DSIJ Mindshare

Auto Industry - Speed Breakers Ahead

The Indian auto sector is firing from all cylinders and month after month auto companies are reporting record sales figures. For example, in the month of August 2010 total vehicles sold in the country was at 12.63 lakh units, the highest-ever achieved in a month in the history of Indian automobile industry. What is encouraging is that this feat is achieved after record sales posted in July this year when total sales was 12,37,461 units.

The growth is so robust that it has surpassed the SIAM (Society of Indian Automobile Manufacturers) estimates by a huge margin. SIAM, which forecasted passenger vehicles sales to grow around 13 per cent this fiscal is now witnessing a growth of around 30 per cent, whereas commercial vehicles segment is also growing at 24 per cent as against a forecast of 19-20 per cent.  R C Bhargava, Chairman, Maruti Suzuki, when asked how he foresees this growth going forward, explained thus: “High GDP growth rate of 8.5 per cent this fiscal and Government of India’s forecast of 9 per cent next fiscal will help the entire automobile sector to grow going forward”. Vijay Kedia, Director, Atul Auto agrees and says, “There is no reason to believe that this demand will not last.

This should continue till the end of FY11 and beyond for the simple matter that demand is still outstripping the supply. ”India was the place to be for global auto companies since early 2000 as demographics were improving (which means that with younger population per capita average disposable income was increasing bringing down the affordability barrier) accompanied by growth in road infrastructure and favourable government policies. Add to that the lower penetration of vehicles per 1,000 persons, the potential for massive growth becomes evident. True to this expectation, Indian auto industry, which was expected to become seventh largest vehicle producing country in the world by 2016, has already achieved the milestone six years ahead of the target.

Such outperformance did not go unnoticed by the stock market and BSE Auto index remains one of the best performing indices. In the year till date, BSE Auto index has risen by 22 per cent while the broader market index has given a return of 11 per cent during the same period. Even if we take last one year’s figures, we find that BSE Auto has moved up by 51 per cent as compared to just 18 per cent rise in BSE Sensex. So far, so good, but now the question is whether the auto sector still has any steam left and whether it will continue to outperform or whether it will moderate in the coming quarters as the industry might face some headwinds on account of shortage in components, rising commodity prices and tightening of interest rates. [PAGE BREAK]

“The momentum should continue but growth rates may slow compared to H1 of FY11 due to higher base effect,” says Rakesh Batra, National Leader, Automotive Sector, Infrastructure, Industrial & Consumer, Ernst & Young, when asked how auto sector sales will fare going forward. In the ensuing paragraphs, we will look at each segment of the auto industry (restricting to OEMs only) separately, viz. 2-wheelers, passenger cars and light/heavy commercial vehicles and try to understand the dynamics that shape the future of the respective segments and how auto companies’ shares would behave going forward.

Two-wheelers
The two-wheeler segment that constitutes more than three-fourths of the entire automobile sales in terms of units has grown at a CAGR (compounded annual growth rate) of 10 per cent between FY04 to FY10. It has grown from 53.64 lakh units of sales in FY04 to 93.71 lakh units in FY10. It is motorcycles which dominates this segment, representing more than 75 per cent of the total two-wheeler sales in India, followed by scooters that roughly constitute 15 per cent while the rest is taken up by mopeds. There are primarily three major players, viz. Hero Honda, Bajaj Auto, and TVS that corner more than 90 per cent of this segment and even in these three players it is Hero Honda that has more than 55 per cent market share. After passing the speed-breaker of FY09, wherein this segment grew by just one per cent, it regained its momentum and registered growth of 26 per cent in FY10. For this fiscal (April to August 2010), the growth rate is 27.22 per cent and if this momentum is continued it will surpass the FY10 growth rate.

The factors that helped to gain the momentum were definitely an improvement in consumer sentiments due to the revival in the economy wherein the GDP grew at a rate of of 7.4 per cent in FY10 as against 6.8 per cent in FY09. For the first quarter of FY11 this figure stood at 8.8 per cent. This helped to increase the employment levels and personal disposable incomes that influenced this growth. What is noteworthy is the performance of the scooter segment that witnessed a growth of 44.45 per cent on a YoY basis, beating the motorcycle segment growth which grew by just 24.41 per cent. A case in point is of TVS Motors that saw its scooter sales growing by 43.1 per cent compared to 32.8 per cent exhibited by motorcycles.

The reason for such an increase apart from the lower base is the popularity of scooters with the women segment and the penetration of scooters in the eastern part of India where it earlier had a very low presence. In terms of companies it is Bajaj Auto (BAL) which has displayed the maximum growth among its peers.[PAGE BREAK]

On a yearly basis, year-to-date, its two-wheeler sales has been up by 67.7 per cent. It has already sold 13.97 lakh units this year compared to 8.33 lakh units sold last year during the same period. It is Pulsar and Discover that are spearheading the growth and constitute 73 per cent of the entire motorcycle portfolio of the company. But when we see the figure of the industry leader Hero Honda, we find that the growth of its motorcycles has moderated and is lagging behind the industry average. Its YTD growth in sales has increased by just 13.2 per cent on a YoY basis and in the month of August 2010 its sales declined by 1 per cent sequentially. The reason for such low growth (and drop in volume on a month-on-month basis) is the higher base as the company has been selling more than four lakh units consecutively since the last four months.

The company attributes this performance to the supplier constraints that hampered its sales. Also, its negligible presence in the scooter segment might be limiting the growth as it has been selling only 25,000 units of its ‘Pleasure’ brand scooters. Going forward we feel that the growth in the two-wheeler segment will continue as the penetration level in India is quite low compared to other Asian peers. The replacement market will also be one of the growth drivers. In India, the two-wheeler penetration level is quite low at around 5 per cent compared to 15-20 per cent in the South Asian countries and 6.5 per cent in China. Apart from lower penetration, the replacement market also presents huge potential. According to research by CARE, there are 1.6 crore two-wheelers that are now above ten years and with the replacement cycle on an average reduced to six years we feel there is pent-up demand from this segment too. But it is the scooter and moped segment which forms for a larger share in more than the ten-year age bracket and therefore it is expected, though not necessarily, that the growth in the scooter and moped segment will continue to outstrip the demand for motorcycles. These factors will help the companies exhibit better revenue growth but there are reasons to believe that they will even post healthy profit growth. The big three companies in this segment are building capacities in areas like Uttaranchal and Himachal Pardesh where lot of fiscal incentives like zero tax duty (depending on the level of localisation) and zero corporate tax for the first five years of operation are available. For example, Hero Honda’s almost 40 per cent of capacities come from these areas and for Bajaj Auto it is almost quarter of its capacity.[PAGE BREAK]

The result of this has been visible in the last quarter results (Q1FY11) where the average tax rate for Hero Honda came down to 19.4 per cent compared to 23.4 per cent in Q1FY10 and for it BAL it came down from 29.6 to 28.6 in the same period. Moreover, with every increase in sales, profitability will increase as the companies will enjoy the economics of scale since this is a capital-intensive sector where there is substantial fixed cost to bear. This is clearly evident from the FY10 results of these companies where the average realisation per unit has increased anywhere between 0 to 3 per cent and profit by more than 40 per cent per unit. For example, TVS Motors realisation per unit has increased by two per cent in FY10 over FY09 but, during the same period, profit per unit has increased by 147 per cent. Therefore we believe that this part of the auto segment will remain promising for at least the next couple of years and turn out to be rewarding for the investors.

Passenger Vehicles
The passenger vehicle sector, like the two-wheeler segment, used to be the perfect oligopoly market in India till a few years back when three or four companies used to dominate the market. However, things have changed now and an increasing number of companies are entering the Indian market, thereby fuelling the growth of this segment. This segment has grown at a compounded annual growth rate (CAGR) of 14 per cent since FY04, observing the highest growth in the automobile sector in the same period. Even in FY09 wherein some segments saw de-growth, the passenger car segment grew marginally. The momentum has been carried over even in this fiscal with this segment witnessing a jump of 33.88 per cent in sales (units).

The major players in this segment are Maruti Suzuki (54 per cent market share), Hyundai Motor India (HMIL) (18 per cent), and Tata Motors (15 per cent) who together constitute 87 per cent of the entire market share in units. For the month of August the domestic sales of Maruti Suzuki have increased by 32.9 per cent, whereas the sales of HMIL India grew by 17.21 per cent and those of Tata Motors recorded a 51.8 per cent increase in the same period. The sales would have been more robust had there been no drop in export sales. Both the major players i.e Maruti Suzuki and HMIL saw their exports declining by 18 per cent and 12.3 per cent on a yearly basis.[PAGE BREAK]

The reason for this de-growth is the rather unstable economic condition across Europe and the USA. It can also be attributed to the fact that the companies wanted to first fulfill the burgeoning domestic demand. In this rosy domestic picture, which are the segments driving the demand? Mostly it is through the sale of the compact car A2 segment. For Maruti Suzuki the A2 segment (Alto, Wagon-R, Zen, Swift, Ritz, and A-Star) constitutes 74 per cent of its car portfolio which grew by 21.5 per cent. A similar rise was experienced in HMIL’s A2 segment that shares 90 per cent of its entire passenger car portfolio which includes Santro, i10 and i20. One of the rea-sons for such growth is definitely the launch of new vehicles in this segment. For example, Maruti Suzuki has now launched Alto-K10 with a one-litre K-series engine and five CNG models and the all-new Wagon-R endearingly titled ‘the blue-eyed boy’.

But going forward we feel that this momentum will get moderated due to a couple of reasons. The recent record-breaking sales of passenger cars were due to the stocking before the arrival of festivals such as Eid, Dassera, and Diwali, which is when many people buy cars. Secondly, with nearly 80 per cent of the cars being financed in India, the recent rise in interest rates will slow down the growth. Moreover, there are reports of shortages of components that might limit the sales. “There are some components that are affecting production like tyres, fuel pumps, castings, etc. This is resulting in a waiting list of three to six months for the delivery of some of the models. While the component manufacturers are adding new capacity, this has been somewhat slow because the ramp-up in volumes since last August was rapid and unexpected. In the meanwhile the volumes continue to grow with great momentum,” says Batra.

However, this might be only a temporary effect and as Bhargava puts it, “Indications seem to point out that the momentum will continue for some time if the interest rate does not increase dramatically.” Responding to a query about how the rise in interest rate will affect the demand, Batra says “This will depend on the extent of the increase. So far, the price increase of the vehicles and the small increase in interest rates has had minimal effect but if there is a greater increase in the interest rates the likelihood of negative impact cannot be ruled out. ”If we try to analyse the capex plan of some of the industry leaders, it indicates that this sector is expecting strong demand going forward. With the current capacity utilisation at more than 80 per cent, the combined capex of automobile companies (including the non-listed ones like Honda, Ford, Toyota, etc.) in the next couple of years is expected to be `23,920 crore that will increase the capacity by almost 25 per cent from its current level. In addition to that, what is structurally in favour of the Indian automobile sector is its low penetration of eight cars per 1,000 persons and the rising per capita income (roughly at 12.4 per cent) that will act as a long-term driver of growth for this sector. India is emerging as the ‘hub of small cars’ and this will certainly help the companies to post better numbers going forward.[PAGE BREAK]

Commercial Vehicles
The turn of the last fiscal indicated the worst was over for the commercial vehicle segment, with the segment posting a rapid growth of 36 per cent. This growth was driven mostly in the second half of FY10 with medium and heavy commercial vehicles (M&HCVs) leading from the front. However, an interesting fact is that this is the high- est growth rate the commercial vehicles have shown in the last six fiscals, which is quite commendable. And this growth story only seems to be getting stronger. A look at first five months (i.e., April – August 2010) indicates that the segment grew by 44.75 per cent. What’s important is that M&HCVs continue to drive the numbers and have posted 66 per cent growth, while the light commercial vehicles grew 29.68 per cent, which yet again reiterates that the growth is back.

Factors such as stimulus package provided by the government leading to much faster economic bounce-back, improved domestic and overseas business sentiment, government’s special package for buying buses under the Jawaharlal Nehru National Urban Renewal Mission (JNNURM), pick up in infra projects, consumption demand and investments have led to a speedy recovery for the commercial vehicle segment. But the question that now remains is: will this run continue going forward? Our answer to that is a resounding yes.

Firstly, demand for commercial vehicles is directly related to economic growth. With good monsoon, good performance by services sector and industrial activity picking up well with IIP for July 2010 at 13.8 per cent and 11.4 per cent for April-July 2010, the growth is only expected to sustain and could well surpass government’s 8.5 per cent projection. In fact, with freight-generating industries such as mining, manufacturing, capital goods and consumer durables doing pretty well, the freight rates are bound to move up. Already, we are seeing freight rates firming up in eastern, western and northern region.

This we believe should provide good impetus for commercial vehicles. Secondly, with the strong volumes back, companies continue with the pricing actions. Last fiscal, Tata Motors’ realisation per vehicle increased one per cent, which resulted in profit per vehicle increasing by 180 per cent. As for Ashok Leyland, with its realisation per vehicle increasing by one per cent, its profit per vehicle increased by 90 per cent. In fact, Ashok Leyland continued raising prices and had increased prices in April by `14,500, which translated to about 1.5 per cent of total net revenues in Q1FY11. Similar pricing action was taken again in July, the benefit of which will be seen Q2FY11 onwards and will translate to about 2.5 per cent of total net revenues.[PAGE BREAK]

Thirdly, from this October when Euro II norms shift to Euro III or Bharat Stage III, prices are bound to go up. According to media reports, hike for commercial vehicles could be around 3-5 per cent. For Ashok Leyland, this cost is estimated at `40,000 per vehicle and the company is confident of passing on this cost to the customers, which augurs well for the company. All these will only improve the realisation per vehicle for the company with volumes already in place. What will also improve margins further are the cost management initiatives that companies intend to continue and the benefit of which could be felt in the coming quarters. Hence, we believe there is a long way to go for this segment and one can continue to witness strong numbers.

Enjoy The Dream Ride
From the above discussion, it becomes clear that the boom in Indian automobile sector will continue for a while. Two-wheeler growth will mainly come from scooters and motorcycles in the 125cc segment and above. Passenger car segment will be led by A2 segment as there is continuous drop in entry level prices, rising affordability, new launches and strong exports, whereas the rise in infrastructure and manufacturing will help the commercial vehicles segment. But there are certain risks that may act as speed-breakers for this dream journey. One of the major risks is the volatility in the commodity prices, which may throw up challenges for the companies. Even the fluctuations in currency rates may pose problems for the companies, as exports constitute 13 per cent of the entire sales at the end of FY10, up from mere seven per cent in FY04. When asked how rising commodity prices will affect the companies’ net margins, Rajiv Batra says, “it will have negative impact on margins if manufacturers are unable to pass on the increase to consumers.” The other major risk the auto indus-try is facing is the overcapacity in the passenger car segment, especially com-pact car segment where there is maximum competition. From a handful of companies few years back, there are 50 companies that are currently building capacities in India.[PAGE BREAK]

The exponential rise in auto sector has also thrown up challenges of ramping up infrastructure facilities such parking space to ensure a  smooth ride for the automobile sector. Having said that, we feel that these concerns are not major ones and it will take a few quarters before any of these risks pose any real challenge to the auto sector growth. Coming to the valuation of automobile companies’ shares, we find that most of them are trading above or close to their historical median P/E ratio, barring Mahindra & Mahindra (M&M) and TVS. Even BSE Auto index is trading at its yearly high P/E of 20 times. When we compare it with other global peers like Honda Motors, Toyota or Ford Motor, we find Indian auto companies are trading at 10-30 per cent premium. But when we consider the growth in earnings of Indian auto companies, such concerns wither away. Moreover, on PEG (price earnings to growth) basis, we find M&M and TVS most attractive in the automobile sector currently.

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