Despite the bellwether S&P BSE Sensex gaining about 13 per cent so far in 2018, the BSE mid-cap and small-cap indices have taken it on the chin. The former has dropped by about 9 per cent since January and the latter by a sharper 14 per cent. Most stocks in the auto component sector, which fall predominantly in the mid- and small-cap categories, have individually corrected sharply. With new vehicle sales upbeat, the prospects for the sector remain sanguine, and the fall presents a buying opportunity for long-term investors.

But given the global uncertainties from the trade war, the high crude oil prices and the challenging macro-economic scenario in the country, the fall may not be over. Also, with valuations still above the historical range for many, it is best to adopt a selective approach to stock-picking at this juncture.

Shedding weight

Barring intermittent corrections, auto component stocks have been on a roll since the rally in September 2013. While expectations of a pick-up in earnings growth buoyed the upswing initially, a cyclical upturn in domestic auto sales and improved consumption demand, after the demonetisation and GST transition, lifted the stocks up in the later years.

As a result, many stocks have turned multi-baggers over the last five years. One-fifth or 20 per cent of the 100-odd listed stocks in this space have moved up over 10 times, while another 60 per cent has more than doubled. The list of multi-baggers include well-known names in the industry such as Minda Industries, Sundram Fasteners, TVS Tyres, Jamna Auto Industries, CEAT, Lumax Industries, Suprajit Engineering, Gabriel India, Motherson Sumi, WABCO India and Bosch.

IPO stocks which joined the party late — Endurance Technologies (October 2016) and GNA Axles (September 2016) — did well too. With auto sales going up, earnings growth for many stocks inched up from fiscal 2015/2016 as well, leading to a PE re-rating in most stocks.

Given this scenario, with the market turning choppy this year, a course correction was bound to happen. At least half the stocks in the auto component space have lost between 10 and 40 per cent till date in 2018. Those that corrected were mainly stocks that had made dizzying gains and whose valuations had vaulted.

Take tyre-maker CEAT, for instance. The stock moved up from about ₹113 five years ago to ₹1,945 as on January 1, 2018. Its PE catapulted from less than five times in September 2013 to 28 times at the beginning of this year. The stock shed 28 per cent year-to-date and now trades at 17 times its trailing 12-month earning. Suprajit Engineering too trades at a reasonable consolidated PE multiple of 22 times now, after dropping over 30 per cent so far this year. The valuation of Gabriel India has now come down to 19 times, after a sharp correction this year. This stock has moved up by more than seven times over the last five years.

However, there have been outliers too. In tune with the bellwether index, large-cap stock Bosch gained 6.6 per cent in January-September 2018. Other large-caps such as Bharat Forge and MRF contained losses better, falling less than 10 per cent. Some of the bigger mid-caps such as Exide Industries gained 25 per cent this year, while Sundram Fasteners, which moved up 17 times over the last five years, gained 8 per cent since January.

Path ahead

The domestic auto sector has convincingly recovered from the challenges of the note ban, the BS IV 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 has continued this fiscal as well, with overall auto sales growing by 12.7 per cent in April-August 2018 over the same period last year. Economic recovery, an uptick in rural demand and improved urban consumption helped growth.

Commercial vehicle (CV) sales have been on a purple patch, growing much faster than the industry. In April-August 2018, CV sales volumes grew by a whopping 41 per cent year-on-year. Part of this high growth can be attributed to the low base from GST transition and the pre-buying before April 1, 2017, due to the switchover to BS IV emission norms. However, government investments in housing, road-building and allied infrastructure activities continue to have a beneficial effect on truck sales. The new axle norms, permitting higher loads for new and existing vehicles, are not expected to dampen demand for new vehicles sharply, as overloading is rampant in many pockets.

Like trucks, two-wheeler sales volumes too picked up in 2017-18, growing by a healthy 14.8 per cent, after a mid single-digit growth in the previous year. So far this year, two-wheeler sales volumes have grown by 11.5 per cent. Management commentary from companies indicate traction in demand from rural India as the main driver of growth in this space, apart from higher offtake of premium bikes from urban consumers. Good urban demand is seeing car and utility vehicle sales do well too, with this segment showing about 10 per cent growth in volumes so far this year.

This pick-up in the domestic industry is reflected in the results (standalone) of auto component companies. While aggregate sales of listed companies grew Y-o-Y by 6.2 per cent in 2016-17, they gained strength in 2017-18, with sales moving up by 15.8 per cent. Net profits too showed healthy growth in 2017-18, moving up by 7.2 per cent Y-o-Y, as against the 6 per cent drop in the previous fiscal. Into 2018-19, the run rate has been faster.

Thanks to the revival in demand and the low base of the June 2017 quarter due to GST transition, component makers recorded a 24 per cent growth in net sales and a 75 per cent growth in net profits in the three months ended June 2018.

Given that auto sales so far in 2018-19 too have been healthy, prospects seem sanguine for the auto component industry.

Speed breakers

However, all is not rosy and there may be some speed breakers. For one, crude oil prices have moved up from about $55 a barrel in the beginning of the year to about $80 now.

The sharp depreciation of the rupee against the dollar at this time is a double-whammy for fuel prices. With high running costs because of the increase in fuel pieces, truck fleet operators can postpone their vehicle purchases.

As high diesel and petrol prices pinch their pockets, consumers can postpone car and bike purchases as well.

Second, component makers such as those in the tyre and auto plastics segment, which use crude oil-based inputs, are already seeing margin pressures. The sharp fall in the rupee could also squeeze margins in the next two quarters for component players which import inputs. This apart, the RBI has begun hiking interest rates.

Considering that a softer interest rate regime has also triggered consumption demand, post the note ban and GST, costlier loans could begin hurting the sale of new vehicles, which could affect component makers as well.

On the positive side, for suppliers to international markets that have better growth prospects, such as the US and West East, the rupee depreciation is beneficial. Also, while component makers faced some margin pressures from rising cost of inputs over the last two quarters, this may ease. Thanks to the trade war, prices of many inputs used by the auto ancillary industry such as aluminium, copper and lead are either correcting or at the same levels as last year.

Over the medium term, implementation of the scrappage scheme for CVs older than 20 years and the upcoming transition to BS VI emission norms in April 2020 — which can result in pre-buying from the second half of 2019-20 — will support auto sales and, in turn, the component makers.

Given the multiple factors at play, it is not easy to second guess the future. But taking into account the recent corrections, investors can choose auto component stocks that have good long-term prospects and are reasonably valued.

Where to park your bets

 

The fall in mid- and small-cap stocks presents a good buying opportunity

  • Companies which are tier-I suppliers and, sometimes, market leaders, that have a diversified clientele and pricing power to pass on any cost increases, can be good bets at this juncture.
  • Making ride-control products such as shock absorbers, struts, cartridges, cabin/seat dampers and front forks, Gabriel India supplies to almost all segments of the auto industry. While two-wheelers bring in 57 per cent of the revenues, cars and commercial vehicles (CVs) chip in with 31 per cent and 12 per cent respectively.
  • Gabriel India has over 80 per cent market share in the supply of products such as shock absorbers and dampers to CVs. The stock has lost 32 per cent since the beginning of this year and now trades with an attractive valuation of 19 times its trailing 12-month earnings, down from 32 times in January 2018.
  • Suprajit Engineering, which supplies mechanical control cables and instruments such as speedometers and tachometers to the domestic auto industry, is another stock to bet on. Prospects for Phoenix Lamps — a company it acquired in 2015 — have taken a turn for the better after the initial hiccups. The stock has corrected 31 per cent since January and is currently valued at 22 times vis-à-vis 40 times in the beginning of the year.
  • Setco Auto, which has lost about 25 per cent this year and trades at 13 times, is the third stock to consider. Setco supplies clutches to medium and heavy truck and bus manufacturers through the ‘Lipe’ brand and has about 85 per cent market share in this segment.
  • Though stocks of other CV suppliers, Jamna Auto Industries and Automotive Axles, have not corrected much in this fall, solid earnings growth from good CV sales have kept their valuations grounded. Jamna Auto makes conventional leaf springs, parabolic springs, lift axles and air suspension products predominantly for commercial vehicles. It is the market leader in India, with a share of about 70 per cent and counts Tata Motors, Ashok Leyland, Bharat Benz, Volvo, Volvo-Eicher, AMW and Izuzu, among its clients.
  • The company is also working towards widening its product portfolio to include stabiliser bar, u bolt, z springs and trailer suspension. Automotive Axles makes drive and non-drive axles, front steer axles, and defence axles, among others, for the CV industry. It has diversified into the manufacture of components for air actuated S-CAM brakes too. Both stocks now trade at about 21 times, down from the 30-35 times they were at the beginning of 2018.
  • Sundram Fasteners and Lumax Industries too can be good buys for investors if the stocks correct 10-20 per cent. Shareholders, though, can continue to hold the stocks.
  • Tyres and batteries have a big replacement market, where direct sale to customers fetches them higher margins than from sale to auto manufacturers. The expected shift to the organised market as a result of GST implementation will favour players in this space over the long run.
  • Among battery makers, Exide Industries is on a firm wicket, regaining its valuation premium over Amara Raja Batteries after a long gap. Given the good demand, the stock has run up 25 per cent in 2018 and now trades at 32 times, as against Amara Raja’s 28. Shareholders can continue to hold the stock while fresh exposures can be considered on dips. Considering that electric vehicles still have a long way to go before being considered for mass use, the threat for batteries used in conventional fuel vehicles is not immediate.
  • Tyre stocks are faced with raw material cost pressures both from crude oil derivatives such as synthetic rubber and carbon black and, now, from natural rubber which is expected to be hit by domestic production shortage, necessitating higher imports. But good new vehicle sales and improving radialisation of CV tyres are positives. While MRF is pricey both in terms of per share price and valuation, Apollo Tyres, J K Tyre and Industries and Ceat are good long-term bets.
  • The market has rewarded MNC component makers since this rally began in September 2013, thanks to their technological superiority, low leverage or debt-free status and high margins. While Wabco India, the market leader in air and air assisted brake systems for CVs and bearings-maker SKF, have not shed much this year, the stock price of Bosch, which makes fuel injection systems for diesel engines, has moved up. Other MNC stocks such as Timken India and Cummins have corrected 15-25 per cent. But they aren’t cheap either. Wabco, Bosch and Timken trade at lofty valuations of over 40 times even now.
  • Other players with good global exposure such as Endurance Technologies, Balkrishna Industries, Bharat Forge and Motherson Sumi too don’t come cheap to make for attractive buys at this point in time. Also, barring the US and West Asia, the growth prospects elsewhere are not clear. The International Monetary Fund expects growth in China and Europe to slow down this year and next.
  • Emerging markets too are faced with uncertainties from rising oil prices, dollar appreciation and trade/geopolitical tensions. With most companies serving a basket of international markets, it is not easy to fully insulate earnings from the weak demand elsewhere.

Published on September 15, 2018