Weak Q3, analysts' downgrades show a painful road ahead for auto stocks

After underperforming the broader markets in CY2018, the auto sector is likely to trail the key benchmarks even in the first half of CY19. The BSE Auto Index, which fell by a third since the start of 2018, is expected to see more downgrades, given the demand headwinds. 

Amyn Pirani of Deutsche Bank, in a report last month, indicated that growth and margin expectations could continue to moderate over the next couple of quarters. 

While stock prices have corrected (auto index down 11 per cent since the start of 2019), the bank believes that there is further scope for de-rating, as valuations in most cases are still above the long-term averages. Institutional investors, such as mutual funds, have also been paring their position in this space with the auto sector weightage reaching a new low of 7 per cent, the lowest in at least two and a half years. 

The near-term trigger for the downgrades has been muted demand sentiment, given the increase in total cost of ownership, especially in the two wheelers and passenger vehicle segments. Be it fuel prices or insurance cost or the 20-30 basis points uptick in interest rates, these have led to a sluggish festive season, denting the 20 per cent of volumes that is typically recorded during the period. Higher inventory at the dealer’s end was responsible for the record high discounts offered by manufacturers in an effort to liquidate stocks, says Hetal Gandhi, director, CRISIL Research.

Even in the medium and heavy truck segments, liquidity crunch due to the pressure on NBFCs, and therefore lower availability of finance, hurt resale values, replacement demand as well as new vehicle sales. Weak volumes were also due to new axle norms, which increased freight carrying capacity of trucks by 20 per cent. Higher capacity and supply at a time of weak freight demand, meant slower order inflow for trucks. 

Weak demand trends in the December quarter also extended to January for most manufacturers due to a high base, selective funding by NBFCs and deferred purchases.

The worry for the sector is not limited to the domestic market. Tata Motors, Motherson Sumi and Bharat Forge, which get a substantial chunk of revenues from exports or have large overseas subsidiaries, too, have been facing the slowdown impact. While Tata Motors had to a take a substantial hit (asset impairment), given the demand weakness in key markets such as China and technological changes, Motherson Sumi was impacted by emission norm changes in Europe.

Moreover, the Street is also worried about the operating profit margins which were under pressure in the December quarter. Margin miss for India’s largest car maker Maruti was on account of higher commodity costs, higher discounts and negative operating leverage. The pressure on margins was visible not only for Maruti but across passenger vehicle and utility vehicle manufacturers who reported single digit margins after nearly 5-6 years. Margins could continue to be under pressure as the demand environment is still subdued and cost pressures will increase over time with BSVI related and other safety related costs which may not be passed on instantly, feel Jamshed Dadabhoy and Arvind Sharma of Citi Research.

What could compound demand worries, however, are a below normal monsoon in CY2019, lower pace of infrastructure spending post elections and higher fuel prices. Most brokerages have already revised their growth estimates, which were in double digits in the first half of FY19, to single digits now for the fiscal as well as for FY20. Given the 15-20 per cent price increase before the new emission norms kick in by April 1, 2020, brokerages believe that there could be a spike in demand in the September and December quarters of CY2019. 

Despite the sharp fall in auto stocks, analysts are cautious and believe that near-term outlook for the sector is muted, and exposure, especially for the short term would be akin to catching a falling knife.