Auto sector - where to invest?

SECTOR UPDATE

"World auto sales will climb to record highs in 2004 and 2005, as a synchronised global economic recovery more than offsets the impact of record oil prices. Purchases should advance by 3 per cent to 45.3 million units this year and 2 per cent in 2005, led by solid gains in developing Asia. Despite the much-publicised recent slowdown in China's auto sales, year-to-date purchases have climbed by more than 20 per cent. However, India has overtaken China as the fastest-growing auto market in 2004."

This bullish forecast, made in a recent report of the Scotiabank group, summarises the dream run that Indian automakers have had this year. Figures from the Society of Indian Automobile Manufacturers (SIAM) tell the same story, with sales showing growth in passenger vehicles, two-wheelers and commercial vehicles. 
 

Car, CV sales surge; two-wheelers lag
(Sales growth % year-on-year)	Passenger cars	Motorcycles	CVs (M+HCVs)	LCVs
October	31.84	10.20	23.13	21.93
September	25.11	15.73	22.69	10.36
August	18.18	14.57	13.76	21.17
July	18.04	25.27	17.19	18.98
June	25.02	12.88	27.07	31.94
May	9.88	4.06	32.80	26.05
April	32.39	14.60	79.72	50.53
March	11.83	31.46	54.19	43.79
February	73.11	17.69	29.05	37.86
January	31.49	14.89	58.57	31.35

The story is also far from over, as the Scotiabank forecast suggests that 2005 will also be a good year for automobiles.

The report goes on to say that full-year FY04 vehicle sales volumes are expected to total 900,000 units - nearly double the level of five years ago. While India's auto market is currently less than half the size of China's, the two nations will be the major growth drivers for the global auto industry.

UN estimates project that India will overtake China's population sometime after 2035 - a scary thought for some, but not for auto manufacturers. For the latter, this amounts to favourable demographics, a big increase in the potential vehicle owning population.

Based on favourable demographics, Indian car sales are expected to exceed 2 million by 2010. The report has highlighted the fact that India has surpassed China as the fastest-growing auto market in 2004. Vehicle purchases in India have soared by 29 per cent so far this calendar year, with full-year volumes expected to total 900,000 units - nearly double the level of five years ago.

Home truths
Although vehicle sales have been on an overdrive, a telling point is operating margins. One analyst says that apart from Mahindra & Mahindra and Maruti, none of the other players in the auto segment has witnessed any strength in operating margins.

While competitive conditions prevent manufacturers from increasing prices, costs are going up, thanks to the uptrend in the prices of steel and other raw materials. The single-biggest worry for vehicle manufacturers this year, too, will be the cost of sheet metal used for car body panels.

Just as analysts were thinking that steel prices would take a breather after the latest hike in prices, the news of the railways hiking freight rates of coal, iron ore, manganese ore and clinker by 7.7 per cent filtered in. Steel prices are likely to firm up as a consequence of this, feel analysts.

To protect or improve margins, manufacturers will have to begin passing on some of the cost increases to customers, but this is easier said than done, feel a majority of industry experts.

Two-wheeler manufacturers, in particular, have no chance to do this, especially considering the competition in the segment. Passenger cars have a relatively better comfort level in this regard and can manage to get incremental sales by churning out variants.

The position of commercial vehicles (CVs) is better in the price front with some players like Tata Motors and Ashok Leyland having already effected price increases. Margins of domestic car manufacturers are already ruling around 15 per cent, which is high compared with 5-10 per cent margins of global car manufacturers.

Four-wheels are better off
A cursory glance at the latest quarterly financials makes it clear that two-wheeler manufacturers are lagging. Majors like TVS and Bajaj Auto witnessed declines in their bottomlines while the former saw a slip in sales also.

The same was the case with CV major Ashok Leyland but other four-wheeler majors posted double-digit growth in both topline and bottomline. Not that there were no exceptions among two-wheelers.

Hero Honda witnessed handsome 39 per cent and 24 per cent jumps in its topline and bottomline respectively. Analysts reckon that an unfavourable monsoon has left its mark in the rural areas, affecting two-wheeler sales from rural areas.

Another negative is the increasing popularity of entry-level motorcycles, which is impacting price realisations of companies due to the shift in product-mix, which has resulted in the topline growing at a lower rate in FY04.

Sales revenues of the four-wheeler companies have moved in tandem with the overall macro-economic environment in the country as cars are more price- and income-elastic as compared to two-wheelers.

Coupled with fiscal incentives by way of excise duty cuts and an impressive performance by the economy in FY04, the topline performance of four-wheeler firms has been far better than that of two-wheeler companies during the year.

Two-wheeler firms have also suffered from price erosions as increasing competition has led to a fall in realisations, affecting margins. The rapid growth in demand in the domestic and export markets has seen many of the leading passenger vehicle manufacturers look at a second round of expansion in production capacities to cater to future demand.

Lower interest rates have also helped four-wheeler majors post better net profit margins as high financial leverage has helped them reap more benefits than their two-wheeler counterparts during the past few years.

This is because most two-wheeler companies are almost zero debt firms, which were not able to benefit from the low interest regime in the last couple of years.

Smooth drive ahead?
Indicators like a growing economy, deeper penetration of organised vehicle finance and improving road infrastructure will drive the growth of the automobile industry in future, just as it did in developed countries, say analysts.

Further, the current low penetration levels and favourable demographics are likely to aid growth. According to global car and commercial vehicle ownership data, there are only 10 vehicle owners for every 1,000 persons in India compared to developed nations like the US (795 per 1,000) or Europe (580). India even lags Asian countries like South Korea (305), Thailand (125) and China (19) apart from neighbours Pakistan and Sri Lanka (12 each).

Demographically, India's young population (the young and working population between 15 and 59 years is expected to grow by 3.5 per cent annually between 2003 and 2009), increasingly affluent and bulging middle class, and the continuing trend of urbanisation are favourable factors for the growth of the automobile sector.

October sales figures appear as a positive indication. Car sales surged 31.8 per cent in the month, spurred by low interest rates and launches of a spate of new models.

The sales of utility vehicles were up 21.6 per cent at 15,983 units while multi-purpose vehicle (MPV) sales surged 15.8 per cent to 6,106 units.

Re-valuations
While sales growth has been impressive, the overall performance of auto companies at the bourses has been sluggish (especially considering that the Sensex's surged past 6,000 recently), with many majors trading close to 20 per cent lower than their February-April highs.

Fund managers say this had more to do with negative factors like rising raw material and oil prices which are perceived to be bad for auto companies.

Analysts say rising oil prices generally affect car sales globally, but India is an exception as for Indians buying a car is a psychological decision that discounts the effect on sales.

However, where valuations are concerned, analysts feel that if material costs do not move up much and GDP continues to grow at around 6-6.5 per cent, both two- and four-wheelers would continue to post robust growth. Analysts expect two- and four-wheelers to grow at a compounded annual growth rate (CAGR) of 10-12 per cent in the next three years. The trend is also encouraging in cars, with the market for the premium C and D segments taking off.

"Valuations in the Indian auto sector are attractive given the robust outlook on sales growth and the high margins that they still enjoy," says Aditya Palwankar, fund manager, JM Capital Management.

He feels that car sales in India would touch the 2 million mark in the next three-five years. "Auto stocks have not been part of the second rally of the Sensex. The numbers still look good and valuations leave room for upsides," says an analyst from a leading brokerage.

Bumps ahoy!
'Base effect' is a dreaded usage in auto lingo, especially after the searing sales in the last six-nine months. Although vehicle financing has been a major reason for the sales (75-80 per cent of CV and two-wheeler sales has been through finance), interest rates for financing are unlikely to go down any further. 
 

Financials
(In Rs crore)	Sales			Net Profit				EPS (Rs)	P/E(x)
	Sept  04	Sept  03	% chg	Sept 04	Sept 03	% chg	Price (Rs)	FY05	FY05
Ashok Leyland	914.76	962.18	-4.93	43.06	53.46	-19.45	20.70	2.10	9.86
Swaraj Mazda	139.20	104.30	33.46	6.50	4.60	41.30	310.00	27.10	11.44
Eicher Motors	445.95	279.01	59.83	10.32	4.59	124.84	226.00	25.00	9.04
M & M	1554.41	1139.09	36.46	122.92	72.99	68.41	483.50	39.90	12.12
Tata Motors	4147.05	3177.73	30.50	309.21	206.68	49.61	464.80	29.70	15.65
Maruti	2711.65	2164.20	25.30	183.60	123.99	48.08	397.25	31.40	12.65
Bajaj Auto	1448.25	1249.00	15.95	179.92	193.37	-6.96	999.90	84.40	11.85
TVS Motor	742.87	764.55	-2.84	34.24	36.98	-7.41	86.50	5.10	16.96
Hero Honda	1757.16	1261.00	39.35	194.36	156.55	24.15	473.15	41.00	11.54
Punjab Tractors	189.70	127.60	48.67	10.80	6.10	77.05	184.70	13.60	13.58

In fact, with the interest rate scenario threatening to do a reversal, the impact on vehicle sales may not be small, feel analysts. Another gripe of analysts is the catching-up that road infrastructure has to do, especially in urban areas, to make room for the sheer growth in vehicle numbers.

Segmental performance
Although analysts are bullish on the growth prospects of both two- and four-wheelers, they give cars and utility vehicles (UV) makers the edge over the rest of the sector. The reason is that the competitive scenario in the segment is better than the rest of the sector.

Another reason is the relative insularity of the segment to factors like rising oil prices and ability to raise prices and churn out variants to increase sales. Analysts feel that the best bets in the sector are M&M and Maruti.

M&M is an analysts' favourite because of the growth prospects in tractors which are expected to witness volumes growth of 10-12 per cent over the next two to three years, driven by the government's focus on rural economy and initiatives to boost agri-loans.

The lifting of production constraints over the Scorpio and the improving outlook for UV demand are the other positives for the company. Maruti is the undisputed leader in the domestic passenger car segment and posted upbeat fiscal results.

Sales in the A2 segment comprising the Alto, Zen and Wagon R, continue to be its mainstay. It has successfully repositioned Baleno and Esteem through a series of price cuts and upgrades.

Among CVs, Tata Motors continues to grow in the domestic medium/heavy commercial vehicle (M/HCV) segment and has increased its marketshare to around the 66 per cent levels.

However, its marketshare in the domestic LCV segment has declined to around 48 per cent, largely due to production constraints. Ashok Leyland has lost marketshare in both the segments, while M&M and Eicher Motors have increased their presence in the LCV segment.

On the two-wheeler front, Hero Honda is the analysts' choice after the good response to its 'free to roam' promotional scheme, especially in the northern areas. The company would be shortly churning out 2.5 lakh motorcycles a month and is looking to augment its capacity to maintain its dominance in the executive segment.

The only auto scrip that analysts have an underperformer tag on it is Bajaj Auto, whose latest results have demonstrated that volume growth is not translating to profit growth.

They blame the aggressive pricing that the company has resorted to and the apparent danger to its best-selling Pulsar 150 from various quarters like Honda Motor's Unicorn apart from cannibalisation by its own executive bike Discover, which has got a very good response.

The flipside is that the best sellers are not premium offerings. The woes of TVS Motors seem linked to the fact that the company's only best-selling product remains the Victor. The impending launch of a promising model - Star - is expected to revive some of its flagging fortunes.