Demand stability key for auto stock valuations to improve

Share prices of most automakers are down 20-30% from year-ago levels. The BSE Auto index has underperformed the broader market since July, with most stocks in the index showing a decline. The steady decline in auto sales in the past six months, including unusual sluggishness during the festive season, has impacted investor sentiment.

Price-to-earnings multiple based on Bloomberg’s forecast for FY19 and FY20 has fallen by 10% and 7%, respectively, since mid-December, when hopes of a recovery in demand faded.

The growing pessimism is due to many factors. Apart from the weak rupee and the incessant rise in fuel prices through most part of calendar year 2018, a rise in insurance costs and higher interest rates weighed on demand.

Meanwhile, rural demand weakened on lower farm income. Demand during the festival season dropped to the lowest in five years. The situation worsened in December, with dealer feedback suggesting that even hefty discounts failed to push sales.

So while two-wheeler sales growth petered down to about 10-11% in the December quarter, car sales contracted too. Even medium and heavy commercial vehicle sales declined on higher axle-load norms.

In other words, weak demand and poor pricing power are set to dampen realizations in the December quarter. Further, high input costs and the depreciating rupee too will weigh on profitability. Motilal Oswal Financial Services Ltd expects an Ebitda (earnings before interest, tax, depreciation and amortization) margin contraction due to raw material inflation, foreign exchange movements and variable marketing expenses.

The brokerage firm adds that the 16 companies under its coverage (auto and auto components) may register a decline in profit after tax for the first time in six quarters.

What’s keeping investors and brokerage firms on the edge is the uncertainty. Will demand revive at all?

Some are hopeful that both weak sales and falling margins are an aberration, due to adverse macroeconomic factors, which have eased now. Oil prices are down, the rupee has retraced and looks relatively stable, and prices of key inputs such as steel and aluminium have softened in the last three months.

Brokerage house CLSA points out that while input costs have eased, regulatory changes (in 2019 and 2020) may put pressure on margins and also impact demand. Most brokerage firms concede that competition may be higher in two-wheelers and trucks compared to passenger vehicles.

Amid this uncertainty, there is hope that margin pressure will bottom out in the December quarter. Of course, for valuations to pull back, there needs to be a sure and steady increase in sales.