Will auto components overshadow autos?

 Forget software. Or even pharma, for that matter. If you are looking for an industry which has the opportunity to emerge as the export powerhouse of India's burgeoning economy, look no further than the auto ancillary segment.

 Future growth rates in terms of exports by auto ancillary companies are expected to match the 30-40 per cent achieved by software and pharma companies, say industry watchers.

 According to industry estimates, exports by the the auto ancillary industry will total to roughly $50 billion by FY15.

 Even as technology and pharma companies blazed a new trail in terms of foreign revenues, companies like Bharat Forge and Mico have been busy making a strong case for the auto components sector.

 Take Bharat Forge, for example. While the company reported a 45 per cent increase in total sales for FY03 to Rs 689.20 crore compared to the previous fiscal, exports zoomed by a whopping 146 per cent to Rs 271.40 crore, amounting to 39 per cent of total sales compared to 23 per cent for FY02.

 The outstanding performances by auto component companies have not been in vain. The markets have taken an active interest in these scrips, most of which have outperformed even after taking the big bull run of this year into account.

 While the Bharat Forge stock surged by more than 250 per cent over the past year to Rs 620 levels, other lesser-known scrips like Amforge Industries (up 953 per cent at Rs 120), Motherson Sumi (up 411 per cent at Rs 276), Mico (up 255 per cent at Rs 11,355), Sundram Fasteners (up 193 per cent at Rs 905) and Sundaram Clayton (up 174 per cent at Rs 475) have left most other sectors far behind.

 The trading volumes at these counters have witnessed a big spurt.

 Given this scorching pace, some auto analysts believe that auto components - which are riding two booms (domestic and the outsourcing boom abroad) - could soon become even better bets than companies like Tata Motors, Hero Honda or TVS which have seen a dream run this year.

 Advantage India

 While the booming markets may have partly contributed to this success story, there is more to it than meets the eye, say analysts.

 An ever increasing number of global vehicle manufacturers is searching for low-cost manufacturing bases by for sourcing equipment and parts for vehicles.

 India, along with countries such as Mexico, China, Brazil and Thailand, offers OEMs (original equipment manufacturers) a great cost-quality proposition, thus making it a preferred destination for outsourcing.

 According to analysts, component manufacturers in these countries are able to offer products at significantly lower costs without compromising quality. By outsourcing components from these countries, global auto manufacturers seek to improve their profitability.

 India offers other advantages, too, like availability of cheap raw materials, educated and skilled work force, and design and engineering skills.

 According to analyst Rashi Talwar Bhatia of Motilal Oswal Securities, manufacturing costs for Indian component manufacturers are 20-30 per cent lower than their American counterparts on an average, despite the fact that Indian productivity is 50-75 per cent below international standards.

 The availability of skilled manpower also makes the country a favourite outsourcing destination with foreign firms.

 "Global companies prefer vendors that provide them with integrated system solutions, including design-based skills in CAD/CAM. Indian companies score high on this point," says Bhatia in a recent report on the sector.

 "Companies like Bharat Forge, Mico, Motherson Sumi, Sundram Fasteners and Sundaram Clayton have in-house design centres with capabilities on all globally-recognised designing skills. As a result, these companies have graduated from mere outsourcing partners to integrated partners involved with OEMs right from the stage of product development. This creates significant switching costs for OEMs and barriers to entry for other players," she adds.

 According to Ashish Jagnani, analyst with the Mumbai-based HDFC Securities, the industry's dynamics are undergoing a change and there is a positive shift in perceptions about Indian auto component manufacturers globally.

 "Indian manufacturers are getting recognition globally in terms of their product quality, process standards and the ability to manufacture at lower costs. These are the main factors driving sector valuations," he says.

 Stringent environmental laws in developed countries are also forcing the global manufacturers to source components from developing nations like India.

 With global auto majors like Ford, General Motors, DaimlerChrysler, Volkswagen and Volvo increasingly looking at India for outsourcing auto components in an attempt to reduce costs, the future looks promising to say the least.

 According to Bhatia, the success of the likes of Bharat Forge and Mico in the export markets is only the proverbial tip of the iceberg.

 The point is driven home by the fact that entire auto components industry in India forms only 15 per cent of the size of the largest auto component company in the world - Delphi Corporation of the US.

 India is still a minnow in the global ocean of auto components: it accounted for a mere 0.2 per cent of the global business, with exports of $800 million in FY03. That figure is expected to rise to around $1-1.5 billion by the end of FY04.

 According to estimates, exports already account for nearly 10 per cent of the total sales of auto components in India.

 Considering that global trade in auto components at the beginning of the decade was about $250 billion, there's a whole big market waiting to be conquered.

 "Volumes, though high for Indian manufacturers, are inconsequential by global manufacturing standards. Multinationals setting up international procurement offices (IPOs) in India provide a big impetus to the concept of outsourcing. Volvo, DaimlerChrysler, Caterpillar, Cummins and Ford are among a dozen odd OEMs to have set up Indian offices over the last two to three years. These offices are currently sourcing $5-20 million worth of products from India annually, though most outsourcing contracts are still sub-$10 million," notes Bhatia.

 "As far as exports go, companies like Bharat Forge have made a good beginning. Most players are at a stage where they are winning preliminary orders. There exists an opportunity for scalability to meet the current orders," notes Jagnani.

 Less domestic dependence

 The opening up of the export window also means that dependence on the domestic auto industry is steadily reducing.

 While India's economic revival, lower interest rates and improving road infrastructure are driving domestic demand, the export markets enable Indian manufacturers to go up the value chain.

 "The trend of global auto majors outsourcing auto components from emerging markets provides Indian manufacturers a dramatic opportunity not only to reduce their dependence on the domestic auto industry, but also to participate at a global scale on the development of new technologies and products," says Bhatia.

 However, the ancillary companies may not be ready to give up on the domestic market.

 "Domestic demand is also strong at the moment. Indian companies won't be willing to give up on domestic market due to their long-term relationships with Indian vehicle manufacturers. Considering the fact that they have a bigger export window open to them, the auto component sector will see higher capacity expansion than Indian OEMs," notes Jagnani.

 But the story is not just about the future. Today's hope was built more on the change in industry dynamics witnessed over the past few years.

 Earlier, most Indian auto component manufacturers were supplying to multinational auto companies like Ford, Hyundai and GM, which already had a presence in India.

 Analysts say that catering to these MNCs helped domestic component manufacturers improve their product quality and process standards.

 Cost competencies have also improved, mainly due to the restructuring exercises undertaken by companies and initiatives like the adoption of Japanese shopfloor practices like TPM and TQM.

 The worry is....

 The increasing flow of export orders means that components companies need to develop the ability to execute orders in time. This could lead to further capacity additions, which will mean infusion of fresh capital.

 Given the prevailing single-source supplier system, companies have to make significant investments in areas such as design, tooling, production and delivery - and are exposed to the risk of model failure.

 According to analysts, India also ranks low in terms of R&D and scalability. The present cost advantages cannot be taken for granted either.

 "Indian companies need to leverage on the labour arbitrage immediately, specifically in the skilled manpower category, to build stronger core competencies for themselves before the cost advantage disappears," cautions Bhatia.

 According to Jagnani, it is difficult to predict future growth rates. "Though I am very positive on the sector at the moment, it is difficult to say what kind growth is likely to happen in the sector. That will depend on order flows. The main risks lie in execution of orders and the ability to scale up according to the demand," he adds.

 So what lies in the future? The key to the success of many ancillaries will be their ability to manage penalties and punitive damages for line stoppage, delivery delays and quality problems.

 Though insurance cover is available for most of these issues, "the critical aspect will be the ability of the companies to manage these issues with least expenditure," notes Bhatia in her report.

 "With current volumes only a fraction of actual requirements, ancillary manufacturers will be required to ramp up production dramatically when the orders start flowing in. Innovative and timely financing of capex and working capital requirements will be critical to the success of these companies," she adds.

 Companies like Mico, Bharat Forge, Sundram Fasteners and Motherson Sumi Systems have already built an export base and established themselves as regular sourcing partners with a number of OEMs and Tier I suppliers.

 "These companies are four to six years ahead of the rest and are already beneficiaries of big-ticket orders. Therefore, their stocks would typically trade at higher valuations than the rest, as they have been through the learning curve and have upgraded themselves to the level of global suppliers," she adds.

 However there is hope for others. "Companies like Sundaram Clayton, Rico, Amforge and Omax are currently in the stage of getting approvals or are submitting pilot orders. These companies, though on the right track, will still take at least two years before big-ticket orders start flowing in," Bhatia adds.

 According to her, as the visibility of exports is still crystallising, these companies would typically trade at a discount to the likes of big firms like Mico, Bharat Forge, Sundram Fasteners and Motherson Sumi. Jagnani suggests Ucal Fuel Systems, Rico Auto and FAG Bearings as his top picks.

 According to Sachin Kasera, analyst with Mumbai-based securities firm Pioneer Intermediaries, the outlook is definitely positive in the longer-term. "There may not be many great upsides in the short-term but all scrips in the sector look good over the long-term," he says.

 Autos Vs auto ancillaries

 Keeping in mind the relatively lower valuations compared to auto manufacturing companies like Maruti, Telco, M&M and Ashok Leyland, an exposure to the auto ancillary segment could provide investors with an opportunity to enter the auto sector at cheaper prices.

 When you consider that most Indian vehicle manufacturers source predominantly from their local ancillary counterparts, it stands to reason that their growth paths are also interlinked.

 Since larger companies like Bharat Forge and Sundaram Clayton already have high valuations, analysts reason that the real opportunity lies in scrips like Amforge, Motherson Sumi and Omax Auto.

 For all the emphasis on exports, it is still domestic demand that is driving the ancillary success story currently.

 "Exports still constitute only a small part of the overall business for many of the auto ancillary companies. However, going forward, these companies can derive a double benefit from both exports as well as the domestic market. This marks them out as better opportunities for those seeking an exposure to the auto sector as compared to vehicle manufacturers," notes Sachin Kasera, analyst with Mumbai-based securities firm Pioneer Intermediaries.

 Valuations and projected growth both look better for now. While the auto sector and two-wheelers are expected to grow by 20 per cent and 15-18 per cent respectively, the auto ancillary segment is expected to grow in the region of 30-40 per cent.