M&M and Tata Motors preferred by Motilal Oswal in Auto sector

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AUTO: 2QFY11 Preview; Strong volumes; Soft commodity prices to improve margins; Retain M&M as top pick

Key highlights of 2QFY11 for Auto:

1] Volume growth of 26% YoY (~7.1% QoQ), driven by strong retail demand across all segments.

2] Increase in prices coupled with commodity price softening to benefit margins by 70bp QoQ despite BS-IV compliance cost.

3] Production bottlenecks, product price changes, RM cost movement and trend in retail demand are the key factors to watch out for.

Robust demand at retail level continues

-          Strong momentum in volumes continued in 2QFY11, supported by overall improvement in sentiments, availability of credit, pre-buying due to BS-III norm implementation in Oct-10 as well as benefit of new product launches. Volumes are estimated to grow at 26.5% YoY (7.1% QoQ).

-          Volume growth robust across key segments viz 2W (+25.9% YoY, +5.5% QoQ), cars (+24.4% YoY, 10.1% QoQ) and CVs (+34.9% YoY, 10.3% QoQ).

-          Retail demand continues to be strong, driven by continued improvement in the economic environment, and as a result, overall inventory in the system is below normal levels

Key things to watch out for in 3QFY11

-          Easing of supply-side bottleneck which had impacted volumes 2QFY11.

-          Trend in retail demand as cost of ownership and operation increases (price of vehicle, fuel, increase in interest rates etc).

-          Expected hardening in monetary policy, as inflation rises, which would result in higher interest rates for auto.

-          Expected increase in selling price of vehicles to partly offset RM cost inflation.

-          Increasing competitive intensity in two wheeler space with entry of M&M in motorcycle segment.

Valuation and view

-          Volume growth in the domestic market continues to be very robust across all segments.

-          Most auto stocks have outperformed the benchmark over the past year due to recovery in volumes and margin expansion.

-          While volume outlook remains positive, operating margins are expected to moderate from peak levels of FY10 but are expected to remain higher than historical average margins.

-          Valuations in the sector are attractive. Our top picks are M&M and Tata Motors.