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Auto: When to invest - II
Dec 5, 2005

Automobile industry is a capital-intensive industry and hence the performance of auto manufacturers depends upon the utilisation of its fixed assets. This is because, higher the utilisation of the assets, more will be the production of units and hence there will be a reduction in the fixed operating cost per unit. Asset utilisation also assumes importance because automobile players have to undertake capital expansion plans regularly. As stated in our previous article , when a company incurs capital expenditure, the benefits flow with a lag. This can depress the utilisation ratios during the period when the capacity enhancement is underway. In a perfect market scenario, this should be reflected in the operating margins of the company, as it should move in line with the asset utilisation. However, the market scenario is not perfect and hence correlation between the asset utilisation and the operating margins can give a misleading picture sometimes.

For an automobile manufacturer, the ability to raise prices in tandem with increasing costs also plays an important role in bringing out the full impact of better asset utilisation on operating margins. One should note that steel accounts for a significant part of operating costs (around 70% of the total operating costs). Hence, any significant movement in steel prices has a direct impact on the performance of the company.

In this article we shall look to correlate, the asset utilisation and operating margins, keeping in mind the movement in steel prices.

What is the appropriate ratio for fixed asset utilisation – Sales/GFA or Sales/NFA? We believe that the appropriate denominator is gross fixed asset (GFA) as depreciation is more of an accounting entry. Similarly, even after assets are fully depreciated, it is possible to use them efficiently with proper maintenance. Based on our interaction with the management of different companies, we understand that while an asset can be used for more than 15 years, the asset can be significantly depreciated in 5 years time. This could easily deflate the denominator if the ratio is based on net fixed assets (NFA) and hence improve the utilisation ratio, which is infact the case in some of the automobile companies.

For the purpose of this article we have used the financials of Bajaj Auto, Tata Motors and M&M.

As can be seen from the graphs, for both Bajaj Auto and Tata Motors, there exists a direct correlation between utilisation levels and operating margins for most of the years. In case of M&M, however, there has been deviation from this general rule during FY99 and FY00. During this period, though the company incurred higher capital expenditure, improved demand in tractors (capacity utilisation of 90%), enabled it to report better margins. It should be noted that the fixed cost for manufacturing a tractor are relatively lower.

The steel price impact: As stated earlier, steel accounts for a significant portion of operating costs. Hence any movement in the prices of the steel has a direct impact on operating margins, given the limited power of auto manufacturers to raise prices in a competitive market. To give an example, both M&M and Tata Motors reported increase in margins in FY02, despite falling/stagnant utilisation of assets. This was because steel prices were at their bottom during FY01 and FY02. Based on our interaction with the management and our workings, we feel that a 10% change in steel price can affect the margins of automobile players by 0.5%. Similarly, in FY05, despite improvement in utilisation levels for both Bajaj Auto and Tata Motors, the operating margins declined primarily on account of almost 100% increase in average steel prices during FY03-FY05.

To conclude…
Lower utilisation levels can be on two counts. Firstly, lower volume sales due to industry or company specific reasons and secondly, due to increase in the capital expenditure by the company. In both the cases, generally the operating margins tend to be lower. Thus, for a long-term investor, with a horizon of 3 to 5 years, investing at a point when the asset utilisation ratio is near the bottom can provide good returns. Having said that, the risk of failure of the anticipated demand materialising has to be borne in mind.

  FY00 FY01 FY02 FY03 FY04 FY05
Bajaj Auto            
Sales/GFA 1.5 1.2 1.4 1.6 1.8 2.1
Share price 377 248 502 487 917 1,063
Sales/GFA 2.5 2.2 1.9 1.8 2.3 2.8
Share price 159 60 57 50 232 251
Tata Motors            
Sales/GFA 1.3 1.2 1.3 1.5 2.2 2.6
Share price 136 65 126 156 486 414

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