Auto Sector - Cruising through barriers :: Emkay

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Auto Sector

Cruising through barriers

We have been overweight on the automobile sector post 3QFY11 with ~88% of the stocks having a positive view as compared to only ~43% in the preceding quarter. This was despite the near term concerns like higher interest rate/inflation, base effect, etc. Our view was primarily based on (1) Valuations (especially relative valuations), which were trading at a significant discount due to excessive focus on near term concerns (2) Strong cash flow generation and high ROIC business (3) Our FY11-FY13E estimates factoring in the slowdown impact.

Our automobile universe has since then outperformed the broader market indices significantly with some stocks even posting absolute returns. Despite the strong relative outperformance, we still find the current valuations reasonable as our analysis reveals adequate near term positives as well as long term triggers. The near term positives emerge from (1) High base effect of inflation/interest rate (2) Favorable base effect for IIP (3) Good monsoon and (4) Easing of raw material cost pressures.

Similarly, our long term analysis reveals ample growth potential across segments, which are enumerated below..

n M&HCVs – The positives emerge from (1) High multiplier effect (2) Strong demand during weak IIP but strong agri GDP (3) Diminishing lag impact of IIP and (4) No impact of higher fuel prices on demand. Also, availability of finance is more important than interest rates

n Tractors – The positives emerge from (1) High multiplier effect (2) Higher farm income and land prices (3) Increasing reach of formal financing channels (4) Labour shortage and (5) Industry consolidation

n Passenger vehicles – The positives emerge from (1) Low penetration levels (income and geographical) (2) High multiplier effect (3) Significant correlation with wealth creation & employment and (4) availability of finance rather than interest rates

n Two wheelers – The positives emerge from  (1) Low penetration levels (income and geographical) (2) Rising rural income vis-à-vis urban income (3) Low reliance on finance (stable demand) and (4) Improving multiplier effect (since FY08)

However, we would like to caution that the near term concerns are yet to play out fully and expect 3QFY12 to witness maximum impact of the same. The impact will be different across segments. We expect maximum impact on PVs/M&HCVs. The recent strong outperformance of the stocks can result in a subdued performance of the sector in the near term.  We believe 3QFY12 provides a solid opportunity to re-enter auto stocks.

We retain our overweight position on the sector. However, from here on, maximum value is in four wheelers mainly due to upgrade in valuations as well as earnings over next 4 quarters. From hereon, two wheeler stocks will track earnings/dividend yield with limited scope for valuation re-rating. Also, we are changing our recommendations. We have downgraded our rating for two wheeler stocks a notch lower. We downgrade Bajaj Auto from BUY to ACCUMULATE, Hero Honda from HOLD to REDUCE and TVS Motor from ACCUMULATE to HOLD. We retain BUY on M&M, Tata Motors and Eicher Motors. Despite attractive valuations, we retain our ACCUMULATE on Ashok Leyland and Maruti, due to company specific issues. Key concerns arise from a slump in economic activity and /or a sharp jump in metal prices.