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Auto - Is there 'value'?

Dec 30, 2004

Assuming an investor invested Rs 10,000 each in 10 auto stocks on December 28th 2003, the portfolio would have appreciated by 4% in the last one year. Compare this to the previous year i.e. calendar year 2003 when the same portfolio appreciated by as much as 129% in one year! As we had mentioned in our auto sector outlook at the begining of the year, growth was already factored into the price and is vindicated by this marginal outperformance relative to the benchmark index.

What was different in 2004 as compared to 2003?
Looking at the performance of a sector or the stock market with one year in isolation may not reflect the actual macro trend. It is therefore, important to consider whether the fundamentals in FY04 and for the most part of FY05 (till November 2004) were any different for the auto sector as compared to FY03 so as to put things in context. While the graph above indicates the return on each of the auto stocks on Rs 100 invested in December 2003 and the graph below reflects the change in volumes in FY04 and FY05 (till date), as compared to FY03. We will co-relate the actual industry performance and the stock performance as we go forward.

It is apparent from the graph above that the passenger car segment has come out of a trough. As compared to a YoY decline in industry volume sales in FY03, growth accelerated in FY04 and for the period till November 2004, passenger car sales has increased by 22% with a quarter remaining. While new launches have played their part in expanding the market, the key growth driver in the period under review has been the interest rate factor. In light of the sharp fall in interest rates over the last four years, cars are more affordable at the current juncture (it is estimated that close to 80% of cars sold in the country are loan financed). While the growth rate may slowdown in the future owing to increase in interest rate and higher fuel cost, demand for cars is likely to trace GNP per capita growth in the long-term (as the historical evidence suggests). The GNP per capita between 1971 to 2001 was around 11%, with passenger car sales mirroring this growth trend.

Another segment that has witnessed a turnaround in fortunes has been tractors. Owing to erratic monsoons, demand for tractors was lacklustre between FY01 to FY04. Without realising the fundamental issue, manuafacturers stocked up inventory with the dealers. With demand growing at a slower rate or declining in some regions (Southern and Western), manufacturers were forced to clear the inventory in the system that eventually led to a decline in volumes at the wholesale level. However, good monsoons in FY03 and in FY04 has helped matters and the industry is slowly coming out of the trough. Besides, the measure by the current government to reduce excise duty on tractors to zero percent in the last budget was also a trigger. in the last budget But the sector remains vulnerable to monsoons.

The dream run for the commercial vehicle (CV) segment continued in FY04 and going by the volume numbers till November 2004, it is going to be yet another stellar year for Tata Motors and Ashok Leyland. While we expect the rate of growth to slowdown in FY06, in terms of volume sales, the industry will continue to grow at the higher tonnage segment in line with the road construction projects. Historical evidence from other developed and developing countries suggests that in the long-term, the share of goods transportation through road increases, with railways losing steam, depending upon the pace of the road construction activity. The demand slowdown could arise from higher fuel cost, which the transport operators may not find it easy to pass on to the customers.

The outperformer of the year: M&M
The reason why M&M has outperformed all other auto stocks is apparent from the analysis. Both the tractors and the UV segments, where M&M holds more than 35% and 50% market share respectively, has remained robust. While UV demand has slowed in FY05, the fact that the tractor segment turned around boosted the overall margin of the company. After touching a historical low of 3% PBIT margin in 2QFY04, the tractor division has seen a consistent improvement in EBIT margins (above 14% in 4QFY04). This combined with the impressive performance on the export side enthused investors and is reflected in outperformance of the stock.

The laggard of the year: TVS Motors
There is a price to be paid for being inconsistent. TVS' financial and stock performance is as simple as that. Post the flagship motorcycle model 'Victor', the company's inability to launch new competitive models has resulted in market share loss and consequently, decline in volumes sold in 1HFY05 and fall in net profit in the same period. Besides, the company's capital expenditure of Rs 5 bn per annum, which is more than 5% of revenues, is a cause of concern. Though it plans to enter the three-wheeler segment that is dominated by Bajaj Auto and launch new motorcycle models in the next two years, the fact that it has been inconsistent is likely to weigh on the stock valuations.

What to expect?
  1. Volume growth across segments, barring tractors, is likely to slowdown in FY06 and beyond on the back of higher interest rates and significantly higher fuel prices.

  2. Competition is likely to increase in the hitherto consolidated CV segment in the future, especially in the above 16 tonne vehicle sgement. Two-wheelers will continue to remain competitive and scope for margin improvement will be restricted.

  3. Most of the auto majors have significant capital expenditure plans towards complying with new emission norms, safety regulations, research and development and capacity additions. The incremental costs to be incurred towards complying with new regulations is unlikely to be passed on to the consumers in light of competitive pressure. Given the fact that the Indian passenger car manufacturers' operating margins are significantly higher than some of the best auto manufacturers in the world, the decline seems inevitable.

  4. As far as valuations are concerned, auto stocks are no longer 'value' plays (like in 2003). Stock prices and valuations will be influenced by market performance, which is increasingly becoming competitive. In this context, the risk profile is on the higher side. If investors are looking for auto stocks, the trick is to invest in companies that have diversified market presence (not just leveraged on India), which would then enable manufacturers to maintain capacity utilisation and keep cost per unit at a managable level. Besides geographical diversification, segment diversification will limit the downside for investors.

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