How automakers are risking their margins

A rise in discounts is expected more in the entry-level passenger vehicle and the 2W segments, where demand has yet to rebound strongly. Photo: Bloomberg 
A rise in discounts is expected more in the entry-level passenger vehicle and the 2W segments, where demand has yet to rebound strongly. Photo: Bloomberg 

Summary

  • The increase in discounts may negate a part of the commodity benefit.

Among automakers, Bajaj Auto Ltd will be the first to announce the September quarter (Q2FY23) results on Friday. Export markets are muted in the two-wheeler (2W) segment and Bajaj would bear the brunt of this. The share of relatively more profitable exports fell to 39% of Bajaj’s total 2W volumes in Q2 from roughly 63% in Q1.

Even so, softening prices of key inputs are likely to offer some respite on margins for all auto companies, including Bajaj. Data sourced from Kotak Institutional Equities showed prices of commodities such as steel and aluminium in Q2 are down by 15-19% sequentially. Given this, investors in shares of auto companies would keep a close eye on margin performance this time around. Kotak expects gross margins to expand for some original equipment manufacturers in Q2. Further, price hikes by automakers would support margin expansion. Moreover, the sequential rise in volumes across most segments means better operating leverage. Even so, adverse product mix in some auto companies could be a dampener. For instance, Mahindra & Mahindra Ltd’s tractor volume share fell to 34% in Q2 from nearly 44% in Q1. The tractor business is high-margin and will weigh on overall performance.

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Substantial margin improvement because of lower commodity costs is likely to reflect from Q3 onwards as the effect comes with a lag. Further, volume growth would also act as a lever for margin expansion with the chip shortage situation easing. However, amid threats of a global recession, which is weighing on commodity prices, it may not be easy for automakers to take large price hikes. Additionally, a potential rise in discounts on vehicles pose a risk to margins. This is expected to be more prevalent in the entry-level passenger vehicle (PV) and the 2W segments, where demand is yet to rebound strongly on a sustained basis. Nomura Global Markets Research points out that discounts by Maruti Suzuki India Ltd for some models have risen sequentially so far in October. The increase in discounts may negate a part of the commodity benefit.

For 2Ws, demand has picked up in the festive season as is evident from Navratri ’22 vehicle retail data released recently by the Federation of Automobile Dealers Associations (FADA). Retail sales of 2Ws grew by 4% versus pre-covid levels (Navratri ’19). However, the moot question is whether this momentum will continue. “Sales of 2Ws during Navratri have been good, but any slowdown during Diwali may lead to higher inventory levels and might result in an increase in discounts. This will weigh on margins but falling raw material costs would provide more cushion," said Varun Baxi, an analyst at Nirmal Bang Equities. Against this backdrop, investors should closely track the management commentary on expected demand trends in 2Ws after the festive season. A subdued rural market is a hurdle for demand.

PV retails during Navratri ’22 grew by almost 59% versus pre-covid levels , according to FADA. They are expected to hold their ground even after the festive season. The commercial vehicle (CV) segment is seeing strong replacement demand and this should hold CV makers such as Tata Motors Ltd and Ashok Leyland Ltd in good stead.

Meanwhile, the Nifty Auto index has gained by 15% in CY22 so far, as opposed to the 1% drop in the Nifty 50 index. Improving prospects, coupled with a slew of launches and electric vehicle announcements by automakers have led to this outperformance. With the run-up in share prices, valuations of auto companies are reasonable and not exactly cheap, said analysts.

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