state government support, this pie will increase. medium111250542Interestingly, Hyundai has almost no currency risk to its profits. A 5% appreciation of the rupee against the US dollar will result in EPS rising 1%, while a 5% depreciation in the rupee will result in a 1% decline in EPS. The exchange impact from fluctuations in the South Korean won is imperceptible, indicating that inflows and outflows are hedged.