Winning formula for the auto sector

Auto majors were judged on five parameters to gauge which one can ride out the bumps and record higher growth.

After growing at a scorching pace of 26 per cent (inclusive of cars, bikes and commercial vehicles) in the last two years, the auto sector appears set for moderation. Macro-economic factors such as increasing interest rates, high inflation, and rising commodity prices pose a threat to this pace of growth.

The Society of Indian Automobile Manufacturers (SIAM) too expects industry growth to settle around a much lower 12-15 per cent in 2011-12. But this moderation may not lead to a slowdown, as in 2007-09, a period characterised more by global uncertainties, the liquidity crunch, pay-cuts and a fall in hiring.

Which auto stocks are well-placed to ride out the current challenges? The major listed auto companies were run through five filters, to check which can deliver better growth.

Being in the right segments

Traditionally, the impact of rising interest rates is felt first by the commercial vehicles sector. Higher interest rates may affect the pace of economic activity, which, in turn, brings down the freight availability for goods carriers. As a result, the ability of a fleet operator to utilise existing capacities fully or pass on cost increases to hirers goes down.

Though rising interest rates could curtail the capex cycle and pave the way for a moderation in economic growth, the slowdown this time round may be far less severe than the one witnessed in 2007-08. The strong growth in the services sector, robust hiring outlook and rising incomes may continue to support consumer demand for passenger vehicles.

This favours companies such as Maruti Suzuki, Bajaj Auto, Hero Honda or Mahindra and Mahindra (M&M) whose current pace of volume growth may continue for longer than, say, Ashok Leyland, which may feel the pinch more quickly.

Withstanding competition

However, both Maruti and Hero Honda, with dominant shares in their markets, are being challenged by competition. Faced with intense heat from launches such as Ford Figo, GM Beat and Nissan Micra, Maruti's market share in its core compact segment has progressively declined from 58 per cent in 2007-08 to about 55.5 per cent in 2010-11. The company has also not been able to make further inroads into the mid-size segment either, with its share remaining constant at 35 per cent over the last two years. This has clearly affected the company's pricing power.

Hero Honda too doesn't appear to be as solidly entrenched as it was during the previous slowdown, where its wide product portfolio and regular launches did the trick.

Bajaj Auto's strategy of launching products for a new ‘middle of the market segment' (based on differentiation of the Discover and Pulsar brands) and attractive pricing has eaten into the company's market share since the recovery in 2009. This has also prevented it from making price increases as aggressively as other players.

Again, in what was a high-growth year for the industry with two-wheeler volumes growing by 26 per cent in 2010-11, the company's volumes have grown by only 17 per cent. Hero Honda showed a drop in year-on-year profit growth for all four quarters of 2010-11. As volumes moderate and costs escalate further, the impact of the handicap on the bottom-line could become more pronounced.

Managing costs

With raw material costs constituting about 65-75 per cent of sales for most automakers, a company's ability to manage the unrelenting rise in prices of inputs such as steel, rubber and copper and deliver profit growth matters.

One way of mitigating this is through cost reduction efforts, which all companies invariably do. The other is through price increases, which automakers have resorted to several times in the last year or more. Going forward, with inflation continuing to rule high and interest rates beginning to pinch, every further price increase might become a gamble with demand.

This brings Tata Motors into the picture. If volume growth at Jaguar Land Rover continues the current way, the impact of high commodity prices on consolidated earnings (relevant post-JLR acquisition) could be less felt. For example, for the nine months ended December 2010, a healthy 16.5 per cent margin at JLR helped shore up consolidated margins to 15.2 per cent despite a 2.20 percentage point in standalone margins to 10.4 per cent.

Cost control notwithstanding, the margins at JLR are a function of the segment it caters to. JLR's focus on high-content, high-technology cars reduces its raw materials-to-sales proportion, in comparison to Indian manufacturers. Its consolidated raw material costs as a proportion to sales hover around 55 per cent, well below the industry average.

Back home, although all auto companies have been affected by input cost pressures in one way or the other, their product mix has helped M&M and Bajaj hold on to margins.

Winning product mix

M&M derives a good portion of its revenues from the sale of tractors, which enjoy superior margins, and provide the push to overall margins. Being a predominantly small-car player, this is where Maruti hits road-bumps, although the launch of the Kizashi and plans for MPVs show that the company might be able to enjoy higher operating profitability over the long-term.

Bajaj Auto too has been able to steadily maintain margins at 20 per cent. Its ability to hold on to profit margins stems from its strong brands in mid-to-premium motorcycles and its good hold on the three-wheelers market. It derives 11 per cent of its revenues from three-wheeler sales where margins are in excess of 30 per cent.

Also, about 28 per cent of Bajaj's revenues come from exports, where margins are higher than 20 per cent. Majoring in lower-margin commuter bikes, with no three-wheeler offerings and export restrictions until it recently parted ways with Honda, Hero Honda obviously scores poorly on this front.

The verdict

Thus a SWOT analsyis of auto majors on these parameters suggest that for investors with a two- to three-year perspective, Bajaj Auto, Mahindra and Mahindra and Tata Motors seem to be the good bets to hold on to. From a valuation perspective too, as per Bloomberg consensus earnings estimates for FY12, Bajaj at a PE of 12.5 times, M&M at 14.5 times, and Tata Motors (consolidated) at reasonable 7 times provide some room for appreciation, considering that they may out pace industry growth.

Business Line also has ‘buy' recommendations outstanding on all the above stocks. Hero Honda at 14.8 times, trades at a premium to Bajaj, which may not be justifiable. Although Maruti, at 13.5 times, trades close to the lower end of its historical PE band, it is not an ideal choice for the risk-averse investor.

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