Auto sector could be lead indicator

The auto industry is a good indicator of consumption demand. It also has a long value chain extending from primary commodities through to sophisticated electronic gear. It employs millions with many different skills. There are approximately 30,000 parts in a single vehicle. In addition to the manufacturing chain, there's a long services chain what with dealers, advertisers and financiers. Plus, there's repair and maintenance, and of course, employment for professional drivers, etc.

The sector releases production numbers on monthly basis through the SIAM, though this doesn't necessarily translate into sales. Despatches to the dealer are booked as sales and there can be inventory pileups. In 2017-18, India produced 29,075,605 vehicles including passenger vehicles, commercial vehicles, three-wheelers, two-wheelers , a robust growth of 14.8 per cent over 25,330,967 vehicles in 2016-17.

Domestic growth was well-distributed. Passenger vehicle sales grew 7.9 per cent. The overall commercial vehicle segment grew by 19.94 per cent. Three-wheeler sales grew by 24.2 per cent and two-wheeler at 14.80 per cent.  

The second half of 2017-18, especially the period from December 2017-March 2018, gained from a low-base effect caused by demonetisation. This reduced sales in the last four months of the 2016-17 fiscal. However, the first half (April-September, 2017), especially the period between June 2018-August 2018 saw reduced volumes due to the nervousness caused by Goods and Services Tax launch. Commercial vehicles were hit even earlier by the upgrade to Bharat Stage IV emission norms. 

Volumes have grown at 15.2 per cent in April-May 2018 over April-May 2017, with 5,378,591 vehicles produced, compared to 4,670,687 vehicles in April-May 2017.

The base effects were pronounced. The commercial vehicles segment saw growth of 57.44 per cent in April-May 2018 compared to the same period of 2017. Medium and heavy commercial vehicles (M&HCVs) increased by 114.79 per cent and light commercial vehicles grew by 34.27 per cent in April-May 2018. In June 2018 versus June 2017, the GST base effect was also large. Tata Motors sold 50 per cent in June 2018, compared to June 2017, Maruti saw 35 per cent growth, Bajaj Auto grew 65 per cent, etc.

It is, therefore, hard to compare these periods meaningfully. Nevertheless, the numbers suggest a revival in demand. So, why has the NSE Auto index underperformed the Nifty through this period? The NSE Auto index is up 3 per cent in the last 12 months and it's down about 1 per cent in the last month. The Nifty is up by 11.5 per cent in the last year and by up 1 per cent in the last month.

There are multiple reasons why investors have remained cautious. Many sales have been conducted to clear inventories at discounts. Higher fuel prices have often negatively impacted demand in the past. If the petro-cycle stays up, it could put the brakes on demand. As interest rates now start to rise, financing costs will hit both the working-capital intensive industry, and negatively impact demand. Rising commodity prices are also leading to higher input costs.

Analysts have pointed to the disappointing margins of the Q4, 2017-18 (January-March 2018). Volume growth was 17 per cent for cars and 27.5 per cent for two and three wheelers compared to January-March 2017. (Note the base effects due to the demonetisation). However the Q4 2017-18 operating margins were flat across the industry. Profitability and EBITDA estimates were missed by many companies. 

As the results season comes around, the broad trends in Q1, 2018-19, could be similar. Inflation continues to run up and it won't be easy for the industry to pass on all input costs. Equated monthly instalments may also rise. Fuel prices look unlikely to reduce substantially.  So while most auto companies will record strong revenue growth, margins could be tight.  

The auto index is fairly well-correlated with the Nifty over the past five years. It has a high beta and it has far more volatility, on daily, monthly and annual basis. Due to the long value chain, it has a lot of influence on other industries. It could be a lead indicator.