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CVs: Cash is the king!

Oct 13, 2005

The commercial vehicle (CV) industry is inherently cyclical in nature. In this article, we shall try to understand whether working capital is an indicator of the cyclical nature of the CV industry and also its impact on financials. For the purpose of this article, we have considered the financial details of Ashok Leyland, as it is not only a pure commercial vehicle manufacturer but also the second largest player in the CV industry. Hence, its performance can be considered as a proxy to that of the industry. A brief about the industry performance:
After growing at a steady rate of 5% CAGR during FY71-FY90 (witnessing ups and downs during the intermittent period), the CV industry 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&HCVs (medium and heavy commercial vehicles) and LCVs (light commercial vehicles) registering CAGR of 31% and 41% respectively. Thus it is evident, that CV industry is cyclical in nature.

How important is the working capital?
Indicator of the cyclical nature? Working capital trends, to an extent, can give insights into the future industry performance. We are not saying that it is the ultimate indicator of the trend, as there are numerous other factors that influence demand and supply. However, an insight into the working capital trend over the last three years highlights the current position of the cycle.

As can be seen from the above graph (left), the growth in the demand for the company's CVs during FY95-FY97 (22% CAGR) was accompanied by increasing cash cycle (i.e. debtor days + inventory days - creditor days). This was mainly because the company had adopted an aggressive sales strategy, which was based on expectation of strong growth potential in the next few years, led by expansion plans of corporate sector (the first phase of significant expansion post liberalization). As the expected potential demand failed to materialize, the dealers were saddled with excessive inventory. This affected the performance of the original equipment manufacturers (OEM) like Ashok Leyland and Tata Motors in the subsequent years, as the dealers took some time to clear the huge pile of inventories. Thus, while new CVs were being introduced into the system, the same was not reflected in the performance of the OEMs in the subsequent years with the industry shifting into a consolidation phase (till FY02).

As the cash cycle continued to shorten, the performance of the OEMs started improving. During last three years, though Ashok Leyland has registered a growth similar to that during FY95-FY97, the cash cycle is significant lower (infact reducing since FY01) as compared to the previous growth phase.

Financial impact: A high working capital results in blockage of funds of the company, which otherwise could be used to fund future growth. This results in increased borrowings by the company. It should be noted that during this period (FY96-FY05) Ashok Leyland has also been incurring capital expenditure averaging around Rs 1.2 to 1.3 bn, which it was able to finance from internal sources.

To conclude…
As seen from the above charts, the phenomenal growth witnessed in the last few years is not characterized by the factors that led to the growth during the FY94-FY97 period, atleast on the working capital front. This together with the structural changes taking place in the economy makes us to believe that the demand for the CVs will be at a steady pace. Further, the fall in demand, if any, will not be as drastic as it had been in the past. Having said that, we believe that the robust growth witnessed during last few years is not sustainable. We expect the commercial vehicle industry to grow at around 6% to 8% in the next three years. From a retail investor's perspective, a simple working capital analysis is likely to reflect the future growth prospects of the sector and how efficiently is the company utilizing its very valuable cash reserves.

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