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Auto: the good run may end soon

Prospects are trickiest for two-wheeler makers, whose sales hinge on rural sales

The automobile sector rode through fiscal 2016 with cushy profitability in spite of weak demand in retail segments such as passenger vehicles and two-wheelers. This was mainly due to low commodity prices across raw material categories.

But this good run may be ending. Over the past few months, prices of metals such as steel, which are critical to the auto industry, have risen by at least 8%. Prices of other commodities, such as rubber and lead, don’t look like they will fall further as producers across the world are cutting output to prop up prices.

So, what does this mean for auto companies? A reduction in gross margins that would start appearing in their results in the middle of the current financial year. This comes at a bad time. Most auto companies, especially those making cars and two-wheelers, are likely renewing their advertising and marketing expenses to boost sales and grab a higher share of the market. This would reduce profit margins further.

Most analysts are building in a 50-100 basis points dip in operating margin over the next 12-18 months and this has dented investor interest. The S&P BSE Auto index is almost at the same level as it was at the end of December. Shares of Maruti Suzuki India Ltd, which many consider a proxy for India’s car industry, have cooled off by 18% since the beginning of 2016, though that also has to do with its valuations and its capacity constraints.

If at all, higher sales may alleviate the pain at least partially. Hopes are that after a flattish sales growth over the past three to four years, passenger cars, especially utility vehicles (UVs), may do better in FY17. Riding on UV sales, Mahindra & Mahindra Ltd, a stock beaten down over the past several quarters, has made some sort of a comeback, relatively. But it is trading at close to 18 times expected earnings for the current fiscal.

Prospects are trickiest for two-wheeler makers, whose sales hinge on rural sales. TVS Motor Company Ltd and Hero Motocorp Ltd are better poised to gain from rural sales growth, while Bajaj Auto Ltd may see some pain due to a damp export outlook. This segment depends a lot on the monsoons.

On the whole, stock gains in fiscal 2017 will depend largely on sales performance, unlike the year ago, when lower input costs drove share prices.

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