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Business News/ Market / Mark-to-market/  Are high valuations for the auto sector justified?
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Are high valuations for the auto sector justified?

Valuation changes mirror the optimism about the industry prospects

Ironically, in absolute terms, the June quarter sales of most automobile manufacturers are still at the levels seen in the corresponding quarter of 2012—two years ago. Photo: Ramesh Pathania/MintPremium
Ironically, in absolute terms, the June quarter sales of most automobile manufacturers are still at the levels seen in the corresponding quarter of 2012—two years ago. Photo: Ramesh Pathania/Mint

Auto sales growth in June not only reinforced the positive sentiment of recovery seen in April and May, but also resulted in a strong re-rating of the sector. A year ago, leading auto stocks like Maruti Suzuki India Ltd and Hero MotoCorp Ltd, along with most of their peers, were trading at about 13 times one-year forward earnings per share. At current prices, they are trading at about 16 to 17 times 2015-16 earnings, about 20 months ahead.

Ironically, in absolute terms, the June quarter sales of most automobile manufacturers are still at the levels seen in the corresponding quarter of 2012—two years ago! For example, Maruti Suzuki, the country’s largest car manufacturer, sold about 2.99 lakh cars in June 2014 compared with 2.96 lakh in June 2012. Likewise, Mahindra and Mahindra Ltd sold just a few more vehicles during the June quarter, compared with the corresponding 2012 quarter. The relatively lower base during 2013 partly shored up the growth rate figures, in addition to new launches by some two-wheeler and car manufacturers, which lured customers.

The question then is, why the euphoria and high valuation? In fact, the S&P BSE Auto index has outperformed the broader market in the last three months.

One reason is the sustained trend in improved demand over the last three months, in spite of the absence of festive triggers. “Entry of first-time buyers and pent-up demand (last three years were flat for the industry) are likely to lead to 12-13% volume growth in passenger car industry," says Surjit Arora, analyst at Prabhudas Lilladher Pvt. Ltd. Two-wheelers would continue to grow in a relatively stable fashion as seen last year. Commercial vehicles would gain substantially from the industrial revival expected in the next two years.

Another reason is that the auto industry has, through cost-cutting measures, weathered the challenges in the sector. In fiscal 2015 and 2016, companies will see the benefits of better capacity utilization that will boost profit margins too. Another key positive is that when most other core sectors are reeling under a cash crunch, automobile manufacturers’ balance-sheets have cash surplus.

Besides, valuation changes mirror the optimism about the industry prospects. According to Chirag Shah, analyst at Edelweiss Research, “the auto companies’ balance sheets are healthy, with return on equity and assets being stable through the slowdown. More importantly, auto is an early-cycle recovery sector, which implies that among cyclicals, it revs up faster than others, as the economic cycle improves." Infrastructure and capital goods, along with most manufacturing segments take longer for policy decisions to translate into earnings momentum.

That said, any let-down in expectations, in terms of sales volumes or earnings growth, may trigger an adverse reaction.

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Published: 09 Jul 2014, 04:37 PM IST
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