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India: Automobiles
Equity Research
Increasing cyclical risks; downgrading Hero Honda, M&M to Sell
Increasing cyclical risks to demand growth and valuations
Four reasons driving this update: - 1) We believe 2011 is likely to see 10-
year high inflation and interest rates (levels last seen during 1HCY08). 2)
Historically, Indian auto demand has been inversely correlated with these
variables (R-squared of 50-80%). 3) As a consequence, we believe demand
growth is likely to normalize, and could even fall below normal during
FY2012-13. 4) Sector valuation has historically correlated with the demand
cycle, is currently at upcycle levels and looks expensive on balance sheet
based multiples in our view. We revise our EPS estimates for FY11-13 by -
25% to 22%, and TP’s by -27% to 1%.
Downgrade Hero Honda to Sell on valuation, strategic challenges
1) We believe Hero Honda saw the maximum margin decline relative to the
industry during the strong demand momentum in 2010, and believe
margins could come under further pressure due to moderating growth
over FY12-13. 2) Increased challenges on R&D and branding post Honda’s
exit from the JV could act as further headwinds to margins. 3) We note that
valuation is currently at upcycle levels, and has been historically correlated
with EPS growth which is likely to moderate in our view.
Downgrade M&M to Sell on rich valuation and rising macro risks
M&M valuation has historically moved in line with the demand cycle, and
looks likely to correct with moderation in demand growth. The stock is
currently close to peak on earnings based metrics and at upcycle averages
on balance sheet based metrics, which implies high market expectations
and consequent vulnerability to any disappointments in our view.
Upgrade MSIL to Neutral; Reiterate Buy on Bosch India, Bajaj Auto
We upgrade Maruti Suzuki (MSIL) to Neutral mainly on underperformance
and reasonable valuation relative to the sector. In the changing industry
environment, we continue to prefer Bosch India and Bajaj Auto for their
high industry leading margins, and Ashok Leyland due to its exposure to
the current strong momentum in commercial vehicle demand.
Key risks – strong demand momentum; rising commodity costs
Upside – strong near term demand momentum and consequent impact on
operating leverage and margins. Downside – higher than expected
inflation, commodity costs, government tax rates and competition.
Rising cyclical risks: Adjusting TP’s & estimates; Downgrade M&M,
Hero Honda to Sell; upgrade MSIL to Neutral
Rising cyclical risks to demand growth and valuation
1) We believe 2011 is likely to see 10-year high inflation and interest rates (levels last seen
during 1HCY08).
2) Historically, Indian auto demand has been inversely correlated with both of these
variables (R-squared of 50-80%).
3) As a consequence, we believe auto demand growth is likely to normalize (10-15% across
segments), and could even fall below normal during FY2012-13.
4) Indian auto sector valuations have been historically correlated with the demand cycle,
and are currently at upcycle levels in our view.
We downgrade Hero Honda and Mahindra & Mahindra to Sell, mainly on rich valuation
and rising macro risks. We upgrade Maruti Suzuki to Neutral due to underperformance,
lower valuation relative to the sector, and higher than expected strength in Indian car
demand. We believe that in a slowing growth environment high industry relative operating
margins could be a strategic advantage, and we continue to prefer Bosch India and Bajaj
Auto due to high industry leading margins. We also like Ashok Leyland due to its exposure
to the current strong momentum in truck demand.
Adjusting target prices and estimates
We adjust our target prices and estimates for the coverage group for 3 reasons –
1) We adjust for lower revised demand growth and margin estimates for the sector, and cut
our FY12-13 EPS estimates by 4-6% on average.
2) We also take a normalized view on valuations and adjust our target P/E multiples
accordingly (versus upcycle levels previously). We also cross check our valuation with
balance sheet and relative returns based methodologies. January 27, 2011 India: Automobiles
3) We also raise our estimates for Maruti Suzuki and Tata Motors mainly on higher volume
assumptions due to stronger than expected Indian passenger car and global luxury car
demand respectively.
2010 recap: strong demand growth, valuations now at upcycle
We make the following brief observations on Indian auto sector’s performance during
calendar year 2010: -
1) We note that in 2010 the Indian auto industry witnessed one of the strongest periods of
demand growth in history, with total demand growing in excess of 31%. The 6-month
moving average of yoy% growth reached one of the highest levels since 1993 (Exhibit
3)
2) This resulted in strong stock price performance, with the large OEM’s under our
coverage outperforming the index by 25% on average. (Exhibit 4)
3) As a consequence, we believe the sector is trading at upcycle multiples on balance
sheet based metrics such as P/B and EV/EBITDA, though on consensus earnings
expectations the sector is still trading close to historical averages on earnings multiple
based approaches P/E and EV/EBITDA
Increasing cyclical risks I - How inflation could affect growth
We make the following analysis & observations on the impact of macro variables on Indian
auto demand: -
1) We observe a high historical inverse correlation between auto demand growth in India
and level of inflation and interest rates, with R-squared going as high as 50-80% at some
points of the demand cycle (Exhibits 6-9). We also note that this relationship may vary
depending on the stage of the cycle resulting in volatility in R-squared (Exhibit 7 and 8), but
inverse relationship tends to become stronger in a high inflation and interest environment
in our view.
2) We believe that interest rates and inflation could touch 10-year highs during 2011, at
levels last experienced during 1H2008. This poses downside risks to growth, and we
believe that though current demand momentum remains strong, growth could materially
decelerate from 2H2011. We hence cut our demand growth forecasts for the total industry
from 14% to 11% in FY12 (Exhibit 1 and 11-14).
3) While it is difficult to foresee the relative impact of macro risks on various sub-segments
of the Indian auto industry in our view, we believe that the impact could be more
pronounced on consumption driven segments such as 2-wheelers and passenger cars.
Increasing cyclical risks II - How growth impacts valuation
We make the following observations on the impact of the demand cycle on sector
valuations:
1) We note that historically, valuation for the sector in terms of balance sheet based
multiples such as Enterprise Value to Gross Cash Invested (EV/GCI) has been highly
correlated with the demand cycle (Exhibit 15).
2) Correlation is lower for earnings based multiples such as P/E and EV/EBITDA, which
could be more due to the noise created by volatile market expectations (earnings
estimates and target multiples). (Exhibit 16)
3) We note that sector on average is trading close to peak multiples on EV/GCI, which we
believe is a reflection of the strong demand momentum experienced during CY2010,
but looks unsustainable over next 12 months given macro risks to demand as
discussed earlier.
4) From our coverage group, we find that M&M and Hero Honda valuation look the most
vulnerable as they are trading at peaks or upcycle averages on EV/GCI (Exhibits 17 and
18). M&M and Hero Honda are also trading at a premium relative to sector peers on
relative returns based valuation (Exhibits 21-22).
5) We also find that Bosch India and Ashok Leyland valuations are close to historical
averages, and therefore less vulnerable to growing macro risks to demand and
valuation (Exhibits 19 and 20). Similarly Maruti Suzuki is also trading at close to
historical average on EV/GCI (Exhibit 38).
With individual company updates on the key rating changes, we also support our views on
valuation as discussed above with additional stock-specific analysis using alternative
valuation metrics like earnings based multiples (P/E, EV/EBITDA) and balance sheet based
multiples
India Equity Research Reports, IPO and Stock News Visit http://indiaer.blogspot.com/ for complete details �� ��
India: Automobiles
Equity Research
Increasing cyclical risks; downgrading Hero Honda, M&M to Sell
Increasing cyclical risks to demand growth and valuations
Four reasons driving this update: - 1) We believe 2011 is likely to see 10-
year high inflation and interest rates (levels last seen during 1HCY08). 2)
Historically, Indian auto demand has been inversely correlated with these
variables (R-squared of 50-80%). 3) As a consequence, we believe demand
growth is likely to normalize, and could even fall below normal during
FY2012-13. 4) Sector valuation has historically correlated with the demand
cycle, is currently at upcycle levels and looks expensive on balance sheet
based multiples in our view. We revise our EPS estimates for FY11-13 by -
25% to 22%, and TP’s by -27% to 1%.
Downgrade Hero Honda to Sell on valuation, strategic challenges
1) We believe Hero Honda saw the maximum margin decline relative to the
industry during the strong demand momentum in 2010, and believe
margins could come under further pressure due to moderating growth
over FY12-13. 2) Increased challenges on R&D and branding post Honda’s
exit from the JV could act as further headwinds to margins. 3) We note that
valuation is currently at upcycle levels, and has been historically correlated
with EPS growth which is likely to moderate in our view.
Downgrade M&M to Sell on rich valuation and rising macro risks
M&M valuation has historically moved in line with the demand cycle, and
looks likely to correct with moderation in demand growth. The stock is
currently close to peak on earnings based metrics and at upcycle averages
on balance sheet based metrics, which implies high market expectations
and consequent vulnerability to any disappointments in our view.
Upgrade MSIL to Neutral; Reiterate Buy on Bosch India, Bajaj Auto
We upgrade Maruti Suzuki (MSIL) to Neutral mainly on underperformance
and reasonable valuation relative to the sector. In the changing industry
environment, we continue to prefer Bosch India and Bajaj Auto for their
high industry leading margins, and Ashok Leyland due to its exposure to
the current strong momentum in commercial vehicle demand.
Key risks – strong demand momentum; rising commodity costs
Upside – strong near term demand momentum and consequent impact on
operating leverage and margins. Downside – higher than expected
inflation, commodity costs, government tax rates and competition.
Rising cyclical risks: Adjusting TP’s & estimates; Downgrade M&M,
Hero Honda to Sell; upgrade MSIL to Neutral
Rising cyclical risks to demand growth and valuation
1) We believe 2011 is likely to see 10-year high inflation and interest rates (levels last seen
during 1HCY08).
2) Historically, Indian auto demand has been inversely correlated with both of these
variables (R-squared of 50-80%).
3) As a consequence, we believe auto demand growth is likely to normalize (10-15% across
segments), and could even fall below normal during FY2012-13.
4) Indian auto sector valuations have been historically correlated with the demand cycle,
and are currently at upcycle levels in our view.
We downgrade Hero Honda and Mahindra & Mahindra to Sell, mainly on rich valuation
and rising macro risks. We upgrade Maruti Suzuki to Neutral due to underperformance,
lower valuation relative to the sector, and higher than expected strength in Indian car
demand. We believe that in a slowing growth environment high industry relative operating
margins could be a strategic advantage, and we continue to prefer Bosch India and Bajaj
Auto due to high industry leading margins. We also like Ashok Leyland due to its exposure
to the current strong momentum in truck demand.
Adjusting target prices and estimates
We adjust our target prices and estimates for the coverage group for 3 reasons –
1) We adjust for lower revised demand growth and margin estimates for the sector, and cut
our FY12-13 EPS estimates by 4-6% on average.
2) We also take a normalized view on valuations and adjust our target P/E multiples
accordingly (versus upcycle levels previously). We also cross check our valuation with
balance sheet and relative returns based methodologies. January 27, 2011 India: Automobiles
3) We also raise our estimates for Maruti Suzuki and Tata Motors mainly on higher volume
assumptions due to stronger than expected Indian passenger car and global luxury car
demand respectively.
2010 recap: strong demand growth, valuations now at upcycle
We make the following brief observations on Indian auto sector’s performance during
calendar year 2010: -
1) We note that in 2010 the Indian auto industry witnessed one of the strongest periods of
demand growth in history, with total demand growing in excess of 31%. The 6-month
moving average of yoy% growth reached one of the highest levels since 1993 (Exhibit
3)
2) This resulted in strong stock price performance, with the large OEM’s under our
coverage outperforming the index by 25% on average. (Exhibit 4)
3) As a consequence, we believe the sector is trading at upcycle multiples on balance
sheet based metrics such as P/B and EV/EBITDA, though on consensus earnings
expectations the sector is still trading close to historical averages on earnings multiple
based approaches P/E and EV/EBITDA
Increasing cyclical risks I - How inflation could affect growth
We make the following analysis & observations on the impact of macro variables on Indian
auto demand: -
1) We observe a high historical inverse correlation between auto demand growth in India
and level of inflation and interest rates, with R-squared going as high as 50-80% at some
points of the demand cycle (Exhibits 6-9). We also note that this relationship may vary
depending on the stage of the cycle resulting in volatility in R-squared (Exhibit 7 and 8), but
inverse relationship tends to become stronger in a high inflation and interest environment
in our view.
2) We believe that interest rates and inflation could touch 10-year highs during 2011, at
levels last experienced during 1H2008. This poses downside risks to growth, and we
believe that though current demand momentum remains strong, growth could materially
decelerate from 2H2011. We hence cut our demand growth forecasts for the total industry
from 14% to 11% in FY12 (Exhibit 1 and 11-14).
3) While it is difficult to foresee the relative impact of macro risks on various sub-segments
of the Indian auto industry in our view, we believe that the impact could be more
pronounced on consumption driven segments such as 2-wheelers and passenger cars.
Increasing cyclical risks II - How growth impacts valuation
We make the following observations on the impact of the demand cycle on sector
valuations:
1) We note that historically, valuation for the sector in terms of balance sheet based
multiples such as Enterprise Value to Gross Cash Invested (EV/GCI) has been highly
correlated with the demand cycle (Exhibit 15).
2) Correlation is lower for earnings based multiples such as P/E and EV/EBITDA, which
could be more due to the noise created by volatile market expectations (earnings
estimates and target multiples). (Exhibit 16)
3) We note that sector on average is trading close to peak multiples on EV/GCI, which we
believe is a reflection of the strong demand momentum experienced during CY2010,
but looks unsustainable over next 12 months given macro risks to demand as
discussed earlier.
4) From our coverage group, we find that M&M and Hero Honda valuation look the most
vulnerable as they are trading at peaks or upcycle averages on EV/GCI (Exhibits 17 and
18). M&M and Hero Honda are also trading at a premium relative to sector peers on
relative returns based valuation (Exhibits 21-22).
5) We also find that Bosch India and Ashok Leyland valuations are close to historical
averages, and therefore less vulnerable to growing macro risks to demand and
valuation (Exhibits 19 and 20). Similarly Maruti Suzuki is also trading at close to
historical average on EV/GCI (Exhibit 38).
With individual company updates on the key rating changes, we also support our views on
valuation as discussed above with additional stock-specific analysis using alternative
valuation metrics like earnings based multiples (P/E, EV/EBITDA) and balance sheet based
multiples
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