Some of the parts

SPECIAL FEATURE

Investing in auto component stocks goes much beyond conventional techniques of valuations.

At first sight, the auto-component sector resembles nothing short of a complex jigsaw puzzle. With over 80 listed companies producing everything from car air-conditioners to connecting rods, the diversity of lines of business is rarely matched elsewhere in the manufacturing space.

"Herein lies the key to investing in the auto components sector, " opines Ambrish Mishra, research analyst, Man Financial Services adding, "The best strategy would be selective-buying based on an understanding of the business and the product opportunities at the right price and reasonable valuations."

And while 'selective investments' may be the operating term, the potential rewards are lucrative too.

Given the benign demand environment as evidenced by the ongoing automobile boom in the domestic arena and increased outsourcing opportunities from global behemoths, investors may well strike a potential goldmine in the sector.

Deceleration in stock prices
There is little doubt that the auto component companies are passing through a rough patch at present. Of 14 prominent stocks, no less than five have been losing value over the past year and six other companies that have positive returns, have underperformed the Sensex. And the bad news doesn't end here.

While car and two-wheeler makers are facing the heat in a fiercely competitive environment, the high raw material proportion to sales hovering at around 60-70 per cent doesn't add comfort either.

Even the much touted outsourcing opportunities have a few flipsides. As Umesh Karne, senior research analyst, Emkay Shares and Stock Brokers, puts it, "As the Global OEMs and Tier-I suppliers get more acquainted with domestic conditions, we can expect the negotiating leverage of Indian companies to get weaker."

But there is no need to despair. "The key to investing lies in identifying those companies which will exhibit enough volume growth to more than compensate the various margin pressures," says an analyst for a domestic broking firm.

And most analysts concur, that while capacity, visibility and product opportunities would be key here; scalability of opportunities would also be important.

"Moreover, how an auto component company has managed to sustain margins under trying times in the past would also tell quite a lot about the efficiency of operations and the cost cutting measures undertaken," says Kishan Gupta, research analyst, SKP Securities.

In short, rather than relying solely on conventional financial valuations, understanding the demand environment as also the extent of value addition, the degree of monopoly power, niche segment presence and entry barriers to technology become crucial.

"For example, other than specialised products, components used in critical parts like engines, gears, etc have higher margins, "explains Mishra.

The niche players
Topping the chart of one-year returns is Subros Ltd which returned no less than 39 per cent. This leading manufacturer of automotive air conditioning systems has a 43 per cent share in the domestic market.

"We are the only completely integrated player in the domestic arena," quips Virendra Kumar, vice-president, corporate affairs and company secretary, Subros, "Add to this, the synergies from our technical collaboration with Denso Corporation, Japan and our existing strong R&D base."

With two top car makers, Maruti Udyog and Tata Motors as its clients, Subros looks all set to ride the domestic boom in the passenger vehicle market. This segment is expected to grow at about 13-14 per cent in the next three years, with a Frost and Sullivan report even estimating it to cross the 2 million mark in 2010.

And while these two OEMs comprise up to 96 per cent of its sales, Subros has been making efforts to expand both its client and product base. It is all set to supply 50,000 units for M&M's newer models.

"We are also keenly focusing on the commercial vehicle AC market which we believe has the potential to be a future growth driver," adds Kumar.

While the company's margins at 11.3 per cent may seem unimpressive at first glance, it has shown increasing ability to sustain margins even in trying conditions. In the first nine months of FY07, while its key customers faced increasing margin pressure, Subros has actually seen its margins improve by 260 basis points.

"This was largely in part due to the in-house development of critical components like heat exchangers, compressors, etc which have to an extent mitigated the rise in input costs and given it a competitive advantage," opines Gupta.

While relatively higher entry barriers related to the cost of operations restrict the threat of competition; the valuations of the company also seem attractive at about 7.7 times FY08 earnings.

MICO Bosch is another company with strong growth prospects. "MICO's valuations are no doubt on the higher side at about 19 times CY07 earnings", says an analyst, "but these have to be understood in the backdrop of the near monopoly status enjoyed in its core business."

MICO is at present the largest manufacturer of diesel fuel injection equipment with an 80 per cent market share. It also has a 65 per cent market share in spark plugs. MICO's key industries - commercial vehicles and tractors are doing well registering a growth of 34 per cent in the first eleven months this fiscal.

The segment is also expected to grow at 16-17 per cent in the next two years. So all the demand drivers appear to be in place. Moreover the company has invested heavily in developing an indigenous common rail system technology which is expected to hold it in good stead.

According to some estimates, CRS will occupy 50-60 per cent of the diesel engine market in the next three-four years. The comfortable debt-equity ratio at 0.11 (FY06), the lowest among its peers would cushion its massive capex plans of Rs 1400 crore till 2008.

However, operating margins have been curtailed due to higher raw material costs and changes in regulatory norms for CVs which has resulted in a shift to distributor pumps from in-line pumps with higher import content.

The tepid growth in the aftermarket and its labour troubles have also been concerns in the past. But overall, with a strong technological backing and the ramp-up in capacity, the company looks all set to take advantage of the strong demand environment in its niche segment.

Another company which could benefit from the diesel boom especially as more diesel cars are sold is Federal Mogul Goetze. The diesel segment which comprises about 27 per cent of the car market is expected to reach the 35 per cent mark by 2010.

"This was a company which was suffering losses till Q1 CY06 and has a debt-equity ratio of over 3 --surely unattractive from the strictly financial angle," says an analyst from a domestic broking firm adding, "but look deeper and you find the fundamental growth potential."

As Emkay's Karne opines, "A good networking with OEMs and focus on critical piston technology are strong positives for the company," Federal Mogul Goetze (FMGI) is the leading supplier of pistons and piston rings to OEMs across vehicle segments, and is the 100 per cent supplier to Maruti for the Swift diesel variant.

These are critical components used in automobile engines. While the company (formerly Goetze India) has witnessed a turnaround since being taken over by global ancillary maker Federal Mogul and has posted an impressive 14.2 per cent operating profit margins in Q3 CY06, as compared with 9.1 per cent in Q2.

Other than the benign domestic environment, FMGI would also be a chief beneficiary of the outsourcing opportunity. Its parent, Federal Mogul (which holds 50.1 per cent stake) has plans to shift no less than ten production lines to its Indian subsidiaries plant at Patiala.

Consequently, analysts estimate exports of FMGI to increase by over 10 times from Rs 15 crore in 2006 to Rs 150 crore in 2008. 
 

THE AUTO COMPONENT STORY
Company	Yearly returns	Performance as compared to the sensex	P/E FY07	P/E FY08
Bharat Forge	-27.60%	Losing investment	23.80	18.50
Amtek Auto	14.40%	Underperformed by 120 bps	15.90	12.70
Subros ltd	39.00%	Overperformed by 2340 bps	9.80	7.80
MICO*	9.70%	Underperformed by 590 bps	21.80*	19.90*
Sona Koya	1.45%	Underperformed by 1415 bps	19.70	14.00
Clutch Auto	-33.00%	Losing investment	7.70	6.70
Motherson Sumi	4.30%	Underperformed by 1130 bps	21.20	15.90
Amtek India	14.70%	Underperformed by 90 bps	15.80	11.70
Rico Auto industries	-38.80%	Losing investment	13.60	11.10
Omax Auto	-34.60%	Losing investment	7.15	6.30
NRB bearings	1.80%	Underperformed by 1380 bps	11.40	8.90
Federal Mogul Goetze	25.90%	Overperformed by 1030 bps	14.90	11.60
Ramkrishna Forgings	-12.00%	Losing investment	9.70	6.20
Ahmadnagar Forgings	17.60%	Overperformed by 200 bps	8.20	5.70
Source: Bloomberg , Capitalline For MICO estimates are based on the year ending December (CY06 and CY07)

The outsourcing boom
While Federal Mogul's outsourcing will gather pace over the next two years, many other companies are already cashing in.

According to some estimates, Indian auto components exports will grow at over 30 per cent a year till 2015. In this, the forgings and castings space is set to be the greatest beneficiary, with exports estimated to expand by about 35 plus per cent in the next few years.

As AK Syal, director-marketing, Amtek Group puts it, "The opportunity is tremendous for companies in the forgings and castings arena as they produce those components which are not only crucial to the global automotive industry but also amenable to relatively higher cost pressures. Hence a low-cost yet high skill-based country like India comes into focus."

It takes no prizes for guessing that at the forefront of the outsourcing boom would be industry behemoths like Bharat Forge and Amtek Auto with their global scale and reach.

While the former has taken a hit in its consolidated margins, due to laggardly performance of it subsidiaries abroad, its dual offshoring model gives it a strong positioning in terms of leveraging scale, costs and reach. Here its subsidiaries are serving both as an overseas front-end for clients as also a customer for its domestic facilities.

While Amtek Auto too has a strong positioning overseas with six subsidiaries across Europe and the US, the other two listed companies of the Amtek group - Amtek Industries and Ahmednagar Forgings - would also benefit.

As Amtek's Syal puts it, "We take an integrated approach while negotiating international deals; positioning ourselves on a range of capabilities from small forged components to complex sub-assemblies and modules."

Moreover Amtek Auto's subsidiaries could themselves boost the two other companies. As SKP's Gupta puts it, "The interesting fact is that at least 30 per cent of Ahmednagar Forgings' exports in the next two years are to be sourced to a group company, GVK UK, which also happens to be Amtek Auto's subsidiary."

Besides the outsourcing opportunity, both Amtek India and Ahmednagar Forgings are also scaling up their capacities.

Amtek India is in the midst of a capex plan that would nearly quadruple its castings capacity to 120,000 tonne per year in FY08 and has approached the market twice in the past 18 months for this purpose. However, the relatively high debt-equity ratio at 1.9 times FY06 needs to be keenly watched.

Ahmednagar Forgings has reported strong financial performance in the last three years with its top line increasing by an annual growth of 56 per cent; while its bottom line rose by about 116 per cent.

Moreover, the company is also ramping up its capacity to 180,000 tonne a year by FY08 from 124,000 tonne at present which would consolidate its position as the largest manufacturer in small and medium component segment.

While operating margins have shown an improvement of 70 basis points, the increasing share of raw materials to total sales is a matter of concern. This proportion has increased from 48.5 per cent in FY03 to 63.41 per cent in FY06 as metal prices have gone up in the period.

Also, its capacity utilisation is just about 50-60 per cent. Besides these dark spots, Ahmadnagar Forgings does appear to have a scalable business model. Amtek India and Ahmednagar Forgings have attractive P/E multiples of 11.1 and 5.7 times FY08 earnings respectively.

The road ahead
So where does all this leave us? Investing in the auto-ancillary space has much to do with understanding the diversity in the business of the different companies. While valuations and financial statistics do help, they may in themselves not tell much.

Investing in companies specialising in products with a lesser extent of value addition like sheet metals, small components, raw forgings, etc may make good valuation sense, but may suffer due to the lesser pricing power and consequently greater margin pressure.

"Pricing power comes from a combination of technological, entry barriers and the competitive positioning of the company," opines an analyst. And there may be some extremely small companies which may be worth watching if not investing right away.

"For example, Ramkrishna Forgings has been growing at a CAGR of over 73 per cent between FY04 and FY06 and appears to have the elements of a scalable model," opines an analyst. But given the small scale of operations, investors would be best advised to watch the company's performance in the coming few quarters.

Overall , investing in certain auto-parts scrips may turn out to be a good investment. And a sum of parts could well make a lucrative whole.