Ashok Leyland finds growth triggers in the rising demand for M&HCVs

Strong volume growth in recent months and improvement in product mix has led analysts to upgrade their volume, revenue and margin estimates for Ashok Leyland. The company, which is the only pure-play listed player with an exposure to the high-growth medium and heavy commercial vehicle (M&HCV) segment, should see higher gains given the shift in customer preference towards the more profitable higher-tonnage CVs. Given this backdrop, investors with a two-year horizon can consider adding the stock, which currently trades at 18 times its FY19 estimates.

Volumes surge, market share up

The recent trigger has been the 79 per cent year-on-year (y-o-y) surge in M&HCV volumes in December, which comes after a 60 per cent increase in November. Given the recent performance and the 56 per cent volume jump in the December 2017 quarter (Q3), analysts at Nomura have revised upwards their FY18 volume growth estimates for Ashok Leyland from five per cent to 18 per cent. While the low base of last year has helped the sector's volumes to some extent in the last couple of months, analysts believe the surge is driven by the ban on overloading trucks in some of the states and pre-buying before the new truck cabin code became effective on January 1, 2018. 

The outperformance by the company has helped it to gain market share to the tune of 26 basis points in the M&HCV and 69 basis points in the light commercial vehicle (LCV) segment on a sequential basis in the December quarter, despite aggressive competition. Brokerages, however, believe that market share for the company may stabilise at the current levels of about 32 per cent for M&HCV and about 8 per cent for LCVs given the volume focus of Tata Motors. Unlike M&HCVs, the company is a smaller player in the LCV segment, which is dominated by Tata Motors and Mahindra & Mahindra (M&M), which account for 41-42 per cent each. 

While higher volumes in FY18 is a positive, the Street believes the trend will spill over to FY19, with volumes expected to grow by 15 per cent. Prior to FY20, any pre-buying before the implementation of BS-VI will only add to the volumes of CV makers. Ashok Leyland recently tied up with Hino Motors of Japan, which will enable it to utilise Hino’s engine technology to manufacture BS-VI compliant diesel engines.

Many demand drivers

Analysts believe the positive M&HCV cycle is largely on the back of broad-based freight revival, stricter implementation of overloading restrictions by more states (limited earlier to Rajasthan and Uttar Pradesh), the government’s focus on infrastructure projects and possible upside from the E-way bill (relating to goods and services tax), which may further restrict overloading. ICRA’s senior group vice-president Corporate Ratings, Subrata Ray, said that in addition to stricter overloading restriction, demand from construction and mining segments for tippers and tractor trailers from industries such as automobiles, container movement and steel, will help heavier trucks (heavy commercial vehicles or HCVs) outperform the industry. HCVs tend to have higher margins vis-a-vis other segments, he said. 

This will have a positive impact on the profitability of the company as the share of higher-tonnage vehicles has increased to 55 per cent in the current fiscal year as compared to 45 per cent in FY17. Ashok Leyland, which has expanded its operating profit margins by 410 basis points over FY13-17, is expected to add more than another 100 basis points over the next two years on the back of volume and product mix benefits. 

What could also add to revenues and margins of Ashok Leyland are exports, which currently constitute 10 per cent of revenues, and sales to the defence sector. Realisations are expected to increase as the company improves the share of sales to the Africa region, which are more profitable. The other revenue booster is orders from the defence segment, where the company is focussing on tactical, armoured and tracked vehicles. 

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But, not without risks

There are, however, a couple of risks that investors should take into consideration. The first, an industry trend, is the higher discounts that CVs are being sold at currently. Higher discounts had also impacted Ashok Leyland’s September quarter margins. While discounting rates have been as high as 10 per cent, analysts believe that higher demand and utilisation should help stabilise the situation. Utilisation levels for the sector, which was at 51 per cent in FY17, is expected to hit 71 per cent by FY20. 

Spike in raw material costs remains the biggest risk. Prices of steel, aluminium, lead and copper after gaining up to 19 per cent in the September quarter, have increased further in Q3. While companies will pass on part of the costs, the extent of price hikes will vary on the segment and its competitive pressures.