Margin woes crash two-wheeler makers' 'joy' ride, stocks take a beating

Two-wheeler stocks have been the biggest underperformers in the auto pack and have shed between 7.5 per cent and 15 per cent over the last month, in contrast to the 4 per cent gains for the broader markets. Analysts say the trend may not change given the pressure on margins due to firm input costs, high competitive intensity and price discounting strategy of some players.

Strong demand

The weak investor appetite comes at a time when the demand and volume outlook for the sector remains strong. After clocking over 14 per cent volume growth in FY18, the two-wheeler sector has reported a similar year-on-year growth in the first four months of the current fiscal. Hetal Gandhi, director, CRISIL Research, expects the industry to grow by 10-12 per cent in FY19 on a high base of the last fiscal. Gandhi believes that government spending could boost demand in the second half of FY19, potentially pushing demand upwards by 1-2 percentage points. The volume, led by strong rural demand and incremental growth in urban markets, is expected to hit record 22.4 million units in FY19. 

 
The key trigger continues to be strong rural demand, with companies indicating 300-400 basis points growth difference between urban and rural demand growth. The resurgence in rural demand in FY18, according to Anupama Arora, vice-president & sector head, corporate sector ratings, ICRA, is likely to continue in FY19, benefiting from upbeat farm-household sentiments, favourable crop seasons and expectations of normal monsoon precipitation. What has also helped are policies aimed at improving insurance coverage, irrigation and crop realisations (higher minimum support prices). On the urban side, pay revisions in FY18 by state governments (more to follow this fiscal) should help drive the double-digit growth for the sector in FY19. 

Headwinds

Despite the positives, analysts also highlight multiple red flags that investors need to keep in mind. Higher fuel costs and rising interest rates would increase funding and operating costs of a two-wheeler and could constrain demand. However, the bigger worries are commodity prices and a sharp rise in the competitive intensity which will have a bearing on operating profit margins of the companies. Arora of ICRA says: “Hardening commodity prices over the last 12 months, aggressive pricing by select companies as well as rising promotional costs have affected the operating margins of two-wheeler OEMs (original equipment manufacturers). With such commodity price pressures and high competitive intensity, the pressure is expected to continue.” Margins, according to her, could continue to moderate in FY19 even as companies are taking price revisions.

 

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While competitive intensity is strong across segments as companies try to fill their gaps in the portfolio, it is perhaps the strongest in the entry-level motorcycle segment. This would aggravate the revenues and profitability of some players given realisations are typically lower in this price-sensitive segment. The price cuts initiated by Bajaj Auto on entry-level bikes, an increase in dealer commission by TVS Motor as well as use of aggressive finance schemes suggest that market share remains the main driver for these moves. With companies getting into categories they were not present (such as Hero MotoCorp’s entry into 125cc scooter segment), expect competitive intensity levels to stay high. 

Some pressure on the two-wheeler business was evident in the June quarter results. While Bajaj Auto’s margins were flat over the year-ago period, they were down 215 basis points sequentially, to 17.3 per cent. This could continue both due to the discount pricing strategy as well as input costs. Margins for Hero are expected to be under pressure due to commodity inflation and expiry of Haridwar plant tax benefits. How Hero responds to price cuts by Bajaj and cost reduction efforts will decide the course of its profitability, which at 15.6 per cent was a tad lower than estimates in the June quarter. While TVS Motor’s margins were up 120 basis points year-on-year and 40 basis points sequentially to 7.4 per cent, its gross margins were down on higher raw material costs. Given the raw material pressures, analysts believe it will be an uphill task for TVS to achieve its double-digit margin target.