Entering Rough Terrain

Has the boom ended for auto ancillary stocks? The Smart Investor analyses the problems faced by the sector.

The euphoria is over. Just when some leading bro-king and research houses were convinced about the long-term bonanza from the auto-ancillary sector, the industry is headed for a downturn. Results for the second half of fiscal 1996-97 and first half of the following year do not hold much promise. Most corporates are likely to show at best a flat performance, if not a slide in bottomline.

Aggravating the damp industry sentiment is the immediate past (1995-96) when the auto and auto-ancillary sector excelled with an average 35 per cent growth in sales. Companies like Denso India, a player in auto-electricals, posted a CAGR of 340.5 per cent in earnings per share (see chart on EPS growth). Again, Sundaram Clayton of the TVS group showed a 54.01 per cent growth, while Kar Mobiles of the Rane group which is significant player in the valves segment, posted a 45.3 per cent CAGR.

With the going better than expectations for over two years and with several auto majors trumpeting major investment plans in India, what is the reason for this reversal? The Smart Investor has analysed some factors which have resulted in the present predicament for both the industry and the investor.

Essentially, the problems arose because of two opposing forces. One, a recession in the auto market, which is seeing a slowdown in sales growth - which is causing a proportionate fall in offtake of auto ancillaries. The second factor was the expansions undertaken by auto ancillary companies over the last year and a half in anticipation of a continuing boom.

Sundram Fasteners (SFL), for instance, expanded from 30,000 tpa to 45,000 tpa. The total project outlay was Rs 50 crore, of which around Rs 25 crore is for fasteners alone, wherein 85 per cent of the turnover accrues from the auto sector.

Wheels India Ltd. set up a new plant at Pune at a cost of Rs 45 crore for making 2 million car wheels and 0.5 million truck wheels. With this going on stream by mid-1997 the total capacity will go up to 5.4 million wheels per an-num. Autolite's gross block has risen from Rs 8.1 crore to Rs 17.97 crore from 1993-94 to 1995-96.

According to K V Shetty, chairman, Automotive Component Manufacturers Association (ACMA- South), the industry which was hitherto ploughing in Rs 2,000 crore every year for expansions and modernisations, has sunk in around Rs 4,600 crore last year.

The obvious fallout is therefore higher depreciation and interest costs which coupled together will translate into depressed margins during the current year. The Smart Investor sorted data of about 91 companies in the industry to depict a rising trend in the interest/sales ratio and depreciation outgo over last three fiscal year. How-ever, only those with sales turn-over above Rs 50 crore (1995-96) have been carried here.

High interest costs:

Typically, the auto-ancillary sector particularly those in the south have been averse to equity dilutions. Besides, the dullness in capital markets at a crucial time when industry needed to access funds, left the corporates with no alternative but to access debt, which in turn was at its peak in terms of cost over the last couple of years.

Only blue-chips like SFL have been able to access funds at relatively low levels. Our cost of funds including term loans average at 16 per cent, says V G Jagannathan, President- finance and secretary, SFL. However, many corporates have had to borrow at around 18-22 per cent.

The table (interest/sales) shows a mixed trend. However, the true impact of rising interest burden has been evident in some first half results.

Sundaram Brake Linings, for example, has displayed higher interest/sales ratio (7.1 per cent) in the first six months this year as opposed to the previous period (5.0 per cent).

Subros Ltd. which portrayed a 0.46 percentage point change during 1995-96 over the previous year, has seen higher interest provisions in the current half year. Interestingly, while sales during the first six months ended September 1996 was slightly higher at Rs 196.4 crore compared with Rs 184.7 crore previously, the interest burden has shot up from Rs 1.9 crore to Rs 2.9 crore during the period.

The analysis indicates that those with foreign financial participation have not succumbed to high interest costs.

Going a step further, there are several projects that are starved for funds. Although there is fund availability now, bankers and institutions are cautious. Further, they prefer an equity issue to precede lending in order to ensure an optimum debt equity ratio, says a source.

Higher depreciation costs:

Most ancillary makers have their expansion plans underway. The table on depreciation change over three years also indicates changes in gross block. While Shriram Pistons has had a 103.49 per cent increase in gross block during 1995-96 over the previous year, Motherson Sumi has seen a 68.02 per cent increase, with the same having doubled in the previous year itself.

However, in many cases like Wheels India, SFL, Engine Valves Ltd, the capacities will come into operation during the current and next financial year. Therefore, the impact of higher depreciation provision will be felt either during the current year or the next.

Subros has provided Rs 2 crore for depreciation in first six months this year against Rs 1.5 crore in the earlier period. Again, last year, the company had displayed 25 per cent growth in depreciation cost with an addition of 58 per cent to the gross block (see table).

Slackening auto sector

Now, both the above factors (costs) would have perhaps been absorbed, if the mother industry (auto sector) had continued to grow. Unfortunately, from August 1996, signals from the auto sector spell a slow-down (see table on AIMA figures). The worst hit are LCV and scooter makers where the drop in sales growth is more pronounced. The cumulative figures for April-December 1996 show only a 13.6 per cent growth over the previous period in the LCV category and 9.6 per cent in scooters. In 1995, however, the growth was a massive 37.5 per cent and 19.3 per cent respectively.

Although some sources feel that January has seen an improvement in figures, industry is still skeptical. The multinationals that entered the country particularly in the passenger cars segment threatened to look for alternate suppliers unless the existing units expanded to their future requirements. Looking back now it appears that the buoyancy in demand was over-estimated. says L Ganesh, vice-chairman and managing director, Engine Valves (EVL).

A general slow down in industrial activity and in exim trade has resulted in lesser movement of goods. Infrastr-ucture activity having reduced, even movement of core commodities like cement and steel has dropped, the impact of which is now being in the auto and ancillary sector.

EVL which had expanded capacity last year is now not confident that this will be utilised fully. In fact, the prevailing trend may force many corporates to review further expansions, says Ganesh talking also of a re-assessment of the company's II Phase expansion.

Therefore, the industry will have an uphill task servicing the capital used to fund the expansions without a concomitant increase in revenues.

The impact of this slow down will therefore saddle companies with high OE (original equipment) sales (see chart with OE/sales for different auto-segments). All engine components, wheels and rims, steering gears and transmission systems are some of these affected segments. A senior official from a leading auto-ancillary company states that there is already a delay in payments from the auto sector resulting in pressure on working capital requirements.

Setback in exports

Among the handful of companies that export a significant portion of their turnover are Aut-olite, Sundaram Brake Linings (SBL), SFL, Sibar Auto Parts, Bharat Gears, and Karmobiles. However, the picture is not very rosy on this front either.

There has been a softening of European markets, says K Mahesh, president ACMA. SBL which had posted a 50 per cent growth in exports during 1995-96 is estimating only 20 to 25 per cent growth this year.

Future scenario

Besides the above factors that may pose a burden at the gross and net profit levels, there has also been a rise in certain inputs. Increase in power tariffs in Tamilnadu will effect units in the state. While some key input costs are moving up, we are unable to pass this on to our customers, says an industry source. All these factors would snowball into poor results in the current financial year. Our second half would not be as bright as the first half, says Jagannathan of SFL.

Wheels India (WIL) had presented good results in the first half of 1996-97, when most corporates posted flat results. Net sales grew 23 per cent to touch Rs 173.23 crore and net profit at Rs 8.4 crore registered a 42 per cent growth over the previous period. But it is doubtful whether they may be able to sustain the same performance during the second half. Despite good operational efficiency, higher tax and interest outflows could bring down the bottom line for the full year.

Needless to say that markets are already beginning to discount this kind of a situation. WIL's price has fallen from Rs 280 a month ago to Rs 215. EVL which dropped to Rs 260 from Rs 520 post bonus issue, is now quoting at Rs 220. As an indicator, group price movements of a few auto-ancillary segments have been given here which show that since May-June of 1996, the prices have taken a beating (see price charts).

With international majors coming into the car segment (Ford, Hyundai, Mitsubishi Lancer, Daewoo), the need for sophisticated technology is being felt. This coupled with factors like high cost of domestic funds may force the hitherto conservative promoters of this sector to enter into joint ventures with global ancillary manufacturers. If such moves are in the long-term interest of the company, we are open to it, comments Ganesh.

The presence of few large players and a multitude of small players may result in some shake-out, mergers and acquisitions in the near future. Smaller players with very low capital base will find it difficult to set up economically viable units.

In the case of some prominent players where there is technical tie-up, the future could see collaborations transforming into equity participation. Lumax Industries' foreign partner Stanley is now planning a 25 per cent equity stake in the company.

However, with respect to financial performance, one can expect marginal growth or a flat bottom line. Says P Krishnan of Anush Shares and Securities, the clear picture will emerge from April 1997. It is likely that inventory levels may even lead to some auto majors cutting back production. Further, even if there is a recovery in interest rates, the need for higher working capital will be felt by the ancillary manufacturers.

The spectacular performance of the industry during 1995-96 has raised the expectations of investors from this industry. The industry has been made out to be more glamorous than it really is, states Ganesh. In the short to medium term therefore, the industry does not have much to offer for the investor. The only relieving factor would be a general improvement in stock market sentiment which may boost the PE levels of these stocks.