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Indian Auto Components Industry Slowdown in OEM demand impacts revenue growth; battling profitability pressures through cost rationalization and scaling down of capex

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WHAT’S INSIDE? 1. Overview 2. End-user demand remains weak across automobile segments 3. Revenue growth drivers of auto component industry Auto component manufacturers that have recorded significant decline in revenues Auto component manufacturers that have maintained relatively steady revenue growth Auto component manufacturers that have maintained healthy growth in revenues 4. Raw material cost pressures have stabilized over last several quarters Ratio of raw material costs to revenues has been on a declining trend; although other costs have increased OPBDIT margin movement of auto component manufacturers Movement in ICRA Car Cost Index What are companies doing to tide over liquidity pressures and to cut costs 5. INR depreciation has stressed balance sheets of select auto component manufacturers 6. Interest coverage movement of auto component manufacturers 7. Credit Rating Trends 8. Quarterly performance update Asahi India Glass Limited Banco Products (India) Limited Bharat Forge Limited Exide Industries Limited Gabriel India Limited Hinduja Foundries Limited Lumax Industries Limited Mahindra Forgings Limited Motherson Sumi Systems Limited Munjal Showa Limited Sona Koyo Steering Systems Limited Sundaram Clayton Limited Sundram Fasteners Limited Wheels India Limited ZF Steering Gear (India) Limited

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INDIAN AUTO COMPONENTS INDUSTRY Slowdown in OEM demand impacts revenue growth; battling profitability pressures through cost rationalization and scaling down of capex JANUARY 2014

Overview Growth in supplies to domestic OEMs to remain weak in the near term in the absence of immediate demand triggers

The Indian automobile industry has witnessed a period of sluggish demand for almost three consecutive years with signs of recovery still appearing distant. As auto component manufacturers derive over 60% of their revenues from supplies to the domestic auto Original Equipment Manufacturers (OEMs), the ongoing weakness in demand for new vehicles has accordingly had an adverse impact on revenue growth of suppliers. Amongst segments, the Commercial Vehicle (CV) segment has been the worst impacted reflected in decline in domestic monthly sales volumes from a high of ~90,000 units in March 2012 to a low of ~44,000 units in November 2013. The Passenger Vehicle (PV) segment had recorded positive volume growth (although in low single digits) in 2011-12 and 2012-13, but growth turned negative (-5.5% YoY) in 9m 2013-14. Still, auto part makers supplying to the PV segment have been relatively better-off than those supplying to the CV segment, although relatively worse-off than those supplying to the Two-Wheeler (2W) segment – where volume growth continues to be positive (5.4% YoY growth in 9m 2013-14). Over the near term, we expect auto component industry’s growth pertaining to supplies to domestic OEMs to remain weak in the absence of immediate demand triggers for endusers. Over the medium term, however, we expect the auto components industry’s revenues to grow at a relatively faster pace than the OEM segment riding on several factors including auto OEMs’ growing thrust on localization, auto suppliers’ efforts to expand business in new geographies, the strong upside potential to replacement market demand and increasing sophistication of vehicles shoring up part prices. Auto part exports likely to recover in CY2014

In terms of exports, the Indian auto part makers witnessed decline in supplies in 9m 2013-14 on YoY basis as CV demand in North America; and PV demand in Europe (the two key export geographies for Indian suppliers) remained dull. However, auto part exports from India are likely to gain traction in CY2014 on the back of expected recovery in automotive demand in key developed markets. In the US, growth in light vehicle sales in the near term is likely to be driven by sustained economic recovery, large supply push in the form of new model launches and a high level of lease maturities1. In Europe, growth trends are likely to be mixed. The low base of European PV volumes in CY2013 as a fallout of persistent decline in volumes over last few years may mean mild growth recovery in CY2014. However, CV sales in Europe may likely be depressed in the near term following significant pre-buying that has already happened in CY2013 prior to implementation of Euro-VI emission norms from January 2014. Yet, export-oriented auto suppliers may benefit from market share gains following the depreciation of the INR against the USD that has made Indian suppliers relatively more cost competitive internationally. Operating profit (OPBDIT) margins may not deteriorate much in 2013-14

Based on our sample of 35 publically-listed auto component manufacturers, the OPBDIT margins of these entities had improved marginally by 30 basis points (bps) in 2012-13 over the previous year. However, our sample’s weighted average margins were skewed by select entities which cater to the automotive replacement market – particularly tyre companies and battery making companies – which were able to maintain elevated pricing in the aftermarket despite lower input costs. Excluding these entities, our sample’s OPBDIT margins were observed to have fallen by around 200 bps in 2012-13 due to somber revenue growth but sticky fixed costs. Our sample’s OPBDIT margins in H1 2013-14, however, were seen to have improved by 200 bps due to two key factors viz., (a) decline in raw material costs, the biggest cost element, as global commodity prices softened in Q1 2013-14; (b) weak revenue base of Q2 2012-13 consequent to drop in output at the manufacturing facilities of the largest PV OEM Maruti Suzuki (due to labour troubles) and the largest 2W OEM Hero MotoCorp (which looked to cut down channel inventory), resulting in 1

Leases account for ~25% of light vehicle sales in the US. New light vehicle sales growth in CY2014 is expected to be supported by expiration of leases entered into in CY2011 (3-year leases) and CY2012 (2 year leases)

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decline in margins of auto suppliers. We expect the sharp depreciation of the INR in Q2 2013-14 to have a trickle-down dampening impact on margins of various industry participants in Q3 2013-14 due to increase in import costs. Yet, we expect overall OPBDIT margins of auto component manufacturers not to deteriorate much in 2013-14 vis-à-vis 2012-13 as the negative impact of lackluster revenue growth in 2013-14 may be suitably offset by expectation of stable commodity prices in the near term and significant focus on internal cost compression. Also, the point of reference of comparing expected margins in 2013-14 would be the year 2012-13, which was a weaker baseline year wherein industry margins were bogged down due to much sharper variation in demand during the year resulting in greater margin gyrations. International commodity prices are likely to remain range bound in the near term due to slow pace of global economic recovery as well as surplus global stocks of select metals such as aluminium and copper. Further, our interaction with auto part suppliers suggests that despite the hike in list price by various domestic steel mills in October 2013 and January 2014, the same has not translated into increase in purchase costs for auto suppliers so far. External factors apart, auto part suppliers have also sharpened focus on internal cost reduction by way of manpower rationalization, plant shutdowns, shift reduction at plants, disposing-off unproductive assets and reducing breakeven output level. Thus, while overall OPBDIT margins of auto component manufacturers may not deteriorate much in 201314, it does not preclude possible dip in OPBDIT on account of revenue decline. Net profit growth to hinge on the currency variable

The aggregate net profits of auto component manufacturers in our sample had declined by around 7% in 2012-13 over the previous year. However, earnings performance was much better in H1 2013-14 on YoY basis growing by 25% with bulk of the growth attributable to entities supplying to the automotive replacement market. The growth in OPBDIT of our sample entities (attributable to factors highlighted earlier), translated into healthy growth in net profits in H1 2013-14. The aggregate growth in net earnings was despite the fact that currency woes came back to haunt auto component manufacturers in H1 2013-14 as both the average USD-INR rate as well as the period-ended rate increased in H1 2013-14 compared to H1 2012-13. The net profits of auto component manufacturers with foreign currency loans has been weighed down by sharp appreciation of the USD against the INR resulting in MTM losses on restatement of foreign currency loans and higher interest outgo. The USD/ INR rate had generally remained in the vicinity of 54-55 in 2012-13, but the INR’s weakness got exacerbated in Q1 2013-14 and further still in Q2 2013-14 resulting in large MTM losses for various auto ancillaries having USD-denominated borrowings. We analyzed 119 auto component manufacturers, having aggregate annualized turnover of Rs. 1,077 billion and aggregate PBT of Rs. 48 billion, to judge the extent of their exposure to forex risk.  Around 36 of these entities have a reasonably high import content (>15% of total buying), implying potential 14% impact on OPBDIT for 10% depreciation of the INR against the USD. However, the actual impact on their P&L is unlikely to have been as onerous given that forex risk arising from increase in cost of imported raw materials is generally passed-through to OEM customers. Yet, the importing entities’ cash flows do remain exposed to forex risk since compensation from OEMs comes with a lag as also the payable cycle with overseas suppliers remains long (30-90 days payment cycle) that puts part of the forex risk on the importing entities’ balance sheet. 

Our sample entities had total debt of Rs. 227 billion outstanding as on March 31, 2013, of which around 27% was foreign currency denominated. Of the total foreign currency debt, around 65% remains un-hedged. As per our analysis, for every Re 1 depreciation of the INR against the USD (on base of USD-INR@60), the aggregate PBT of the aforementioned sample entities is estimated to decline by 2% on an annualized basis, ceteris paribus. Given that the USD-INR rate was 62.7 as on September 30, 2013, higher than the level as on June 30, 2013, the Q2 2013-14 results of auto component manufacturers exhibited forex losses mainly due to restatement of USD-denominated liabilities. However, a moderate MTM gain is expected to be reported in Q3 2013-14 results of auto ancillaries as the quarter-end USD-INR rate was 61.8 as on December 31, 2013 Vs 62.7 as on September 30, 2013.

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For our sample entities, around 25% of total foreign currency debt falls due for repayment in 2013-14, implying higher cash flow burden during the year due to INR weakness. If USD-INR rate stays firm at the current rate, repayment burden and refinancing risks are likely to remain high even in 2014-15.

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Capital Expenditure Plans

The capacity expansion programme of auto component manufacturers generally tends to follow that of their key customer OEMs. Given that auto OEMs such as Maruti Suzuki, Hero MotoCorp and Ford are in the process of establishing greenfield facilities, their respective suppliers of key components are currently at various stages of making investments in close proximity to these new facilities or in the OEMs’ vendor parks. As per ICRA’s estimates, the above greenfield investments may entail total investments of Rs. 70 billion to be incurred by auto component manufacturers over the next three years (a large part of these investments are likely to be incurred post 2013-14). These investments apart, the quantum of capex otherwise planned to be incurred by auto component manufacturers over the near term remains moderate. With the industry going slow on investments towards capacity expansion, we do not expect any major incremental term debt burden to ride on the balance sheet of auto component manufacturers over the near term. However, the large debt-funded capital expenditure executed by auto component manufacturers during the boom period of 2010-11 means that repayment obligations of the term loans availed then is falling due now. At the same time, for gaining business for new models of automobile OEMs, several suppliers had invested in building up capacity (some of which was model-specific) over the last two years. While during the initial period of launch of several of these new models, capacity utilization of suppliers was reasonably high, the same is not the case now after 12 months of model seasoning. Also, effective borrowing rates have increased in recent periods due to tight liquidity conditions as a fall-out of the INR depreciation, implying elevated effective interest costs during 2013-14. In our view, in the prevailing situation marked by pressure on internal accruals, several entities remain exposed to refinancing risks although overall industry stress remains much lower than various other corporate sectors such as construction, infrastructure, power, metals etc.

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