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Auto: Rough terrain ahead

Dec 28, 2006

We have been maintaining for the past couple of years that auto stocks no longer seem to be 'value buys'. And just as we were proven right at the end of 2005, the underperformance of the auto sector vis--vis the Sensex in 2006 has once again made us feel vindicated. If one had invested Rs 100 in the entire basket of auto stocks (represented by the BSE Auto Index) at the end of 2005, one would have earned 19% less returns as compared to Sensex till date.

Our 2006 assumptions Vs reality
Exactly a year back, we had expressed our views on how 2006 will turn out and had made comments with regards to three major parameters viz., volumes, margins and valuations.

Volumes: While we had expected all the major segments barring two-wheelers to grow at single digit rates, we were proved wrong. So far in FY07, while two-wheelers have been able to grow at double-digit rates as per our projections, the other segments have managed to grow at a significantly higher growth rates than the two-wheelers. To put things in perspective, PVs (passenger vehicles; cars and UVs & MPVs combined) and CVs (commercial vehicles; M&HCVs & LCVs) have grown by 21% YoY and 36% YoY respectively between April-November 2006. Tractor sales have also been much higher than what we had anticipated

While economic growth was never in doubt, the rise in interest rates and fuel prices had a much lesser impact on people's ability to purchase vehicles, especially of the four-wheeler types, than was being expected. Indeed, with greater than expected growth in economy and rising paychecks, demand for automobiles moved into higher gear. Reduction in excise duty on small cars, the Supreme Court ban on overloading of trucks, and launch of snazzy new cars and motorcycles added some more zing to the growth in the sector.

Margins: We expected metal prices to soften and provide some relief to margins. But steel prices never fell. Infact, the grey metal in conjunction with other input prices continued to head northwards and put downward pressure on margins. Taking 1HFY07 performance as a yardstick, with the exception of Maruti and M&M, none of the other biggies were able to avoid a fall in operating margins on a YoY basis. The worst hit were the two-wheeler majors, as intense competition for market share did not allow them to pass on the price hike to the end consumer and thus these players ended up taking a margin hit themselves.

Valuations: While we were proved wrong on the volumes and margins front, we were able to take a correct call on the valuations front. We had said that valuations were looking steep and this might result into relative underperformance of the sector vis--vis the benchmark indices. Predictably so, the BSE Auto Index has emerged as a laggard in 2006. This could be attributed to a subdued performance on the profitability front as increased competition and pressure on input costs never really allowed buoyant volumes to translate into concomitant buoyancy in profits.

The outperformer: M&M
For the third year in a row, M&M, the farm equipment and UV major, has managed to emerge as the highest gainer among the auto stocks. While it is no denying that the continued robustness in tractor and UV sales has helped the stock to outperform, we believe the huge plans that the company has outlined for the future is a greater factor behind the dramatic improvement in the company's fortunes. Acquisition of a clutch of auto component companies, both in the domestic as well as international markets to take its auto components business to the next level and inking of a JV agreement with the European car maker Renault for a foray into passenger cars are two of the primary reasons that the stock has emerged as an outperformer during the year. Besides, the successful listing of some of its associate companies (Tech Mahindra) and consequent value unlocking has also helped the stock price to appreciate. Going forward, while we do not doubt the obvious strength of its farm equipment division, the company will have to guard against competition in the UV segment. Further, with the recent spate of acquisitions, a concern regarding the company biting off more than it can chew has started to raise its head and hence one needs to be wary of the same.

Key gainers in 2006
22-Dec-0522-Dec-06% Change
M&M 504 871 72.9%
Eicher Motor239 349 46.2%
Escorts 75 109 45.0%
Maruti641 925 44.3%
Tata Motors637 859 35.0%
Ashok Leyland 32 43 31.6%
Bajaj Auto2,097 2,591 23.6%

The laggard: TVS Motor
TVS, the smallest of the big three 2-wheeler majors emerged as a major underperformer in the year gone by. The company has the highest operating leverage amongst the three two-wheeler companies and as a consequence, when input prices rise, it is the worst affected. Further with a rather weaker balance sheet vis--vis its two big peers, the higher interest costs have also taken a toll on the company's performance. Over the long-term, however, once the company gets its act right in terms of better control over costs, we believe that it has the products to make an impact on the domestic 2-wheeler market. Further, with foray into the 3-wheeler segment and setting up of a greenfield plant in Indonesia, the company is in a position to adequately reward its shareholders over the long term.

Key losers in 2006
22-Dec-0522-Dec-06% Change
LML Ltd. 39 9 -77.0%
Kinetic Motor 61 38 -38.1%
TVS Motor104 84 -19.5%
Hero Honda870 750 -13.8%

What to expect in 2007?
If 2006 saw some action in terms of competition, 2007 could see it moving a notch higher. Of all the segments, we foresee fight for market share to be the most intense in passenger cars as more and more international majors set shop in the country. Thus, while excise duty cut might ring in good news in terms of volume growth, profitability is likely to come under greater pressure. The CV industry is also expected to slow down its hectic pace of growth as already, the segment is into its fifth year of expansion and being a cyclical sector, a dip in demand seems to be around the corner. On the 2-wheeler front, while growth is likely to keep chugging along at double digit rates, especially the motorcycles, we do not foresee any let up in new product launches as also the battle to corner further market share.

Exports could surprise us on the upside, as after competing with the best in the business on home turf, companies seem to have acquired the skill and expertise and above all the confidence to take international players head on. This is particularly true of segments like tractors and motorcycles, where Indian companies are already making waves globally.

Most of the companies, especially in the passenger car segment, have lined up huge capex plans and with the market getting increasingly crowded, incremental returns are likely to be lower, thus pulling the overall returns down. Thus, while there might be an individual outperformer, from a broader sector perspective, we believe the medium term growth prospects seem to be already factored into stock prices.

To read our thoughts on year 2006 and our view for 2007, click here - Reflections 2006.

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