Big Story. The auto sector is turning around, stocks to buy

The fortunes of the auto sector turned upside down last year. Back until the first half of last fiscal (April-September 2018), the sector was cruising, having convincingly recovered from the bumps due to the note ban and GST transition. New vehicle sales grew by 14.2 per cent overall in 2017-18 (over 2016-17), more than double the 6.8 per cent growth in 2016-17 (over 2015-16). The good run continued into April-September 2018, with overall auto sales growing by 10.07 per cent in this period. Economic recovery, an uptick in rural demand and improved urban consumption have aided the sector’s growth.

One year down the line, the scenario has changed completely. After a good first half, domestic sales volumes slowed in the second half of last fiscal (October 2018-March 2019) to close 2018-19 with a mere 4.86 per cent growth. In the first six months of this fiscal, (April-September 2019) new vehicle sales volumes plunged 17.08 per cent. Considering the bleak scenario, auto and auto component stocks have taken a sharp knock, with many stocks even halving their values in the last year.

What’s in store for the sector? Given that the stocks are beaten down, is it a good time to accumulate auto and auto component stocks?

Speed breakers

Post the good run in the April-June quarter of 2018, patchy monsoon and crash in farm prices dented rural sales. Rural demand — which was growing at a faster rate than urban — slowed, affecting car and two-wheeler sales. Commercial vehicle sales began feeling the heat due to, one, quicker turnaround times after GST and, two, the permission to carry higher loads for existing vehicles.

Problems in financing vehicle buys and rise in vehicle prices added to the trouble. Following the defaults by IL&FS and its group entities on repayment of dues and the fraud that was unravelled, non-bank finance companies (NBFCs) ran short of liquidity as access to credit became difficult. Hence, onward lending to borrowers — both dealers and customers — was affected.

Increase in premiums on compulsory third-party cover became a dampener as well. The insurance regulator increased the mandatory third-party cover to three years for cars and five years for two-wheelers, thereby pushing up the upfront cost when buying a vehicle. Stricter safety norms also increased price of vehicles. For instance, anti-lock braking systems/combined braking system (ABS/CBS), air bags and reverse-parking sensors are compulsory for two-wheelers and/or cars from this year. Amidst these, apart from increase in road taxes in some states, new vehicle registration fee was also proposed to be hiked steeply (later deferred), from ₹50- 1,000 for two-wheelers and from ₹600- 5,000 for cars, for example.

It was the festival season of last year that proved to be the beginning of the downtrend. Dealers that usually load up on inventory to meet the festival season demand, saw limited offtake, and were left with piles of unsold stock, as dispatches from manufacturers continued in the hope of a revival. As per estimates of the Federation of Automobile Dealers Associations (FADA), by February 2019, inventory levels touched a peak 50-60 days for passenger vehicles, 80-90 days for two-wheelers and 45-50 days for commercial vehicles. This was a far cry from the ideal level of three weeks or 21 days inventory advocated by the body. It, hence, necessitated production cuts from manufacturers and retrenchment of labour to cut costs.

A look at the earnings growth of auto and auto component companies over the last five quarters makes the deterioration very clear. Adjusted profit growth (year-on-year) for these companies, which came in at 18.4 per cent in the quarter ended June 2018, deteriorated steadily to show a 50.6 per cent fall in the three months ended June 2019. Going by the results so far, this quarter is no better.

Improving sentiments

While the fall is probably the sharpest seen in recent times, the good news is that the slowdown could have bottomed out and may not get worse from here.

For one, the retail volumes — measured by the number of vehicles sold to the customer — is looking better than wholesale volumes, which are simply the number of vehicles sent to the dealers by the manufacturers. In the last few months, the Society of Indian Automobile Manufacturers (SIAM), which compiles the wholesale numbers every month, has also been releasing retail volumes, as per vehicle registration numbers on the Centre’s ‘Vahan’ dashboard. The data shows that the need for inventory correction brought down the wholesale volumes by 8- 23 per cent in each of the months since April 2019. However, the drop in retail sales has been lower. Better still, in September 2019, while wholesale volumes plunged 22 per cent, retail volumes actually grew by 6.5 per cent.

There are other ‘feel good’ factors too. Management commentary, post the September 2019 quarter results from companies such as Hero MotoCorp, Bajaj Auto, Maruti Suzuki and Tata Motors, indicate positivity about the festival season sales (retail). Companies have also been seeing increased footfalls after the suspense over GST rate cuts was done with. Given the sharp fall in sales in the last year, the auto industry was earlier clamouring for a GST rate cut to reduce the price of vehicles. In the GST Council meeting on September 20, the government decided against it.

Thirdly, companies expect rural demand to pick-up beginning the fourth quarter of 2019-20 or early next fiscal. Though there has been flooding in some parts of the country this year due the monsoon, the bountiful rains are expected to have a positive impact on rural demand. Companies such as Hero MotoCorp and TVS, which have good exposure to rural India, indicate that the expectations of better yield of kharif crop and higher winter crop sowing, will begin driving rural demand.

Thus, improved sentiments imply that sharp plunges in sales volumes are unlikely from here on, especially in the passenger vehicle and two-wheeler space. The higher proportion of financed purchases year-on-year, as indicated by companies in their recent earnings call, implies that liquidity conditions have eased up. This apart, the move to improve transmission of policy rate cuts to customers by introducing repo/external benchmark-linked loans and corporate tax cuts, which give room for companies to reduce prices, are some tailwinds for growth.

Spokes in the wheel

However, while it can safely be said that fall in auto sales is bottoming out, it may be too early to say the tide has turned completely. The impending transition to BS-VI emission norms mean that there could still be some flux. From April 1, 2020, only vehicles that are BS-VI-compliant can be sold in the country. Ideally, demand for BS-IV vehicles has to be healthy in the coming months, given that compliance with higher emission norms will increase the price of the vehicles from April 1, 2020; hence, customers would want to pre-buy. More so, with some diesel models that may not be available under BS-VI due to lack of economics. But at the same time, companies would want to scale down their production of BS-IV vehicles so that they don’t have BS-IV inventory on April 1, 2020. Thus, while companies strive to increase their BS-VI production as the fiscal draws to a close, customers may be wary of buying until the actual deadline arrives and/or BS-VI fuel becomes available. The changeover could thus become a tightrope walk for both manufacturers and customers and act as a dampener.

Secondly, commercial vehicles may take more time to turn around as freight demand continues to be weak. Data from the Indian Foundation for Transport Research and Training shows that average freight rates for a round trip on 11 trunk routes across the country dropped steadily in the past year — from around ₹1,13,000 per round trip, as on October 1, 2018, to ₹94,827 as on September 1, 2019.

While October rates did see a spike due to festival season as also a rise in fuel prices, it remains to be seen if it is sustainable. Besides, as per Crisil estimates, the relaxation of axle load norms has resulted in the increase in the freight capacity of the entire population of trucks operational in India by 20-25 per cent, equivalent to three years of incremental freight demand. Hence, unless investment and consumption legs of the economy heats up, new CV sales may not double up. Operators would add more trucks to their fleets only when demand for carriage of goods increases substantially.

What could give a leg up to CV sales though is the implementation of a scrappage scheme for vehicles over 20 years old from April 1, 2020, as envisioned. Fleet owners could be encouraged to replace old vehicles as they could get a wavier on GST and discounts from auto manufacturers, in addition to the scrap value of the vehicle.

Stocks to ride on

The troubles over the past year have seen auto and auto component stocks lose sheen. But many stocks have already begun moving up now, on expectations that the worst is over. If you are an investor with a perspective of at least a year, this may be a good time to hop on to the bus.

Pecking order

With passenger vehicle sales expected to look up earlier than commercial vehicles, Mahindra and Mahindra (M&M) and Hero MotoCorp are good bets at this juncture. The M&M stock has lost about 17 per cent in the past year and trades at a reasonable valuation of 16 times its trailing earnings (standalone). In comparison, Maruti Suzuki trades at an expensive 37 times. M&M’s focus on UVs (utility vehicles) is positive as, structurally, the Indian auto buyer is gravitating towards bigger cars and UVs.

At the industry level, UVs constituted 27 per cent of the total passenger vehicles sold in 2018-19, up from about 12 per cent in 2010-11. M&M has spruced up its UV portfolio through launches such as Marazzo and Alturas G4 in the mid- and premium segments and XUV 300 in the highly competitive compact segment. As outlook for rural demand improves, being the market leader in tractors also helps M&M.

Over the last year, thanks to the rural slowdown as well as stiff competition from peers such as Bajaj Auto, Hero’s volume market share in the commuter segment (75-110 cc bikes), where it is the market leader, has taken a beating. From 74.5 per cent in 2017-18, Hero’s market share came down to 72.3 per cent in 2018-19 and fell further to 69.7 per cent in the first half of this year. This dampened prospects for the stock. However, a rural recovery would benefit Hero MotoCorp.

Besides, having invested in Ather Energy for electric bikes, the company is also well-poised to take on Bajaj’s entry into this segment with the launch of the Chetak electric scooter recently. Ather brought out two e-scooters — the 340 and 450 — in 2018. From a valuation viewpoint, Hero MotoCorp looks an attractive bet. The stocks trades at 17 times its trailing earnings, cheaper than Bajaj Auto (20 times) and TVS Motors (36 times).

The turnaround to profitability at Jaguar Land Rover in the quarter ended September 2019 has been somewhat priced in with the Tata Motors stock moving up by over 35 per cent last week, after the results announcement. Uncertainties related to Brexit and the weak demand for luxury vehicles across the globe remain concerns. Besides, with a recovery in commercial vehicles sometime away, the domestic standalone business may not look up in the near to medium term.

Component picks

With auto sales slowing and the market beating down mid- and small-caps in the last year, many component stocks have dropped steeply in this period. CV suppliers have been battered the most with stocks such as Jamna Auto Industries, Setco Automotive, Z F Steering, losing 30-50 per cent in the last year. While bottom-fishing has seen some of these stocks move up in recent times, the upside may be limited until CV sales begin seeing some upswing.

Investors can consider other beaten-down stocks such as Lumax Industries. The stock supplies lighting components to passenger vehicles and is also available at a reasonable valuation of about 16 times its trailing earnings. Tyre and battery manufacturers, which have a sizeable portion of revenues coming from replacement demand, also make for good bets. With a full-fledged recovery in new vehicle sales some months away, the replacement demand for such components in vehicles already on road will keep it going for these companies. Among the stocks in this segment, Apollo Tyres and Exide Industries are attractive.

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