"It makes nearly 60m cars and trucks a year, and employs millions of people around the world. Its products are responsible for almost half the world's oil consumption, and their manufacture uses up nearly half the world's annual output of rubber, 25% of its glass and 15% of its steel. No wonder the car industry accounts for about 10% of GDP in rich countries."
While the above description applies to 'rich' countries, the importance of a well developed auto industry to the overall progress of India's economy in general and manufacturing sector in particular should not be underestimated. Simply because, while the industry in itself is very capital and labour intensive, it also has strong forward and backward linkages. In other words, if the auto industry does well, chances are that a lot of other industries and businesses are also doing well.
But the growth in an industry does not necessarily translate into equally buoyant earnings growth for auto companies as a lot of other factors also come into play here. This in effect forms the crux of this write up. Over the next few paragraphs, we will make an attempt to help investor juxtapose the buoyant growth expected in the Indian auto industry with the company expected to derive the maximum benefit out of it. Please remember that the word 'company' is entirely generic here and implies that we will discuss a few important points that every investor should look at in order to correctly identify a good auto stock from a bad one.
Historical demand: Motorcycles steal the show
Since different auto companies specialize in different segments, an investor would want to restrict his investment decision to companies present only in those segments, which have the highest potential for growth. The charts and the table laid out below would enable him to arrive at a quick decision
As can be seen above, if domestic sales in different segments were to be rebased to 100 in FY98, then by FY06, motorcycles had touched a volume of 680 units, a near 7x growth or an impressive CAGR of 27%. This is significantly higher than the growth witnessed in any of the other segments. During the same period, while CVs have grown at a second highest CAGR of 12%, passenger cars and UVs have grown at a CAGR of 10% and 9% respectively. Tractors have fared the worst and have shown just a 0.6% CAGR.
It should be noted that the growth numbers are point to point and hence it masks the cyclicality, if any, that persisted within the segments mentioned. Here also, the motorcycles segment comes out on top, as it is the only segment that has enjoyed consistent YoY growth. Although the growth rate is different, growth for any year in the period under consideration has been higher than the previous year. All the other segments however had a few periods where volumes have shown a negative growth on a YoY basis.
The reasons behind the same are not difficult to find. With average income levels in the country still very low, growth in car sales have not really taken off and motorcycles have become the vehicles of choice for personal mobility as they are not only easy to maneuver in the country's congested roads but also have low initial and operating costs. Add to this the fact that the median age in the country is 25-26 years and it becomes further evident as to why motorcycle sales have outpaced cars and UVs.
As far as commercial vehicles and tractors are concerned, the growth in these segments is a function of industrial and agricultural growth and hence the higher cyclicality. The CV industry though, is in the midst of some structural changes and hence the higher growth rate than passenger cars and UVs in recent times.
On the future growth front, while we expect the growth in the motorcycles segment to outperform the other segments, the gap is likely to narrow down as income levels rise and better infrastructure is made available. Passenger cars and UVs are likely to emerge as the next highest growing sectors for reasons just outlined and are likely to outperform the CV segment as replacement cycle weakens and some one time demand benefits cease to exist for the CV segment in the future. Tractors would however continue to remain a tough nut to crack, as the growth is governed largely by how the rain gods behave.
While the top down approach to investing on the basis of growth potential of a particular segment as highlighted above does make sense, it has its own set of limitations. For one, the underlying segment may have a high growth potential but if the competition is so intense that profitability is at risk, then the whole exercise is likely to come to a naught. Further, most of the supernormal gains in this sector in the recent past have come from restructuring or turnaround stories, where the top down approach does not do a very good job. Add to this the fact that quite a few companies are present in more than one segment and this renders difficult if not impossible, the idea of concentrating one's investment in select segments. In view of these facts, it becomes important to be flexible in one's approach while analysing potential investment candidates in the auto sector. Key would be to be eclectic in one's approach and use a mix of both top down as well as bottom up approaches in order to zero in on an appropriate stock.
The flowchart below attempts to break up the analysis into simple, easy to understand steps:
Free cash flows: Cash is the lifeblood of any firm, more so in the case of capital-intensive industries like automobiles. Auto manufacturing is a high fixed cost business and putting up a small car plant with a capacity of 1 lakh units per annum can set a company back by as much as US$ 200 to 300 m (~Rs 8.8 bn to Rs 13.2 bn at an exchange rate of Rs 44 per dollar). Add to this the fact that in order to keep the consumer interest going, auto companies have to continually invest in developing new models, R&D, improving emission standards and various other activities. Hence, it is imperative that an auto company generates good cash flows so that it can plough it back into operations and expand its production capacity as well as its product offerings and not rely too much on external borrowings.
As can be seen above, by subtracting capex from the operational cash flow of an auto company, one can arrive at free cash flows. In other words, free cash flow is a function of cash from operations and the capex of an auto company.
We will now focus on cash from operations, which can be further broken down into revenues minus expenses.
Revenues: We believe that the 'popular segments' (segments within segments like 'A, B,C' in passenger cars and 'entry, premium, deluxe' in motorcycles) in the auto industry are nothing but commodities and hence in order to grow the revenues, companies have to rely largely on volume growth. Everything else remaining constant, volume growth in cars and motorcycles is a function of growth in per capita income in the hands of consumers. The table below strengthens this view. While GNP per capita (gross national product) grew at a CAGR of 11% between FY71-FY01, passenger car production increased by 9%. The co-relation seems to be strong, even if one considers the twenty and ten year trend. As economy grows and income levels increase, demand for passenger cars is also likely to improve over the very long term. For motorcycles, demand is likely to grow at a slightly higher rate on account of higher potential customer base and a lower price tag.
||GNP per capita
For other segments like commercial vehicles and tractors, as highlighted above, volume growth and consequently the revenues would largely be a function of growth in industrial activity and agricultural output.
As far as company specific factors like brand strength and distribution network is concerned, while these factors may help some manufacturers in the medium term to notch up higher than industry growth rates, over the long term, they are not likely to be of great utility as these factors are not very difficult to replicate for new players provided they have deep pockets. History suggests that even a brand as prestigious as 'Mercedes Benz' has not been able to achieve industry beating returns consistently over a long time period because competitors have come up with their own luxury marquees like 'Lexus for Toyota', 'Acura for Honda', 'Jaguar for Ford' etc. Hence, if brands as heavily advertised and as heavily reputed as 'Mercedes Benz' finds it difficult to beat market sustainably over a long period of time, it is unlikely some well-known Indian brands would achieve that feat. Thus, it would be safe to assume that over a longer timeframe, industry growth rate should remain as the projected growth rate for all the auto manufacturers.
Expenses: Since the auto companies cannot do much beyond launching new models to grow volumes consistently above the industry growth rates, the major onus of improving profitability and consequently the cash flow falls on the expense heads of the companies. Infact, even the strategy of launching new models is dependent upon how well the costs are controlled. Hence, laying a great deal of emphasis on the cost structure of an auto company becomes critical if one were to separate a good company from the bad.
Raw material costs account for anywhere between 65% and 75% of the total revenues of an auto company, irrespective of the segment. And not surprisingly, this is the area that gets targeted when management decides to cut costs and improve efficiencies. It is often said that if you want to be the best, follow the best and this is exactly what auto companies around the globe, India included, have been doing for quite some time now. Japanese auto companies like Toyota and Honda have revolutionized car making with their cost management techniques like JIT, quality circles, Kaizen and many others and auto companies across the globe have done well to take a leaf out of their book.
Furthermore, auto industry is characterised by structurally rising costs like investments in improving emission and safety standards, enhanced fuel efficiency etc and this puts further pressure on the cost structure, as on account of competition, companies are seldom able to pass it on to the end consumer. Thus, these structural deficiencies are forcing auto companies to cut corners rapidly and indulge in practices such as homogeny in parts where a lot of parts are shared across various models. In car companies, economies of scale in themselves are not sufficient if not backed by common parts sharing across various models. By following these practices, auto companies can use their bargaining powers vis-a-vis their suppliers to good effect and bring about huge cost savings. With operating leverage of auto companies being significantly high, even a small percentage drop in costs can bring about huge improvement in profits. Just to put things in perspective, for a company with 10% EBIT margins and 70% raw material costs as a percentage of sales, even a 5% drop in raw material costs can boost EBIT by as much as 35%. No wonder, analysts and industry observers pay so much attention to the EBIT margins an auto company earns.
Capex: Just like any capital-intensive industry, consistently high capex is a harsh reality for auto industry as well and especially in times of capacity expansion, auto companies can burn up huge amounts of cash. While auto companies tackle capex related issues like any other cost heads, we have taken it separately here purely from an accounting perspective. Further, there is also a difference on what exactly constitutes a capex. While some companies capitalise product development related expenses, others depreciate them over a period of time because they believe benefits from the same can over a time span of 4-5 years. While these differences do not affect a company's cash flows, they nevertheless impact company's EBIT margins. However, one needs to be conservative here and deduct all expenses in the year they were incurred except investments in fixed assets and certain other items like goodwill.
With capex being critical to maintaining balance sheet strength, which can come to the company's rescue during bad times, a lot of management's time and attention is also diverted towards minimizing company's capex needs. Platform sharing, joint development of products between two car companies and employing an asset light strategy by outsourcing auto parts requirement are just some of the measures being taken by auto companies in recent times in order to bring down capex requirement.
Thus, by looking into the various parameters mentioned above, an investor should be able to zero in on companies that consistently produce higher free cash flows. Because, we believe in the long run, only those companies that produce consistently higher free cash flows will be able to grow and even come out relatively unscathed from an industry downturn, if any.
Automobiles, which include commercial vehicles viz. passenger and goods transportation, passenger cars, utility vehicles, tractors and two-wheelers is a very broad sector. Segments like commercial vehicle are cyclical in nature and car demand is largely influenced by per capita income growth over the long term. Given the high dependence on economic performance, earnings tend to be very volatile and therefore, price to earnings ratio will not be a consistent valuation metric. The ability to generate cash and fund expansion plans is of greater significance and as a result, we believe price to cash flow (PAT + depreciation) is a consistent valuation metric. Good quality companies, which have consistently shown superior cash generation and higher EBIT margins, become attractive to us if they are trading at a price to cash flow of around 7-9 times and the risk return ratio turns adverse if the same ratio touches 12 times forward cash flow per share.
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