Auto parts: Best Buys

The clamour for cyclical stocks on expectations of an economic recovery has seen many auto component stocks turn multi-baggers in the last two years. With valuations of many stocks in this space inching up sharply, is there still steam left?

We find out what is working in favour of the industry and who all will gain from it. In an accompanying write-up, we also flag areas of concern and stocks that need to be on the watch list.

Vehicle sales upbeat Even as stocks of component players started picking up on expectations of an upturn about two years ago, auto sales were still going through a rough patch. In fiscal 2013-14, almost every segment, be it cars, utility vehicles, trucks or buses recorded lower sales volumes than the previous year. But into 2014-15, sales did show green shoots.

Overall volume growth for the auto industry inched up to 7.2 per cent, compared to the 2-3 per cent recorded in the previous two fiscals. Trucks spearheaded the turnaround, with the medium and heavy commercial vehicles segment showing a 16 per cent growth, compared with a 25 per cent fall in volumes in 2013-14.

Into this fiscal, commercial vehicle sales continue to be on a purple patch. Sales volumes of medium and heavy commercial vehicles have grown by 27 per cent in April-August 2015. With signs of a pick-up in manufacturing and construction activity visible, this trend is expected to continue.

Besides, since most of the vehicle purchases are financed by lenders, a comfortable inflation situation could prompt more rate cuts and thus provide further impetus to volume growth. Lower inflation and cheaper loans would positively impact urban consumption too, bringing greater demand for cars.

Already, car sales have been steadily moving on to a faster lane since the 5 per cent shrinkage in volumes that was witnessed in 2013-14. Car sales grew at 5 per cent in 2014-15 and at 9.7 per cent in the first five months of this fiscal. Recognising the turnaround, several auto component stocks have moved up steeply in this period. Many have seen their price to earnings multiple re-rate sharply too.

Yet, with vehicle sales on a cyclical upturn, the party is still not over. Despite the run-up, there are quite a few cherry-picking opportunities. Besides, corrections of the last six months have taken some froth away too. Considering the upbeat outlook for commercial vehicle and car sales, mid and small-cap stocks, such as Sundram Fasteners, Jamna Auto Industries and Setco Auto, for instance, still hold potential.

Sundram Fasteners is a supplier of ancillary parts, such as high tensile fasteners, radiator caps, pumps and assemblies, and hubs and shafts, mainly for commercial vehicles (CVs) and cars.

Setco Automotive is the market leader in the supply of clutches to trucks and buses. The company caters to the entire requirement of Tata Motors, Volvo and Bharat Benz in India, and 60-70 per cent of the requirement of Ashok Leyland. Jamna Auto Industries is, again, the market leader in the supply of leaf and parabolic springs for commercial vehicles.

In line with improving vehicle sales, earnings of these companies have also picked up. So, in spite of prices of these stocks moving up three to four times since September 2013, they still trade at reasonable valuations of around 20-25 times their trailing 12-month earnings. Lumax Industries and Gabriel India , which trade at 17-19 times their trailing 12-month earnings, are other similarly promising stocks in this space.

Lumax supplies head lamps, tail lamps and auxiliary lamps to the auto industry and has about 55 per cent market share. Maruti Suzuki, Honda, Mahindra and Mahindra (M&M) and Tata Motors are among its top clients. Gabriel India manufactures shock absorbers. The company is a tier-I supplier to almost all car and truck manufacturers.

Related story : Tread with care on two-wheelers and overheated MNC stocks

Cheap raw materials The auto and auto component industry is among the highly raw material-intensive industries, with raw material inputs as a percentage of sales normally at around 65 per cent. Hence, the fall in prices of key raw materials, such as steel, lead, rubber, and aluminium, among others, works in favour of these players currently.

The June 2015 quarter results are a good example. While aggregate sales for the industry grew 7.6 per cent, adjusted profits grew at a much higher 21.5 per cent, the easing of input prices being a major support.

Raw materials as a percentage of sales came down from 68.3 per cent in the three months ended June 2014 to 65.5 per cent now.

Operating margins expanded by 2 percentage points from 11.6 per cent a year ago to 13.7 per cent now.

Tyre manufacturers have been among the biggest beneficiaries in the last one year, with both rubber and crude oil softening.

Prices of RSS 4 variety of natural rubber used by tyre manufacturers, which touched a peak of ₹240 a kg in 2011, have been cooling off since late 2013. They have now stabilised at around ₹120-130 a kg. International rubber prices too have followed a similar trend. With global rubber production expected to outstrip demand in the months to come, the gains both in domestic and international prices are not expected to be sharp.

Besides, the halving of crude oil prices in the last one year to less than $50 a barrel currently has also led to cheaper prices of crude-based inputs, such as synthetic rubber, nylon tyre cord and carbon black for tyre companies. Markets have also recognised this, rewarding tyre stocks handsomely.

But with earnings catching up with the price gains, there are still good buying opportunities.

JK Tyres is one such. Valuations of companies such as Ceat and MRF have re-rated to around 12-13 times their trailing 12-month earnings now, from about three times and six times respectively, two years ago. But JK Tyres still trades at a reasonable seven times.

The company is a market leader in the fast-growing radial tyres segment for trucks and buses.

In the June 2015 quarter, the company’s margins expanded to 16.7 per cent, compared to 10.3 per cent a year ago. Consolidated profits more than doubled to ₹117 crore, from ₹54 crore in June 2014.

For tyre makers, benign rubber and crude oil prices lend comfort for margin expansion even if there may be some pressures on realisations due to the dumping of Chinese tyres.

Similarly, the cool-off in lead prices will help automotive battery manufacturers. From about $2,300 a tonne in July 2014, prices on the London Metal Exchange have dropped over 25 per cent to around $1,700 a tonne now. This is amongst the lowest levels seen in the last five years. Lead prices may carry on at current levels in the next few months, thanks to expectations of soft demand from top consumers, such as China.

In the last two-three years, at a time when peer Exide Industries suffered market share losses and was forced to resort to price cuts, Amara Raja Batteries made the most of the opportunity. Recognising the strong wicket the company was on, Amara Raja ’s valuations too have re-rated from about 16 times trailing 12-month earnings to about 39 times now.

But with prospects remaining strong, any fall in price can be used as an entry point to the stock.

With prices of other metals, such as steel, copper and aluminium also down sharply, component makers can expect to see a repeat of the June quarter performance on the operating margin and on the bottom-line front in the next few quarters. Besides, with commercial vehicles and cars expected to sell better than others, it is a double bonanza for component makers catering to these two segments, as top-line growth will also strengthen.

Benefit from global diversification Finally, there are also global plays in the component industry, such as Bharat Forge whose prospects are looking bright due to recovery in auto markets across the world.

The company, a leading supplier of forged and machined components, will continue to be a major beneficiary of the turnaround in domestic commercial vehicle sales.

Prospects for the company’s export markets, such as the US and Europe, also look good, with demand for cars and long-haulage trucks showing good traction in the US and the company expecting truck volumes in Europe to recover soon.

The 30 per cent fall in the stock price in the volatility of the last six months presents a good opportunity to enter the stock. It now trades at around 27 times its trailing 12-month earnings.