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Auto: When to invest? - Views on News from Equitymaster
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Auto: When to invest?
Nov 21, 2005

Automobile companies, to sustain growth and market share, have to incur capital expenditure (capex) on a regular basis. An interesting feature to consider is that the benefit from such capex is not immediate. By benefit in the case of the auto sector, we mean volume growth. With resources blocked and depreciation charge increases, earnings growth is suppressed (EPS, from a shareholder perspective). However, once the capex starts yielding benefits, volume growth tend to accelerate and therefore, result in robust earnings, outpacing the increase in depreciation due to capex plan. Hence, it is imperative for a long-term investor (with a horizon of atleast three years), to understand the capex cycles and accordingly, make an investment decision. This is the focus of this article.

To begin with, the following are the key understandings:

  • Mostly in an upturn: Generally, a company will schedule its expansion plans, when the industry is in an upturn and the company is optimistic about the future volume growth. In a downturn, companies tend to have excess capacities.

  • Capex need not be productive: At the same time, there have been instances where despite significant capital expenditure, the new products introduced may not yield the desired results and therefore, can push the company into the red (examples are Tata Motors and TVS Motors).

  • A thing or two about depreciation: Depreciation is a non-cash entry and therefore, tends to boost cash flows of auto companies, even if earnings growth is subdued. During capex cycle, depreciation charges as a percentage of sales can increase and reduce later.

How should an investor read the capex plans?
For the purpose of this article, we have considered the financial details of Bajaj Auto, given the turnaround in fortunes of the company that one has witnessed in the last five years (from a geared-scooter oriented company to a strong No. 2 in the motorcycle segment).

Bajaj Auto FY99 FY00 FY01 FY02 FY03 FY04 FY05
Capex (Rs m) 7,072 3,240 4,267 683 861 808 406
Capex/GFA 41.2% 15.9% 17.3% 2.7% 3.3% 3.0% 1.5%
Units sold 1,423,501 1,412,598 1,209,078 1,358,980 1,445,773 1,518,014 1,824,618
% change   -0.8% -14.4% 12.4% 6.4% 5.0% 20.2%
Operating profit (Rs m) 5,156 4,643 1,782 4,937 6,347 6,912 7,227
% change   -10.0% -61.6% 177.0% 28.6% 8.9% 4.6%
Depreciation (Rs m) 1,327 1,453 1,773 1,797 1,712 1,799 1,854
% change   9.5% 22.0% 1.4% -4.8% 5.1% 3.0%

It should be noted that Bajaj Auto was late to realise that the shift towards motorcycles is here to stay. It started concentrating on this segment since FY99 and has performed well to emerge as a key participant in this segment. As can be seen from the table below, Bajaj spent around Rs 15 bn (or 55% of FY05 gross fixed assets (GFA)) as capex during FY99-FY01. However, the benefits of the expansion started flowing from FY02 onwards, as evident by increase in volumes (see above table). Apart from this, though the volumes during FY99 to FY01 continued to decline, the depreciation burden increased. Post FY02, with new plant started contributing, the increase in operating profits more than adequately compensated for the rise in depreciation charges (see above table).

Relation between EPS and Capex plans:
There exists an inverse relation ship between the capex cycle and the ratio of earnings per share (EPS) to Cash EPS. As can be seen from the adjacent chart, Bajaj Auto incurred significant capital expenditure when the ratio of EPS to CEPS was close to 1. The ratio of close to 1 also imply that the plants of the company are running at optimum level and company may need to invest further, provided there is a growth visibility going forward.

The bottomline is…
From a long-term perspective, one can invest in an automobile stock when the EPS/CEPS ratio is the minimum. In case of Bajaj Auto, this ratio was least in FY01 (see chart below). Incidentally, the share price of the company was also at the bottom. Similarly, when the EPS/CEPS ratio is nearing one, under normal circumstances, an investor should expect capacity expansion plans. Having said that, we would like to caution that though this is an important parameter for an investment decision, it is not ‘the only driving force’. More importantly, as we mentioned earlier, the risk of the capex failing to deliver results also exists. To that extent, investors should exercise prudence.

Bajaj Auto FY99 FY00 FY01 FY02 FY03 FY04 FY05
Share price 612 377 248 502 487 917 1,063
% change   -38.4% -34.2% 102.4% -3.0% 88.3% 15.9%
P/E 11.6 6.2 9.9 10.2 9.7 13.2 15.3
P/CF 11.0 5.9 5.8 7.5 7.3 10.5 12.1

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