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Auto: Things can change...

Mar 14, 2006

Automobile stocks have been key participants in the current 'bull run'. The interest evinced in automobile stocks in general, is justified if one considers the performance over last five years (see table below). However, it should also be borne in mind that this has been at a time when the automobile industry has benefited by an upturn in the economy. Here is our take on what lies ahead for the sector?

What happens in a upturn?
CompanyEBDITA marginRoENetworth (Rs m)EBDITA marginRoENetworth (Rs m)
 FY01FY05
Bajaj Auto5.9%9.6%26,365 12.6%17.0%41,343
Hero Honda13.1%40.5% 6,090 15.7%54.3%14,934
TVS Motor7.1%18.7% 3,570 7.4%23.5% 6,094
M&M7.5%6.8%18,452 10.8%26.5%19,879
Punjab Tractors18.9%25.9% 4,343 13.3%12.3% 5,124
Tata Motors5.5%-15.1%23,619 11.3%30.1%40,932
Ashok Leyland12.1%8.0%11,685 9.9%25.0%11,485
Maruti-2.8%-10.7%25,120 12.4%19.5%43,788

The above table highlights two key things. Firstly, the industry is 'volume driven' i.e. the profitability (measured in terms of operating margins or EBDITA margin) is dependent on the demand for vehicles to a very large extent. When demand for vehicles increases sharply, considering that the sector has high fixed cost component in the total cost, operating profit outpaces topline growth in an upturn (this is what is commonly referred to as operating leverage).

To give a perspective, during FY00-FY05, the demand for commercial vehicles, passenger vehicles and two-wheelers has grown at a CAGR of 23%, 14% and 15% respectively. Secondly, almost all the auto companies have been on a restructuring phase and therefore, despite higher steel prices, EBDITA margins expanded during the period. This is directly reflected in improved RoE (return on equity).

Cost structure of auto companies
(% sales)Tata MotorsHero Honda
CostFY01FY05FY01FY05
Raw material69.5%68.5%71.6%70.1%
Staff8.9%6.0%3.7%3.6%
Others19.4%16.8%11.2%10.6%
Depreciation5.1%2.6%1.4%1.2%
Interest7.1%1.2% - -

The table above throws some light on the cost structure of Tata Motors (commercial vehicle and car manufacturer) and Hero Honda (two-wheeler company). While our intention is not to focus on any specific company, consider the financials. As against Hero Honda, there has been a dramatic change in the cost structure of Tata Motors, which in itself highlights the nature of the business. Tata Motors operates in a business that is more capital-intensive than Hero Honda and therefore, has better operating leverage benefit in case the industry turns around. The same way, in case of the downturn, there is a possibility that Tata Motors will see a faster decline in profitability as compared to Hero Honda (all things remaining the same). However, there are other factors like the product mix and efficiency that also play an important role in the same.

Now, if one were to look forward, just as was the case in the previous peak, Indian companies have outlined significant capacity expansion plans again in anticipation of demand. During the period FY06-FY08, we expect the above-mentioned companies to invest around Rs 100 bn (or 45% of the gross fixed assets in FY05) towards expanding capacity. In case the demand fails to materialise, there could be a significant pressure on the operating performance of the companies.

We are not saying that the tide is going to turn for the automobile industry. Infact, we believe that Indian automobile players (barring a few) have actually worked hard to enhance their efficiency and today, are globally competitive. What we believe is that automobile stocks are no more a value buy going forward and an investor has to exercise caution to that extent.


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