Auto component makers have drawn up ambitious capital expenditure plans because of the need to upgrade their technologies in line with upcoming stricter vehicle emission norms and other regulations in the automobile sector. The investments are being planned despite moderating sales volume and pressures on profit margins. Crisil Ltd pegs auto component companies to spend ₹ 24,000 crore on capex over the next two years, 30% more than the preceding two years.
Why are the component makers investing?
From 1 April 2020, the country will embrace BS-VI emission norms, upgrading from the current BS-IV standards. Analysts expect component makers in the entire power train chain will need to upgrade their technologies to comply with the new norms.
Besides, the government’s thrust on electric vehicles implies a paradigm shift in components too. For instance, battery firms, Amara Raja Batteries Ltd and Exide Industries Ltd, are gearing up to shift from lead acid to lithium-ion batteries. Some original equipment manufacturers (OEM) such as Maruti Suzuki India Ltd and Mahindra & Mahindra Ltd are also investing to prepare for the new wave of electric vehicles.
That apart, there seems to be a consensus on the long-term growth prospects of the auto sector. A report by Morgan Stanley titled India’s Transport Evolution says, “India is 3% of global car sales now but will drive half of the incremental global car demand over 2017-30."
Therefore, optimism among component makers is understandable. In spite of the sales slowdown across various auto segments in the second half of calendar year 2018, component firms are adding capacity in existing areas such as tyres, interiors, forgings and castings to cater to the long-term demand. The trend of component makers forging technology tie-ups or acquiring overseas parts makers is likely to gain traction in the next fiscal year.
This fiscal year could however be a tough year in terms of profit expansion. According to a report by Icra Ltd, component makers’ realizations and content per vehicle is set to improve, translating into a healthy 12-13% revenue growth in FY19. Margin pressure may stem from volatile commodity prices and depreciation of the rupee along with sales moderation, Icra said.
Fortunately, the sector’s fundamentals have been among the best in the country. Most firms, barring some in the tyre segment with huge capex for expansions, have displayed healthy cash flows. Crisil’s data shows an average 15-16% growth in operating profit over the last five years. The robust cash flow accretion thereof will enable manufacturers to meet capex requirements, without any adverse impact on the balance sheet. Meanwhile, technology requirements could also translate into increased imports for a while, until local investments are made to indigenize technology. That said, the need for improved technology along with stringent tax structures such as the GST may result in a consolidation.
To sum up, the year ahead could see a wave of investments in auto components amid challenges of revenue moderation and margin pressure. From investors’ perspective, the rally in component stocks over the last 12-18 months has increased valuations of key firms to about 18-20 times one-year forward earnings. In the near-term, increased capex may pull down earnings growth. This could limit upsides in stocks unless quarterly results surprise positively or there is news flow on strong acquisitions, driving share prices further up.