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Pain Ends, Growth Arrives

Author: Administrator Account/Tuesday, February 23, 2010/Categories: Stocks

Pain Ends, Growth Arrives

Things are looking brighter for the Indian automotive sector after nearly five years. However, the hopes of recovery that have arisen after the change in government may yet disappear if the poor monsoon trend continues. When automobile manufacturers prosper, so too will auto components, or the ancillary firms.  In this special report we look at how the auto component companies will enjoy multiple benefits due to the recovery in the automobile industry over the next two years. Our analysts look at how some key auto ancillary stocks will perform in the short to medium term.
Higher original equipment (OE) sales, scaling up of export volumes and healthy replacement demand will not only fuel the volume growth of ancillary companies, but also help them regain pricing power, which in turn, will drive an expansion in their margins. Moreover, the operating margins of a majority of ancillary companies are highly co-related with medium and heavy commercial vehicles (M&HCV) volumes, which were impacted during the downturn.
With the a recovery expected in commercial vehicles (CV) volumes, the margins of ancillary companies will move up further to their historically high levels. On the other hand, ancillary companies have restructured their businesses in order to rationalize their cost structure during the slowdown. Some of these companies have also discontinued their loss-making foreign operations, resulting in healthy financials and a strong balance sheet position.  Higher margins will lead to an improvement in the profitability of ancillary companies, while their business restructuring activity will reduce the level of capital employed, thus transforming into healthy return ratios for the players. All these factors will certainly drive an expansion in their valuation multiples to historical highs. It’s a good time to stock up on this sector. 
Analysts expect domestic OE sales to pick up from mid-FY15 with a sharp recovery in M&HCVs (volume growth of about 25-30%). A majority of the ancillary companies have been severely impacted by the slowdown in M&HCV sales over the past two years. Given the higher sensitivity of margins of auto players to CV volumes, a recovery in CV volumes will help the companies on scale as well as margins front.

Exports to Witness Sharp Recovery Next Year
The overall global automobile industry has witnessed an improvement over the past 3-4 quarters and we expect a faster recovery in the Western markets over the next two years. Moreover, the contribution of India’s component exports to global OEMs has been rising steadily, as improved quality, world class production standards, along with superior cost advantage have encouraged the top global auto OEMs to make India a sourcing hub for various components. India’s ancillary exports grew at a CAGR of 20% over FY07-13, while the overall global automobile industry grew at a compounded annual rate of ~3% during the same period. We expect ancillary exports to grow at 17% annually over FY14-FY16.
The replacement cycle for a majority of the components is around 3-4 years. Hence, healthy sales recorded by the automobile industry during FY10-FY12 and stretched replacement will kick in replacement demand over FY15-FY16.

Long-Term  Growth Trends
We expect the domestic passenger vehicles industry to grow at 12% over FY14-FY16. The CV segment is likely to outpace with a 15% growth on the back of a recovery in M&HCVs from H2FY15 onwards. We expect the growth momentum in the two wheeler segment to continue and estimate it to record a CAGR of 12% over the same period. Within the two wheeler segment, scooters would remain the key growth driver with a CAGR of 20% over the same period. Thus, overall auto sales are expected to grow at a CAGR of 12% over FY14-FY16. This will be the key growth driver for the auto components industry and a key growth trigger for the sector, going forward.
On the exports front, the industry would regain the lost growth momentum. Exports could grow at a CAGR of 10% over FY14-FY16, on the back of improving growth prospects in the African and Latin  American markets, thus aiding the revenue growth of the auto components industry to some extent.
The Indian auto ancillary industry has grown at a CAGR of 13% in rupee terms and 10% indollar terms over FY07-13, as against a CAGR of 8.5% in volumes of the automobile industry over the same period. On the other hand, the export of components outpaced the industry growth by growing at a CAGR of 14% in dollar terms, which indicates the growing faith of global auto makers in the Indian ancillary industry. Due to its cost advantage, India has emerged as global hub for manufacturers over the years.
We expect the domestic auto ancillary industry to record a higher CAGR of 18% over FY14-FY16, mainly due higher domestic automobile sales, increased contribution from the high-value M&HCV segment, recovery in replacement sales and rising exports of vehicle. We estimate export of auto components to grow at 21% in dollar terms.
 During past one year, the BSE Auto Index outperformed the Sensex by 12.3%, driven mainly by a strong performance by Bharat Forge, Motherson Sumi System, Amara Raja, TVS Motor and Ashok Leyland.
Let’s take a closer look at the prospects of some of the leading auto components stocks.
 
Prudence Pays

CMP 558
Target Price 725
Upside 30

Bharat Forge Limited (BFL) is the market leader in the Indian auto components space with the largest forging operations. We expect BFL to significantly scale up its performance on the back of (i) a strong recovery in the domestic commercial vehicle (CV) industry (ii) steady ongoing improvement in the US and Europe auto industries (iii) strong recovery in non-auto business, led by economic revival post the reforms by new government and (iv) discontinuation of loss-making overseas operations, which will benefit the operating margin and strengthen the balance sheet. There is a strong positive correlation between domestic M&HCV sales and BFL’s standalone revenues and margins. BFL enjoys a share of 90% in the domestic CV market with almost 100% pricing power. We expect the domestic M&HCV market to grow at 20% and BFL’s standalone revenues to grow at a CAGR of 17.5% over FY14-FY16. BFL exports chassis and engine components for US Class 8 CVs and European heavy trucks. Overseas sales contribute around 75% of the company’s consolidated revenues. The ongoing recovery in the US and expected recovery in Europe from its 10-year low augurs well for the company.
We expect BFL to surpass its historical peak valuation. A target price of Rs 725 with a 30% upside looks a good bet.

Global Standards

CMP 319
Target Price 400
Upside 26%

Motherson Sumi Systems Ltd. (MSSL) has emerged as a truly global auto component maker over the years by meeting global quality standards and increasing its focus on top end models. The company’s capacity expansion at the right location at the right time will translate into a healthy revenue growth, aided by a strong recovery in the global automobile industry. Moreover, the company’s value engineering, cost restructuring and business rationalization is exoected to result in double-digit operating margins over the next 2-3 years. The company’s improving profitability and better asset utilization will also continue to benefit its return ratios. The economic recovery in Europe that is aiding the improvement in the performance of Samwardhan Motherson Reflect (SMR) and Samwardhan Motherson Peguform (SMP), increase in value addition to its products and strong recovery in the domestic auto industry will be the key growth triggers for MSSL, going forward. In view of the multiple growth triggers and compounding earning growth, MSSL could hit the Rs 400 per share mark representing a 26% upside on its current trading price.

Catching Up

CMP 483
Target Price 560
Upside 14%

Amara Raja Batteries (AMRJ) is the second largest player in the Indian battery industry. It derives 55% of its revenues from automotive batteries and the 45% from industrial batteries. Over the past five years, AMRJ has been  gaining  market  share  in  both  the  segments. In  recent  times,  the company has grabbed significant share from the market leader, Exide, in the  auto  replacement market,  on  the  back  of  product improvements and network  expansion.  The  company  has  strengthened  its  position  by increasing its pricing power, resulting in its EBIDTA margin expanding by 90bps to 17.6% over FY14-FY16, despite capacity expansion. AMRJ’s capacity expansion will drive further market share gains and meet the growing demand, led by revival in OEM as well as replacement demand. AMRJ’s auto revenues are expected to grow at a CAGR of 24%, while the economic recovery will translate into a CAGR of 14% in the industrial segment over FY14-FY16.

Domestic leader

CMP 142
Target Price 171
Upside 20

Exide Industries  enjoys leadership position in both the OEM and replacement segments. The company derives 65% of its revenues from automotive batteries and the balance from industrial batteries, with 60% of its revenues from automotive batteries coming from the replacement segment. Within the automotive business, Exide caters mainly to M&HCVs and the company’s operating margin is highly sensitive to CV sales. Any uptick in the M&HCV segment will translate into healthy revenues for Exide despite loss of some market share. The company’s bottom line is  also likely to  receive a  boost due to  its  high operating leverage.
In addition to a double-digit growth in the auto segment, we expect a strong uptick in the industrial segment, on the back of the anticipated economic recovery by mid- FY15.  We  expect  the  investment  cycle  to  resume  soon  and  industrial activities to pick up from the current level. Exide enjoys strong brand equity and has a well-penetrated pan-India distribution network. A target price of Rs 170 looks reasonable for exide.

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