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S. Muralidhar

AUTO sector stocks were the darlings of the market during the bull run of 2003-04. Investor interest in auto sector stocks was widespread and companies that were even remotely associated with the automobile industry hit new highs, riding a wave of interest during the year.

Despite growth in the industry being spread across all the segments, including passenger cars, two-wheelers, commercial vehicles and components (which, in turn, led to a rediscovery of hidden value in these stocks), investor fancy was for vehicle manufacturers.

But are the long-term prospects for passenger vehicle companies good? Can the performance of 2003-04 be sustained and will growth in the sector further improve valuations in the next five years? Has the price correction in auto industry stocks improved their attractiveness, particularly those of passenger vehicle manufacturers?

During the past two months, the uncertainty surrounding the new Government's policies has whittled down the valuations of auto stocks. While this followed the overall downward trend of the market, a return to peak valuations will depend on the outlook for the next few years.

Unlike the two-wheeler segment, whose growth momentum will be sustained simply because it addresses the needs of a much larger section of the population, the sales of passenger car and utility vehicle manufacturers are prone to fluctuations due to diverse factors.

So, while the growth potential for the top three two-wheeler manufacturers is less likely to change dramatically, the prospects for passenger car manufacturers can swing either way in the short term.

Challenges for 2004-05

The reason for the spurt in investment interest in auto stocks in 2003-04 was quite obvious . After years of teetering growth, punctuated by periods of surge, passenger vehicle sales (including exports) crossed the one-million-unit mark and exports of auto components went past the historic $1-billion level for the first time.

Despite the searing growth of about 30 per cent last year, passenger car and utility vehicle manufacturers may face a few challenges this year that could affect the growth rates.

From the manufacturer's perspective, the challenges will be two-pronged: One will be related to costs and operational efficiencies, and the other to sustaining the demand growth among customers.

From the point of view of costs, the single biggest worry for vehicle manufacturers this year too will be the cost of sheet metal used for car body panels. Though steel prices are not expected to go up this year, their stagnation at current levels will be enough to keep input costs high for vehicle-makers.

A rise in freight costs in line with an increase in fuel prices will also make a dent in manufacturers' profitability. The other big increase in costs is likely to come from car manufacturers increasingly resorting to discounting and `incentivising' vehicle sales.

Discounting is also likely to increase in its indirect form, where the manufacturer part subsidises the free add-ons or accessories given to the customer or partakes in the lower interest rates offered by the bank for financing the car purchase. This practice, called `subvention', is expected to increase even further this year, since manufacturers will be trying to push demand for their existing products, which have already lost their novelty value in the market. No new models in the key volumes-driven, small car market are expected from the two listed car manufacturers, Maruti Udyog (MUL) and Tata Motors.

From the point of view of sustaining demand growth among customers, manufacturers will face the key challenge of affordability. Affordability is likely to be affected by the projected increase in fuel prices.

Further, two other indirect reasons why this parameter could become less attractive are that interest rates for financing cars are unlikely to go down any further this year.

If at all, the lower financing rates can only be offered through subventions that the manufacturer, dealer and financier trio will have to contribute towards.

Another factor that will affect the affordability parameter will be the lack of an incentive in the form of a cut in excise duties.

The previous two cuts in excise duties, which brought it down to the current 24 per cent, have been nearly erased by the price hikes that car manufacturers effected over the last two years.

Of course, boosting car sales through a cut in duties can only be a temporary phenomenon. But even that may not be available this year, given the pro-poor disposition of the new Government at the Centre.

A study by the National Council for Applied Economic Research (NCAER) in 2001-02 found that the price elasticity of demand for passenger cars was a high 1.8 units.

This meant that for a percentage point reduction in the sticker price of a car, there would be a more than commensurate 1.8 percentage point increase in the demand for the vehicle. So, kick-starting demand in the passenger car segment through a cut in duties is very effective in the short term.

Outlook

At the turn of the millennium, the passenger car industry was saddled with excess unused production capacity that equalled the actual annual production volume. At about 13.5 lakh cars per annum, the industry's capacity was about double the 6.9 lakh passenger vehicles produced in 2000-01.

However, the rapid growth in demand in the domestic and export markets has, in just four years, changed the situation to one where many of the leading passenger vehicle manufacturers are looking at a second round of expansion in production capacities to cater to future demand growth.

The NCAER study on passenger cars and utility vehicles also projected the size of the industry to more than double by the year 2011-12 from 2002-03 levels.

From about 7.43 lakh vehicles in 2002-03, the demand for cars and multi-utility vehicles was projected to reach about 15 lakh vehicles by 2011-12.

After the 2003-04 sales of 9 lakh vehicles in the domestic market, this projected target for 2011-12 is likely to be surpassed earlier than previously estimated.

The growth in demand for passenger vehicles in the next two years will determine the future course of the industry.

However, the 27.4 per cent growth in sales of cars and utility vehicles during 2003-04 will be difficult to replicate for the industry during the current fiscal, partly also because the industry's size, at a million vehicles, has now reached a critical position.

As a result. the growth expectations for sales volumes in the domestic market will have to be tempered down for the next two years. However, with India's emergence as a destination for manufacture of quality sub-compact (small) cars, there is a strong likelihood of exports growing at a faster clip than domestic demand.

Overall, the industry seems set to witness a doubling of production volumes during the next six years to over two million vehicles by 2010-11. That translates into a compounded annual growth rate of just over 12 per cent.

This figure will be easily achievable if the two large listed car manufacturers — MUL and Tata Motors — aggressively push through their plans for new vehicles in the entry-level/small-car segment.

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