To a casual observer, the recent action in the stocks of auto component makers would seem to be disconnected from ground reality. Automobile sales have been steadily losing traction (sales growth down from 26 per cent in 2010-11 to just 2-3 per cent now), prompting the Centre to recently extend excise duty sops to the sector, to expedite a revival.
But the stock prices of companies which supply auto parts to the top automakers are already in third gear.
The bull run from the September 2013 lows of the Sensex saw the BSE Auto Index gain 45 per cent till date.
But small- and mid-cap auto component stocks have raced ahead, with many of them turning out to be multi-baggers for investors who bought them just nine months ago.
Stocks such as Ceat, JMT Auto, Sona Koyo Steering and Ahmednagar Forgings have vaulted 200-400 per cent from September last year.
The bet is that a lowering of inflation and interest rates will put more money in the hands of the consumer to buy cars and bikes; besides, a return of industrial growth could mean greater demand for goods carriages and higher freight rates which, in turn, would encourage sales of trucks and other commercial vehicles.
A cut in excise duties on automobiles in the interim Budget and further extension of the duty cuts till December 2014 have only strengthened these expectations even further.
Some challenges ahead But even as stocks have jumped up based on high expectations, vehicle sales may not pick up in a hurry.
This year may be better than the last, but the economy may not be back to the 8-9 per cent growth levels immediately. GDP growth projections for 2014-15 still stand at 5-6 per cent.
With vehicle sales growth directly dependent on economic growth, the revival is likely to be more gradual. The Society for Indian Automobile Manufacturers (SIAM) expects car sales to grow by about 1-2 per cent in 2014-15. Utility vehicles too, have lost much of their charm after the decision to link diesel prices to market rates. Challenges for quick growth in other segments such as two-wheelers, tractors and commercial vehicles come from the monsoon, widely expected to be below normal.
A not-so-good monsoon will reduce disposable income in the hands of rural consumers which, in turn, could affect demand for two-wheelers and tractors. Bike manufacturers such as Hero MotoCorp, for example, derive almost half their revenues from rural areas. Deficient rainfall will only be a double whammy for tractor sales, which were already expected to be lower this year because of the high base from the last two years.
With industrial output not likely to pick up soon, freight needs of the industry will be lower. This, coupled with lower agricultural freight due to poor rains, could lead to fleet operators postponing their new truck purchases a little further.
Already, commercial vehicle sales were expected to recover only from the second half of this year (2014-15). Thirdly, interest rate cuts, a major sentiment booster, are also some time away.
With a pick-up in vehicle sales not likely soon and most stocks in the sector racing ahead of the event, it pays to zero in on auto component buys from now on, based on the following parameters. This bull market has handed out a blanket reward to a majority of stocks in the auto component space. Take Rico Auto Industries, one of the many companies which supply castings, machined parts, tools and dies to the auto industry.
Look for growth levers Even as the company’s profits dropped by 74 per cent in 2013-14 over the previous year, the stock has zoomed about 225 per cent since September 2013, so much so that the price-earnings (PE) based on the last twelve months’ profits has moved up to 100 times now. Ditto with Ramakrishna Forgings; this stock, while gaining about 168 per cent in this period, saw its PE move up to 50 times. But the entire industry has not seen valuations expand so dramatically.
Consider CEAT, for instance. Even after a chart-busting 459 per cent gain, the stock still trades at a very reasonable trailing PE multiple of nine times, thanks to earnings expansion in this period. Hence, one way to play the components space now is to look for companies with earnings that have managed to keep pace with zooming stock prices. Tyre stocks such as CEAT, MRF and Apollo, trading between nine and 13 times, fit the bill.
These tyre stocks have been favoured on the bourses even before other auto component stocks caught investor attention. For one, a chunk of their revenues comes from direct sales to retail customers for replacing factory-fitted tyres. Hence, their fortunes depend less on new vehicle sales. Besides, with raw material costs accounting for about 70 per cent of the turnover, a cooling off of rubber prices in the last three-four quarters has helped these companies expand their margins.
Thanks to improved operational performance, some with higher debt levels such as CEAT have managed to reduce their leverage during the year. The failure of the Cooper deal too has freed Apollo Tyres from the huge debt burden which it otherwise would have incurred. Tyre companies will continue to benefit from these trends.
Amara Raja Batteries is another player whose fortunes are not bogged down by lacklustre new vehicle sales. The company’s profits for the year ended March 2014 moved up by 26 per cent over the previous year. Like tyres, batteries too have a huge replacement market, where companies have the ability to make better margins.
After Exide’s market share losses and low profitability, Amara Raja has seen a re-rating from the mid-teen PE multiples it used to trade at. But at 22 times trailing PE, it is still a good bet in current times. Amara Raja Batteries is also one of the few auto component stocks in which FIIs have steadily increased their stakes over the last three quarters, from 11 per cent in September 2013 to about 15 per cent now.
Similarly, there are a few other companies that have managed to grow their profits from core operations even amidst the slowdown in the industry. Examples of such companies which are still available at reasonable PEs include Munjal Auto Industries, a leading manufacturer of exhaust systems, fuel tanks and seat frames for two-/four-wheelers (eight times).
Hunting for companies that have negotiated this downturn well need not be the only way to play this cyclical theme. There are many top-of-the-class companies that have been mired in the slowdown but can turn around swiftly with the economic cycle.
Bet on leaders Leaders in select auto components may still be good bets, even if they are trading at higher PEs. For one, these companies have the capacity to withstand market gyrations if growth takes a little longer than expected to revive. Second, in a highly fragmented industry, these companies typically have a wider clientele or may serve several segments (cars, utility vehicles, trucks, buses, small trucks, bikes) instead of one.
So, if growth bounces back sooner in some segments and benefits one auto manufacturer more than the other, these companies will be in a position to latch on quickly.
Being tier-1 suppliers, such companies also have higher pricing power and make better margins. Finally, the market leaders also enjoy low leverage or are even debt-free, making them ideal investment options when interest rates are not expected to retract soon.
Wabco India, the market leader in supply of air and air-assisted brake systems to virtually every commercial vehicle maker in the country, is one such player.
Over the last few years, it has also entered into new product lines such as air compressors, electronically-controlled air suspension systems and anti-lock braking systems. Technological superiority, given its global parentage, along with an ability to maintain high operating margins of over 20 per cent, makes this stock attractive.
Some other market leaders which have promising prospects include Cummins India — manufacturing engines, offering a dual play on both the auto and capital goods sectors — and Bosch, a supplier of fuel injection systems for diesel engines across cars and commercial vehicles.
Among mid- and small-caps, Gabriel India, a company manufacturing shock absorbers for two-wheelers, cars and commercial vehicles, is an attractive stock.
The company counts Maruti Suzuki, Tata Motors, Toyota, M&M, Ashok Leyland, Honda, Bajaj and TVS among its clients. This is a superior pick to Munjal Showa, which manufactures shock absorbers predominantly for two-wheelers of Hero and, to a certain extent, for Honda. Sundram Fasteners fits the bill too.
Consider global players While the recent stock market move has been all about India Shining, let’s not forget that the global economy is on a recovery path too.
With improving macro-economic conditions in the US and European markets, such as Germany and the UK, showing signs of a pick-up in auto demand, betting on component makers focused on global markets can be a third good strategy.
Among Indian component makers such as Bharat Forge, Amtek Auto and Motherson Sumi who have a huge footprint abroad, Bharat Forge seems the best option in this space.
The company, a leading exporter of forged and machined components, has already seen benefits flowing in from improved heavy truck sales in the US.
It expects the European business to pick up from the second half of this fiscal year. Improving profitability at its overseas subsidiaries and declining debt-equity ratio at the consolidated level are other positives.
While the stock has rallied 136 per cent since September 2013 and is trading at a consolidated trailing PE of 32 times currently, it still has promising prospects.
Also read: >Duty cuts may not mend sales