Auto scrips: speed-breakers ahead

With the economy still going strong, auto sales should be good. But rising input costs and competition might see profitability plummet.

Their performance on the ground last year has been more than impressive, even though profit margins were under pressure.

But far from racing ahead, auto stocks have been left behind, thanks to fears of higher fuel and input costs. The BSE Auto Index has lagged the Sensex for the last six months.

Interestingly, while FIIs have increased their stake in key auto stocks during the period, domestic mutual funds have been cautious. 

How the stakes have changed
Company	Chg. in stake (Sep 04-Mar 05)		FII (%)			MF/UTI (%)
	FII	MF	Mar 05	Dec 04	Sep 04	Mar 05	Dec 04	Sep 04
Maruti Udyog	Ý	Ý	16.09	15.92	11.99	2.82	1.97	2.37
Ashok Leyland	Ý	ß	7.22	6.41	6.49	7.58	8.97	9.19
Mahindra & Mahindra	Ý	ß	27.34	24.9	21.16	10.26	12.41	14.39
Tata Motors	ß	ß	21.07	20.86	21.3	2.43	2.53	3.42
Bajaj Auto	Ý	Ý	16.73	17.26	16.14	1.64	0.92	1.2
Hero Honda	NA	NA	-	25.71	23.12	-	2.34	3.68
TVS Motor	Ý	Ý	11.61	11.47	10.72	6.41	6.69	6.19

The road ahead is not going to be easy - higher steel prices would add to costs, denting margins. And should fuel prices get out of hand, it would definitely stymie demand for commercial vehicles (CVs).

With the economy still going strong, trucks, cars and motorcycles should sell in big numbers. But manufacturers, despite being able to pass on some costs, might see lower margins.

Two-wheelers: Increasing urbanisation, higher disposable incomes, falling interest rates and poor public transport saw volumes of two-wheelers surging by over 10 per cent y-o-y in nine of the previous eleven years. Looking ahead, strong double-digit growth is a given.

According to S Sridhar, general manager (sales), Bajaj Auto, penetration, which is at 13 per cent today, should go up to 22-23 per cent in five years. Two-wheeler sales for FY06 are pegged at around 8.25 million vehicles while over nine million are expected to be sold in FY07. Here's a look at what's driving demand:

* A younger population with higher disposable incomes - 90 per cent of two-wheeler customers have gained Rs 8,000 or so from the new income tax rates.

* Shrinking replacement cycles - three years ago, 30 per cent of bikers upgraded after five years, today 25 per cent change bikes after three years

* Lower EMIs - banks offer loans at 9.5 per cent today compared with the 14 per cent that NBFCs offered earlier

* Availability of superior products at affordable prices - a 100cc Splendor (Hero Honda) used to cost Rs 49,000. Today a 125cc Discover (Bajaj Auto) with an electric start costs Rs 44,000.

Motorcycles, which comprise over 80 per cent of total two-wheeler sales, have seen an impressive growth of 25 per cent in the past 10 years.

However, according to Sridhar, that may not continue. "We will see at least 15 per cent growth annually and any growth above this level, to say 20 or 22 per cent, would vary from year to year depending on the monsoon, which has a big impact in rural areas."

Sridhar pegs the growth for FY06 at between 16-17 per cent because of lower sales in rural markets.

2005 promises to be the year of 125cc motorbikes. So, the action this year will be in the executive segment which now comprises 50 per cent of motorcycle sales.

The market promises to get even more crowded with Honda Motorcycles and Scooters India (HMSI) and Suzuki entering the fray. Says Sridhar, "in Q205, sales of 125ccs were 25,000 per month. By Q306 we expect this to be 1.5 lakh units per month".

However, despite selling more two-wheelers, manufacturers will find it difficult to protect their margins. The culprits: rising input costs and keen competition. While Hero Honda has raised prices by Rs 1,000 and Bajaj Auto By Rs 500, this may not be enough to cover all cost increases.

"Hero Honda's operating profit per vehicle has gone down from Rs 4,651 to Rs 4,278, which shows its inability to increase prices. With products matching each other for technology and features, price will play a crucial role," says Amit Kasat, Edelweiss Capital.

"Prices are unlikely to come down because of new entrants," claims Sridhar, though he admits that one cannot ignore what the competition is doing.

CVs: The industry has had a tremendous run in the past two years during which volumes surged 25 per cent in FY04 and 30 per cent in FY05.

However, according to Ravi Kant, executive director, Tata Motors, the growth may have peaked. However, given the low road density and huge proposed spend on infrastructure, the long-term upside is huge.

Says Ramnath S, SSKI Securities, "the growth could taper off to between 10 and 12 per cent in FY06, on the back of a high base effect. Also, Euro III emission norms have resulted in a price hike (Tata Motors has raised prices by 2-4 per cent) and this together with the confusion over VAT could result in demand slackening somewhat." While volumes may not be such an issue, companies are concerned about costs.

According to Ravi Kant, steel manufacturers have asked for another round of price increases. Moreover, if diesel prices get out of hand, it could upset the operating economics of fleet operators. The good news is that freight rates are stable and have not shown signs of coming off.

Tractors: The industry had a field day in FY05, growing at a strong 28 per cent despite a not-so-good monsoon in some states.

The government's emphasis on rural infrastructure and larger doses of agricultural credit can only help tractor sales. Inventories at most companies are down to 70-75 days while sales outlets have grown 10-15 per cent in FY05, making for greater penetration.

According to Gautam Nagwekar, executive vice-president (marketing), Mahindra & Mahindra, the industry should grow between 10 and 13 per cent in FY06, given that the monsoon is likely to be good.

Over the longer term, however, Nagwekar expects the growth to taper off to a CAGR of 7-8 per cent. Cheaper farm credit at 10-11 per cent, lower margin requirements (at 10 per cent, down from 25 per cent) and increasing rural construction activity should make buying tractors cost-effective.

Companies should be able to pass on increasing steel costs since it would barely impact the financing costs for farmers. Higher oil prices though could pose problems since diesel costs account for 90 per cent of the operating cost of a tractor.

Passenger cars: The outlook for this segment is bright given the low penetration at seven vehicles per 1,000 persons, increasing aspirations and affordability.

According to Ashish Jagnani, analyst, HDFC Securities, car sales, which grew at around 20 per cent in FY05, should slow down somewhat in FY06 to around 12-13 per cent and the longer term CAGR should be in the region of 8-10 per cent.

"The market will be driven by newer models at attractive price points and cheap credit," he observes.

Moreover, as Ramnath points out, the cyclicality is far less than that of CVs and so a growth rate of 12-15 per cent appears to be sustainable. The fastest growing segment in FY05 was the C segment, which grew at 42 per cent and is expected to notch up a growth rate of 35 per cent in FY06.

Mahindra & Mahindra: FY05 saw the tractors division posting a 32 per cent growth y-o-y, taking its market share to 27 per cent. In FY06, this division should grow at around 14 per cent.

Sales of UVs, however, are likely to remain flat as Scorpio will face competition from Toyota's Innova, though lower-end UVs should do well. The company is growing its auto components business aggressively and the technology subsidiary adds value to the stock.

At the current price of Rs 465, the stock is trading at a multiple of 8.45 to estimated consolidated earnings of Rs 55 in FY06.

Tata Motors: CV sales should continue to remain strong with the turn in the capex cycle and continuing infrastructure spend. Replacement demand will also drive sales due to the better operating economics of newer trucks.

Margins will be under pressure owing to higher input costs and the inability to pass on the entire hike. The company should post 13-14 per cent sales in passenger cars between FY06-07 and its monopoly in the diesel segment should continue till Maruti's new diesel facility comes up 18 months from now.

Its UVs, however, could face competition from new entrants. At the current price of Rs 424, the stock is trading at a multiple of 9.2 to estimated earnings of Rs 46 in FY06.

Ashok Leyland: CV sales should grow in line with the industry but competition in the HCV segment from players like Eicher and the inability to increase prices beyond a point could put pressure on earnings. While it is a major player in the bus segment, the weak financial situation of state transport units has resulted in poor replacement demand.

Ashok Leyland is expected to increase capacity from 67,000 units at present to 75,000 units by FY06. At the current price of Rs 22, the stock trades at a multiple of 8.8 to estimated earnings of Rs 2.5 in FY06.

Bajaj Auto: Strong volumes in motorcycles and the rising share of higher margin models such as the Discover should help it gain market share. It would also help Bajaj protect and mitigate the impact of sluggish three-wheeler sales, which have high margins of around 20 per cent and contribute 30 per cent of operating profits.

The company hopes to increase sales of Discover to 40,000 units in three to four months from 25,000 at present. Exports of motorcycles are tipped to grow at around 20 per cent in the next five years. At the current price of Rs 1,084, the stock is trading at a 10.2 multiple to FY06 estimated earnings of Rs 106.

Hero Honda: The company should post sales volumes of around 15 per cent in FY06 over the 26 per cent in FY05. Pressure on operating margins will continue and EBITDA margins could fall from 15.7 per cent to around 15.3 per cent.

Moreover, the payout ratio has fallen from 73 per cent in FY02 to 49 per cent in FY05. At the current price of Rs 515, the stock is trading at multiple of 11 to estimated earnings of Rs 47 in FY06.

TVS Motors: After two years of stagnating motorcycles sales and market share losses, the company should retrieve some market share now that it has a wider range of vehicles.

Stronger volumes, bolstered by exports and a check on costs, should help improve margins. At the current price of Rs 70, the stock is trading at a multiple of 8.4 to estimated earnings of Rs 8.3 in FY06.

Maruti: Sales growth, which was at 13.6 per cent in FY05, should continue at a similar pace in FY06. Maruti commands a 50 per cent share of the car market with attractively priced entry-level models, compact cars and entry mid-sized sedans.

New launches like Swift are in the offing. It has a new car plant coming up with Suzuki and its new diesel engine unit (3,00,000 engines per annum capacity) will give it a presence in the fast-growing diesel segment. At the price of Rs 412, the stock is trading at a multiple of 11 to the estimated earnings of Rs 37 for FY06.