The party that takes over Proton has to contend with loss-making Group Lotus

DRB-HICOM Bhd is certainly aware that if it, or any other of the potential suitors, does take over Proton Holdings Bhd, it will acquire all the assets and liabilities of the national carmaker.

And when that happens, the company that will steer Proton's future sooner or later will need to address the obvious elephant in the room Group Lotus, the sports car unit of Proton.

Proton acquired a controlling stake in the Norwich-based Lotus back in 1996 from liquidators of Bugatti Automobili SpA, with the goal of tapping its high-tech automotive engineering capabilities.

However, many would argue today that Lotus is more of a liability than an asset for Proton, although the national carmaker will argue otherwise.

In late 2010, Proton revealed that it had committed to turn around Lotus with a five-year business transformation plan that would potentially cost up to RM2.37bil a feat that has since been a drag on the company's earnings.

This was evidenced in its latest earnings results. Proton's net profit plunged 76% to RM15.5mil for the second quarter ended Sept 30 compared with RM65.9mil recorded in the previous corresponding quarter due to higher expenses incurred by subsidiary Lotus Group International Ltd.

Excluding the provisions made to Lotus, Proton's operational pre-tax profit was 8.8% higher, with revenue climbing to RM2.26bil from RM2.2bil recorded in the first quarter. For the six-month period, the national carmaker recorded a lower net profit of RM20.1mil compared with RM150.6mil previously on the back of RM4.5bil in revenue.

Any potential major shareholder coming into the picture, be it DRB-HICOM or another party, may have substantially different ideas of what it intends to do with the niche subsidiary. In any case, the company will have three options keeping Lotus (ride out the five-year turnaround plan and hopefully reap the benefits thereafter); tweak the existing plan (keep Lotus and come up with an alternative turnaround strategy for the sports car unit); or dispose of the subsidiary entirely.

Keeping Lotus

One analyst says the need to “ride out” Lotus' five-year turnaround plan is a “necessary evil.”

“The costs to be incurred is part of Lotus' rebranding strategy and has to be done or they will lose out,” she says.

According to a local news report in April this year, Group Lotus chief executive officer Dany Bahar was quoted as saying that the turnaround plan of Lotus is on track as the company enters its second year of the plan.

Bahar claims that Lotus' first year had met expectations, adding that the sports car unit aims to emulate the turnaround plans of other illustrious sports car makers such as Aston Martin and Porsche that at one time were not in the pink of health.

Bahar reckons it would take two to three years before the turnaround plan starts generating a profit.

At the time of the news report, Bahar says the first car scheduled for production, namely the Lotus Esprit, had already attracted over 3,000 buyers. The car will be rolled out in the spring of 2013.

Lotus hopes to sell between 6,500 to 7,000 cars per year of the five models it intends to build.

Another analyst points out that despite being a niche product, the brand is quite well known, in some countries including China.

“DRB-HICOM can ride on the Lotus brand to fast-track its presence in other markets quickly where the (Lotus) brand is already popular,” he says.

Last month, Lotus Group opened its first showroom in Beijing via its local dealer, Lotus China.

Lotus China chief executive officer Li-Chen Zhang was quoted as saying that it had already sold some 300 units of Lotus cars even before the showroom opened. The group intends to open 30 more showrooms throughout the country by 2012.

Christopher Nicoll, general manager for Asia-Pacific region at Lotus Cars, meanwhile, was quoted last month as saying that Lotus expects China to contribute 25%-30% to total sales by 2015. The group sold 2,700 vehicles worldwide in its previous fiscal year.

Apart from being able to penetrate new markets, the acquisition of Lotus will allow DRB-HICOM or any other company to have access to the former's technological knowhow, says Kavan Mukhtyar, Frost & Sullivan partner and automotive and transportation practice head for Asia-Pacific.

“Lotus is an iconic and strong brand. But the business is not just about selling cars, it's also the engineering and automotive capabilities associated with its cars.”

Speaking of which, one analyst says the new owner could potentially benefit from Lotus' association with Formula One (F1), the pinnacle of motor sports. Lotus is the title sponsor of the Lotus-Renault GP team.

“DRB-HICOM is not a full-fledged car manufacturer but F1 can be used as a platform to market its brand at the F1 races globally.

“This link could increase DRB-HICOM's appeal to Volkswagen (VW) or other potential joint-venture (JV) partners that are full-fledged car manufacturers that want to transfer F1 technology into their road-driven cars,” he says.

Tweaking Lotus

Alternatively, a plan could be put in place to “re-jig” Lotus' five-year rebranding exercise to reduce the turnaround time and generate profits sooner. Doing that would require deep pockets.

Says UOB Kay Hian Malaysia Research head Vincent Khoo: “If DRB-HICOM pays a significant high price for Proton, then it should look into quickly monetising some of the assets, which includes Lotus.”

As at Sept 30, DRB-HICOM's cash and cash equivalent stood at RM4bil more than enough to help turn around Lotus. However, such a huge commitment may not actually sit well with DRB-HICOM's board.

“If DRB-HICOM can rope in a partner, such as VW (which is more financially sound) on a big scale, it can shorten the turnaround time and maximise profits faster. The five-year rebranding exercise could be shortened to maybe three years.

“VW's involvement in Proton may also make the deal more attractive, considering that Proton needs a partnership with an established auto manufacturer with technological capabilities,” says an analyst from a local bank-backed brokerage.

It is noteworthy to mention that Khazanah Nasional Bhd, Proton's major shareholder, was in negotiations with Volkswagen AG on a number of times, but the talks broke down for the last time in late-2007. DRB-HICOM had previously approached Proton in 2009 and formally submitted a bid to buy 32% of Proton shares.

After the talks with Proton broke down, Volkswagen partnered instead with DRB-HICOM late last year to assemble and manufacture VW vehicles in Malaysia.

But even if VW chooses not to be involved, analysts feel that the Lotus brand is appealing enough to attract potential partners to help turn around the sports car company.

“Lotus would be most useful for regional producers which have global aspirations. Lotus has the global appeal and franchise value for its engineering strength and global brand presence in performance cars,” says Khoo.

“Apart from the engineering expertise, Lotus can create value to DRB-HICOM if Lotus' expertise can be packaged to convince a multinational company to relocate or expand their regional production facilities in Malaysia,” he adds.

A local business weekly recently reported that China-based Shanghai Automotive Industry Corp (SAIC) is interested to acquire a stake in Lotus. Analysts generally agreed that the potential entry of SAIC to acquire a stake in Lotus would bode well for Proton.

“With RM2.3bil in capex needed for Lotus (of which RM1.33bil has been tapped from a syndicate of banks), the injection in capital by SAIC in exchange for an equity ownership would be a relief for Proton,” says OSK Research in its recent report.

“This would ultimately allow Proton to preserve and allocate capital accordingly in view of its own capex needs for the Proton model expansion and potential joint-venture setups, following the recent memorandum of understanding inked with China's Hawtai and Mitsubishi Motor Corp.”

Affin Investment Bank in its report notes that SAIC had an extensive distribution network in China with strong tie-ups with the likes of General Motors and VW.

“Entry of SAIC, even if it does not involve an acquisition of equity interest, is viewed positively as it provides Lotus with a strong partner in the world's fastest growing consumer market, China.”

Having a partner on board to help turn around Lotus would help the new owner reduce the costs that will come with the sports car division. But this also means that the profits would need to be shared also.

Selling Lotus

Critics of Proton's strategy to turn around Lotus generally feel the that money should instead be used to develop the “next” mass marker car a move that they feel will help boost the national carmaker's competitiveness. Some believe that Lotus should be sold off to achieve this goal.

Khoo believes that the decision whether to dispose of the Lotus subsidiary would ultimately depend on whether DRB-HICOM can enlist VW or a global original equipment manufacturer that's looking for a strategic partnership or require the technological and engineering expertise of Lotus.

“From a financial perspective, one may consider letting go of Lotus,” he says.

Another analyst believes that it would be a “big waste” for Lotus to be disposed of, given all of the commitments made by Proton so far.

“Given the heavy capital expenditure (capex) gone into Lotus and the fact that there are interested parties in the company such as SAIC, it would be a waste. DRB-HICOM could always issue new shares in return for cash injection.”

Given Lotus' global brand appeal, analysts generally agree that should DRB-HICOM or any other new owner decide to sell off the sports car unit, it should be able to fetch a good price for it although how high is questionable.

According to reports, Proton acquired Lotus in 1996 for about 51mil. One analyst believes that while Lotus will be worth more than that today, the seller may not be able to recoup the investment costs that went into rebuilding the company over the years.

“If Lotus is sold off, we don't think the sum will be able to cover the annual capex pumped in over the years.”

This sentiment is also shared by Kavan: “It won't make economic sense to sell Lotus immediately because you may not be able to get the right valuation.”

Kavan, however, reckons that Lotus may not even be a factor if DRB-HICOM acquires Khazanah's 42.7% stake.

“My hunch is that Khazanah will keep the Lotus brand out of the stake-sale equation,” he says