Changing Gears

With the auto sector headed for slower growth in FY08, investors may need to reassess their auto portfolio.

"Its tough as an auto analyst to fight the massive negative sentiment surrounding auto stocks today," exclaims Mahantesh Sabarad, senior research analyst, Prabhudas Lilladher, adding, "you have to be at your best to placate anxious and harried investors who are perplexed about the present situation."

And yet, Sabarad is not alone in the analyst fraternity which has had to virtually sweat it out to try and make a coherent whole of the auto puzzle. Across the spectrum auto stocks have in the past four months bled and bled hard. Since the beginning of this year, the BSE Auto index has severely underperformed the Sensex.

While the bellwether index has fallen by 2.3 per cent, the auto index has collapsed over 15.6 per cent. Auto bigwigs including Maruti (-20 per cent), Tata Motors (-23.3 per cent), Bajaj Auto (-10.9), Hero Honda (-16.5) have been battered to an extent one would hardly expect frontline scrips to experience. And while margin pressures have been the constant bugbear of the sector, newer concerns have arisen at present.

First, the rising interest rate scenario is not really comforting. Just in the past four months prime lending rates of banks have risen by over 200 basis points to 15 per cent at present. About 75 per cent of car sales and 60 per cent of two wheelers are presently financed by loans.

Moreover as Hitesh Kuvelkar, associate director of research, First Global, puts it, "The problem is especially compounded in the case of two wheelers where a significant portion of the loans are through non-institutional sources where rates are significantly higher than what the the institutional lenders offer."

Adding fuel to fire has been the tepid March sales. In the month of March, while domestic passenger car sales were up by a measly 2.9 per cent y-o-y, two wheelers actually declined to about 643,900 from 647,200 an year ago, according to data provided by SIAM.

And commercial vehicles (CVs) known for their scorching growth of 36 per cent in the first eleven months of FY07 grew significantly slower at 13 per cent y-o-y in the month of March. So, given the pall of gloom surrounding the sector, would auto stocks remain an unattractive investment proposition?

"Not really, but definitely the time horizon for investing in auto stocks has changed," opines Amitabh Chakraborty, president (equities) Religare Securities, adding, "Investors investing in auto stocks have to take a 9-12 month perspective at the least depending on the stock they are investing in."

And while the time horizon may have changed, the massive correction in the auto scrips witnessed in recent times has also brought with it a few positives.

As Sabarad puts it, "Sector outlook and valuations are the two key fundamentals for any investing decision. While the outlook is quite negative at present, the valuations are indeed attractive."

At the same time those comforted by cosy brokerage reports of booming demand prospects due to the disposable income growth and rosy pictures of car launches need to perhaps take notice of the changing dynamics of auto investing.

According to analysts, the rough period for the auto sector may continue for at least another few months.

As Ambrish Mishra, research analyst, Man Financial Services, puts it, "Given the uncertainty surrounding the degree of the impact of the interest rate hike, it would be prudent for investors to go in for a cautious accumulation of select stocks in the next few months."

So if selective accumulation is the key, then what could be the parameters for investing in auto stocks at present?

Bigger is better
Most analysts concur that the outlook for four wheeler is better than two wheelers. For example, the decline in March sales for two wheelers came after a tepid growth of 6 per cent in February.

As a Hero Honda spokesperson puts it, "No doubt, after the good festive season in Q3 there has been a slowdown in the past few months with the uncertainty regarding the rising interest rates and consequent postponment of purchases by consumers."

However, some analysts infer much deeper problems. For example as Viren Bajalia, research analyst, IDBI Capital says, "The two-wheeler manufacturers are witnessing a huge mismatch in terms of their retail sales and their despatch sales. The inventory levels in the two-wheeler industry have been on a rise in the past few months. The industry is carrying inventory levels of about 45 days against the normal 12-15 days."

Combined with the rising interest rates, a rising inventory level does not provide much comfort. On top of this, is the massive margin pressure witnessed by two wheeler companies in the past fiscal due to rising input costs (steel, aluminium) and higher sales expenses due to fierce competition.

In the first nine months of FY07, for example, the top three players namely Hero Honda, Bajaj Auto and TVS Motor have faced a massive erosion in their operating profit margins to the order of around 170-300 basis points.

While rising input costs have been a crucial factor "� steel prices have increased by 21 per cent in 2006 while aluminium prices have risen 17 per cent in the same period "� a major element of this pressure has come from the sales expenses and aggressive product pricing.

As Umesh Karne, senior research analyst, Emkay Shares and stock brokers says, "Aggressive discounts have meant a closing in the pricing differential between the economy and mid-size segment."

While this hasn't meant great news on the margin front given the less than 10 per cent operating margin on economy bikes, the closing price differential in the mid sized bikes implying higher costs would thus imply margin pressures.

Some analysts also see challenges for the premium segment of the motorcycle market at present.As Bajalia puts it, "The phenomenal growth of the second hand car market is a possible threat to the premium bikes."

The secondhand car market which grew about 20 per cent in FY07 is estimated to grow about 20-25 per cent in the next two years. Moreover with Tata's one lakh car set to roll out in 2008, and car makers making aggressive marketing bids, further challenges await the premium bike segment.

Overall most analysts estimate a slowdown in the domestic sales of two wheelers from the current 11.5 per cent to about 8-10 per cent at best with some conservative estimates even pegging the rate at about five per cent.

"As growth slows, it is obvious that we may enter a period of consolidation, where the weaker players would get left out and only the top players by volume may remain," says Karne.

But despite the various pressures facing the two wheeler space, some analysts are still keeping faith.

"The prevalent sentiment is in many ways an overreaction. There is little change in the fundamental growth story of companies like Bajaj Auto with its strong product development capabilities or a Hero Honda with its massive volume play and dominant presence in the executive segment," opines an analyst.

Many other analysts feel that investors may also look at the value and extent of companies' interest in non-core business which may cushion the impact of any pressures in the primary domain.

"For example Bajaj Auto's insurance business holds a tremendous potential for value unlocking," says Religare's Chakraborty.

Another upside remains the tax exemptions of the bikes rolling out from the tax free zones which could give some breathing space to two wheeler companies. But overall as Mishra puts it, "There is little doubt that at least the next one or two quarters would be very challenging to two wheeler companies." 
 

BUY OR NOT TO BUY?
	EPS		P/E		Annual return (%)
	FY08E	FY09E	FY08E	FY09E
Bajaj Auto	147.00	174.00	16.60	14.00	-21.00
TVS	4.90	5.20	11.60	11.00	-64.00
Hero Honda	53.00	60.00	12.30	10.80	-25.00
Maruti Udyog	62.00	72.00	12.50	10.80	-11.00
Tata Motors	58.00	68.00	12.40	10.60	-22.00
Ashok Leyland	3.40	4.00	11.00	9.40	-11.00
Mahindra and Mahindra	61.00	73.90	12.20	10.00	16.00
Source: Analysts Estimates

The car story...
Talk about margin pressures and the story can be told all over again for the passenger car space. Other than the usual culprits "� rising raw material and tyre prices "� sales and marketing expenses have been increasing too. And the outlook on this front is quite mixed.

While steel prices are expected to be firm at least for another two quarters, aluminium prices could show a slight softening only in the medium term. On the other hand the flurry of new entrants in the A2 segment (comprising 63 per cent of the car market) or compact cars, the latest being GM's Spark could intensify aggressive price competition thus putting further pressure on margins.

"A key parameter to invest in difficult times would be to assess the pricing power of a company. And pricing power is in turn linked to a mixture of factors like the extent of market dominance and the ability to sustain margins even during trying times," says Chakraborty.

Bajalia adds, "A key element complementing pricing power would be a diverse presence where a virtual dominance in a certain segment could cushion the fierce competition in another."

And if diversification and margin sustenance were any indications, then it would be hard to skip Mahindra and Mahindra. In the first nine months of FY07, M&M turned out to be the best financial performer on the profit margin front with its operating margins actually increasing 130 basis points to 13 per cent.

And with its recent acquisition of Punjab Tractors, the company with a 43 per cent national market share and resurgent presence in the northern markets, has really left the other players streets behind.

"Other than the various cost efficiency measures undertaken, M&M's strong volume growth in the utility vehicle (UV) space is complemented by the clout it enjoys in the tractor market," says an analyst from a domestic broking firm.

And the UV segment has truly been the saving grace for the tepid March story. While car sales were reduced to mere single digits during the month, UVs were the best performers growing at 17 per cent. This puts M&M with a nearly 41 per cent market share in UVs on a strong wicket.

"Moreover M&M's strategy of diversifying aggressively into virtually every segment of the auto space backed by a emerging auto component business should help the company tide over the challenges facing the sector," says an analyst.

While the recent launch of the Logan through the JV with Renault is a step in this direction, some analysts feel that in the near term the company may face margin pressures given the aggressive pricing and the over 50 per cent imported components going into the car currently. While Tata's own sedan with a higher level of indigenisation enjoys a net margins of around 5-8 per cent, it is interesting to see how the Logan would do better. But many others disagree.

As Emkay's Karne puts it, "The hallmark of Mahindra's foray into both the passenger car and later the medium and heavy commercial vehicle space has been its leveraging its strong distribution network with international brands like Renault or Navistar (MHCVs)."

Talk of dominance and the one player that comes to your mind is Maruti with its mammoth 48 per cent market share in the domestic car market and its breadth of product offerings.

But analysts are divided over taking a call on the stock right now. As Sabarad puts it, "With increased competition in its cash cow, the compact car or A2 segment, Maruti is bound to face the heat of competition."

Other concerns besides the rising interest rates also emanate from the higher royalty burden from sourcing crucial components for newer models like Swift diesel and Zen Estilo which should remain at about 2-3 per cent of sales in the near term.

Maruti's older versions of Zen did not entail any royalty payment. Recent times have also seen a massive increase in sales and advertising expenditure. But while margin pressure may be entailed in the next two-three quarters, Maruti has also shown an increased dynamism by eyeing areas of future growth.

For example, with its Swift diesel it has entered the diesel segment which comprises about 27 per cent of the car market today and is estimated to increase to 35 per cent by 2010. But boosting its flagging sales in the A3 segment will remain a key challenge.

Some analysts look at the stock from a different angle. Mishra opines, "One of the key rationale to consider investing into stocks like Maruti in the present circumstances is that the correction in stock prices have made them a value play, without any significant threat to the fundamental growth prospects in the medium to long term." 
 

FEELING THE HEAT
March sales (units)	FY07	FY06	% chg
Two wheelers	643857.00	647182.00	-0.51
Commercial vehicles	49245.00	43502.00	13.20
Passenger cars	114195.00	110978.00	2.90
Utility Vehicles	27218.00	23255.00	17.04
Source: SIAM

Too much load...
After a phenomenal year of nearly 35 per cent growth, most analysts expect growth to moderate down to around 12-13 per cent in the commercial vehicle segment in FY08.

Some indications of a slowdown can be seen from March figures when CVs grew by a tepid 13 per cent y-o-y as against 26 per cent growth y-o-y in February and a whopping 36 per cent for the first eleven months of the year.

"Going ahead growth should remain strong in key pockets like tippers linked to the construction industry and trailers linked to segmental shift towards higher tonnage vehicles that we are witnessing," says K Sridharan,CFO, Ashok Leyland.

Though sales growth may be modest, the shift in demand towards high tonnage trucks should help companies hold up profitability somewhat.

Analysts estimate that while the operating margins on a 16 MT HCV would be around 5.3 per cent, that of 25 MT and 35 MT about 15 per cent and 18.5 per cent respectively.

Last fiscal, the proportion of over 16 tonnage trucks (including haulage, tractor trailer and rigid) to total sales saw a massive jump to 45 per cent, up from 29 per cent in FY06.

The shift towards multi-axle, trailer and haulage trucks could become profitable for commercial vehicle makers. While both Ashok Leyland and Tata Motors would benefit from the above trend, Tata Motors' Daewoo association through its South Korean subsidiary is a definite positive for the company in terms of product portfolio.

The bigger picture does not look rosy for CV makers. While there are demand drivers like shortening replacement cycle, strong GDP growth, the segment could face tough times once the effect of the overloading ban slowly starts tapering off. Interest rate hikes could also have a major impact.

As Bajalia says, "The hardening of interest rates have led to an rise in the cost of ownership of a CV by over 40 percent. In fact the truckers are planning to increase freight rates by 10-15 percent to offset the rising cost of buying commercial vehicles due to hardening interest rates."

And competition looms around the horizon too. While the Mahindra-ITEC M&HCV trucks are all set to roll out this year, new entrants like Asia MotorWorks are trying to tap the higher tonnage segment to.

"And ultimately its really hard to keep up with the 30 per cent growth due to the simple logic of base effect," says an analyst. 
 

MARGIN MATTERS
OPM (%)	9mFY07	9mFY06
Bajaj Auto	15.14	16.90
TVS Motors	4.30	6.50
Hero Honda	12.50	15.56
Maruti Udyog	14.14	13.04
Tata Motors	12.64	12.67
M&M	13.00	11.70
Ashok Leyland	8.90	9.14

The valuation tangle
M&M's valuations at about 12.2 times estimated FY08 earnings remain in line with other frontline four wheeler heavy weights like Tata Motors and Maruti..

However In the entire auto space, M&M has been the best performer at the bourses in the past one year, rising about 16.4 per cent outpacing the auto index which actually fell 11.1 per cent or other four wheelers which are down by about 11-22 per cent.

While TVS valuations at 11 times FY08 appear attractive, its low margins at about four per cent (9 months fiscal 07) and doubts on its ability to sustain these going forward makes it risky. The TVS share have fallen 64 per cent over the past year reflecting the pessimism around the stock.

On the other hand, Bajaj has been able to hold up reasonably well falling the least (21 per cent vs 25-64 per cent), and despite its premium valuation of 16.6 times FY08 earnings, most analysts concur that it remains the best bet among two wheelers, though the sector outlook itself doesn't look great.

M&M is the most preferred stock while some analysts have a buy on Maruti too. Thanks to its strong franchise and its product line up, Maruti should also be in a position to hold its turf better.