Automobiles: Has the profit margin peaked?

The March-quarter operating margins expanded 100-200 basis points for most auto firms, thanks to low raw material costs


FY17 started on a positive note, with most segments posting double-digit sales growth. The next trigger will be adequate monsoon that will aid sales growth and profits. Photo: Bloomberg
FY17 started on a positive note, with most segments posting double-digit sales growth. The next trigger will be adequate monsoon that will aid sales growth and profits. Photo: Bloomberg

The March-quarter earnings of auto firms indicated two trends. One is the better-than-expected revenue growth. Two, and more important, is the peaking out of profit margins.

The revenues of auto firms grew on the back of better volumes for some firms such as Mahindra and Mahindra Ltd, the market leader in utility vehicles. The quarter’s sales picked up after a lull for many quarters. Likewise, the benefits of high demand for medium and heavy commercial vehicles was seen in Tata Motors Ltd, Ashok Leyland Ltd and Eicher Motors Ltd.

In some cases, a better product mix and lower discounts propped up revenue, as in the case of Maruti Suzuki India Ltd.

Two-wheeler firms, too, surprised positively as demand rose across the board. On the whole, rural demand inched up and robust urban sales brought down discounts. Passenger car firms lured customers with new launches, too.

Meanwhile, the March-quarter operating margins expanded 100-200 basis points—one basis point is one-hundredth of a percentage point—for most auto firms, thanks to low raw material costs. But then, this is unlikely to continue. Commodity prices are up from a year ago, though volatile in the last few months. Steel prices, for instance, are up 6% from a year ago. This is not all. Going ahead, there are likely to be more refreshes and new launches from original equipment makers, both in cars and two-wheelers. The need is to capture market share and grow sales. This will continue to keep advertising spends high, as has been the case in the quarters gone by.

These developments point to peaking profitability unless sales rally so much that the economics of higher capacity utilization pan out in favour of better margins. Much, of course, depends on the monsoon and recovery in export markets, too. Some firms such as Bajaj Auto Ltd had faced challenges in export markets.

Investors in auto stocks are quick to jump on to the bandwagon when they spot the up cycle. This time around, the question is whether the stock valuation will sustain at current levels, which are pretty high, given that margin expansion will be limited in the near term. Shares of Maruti, which is the market leader in cars and which has been an outperformer in the pack of listed firms, trade at a steep valuation of 25 times expected earnings. Other such as those of Ashok Leyland Ltd and Hero MotoCorp Ltd trade at valuations higher than their average price-to-earnings multiples. If anything, analysts peg hopes on Tata Motors, as recovery in the domestic standalone business is good news, while its UK subsidiary, Jaguar Land Rover Plc, continues to chip in with higher volume growth.

For now, FY17 started on a positive note, with most segments posting double-digit sales growth. The next trigger will be adequate monsoon that will aid sales growth and profits.

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