All about investing in auto stocks

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

"It's 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 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 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 postponement 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 Rs1 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."

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