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Auto: Why to invest in the sector?

Apr 4, 2006

Last year, automobile stocks have been key participants in the bull run. In fact, the automobile universe of QIS has outperformed the broader indices. Given the broader outperformance, an investor should have compelling reasons to invest in automobile stocks. In this article, we shall look at the macro factors that justify an investment in the automobile industry from a long-term perspective. By long term, we mean a time horizon of at least three years.Proxy for GDP
The automobile industry is said to be a barometer of the economy. Thus, if one expects the Indian economy to register steady real GDP growth in the region of 8% to 10% in the future, as a proxy to the economy, investment in auto stocks can be considered. Similarly, on other parameters like penetration levels and contribution to GDP, there is huge growth potential from a five-year horizon. To give a perspective, the contribution of the automobile sector to industrial output is around 5% as compared to other developing nations, where it is around 10%.

Shortening replacement age

Potential replacement demand
FY07EFY08E
Cars433,193 556,966
Motorcycles3,336,367 3,971,538
From a long-term perspective, another key driver for the auto sector is likely to be replacement demand. In the last two years, the replacement age of vehicles has shortened across segments. To give a perspective, the replacement age for two-wheelers (read motorcycles) has shortened to around 3 years as compared to 5 years till 2003. Similarly, the replacement age in the case of passenger cars has come down from around 7 years in 2003 to around 5 years. While this is partly due to rising income levels and increasing awareness amongst consumers, the availability of easy finance and a plethora of new models being launched have also contributed to this phenomenon.

Based on our interaction with the managements of auto companies and our understanding, the replacement age can shorten further. For example, in the next two to three years, the replacement age in the case of motorcycles is expected to be around 2 years. Similarly, in case of the passenger car segment, one is likely to replace the car every 4 years. However, this is on the presumption that the economy will continue to grow at a steady rate (7% to 8% per annum).

Exports to provide a cushion

Exports % total sales
FY02FY05
Tata Motors8.3%8.3%
Ashok Leyland6.8%12.3%
Maruti2.6%7.4%
M&M0.0%4.7%
Bajaj Auto4.1%11.2%
Hero Honda1.1%2.4%
TVS Motors0.9%4.2%
Traditionally, Indian auto majors were content focusing on the domestic market. This can be attributed to a number of factors, ranging from the lack of competitive models and a lack of confidence to enter the global arena. But in the last three years, there has been a significant change in the mindset of the automobile majors. Not only have they beefed up their product portfolios, they have also gained adequate technical skills to keep product development costs at lower levels. To give a perspective, M&M's 'Scorpio' project entailed an investment of around Rs 6 bn, which is at least at a 50% discount to the amount of investments that global majors would have allocated to a similar project. Though Tata Motors' Rover deal did not materialise, it vindicates the fact that global majors are willing to work with Indian companies as far as product development is concerned. The Tata Motors-Fiat deal is another step in this direction.

Going forward, almost all Indian companies are looking to grow exports. Almost all the companies (baring Maruti and Hero Honda) are looking at acquisitions/greenfield projects. Similarly, over next three to five years, most of the automobile companies are aiming at generating around 20% of their revenues from exports. The focus on exports is likely to provide some cushion to overall revenues for Indian companies, in case of a domestic downturn. While this is a positive side of the story, on the other side, margins are wafer-thin in exports.

Rural economy - an untapped market: Rural India accounts for 2/3rd of the country's population and is dependent on agriculture and allied activities. Despite its size, this segment has been largely ignored for a long time now. However, there are few structural changes taking place in this part of the country. Among many positive factors like rural development, increased private sector participation in farming, we believe that Indian infrastructure development will drive growth in rural areas in the long term. Accessibility has been an issue till now, which will steadily improve going forward. In the long run, the rural economy can grow by around 4%, as against the current rate of 2% during last decade. As per NCAER, the penetration of cars/jeeps in the rural households is mere 0.3% as compared to 10% in the urban centers.

Infrastructure thrust: Over the past six years, we have seen significant improvements in road infrastructure. To give a perspective, the Golden Quadrilateral, which is now 90% complete, accounts for around 1% of the total road surface in the country. Similarly, the government is expected to spend around Rs 750 bn (accounting for 34% of the infrastructure outlay) towards road development in the next three years. If one looks at the developing (that have better road infrastructure) as well as developed nations, it would not be wrong to assume that this is just the beginning. Development in road infrastructure is generally accompanied by a steady rise in demand for vehicles.

To conclude...
The above factors do make a strong case for being invested in the automobile sector. But we would like to reiterate that auto stocks, in general, are not a value buy currently. In the next two years, we expect the auto companies under our coverage to invest around Rs 100 bn (or 45% of their gross fixed assets in FY05). Thus, in the next two years, while the depreciation and interest expenses will increase, benefits will accrue post the completion of projects (starting 18 to 24 months from now). Similarly, we expect the competition to rise, which will force auto companies to increase marketing expenses. Increased competition also hampers the ability of companies to increase prices. In totality, from an investment horizon of 5 years, we feel that there is upside in select automobile stocks.


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