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CV Industry: Is there steam left? - Views on News from Equitymaster
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CV Industry: Is there steam left?
May 24, 2005

Growth of the commercial vehicle (CV) industry, as carriers of goods, is one of the key barometers of measuring the growth of the Indian economy. Like an economy however, the CV industry goes through cycles and therefore, gauging from historical evidence (going back 30 years), the performance has not been consistent. In this article, we analyse the factors that influence CV demand and where do we see this industry in the long-term. To start of with, here are some facts to prove that CV demand is cyclical in nature. After growing at a steady rate of 5% CAGR during FY71-FY90 (witnessing ups and downs during the intermittent period), it grew at a CAGR of 22% during FY94-FY97. From FY97 to FY02, the ride had been very bumpy. However, in the last three years (FY02-FY05), the industry has been recovered sharply with the M&HCV (medium and heavy commercial vehicles) and LCVs (light commercial vehicles) registering CAGR of 31% and 41% respectively.

Having looked at the historical volume trend, there are some concerns facing the industry currently. Firm crude prices, expectations of hardening of interest rates and rapid volume growth in the last three years have raise doubts regarding the continuity of the demand surge. On the face of it, the concerns are genuine, but we try and reflect the other side.

Let us first begin with the factors that affect the CV industry.

  • Gross Domestic Production (GDP)

  • Infrastructure development

  • Interest rates

  • Fuel prices

GDP – The industrial sector influence:  As can be seen from the chart, there is a direct correlation between the Index of Industrial Production (IIP) and the performance of the CV industry. As the industrial output increases (led by manufacturing), the need for transportation also increases, which includes metals, consumer goods, infrastructure development, mining, oil and lubricant sectors. Except for FY97, the performance of the industry is directly impacted by the performance of industrial production.

The reasons for the sharp rise in CV demand in FY97 were due to excessive buying of CVs that were largely financed. During that period, it has to be remembered that the corporate sector was aggressively expanding (the first phase of significant expansion post liberalization) and everyone overestimated the demand potential for goods. Inadequate investment in infrastructure sectors like power and transport, mismatch in capacity creation and its utilisation and decline in the production of capital goods were some of the reasons for relatively unimpressive performance of the industrial sector during the FY98-FY02. On the external side, the after-effects of the East Asian crisis, September 11 attacks on the US and a weaker global economy affected demand impacted the industry fortunes. On the back of the aforesaid factors, both the manufacturing index and CV demand fell.

Going forward, the Indian economy is poised for a sustainable growth, with the industry predicting GDP growth rate of 6.5% to 7.5% for the next 2 to 3 years. With the Indian economy being further opened and foreign direct investment (FDI) in various sectors being allowed, global majors are looking upon Indian as a sourcing hub (currently, India’s relative contribution in the global trade is miniscule as compared to its competitors). Similarly, increasing thrust of government on public-private partnerships in different spheres of the economy will be able to fuel industrial production. Apart from this, Indian corporate houses have lined up huge expansion plans in coming few years (after a gap of almost 5 years). This, we believe, is a positive for the CV sector.

Infrastructure:  Traditionally, India has been lacking in infrastructure. Though estimates vary, before 2000, not more than 200 km of roads were developed annually. This significantly affected freight operators, as their margins were affected because of low level of efficiencies (inability to carry large tonnages being one of them), increasing lead-time and higher maintenance cost (due to poor quality of roads). To put things in perspective, out of the total length of 3.3 m kilometers, highways account for less than 5% of the total area but manage freight traffic of approximately 45%.

However, since the last five years, the government’s thrust on infrastructure has significantly aided the high growth rate observed during the past three years. With a plan of covering approximately 15,000 kms by 2007 (under the Golden Quadrilateral, North-South-East-West corridor and port connectivity plans), the right platform for providing an impetus for the road transport is being put in place. This will significantly improve the cost of operations and thereby, improve the freight movement. It should be noted that in developed economies, road transports are the preferred route mainly due to flexibility in operations, lower handling and carriage costs.

Interest rates and fuel prices:  As of date, 90% of the new purchases are said to be on credit. The decline in interest rates (from as high as 19.0% in FY94 to 10.3% in FY05) facilitated the growth in CV demand. However, it is not the primary growth driver. As can be seen from the chart during the period FY98-FY02, even as interest rates softened, CV demand failed to grow.

Similarly, though fuel cost accounts for 55% of the total cost of the freight operators, past trends show that rising fuel prices have not created a significant impact on the demand. As long as the industrial and agricultural production growth is maintained, the demand for freight exist, which in turn improves freights rates. This will enable the freight operators to not only pass on the rising costs but also increase earnings. This, in turn, fuels demand for trucks. Post FY97, the scenario was completely opposite as apart from overcapacity, the demand for the CVs also declined.

Going forward, with rising crude prices creating an inflationary pressure, we do expect interest rates to rise in future. However, the fears of rising rates is overdone as our calculation shows that a 1% increase in interest rates for a loan amount of Rs 1 m (tenure of 36 months) results in an increase of Rs 475 in the EMI. But rising crude prices is a cause of concern, as it will not only affect the profitability of the truck operators but also the pricing power of the consumers. This assumes more significance in the backdrop of reports of the Government organizations that the income of the rural middle class is rising at a faster rate than that of their urban counter parts (as they are more price sensitive to inflationary pressure).

Shift in preference:  With the development of road infrastructure, the CV industry is witnessing a shift in preference towards M&HCVs against LCVs. The demand for multi-axle vehicles, higher tonnage trucks, tippers and tractor-trailers are expected to lead the industry growth for obvious reasons of economies of operations. Even if volumes sold do not grow in absolute terms, in terms of tonnages sold, the direction is likely to be secular.

What to expect?
Though the exponential growth witnessed in the CV industry in the past few years is not sustainable, on a long-term basis, we expect the demand to be in the range of 6% to 7%per annum. Apart from economic performance, CV demand will be further facilitated by the replacement demand cycle. To put things in perspective, of the current population of 2.7 m CVs plying on the road, approximately 30% are more than 10 years old. If one were to assume that this replacement demand would be spread over next 10 years, this could result in an additional demand of 81,000 units per annum. Further not much of purchases have been made during the period FY97-01 due to weak demand. With a perceptible shift in preference and low interest rate regime, the replacement cycle can further be propelled in favour of M&HCVs over above the aforesaid demand.

To conclude,

  1. The fact that the CV sector is cyclical in nature cannot be disputed. But in our view, cyclicality is likely to be muted going forward due to structural reasons (mentioned above).

  2. As road infrastructure improves, like any other developed market, larger tonnage CVs will ply on trunk routes while MHCVs and LCVs will be in demand for rural transportation. We expect higher tonnage vehicles (above 16 tonnes) to grow faster (accounted for around 43% of industry volumes in FY05).

  3. The industry is likely to be more fragmented than in the past. In the last fifty years, Ashok Leyland and Tata Motors have virtually dominated the scene with players like Eicher and Volvo playing a smaller role till now. But more global majors are set to enter the Indian markets (MAN and Mercedes), especially in the higher tonnage segment. Technology is critical to sustain market share in the higher-end of the CV chain.

On the balance, amidst positives, we would place stocks from this sector in the high-risk category.

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