How to pick auto ancillary stocks

In the outsourcing space, the prospects for auto ancillary manufacturers are bright from the long-term perspective.

But identifying the right stock from this sector becomes difficult on account of technical complexities involved and higher nature of fragmentation of the industry. In this article, we have made an attempt to simplify this process and help investors identify a good auto ancillary stock.

Profile
The Indian auto component industry is highly fragmented in nature and has 416 players, employing 250,000 people. The output of the Indian auto component segment, as per ACMA, was estimated at around $5.1 billion (Rs 245 billion) in FY03.

Since an auto assembly involves large number of parts, ACMA has classified sector companies on the basis of components that they supply to auto manufacturers. The following table lists the industry segmentation on the basis of components, their contribution to the overall industry revenues and some of the leading players in those segments.

Since auto ancillary companies mainly act as vendors, it is extremely important for them to remain competitive, both in terms of cost as well as quality.

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As a consequence, the profitability of the company at the operating level assumes great significance. Therefore, we consider operating profits as a good starting point in separating a good auto ancillary company from the rest.

Let us throw some light on the various operating parameters presented in the flow chart below:

Operating profits: The operating profit of an auto ancillary company is the difference between the revenues earned and the expenses incurred. We shall now focus on the revenue side first.

An auto ancillary company can generate revenues from two major sources, the first is from supplies to OEM (original equipment manufacturers) and the second is through after market sales.

With the advent of the best manufacturing practices in the domestic auto industry, auto players have significantly cut the number of auto ancillary manufacturers they source their components from and in line with the global trend, this has led to the tierisation.

Naturally, the auto ancillary manufacturer, which directly supplies to the OEMs and offers more value added products, is the one that is known as a Tier I player. Further, the components and sub-assemblies required by the Tier I players are sourced from Tier II and Tier III suppliers.

Thus, an auto ancillary company can generate its revenues from any one of the above-mentioned three ways. In this sector, Tier I players on account of their direct interface with OEMs have a better bargaining power and consequently enjoy higher margins.

On the flip side, these players have to be very particular about their quality and have to keep high levels of inventory, thus increasing working capital needs.

Apart from direct supplies, an auto ancillary player can also generate revenues from after market sales, i.e. it can have a presence in the replacement market.

Here, the margins are not only higher on account of superior realisations, but it also provides a cushion against slowdown in the auto industry when the demand from OEMs decline.

Thus, while selecting an auto ancillary stock, it becomes necessary to delve into the position of the company on the supply value chain and at the same time, check whether the company derives some of its revenues from after market sales.

The higher the company on the value chain and larger the percentage of revenues derived from the after market, the better it is.

Since companies in the industry are suppliers to the auto industry, the performance of the auto industry has the single largest impact on the fortunes of the auto ancillary industry.

Therefore, it becomes imperative for an investor to track the performance of the auto industry (both domestic as well as international), in order to determine the growth prospects of an auto ancillary company.

What would happen if an auto ancillary company generates majority of its revenues by supplying to just a single auto company and the latter shuts down? Not surprisingly, even the auto ancillary company might have to shut down or scout for other clients, which would be hard to come by.

Therefore, in order to avoid such a scenario, an investor should look for companies that have adequate client diversification, both in the domestic as well as international markets. The larger and stronger the number of clients, the lesser the risk for the auto ancillary company.

Apart from client diversification, geographical diversification, where the company derives a good part of its revenues from exports or supplies to overseas players is also an important criterion for identifying a good auto ancillary company.

Since auto ancillary companies usually supply to leading automakers, quality issue becomes extremely important. This assumes even more serious dimensions while supplying to foreign auto majors.

Even a small defect in quality could lead to heavy penalties. Therefore, if a company has some sort of recognition such as the Deming quality awards or best supplier award from respected auto companies, it always adds to its credibility and ability to win lucrative contracts.

Thus, after looking into the major aspects of the revenues side, it becomes clear that companies with more value added products and sufficient client and geographical diversification will prove to be a safer bet than its peers, which do not have the same characteristics.

Having gone through the revenues part of the flow chart, let us now glance through the major expenses that are incurred by an auto ancillary company.

Expenses:
The auto industry has evolved to a stage where auto companies have substantially increased the number of components they outsource. Apart from design and development work and manufacturing of some key components, almost all the other components are outsourced.

In such a scenario, auto ancillary players have been increasingly burdened with higher raw material expenses, notably steel.

Since auto ancillary companies have a weaker bargaining power, majority of the input cost rises are absorbed internally (either through cost restructuring or lowering margins). This increases the risk profile of the sector.

Here also, Tier I players have been less affected as opposed to Tier II and III players on account of the formers' higher bargaining power.

Even for those manufacturers, where steel does not form a major part of input, raw materials prices account for 50%-60% of the total sales (tyres, for instance). So, investors have to monitor prices of steel, rubber and petrochemicals, which are key inputs.

Apart from raw material prices, salaries and wages is the other important expense head for an auto ancillary company. These typically tend to be on the higher side (10%-12% of sales) if the operations of the company are more labor intensive, whereas for companies with a high degree of automation, the same stands at 5%-6% of the total sales of the company.

For a company, where exports form a significant part of total revenues or where most of the inputs are imported, exchange rate prevailing in the markets also tend to affect the operating margins of an auto ancillary player.

Apart from these, asset turnover ratio, return on assets and working capital to sales are other factors that a investors should compare for investment purposes.

Thus, having broadly looked at the parameters that determine the profitability of an auto ancillary company, we now have a look at what kind of valuations should an auto ancillary company command.

Valuations:
The fortunes of auto ancillary companies are linked to the fortunes of the auto industry and as a result the bargaining power stands considerably reduced. Thus, these companies have little leeway in improving their topline performance by raising prices.

The onus of improving profitability therefore falls on cost reduction measures and effective deployment of funds.

Hence we feel that P/E multiple is an important metric in evaluating the performance of a company from this sector. Companies that cater to domestic market deserve a lower P/E multiple as compared to a company that derives a significant share from export markets.

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