Auto sector: Speed breakers ahead

A fast growing economy, lower interest rates and a changing demography had been a perfect recipe for the growth of the auto sector. But with two out of these three factors having reversed the sector has been finding itself in a real tight spot. The performance of the sector which was very much dependent on these factors was further exacerbated by a host of other factors such as volatile oil prices which led to higher fuel costs and also by the fact that competition among players was on the rise. Moreover fluctuating commodity prices coupled with a rapidly depreciating rupee also dampened the prospects of a hitherto resurgent auto sector badly. Poor infrastructure has always been a problem for the development of this sector and it continues to be so even today. So where does it go from here? Will it regain its past glory where volumes would drive growth to dizzying heights? Or is the sector staring at a downhill grind from where coming back could be rather painful?

After recording a scorching pace of growth across various segments, the automobile sector over the past one year or so has been facing several roadblocks as mentioned above. Growth has been slowing down which is evident in the sales trend for 9MFY12. But before we get into where we are headed here is what is happening or rather what has happened in terms of numbers.

Taking Stock

Passenger Vehicles
This is probably one sub-segment which has been the worst affected. As a whole for 9MFY12, the companies in this segment have sold 1378834 cars as compared to 1410998 cars sold during the same period in the previous year. This translates into a decline of 2.50 per cent.

Utility Vehicles
The total Utility Vehicle (UV) sales for 9MFY12 stood at 256485 as against 227640 in 9MFY11. But this is not the kind of growth one should be enthused about. Moreover the number of players in this segment has gone up. The preference of customers too is seen changing. But does that really mean that this segment alone can propel the fortunes of the auto sector? We think, not so.[PAGE BREAK]

Commercial Vehicles
The commercial vehicle segment reported sales of 572367 units for 9MFY12 as against 479848 for 9MFY11. This segment can be sub-divided into two categories namely medium and heavy commercial vehicles (M&HCV) and light commercial vehicles (LCV). For 9MFY12, M&HCV (Passenger Carriers) witnessed sales of 33450 units as against 35450 units in 9MFY11. Companies like Ashok Leyland, Tata Motors and Eicher Motors have witnessed a definite slowdown in the number of units that were sold.

Some consolation for the bleeding auto sector comes from the performance of the M&HCV (Goods Carrier) segment. It has witnessed a sale of 211153 units for 9MFY12 as against 188266 units for 9MFY11. But is this enough?

In the LCV (Passenger Carriers) segment too, some growth has been witnessed, as the overall sales figure stood at 35983 units for 9MFY12 as against 32826 units for 9MFY11. In the other sub-segment of LCV (Goods Carrier), the total units sold for 9MFY12 stood at 291781 units for 9MFY12 as against 223306 units 9MFY11. But this should not be much of a thing to cheer about, as the volumes are still on the lower side as compared to the peak volumes that have been reported in these segments.

Two and Three-Wheelers
For 9MFY12, the two-wheeler segment reported a total sale of 12753499 units as against 11331869 units for 9MFY11. This is probably to do with the thought process of consumers who have rather scaled down their aspirations of owning a vehicle. So, this is probably the only segment which is reflecting some respectable growth. The three-wheelers segment for 9MFY12 has witnessed a flat performance selling 383101 units for 9MFY12 as against 383355 units for 9MFY11.[PAGE BREAK]

Exports

The only good thing at least for the time being that is happening to the auto sector is a strong export growth. Exports continued to be strong for 9MFY12 on a YoY basis. Overall export sales witnessed a growth of 28.97 per cent. The PV (18.14 per cent), CV (24.66 per cent), three wheelers (42.63 per cent) and the two wheelers (29.75 per cent) have all done well on the export front.[PAGE BREAK]

How much does this matter? Overall exports account for 15 per cent of total vehicle sales in India. Though it certainly looks to be an encouraging sign, but is not enough to put someone in a comfort zone. With the global economic scenario still shrouded under the clouds of uncertainty it would be too early to take export growth going ahead for granted.

So, why is the auto sector in a downtrend? Will the slowdown persist and get even severe? Or will it bounce back? Here is what you should know.

Interest Rates

The RBI has raised interest rates 13 times in the last 19 months in order to fight inflation even if it were at the cost of growth. The result of this was loans became dearer as banks hiked their lending rates as a natural consequence. One of the major catalysts of growth for the auto sector was the lower interest rates that were prevalent, which enabled customers to take the financing route to owning a vehicle. The moment loans became costlier, the demand started going down. This only became severe as time passed. As Maitreya Doshi, CMD, Premier, points out, “The single largest factor affecting the industry’s growth will be high interest rates. There is an established inverse co-relation between interest rates and automobile demand worldwide; this is also now applicable to India”.

There is an expectation that the interest rates have almost peaked out. The RBI has signalled towards this by decreasing the CRR by 50 basis points in its latest monetary review meeting. Though there are talks of the interest rate cycle reversing from here on, we are of the opinion that it will not happen on an immediate basis. It would be at least two to three quarters from now before the RBI actually starts reversing rates. So the expectation that lower interest rates will propel vehicle sales once again is too early to build.

The Oil Factor

One major factor that affects the auto industry is the price of fuel. Crude oil prices have been fluctuating badly over the past couple of years.[PAGE BREAK]

Even as we write this story, Brent Crude is trading above USD 125 to a barrel. The Iranian issue is hot and boiling and this will keep crude in a very volatile frame. In these circumstances prices of fuel are likely to remain on the higher side. On the domestic front petrol prices have only risen, having gone up four times in 2011. In the last calendar year petrol prices have moved up by Rs 13.46 per litre. All this has not really been good for the auto sector. Neither is it going to change very fast. In fact, the government’s compulsion to keep subsidies under control will soon see diesel prices being decontrolled.  The real trouble will actually start then. According to Ajay Seth, CFO, Maruti Suzuki India, “The price difference between petrol and diesel is quite steep Rs. 24.75. This has led to polarisation in the industry demand towards diesel vehicles”. But if diesel prices too are decontrolled and they start moving up this demand too will naturally come down.

Government’s Policy Initiatives

The government’s policy making to a large extent has a major impact on the fortunes of any sector in general. The vibes that have been coming from this quarter are also not favourable. There are talks of an additional excise duty that could be imposed by the government in the ensuing budget on the auto sector. This gets further complicated as the government has hinted on imposing an additional duty on diesel vehicles (passenger cars). Another factor that spells trouble for the sector is the Free Trade Agreement that is likely to be signed by the government with the European Union. Accordingly imports from this region will get cheaper and further hamper the growth prospects of the Indian auto industry. Though the industry has been rallying against this decision, we see little hope in it for them.

Commodity Prices

Another significant factor that impacts the sector is commodity prices. Steel, Aluminium and Rubber prices have come down over the past one year, thanks to the turmoil in the European region and also the softening of demand from China. But this decrease in commodity prices has not translated into any real benefit as these benefits were wiped off by a depreciating rupee. This sentiment is echoed in what Seth says. “Commodity prices are expected to remain flat or see some reduction due to the Euro zone crisis and weak global demand. We will have to keep an eye on the rupee-dollar movement closely as it impacts the absolute landed prices”, says Seth.[PAGE BREAK]

Increasing Competition

A very significant factor that will play a major role on the overall fortunes of companies in the auto sector is the increasing competition between them. Newer models and more variants is becoming the norm of the day. In these circumstances maintaining product prices is not going to be an easy task. All this calls for significant capital investments on an ongoing basis. Companies have already launched many new models and more are in the pipeline. Also, the revisions of emission norms and demand from customers for more fuel-efficient technologies will necessitate continuous investment in research and development. All this is likely to squeeze profitability going forward.

Demand/Supply Scenario

In the last two fiscals lured by a 30 per cent growth in the automotive sector, car makers have announced capacity additions keeping in mind the demand they foresee in the coming fiscals too. But, to their utter disappointment the demand has not sustained to those high levels. Indian companies have committed to invest around USD 6 billion to almost double India's annual production to more than 6 million vehicles. In September 2010, Maruti Suzuki, the industry's biggest player, announced a USD 390 million investment to expand capacity by 250000 cars a year. It looked like a smart move then. But, how this capacity addition will have an impact on the sector is a factor that has to be looked at.[PAGE BREAK]

According to Seth, “Going by the present trend when car sales are expected to shrink in the current fiscal year (for the first time in nine years), we may face an excess capacity situation in the short term”. Over the same period, India's total installed capacity will have risen to around 4.5 million cars, and could reach six million in a few years. Export growth is strong, but only around 550000 cars are expected to leave the country's ports this fiscal year. Considering this, the demand and supply gap may remain a concern not only for the current calendar year but also going forward.

Conclusion & Recommendation

From all that has been discussed above, there seems to be no respite coming in for the auto sector in the short to medium term. There are only certain pockets which have shown incremental growth in sales volume but margins and profitability will continue to be under pressure thanks to various factors enlisted above. As mentioned earlier with the Union Budget due this week we are likely to see some more steps taken by the government that may hinder the growth of the auto sector for CY12 further. Right now there seems to be no point in looking at the sector as an investible area. The brakes are firmly in place, and the momentum has come to a screeching halt for now. We continue to be bearish on the sector, and advise our readers to stay away from it for now.