Fitch Ratings: 2009 Indian automotive sector outlook – a special report

Overview

The Indian auto sector (passenger cars and commercial vehicles (CVs)) underwent one of the longest and strongest positive cycles to end-September 2008 (Q3CY08), while year-on-year (yoy) sales growth has since decelerated rapidly. In Fitch Ratings’ 2008 Outlook for the sector, the agency acknowledged the inherent cyclicality of the demand pattern, wherein a three-to four-year growth spurt was followed by a two-year downturn.

However, Fitch’s expectation for a sector recovery from H2CY08 has been delayed due to various macroeconomic factors, including tight liquidity and credit availability, slower GDP and industrial production (measured by the index of industrial production (IIP)) growth rates, and depressed investment/consumer sentiment. Fitch remains cautious with regard to the demand outlook for the sector in calendar-year 2009 (CY09), as these key environmental factors are unlikely to improve in the near term.

Fitch expects volumes to stabilise over H1CY09, although at lower levels than in CY08. This will result in negative yoy growth rates compared with CY08 until end2009, when the high base effect is corrected. Whilst the long-term fundamentals of the sector remain strong, the reversion to long-term growth rates (around 10%-12% for cars and 8%-10% for CVs) is likely to take longer and be slower than in earlier cycles.

The agency expects the industry volume graph over the medium-term to follow more of an ‘L-shaped’ pattern rather than the ‘U-shaped’ pattern seen through the earlier positive cycle. Furthermore, exports have been unable to provide the earlier cushion over CY08 due to a severe slowdown in their respective markets.

CV decline to continue over the short to medium term

Growth rates have traditionally been more volatile for CVs than for cars – a trend being indeed witnessed in the current slowdown. Domestic CV sales declined by 9.5% in April-November 2008 compared with the same period in 2007, to 298,208 units. However, the full impact of the deceleration will only be seen in the April-March financial year-end (FYE09) figures, as the yoy declines continue through Q1CY09. Although CV makers have been offering discounts, it has not been enough to offset the current negatives being faced by freight operators – a reflection of the current economic environment. Operators have faced pressures over H2CY08 due to the following:

>Pressure on freight volumes due to lower freight demand from exporters, slower growth in IIP, and competition from railways for large commodities. This, coupled with increased capacity built up over the cycle, has led to lower capacity utilisation.

>Operators have also faced severe cost pressures due to higher fuel and financing costs, putting further pressure on margins. However, with excess capacity, they have relatively limited ability to pass these costs on to their customers. This is seen in the softer trends in the freight indices. However, the recent softening in interest rates and reduction in fuel costs over H2CY08 could boost operators’ liquidity, although with a lag effect.

>Operators are also facing issues with regard to the higher cost of credit, and availability of finance with regard to new truck purchases. The problem is compounded by Fitch’s expectation of higher NPL levels across truck financiers, which could further hamper credit availability.

Fitch notes that stable CV demand remains contingent upon a stable economic environment, including continued positive growth in freight volumes and stabilisation of freight rates at higher levels. This will likely lead to an improvement in the financial and liquidity position of operators. Demand could also benefit towards end-CY09 from the advancement of purchases in anticipation of the new emission norms in April 2010, although this will be one-time in nature – similar to that of the overloading ban two years ago. Fitch expects the above demand drivers to stabilise over CY09, and anticipates a marginal soft recovery to start towards end CY09.

Car sales also negative, but not as bad as for CVs

Car sales started to decline over H208, primarily due to increased financing costs and lack of credit availability. Domestic car sales remained largely flat at around one million units for the period April-November 2008 compared with the corresponding period in 2007. The extent of decline has been partly mitigated by the number of new model launches, although this has resulted in a re-alignment of market share away from players with aging product portfolios.

Car sales have primarily been impacted by the availability and currently high cost of consumer finance, combined with lower visibility of income growth. However, Fitch expects car sales to recover faster than CVs once credit availability is eased. Volumes in CY09 are also likely to be supported by the large number of new launches planned by various players, although this will also increase competitive intensity. Car makers have also been offering incentives and discounts to stem the ongoing slowdown in sales, which have helped mitigate the decline in volumes.

Margin pressures across the board

The discounts being offered by original equipment manufacturers (OEMs) are likely to have a significant impact on their operating margins over the short term. The current lower capacity utilisations across the sector will also likely magnify the margin impact of overheads. However, companies are implementing stringent cost-cutting measures such as laying off temporary workers and reducing overtime.

Although some relief can be expected over the near-term from price cuts from vendors, as well as softer input prices (steel, copper and aluminium), this will benefit OEMs only once the current raw material inventories purchased at higher costs are liquidated.

Rising working capital pressures across the sector

Slower demand coupled with lack of financing access by dealers has put pressure on the working capital cycles of most OEMs. Slower demand has led to inventory pileups both at the dealer level and at the OEMs’ own plants. However, car and CV makers have been taking corrective measures, primarily in the form of cutting back on production to prevent further inventory pile-ups. But these production cuts have taken place with a lag effect, resulting in stretched working capital cycles for most OEMs and putting further pressure on their liquidity.

As production and dispatches continue to lag market demand, Fitch expects the situation to correct itself over the short term. OEMs are stretching their utilisation levels of working capital limits, as well as stretching their suppliers’ payment terms to finance this liquidity mismatch.

Deterioration in credit profiles – partly mitigated by deferments in capex

Most OEMs are likely to face substantial pressure on operating cash flows due to slower demand, lower margins and higher working capital requirements. This will in turn put pressure on their liquidity and credit metrics over the short to medium term. Interest coverage is likely to remain under pressure due to a combination of higher working capital utilisation, increased interest costs, and Fitch’s expectation of negative free cash flow (FCF) for the sector. Fitch notes that the impact on credit profiles has been more severe for pure-play CV makers, which have faced the brunt of the impact of the slowdown.

Whilst most OEMs are currently implementing large-scale expansion, some of the greenfield projects are being scaled down/deferred, which could stem the extent of deterioration. That said, a substantial part of their expansion is nondiscretionary in nature, eg critical capex required for new model launches, and long-term strategic initiatives.

Thus, whilst the extent of capex will remain large in relation to operating cash flows, the size of these investments is likely to be lower than that projected by Fitch in CY08. The agency expects the lower growth to translate into higher negative FCF in FY10 than anticipated earlier, which will exert additional pressure on operating metrics.

Negative outlook over the short to medium term; Long term fundamentals remain

A recovery of the sector remains contingent upon improved credit availability as well as recovery of key demand drivers including GDP growth and the freight markets. The government has set out a stimulus package for the sector, which includes better credit availability for CV financiers, increased deprecation benefits for CV purchases, and a reduction in excise duties (which have already been passed on).

In addition, bus sales could also benefit from the proposed assistance to be given to state governments under the Jawaharlal Nehru National Urban Renewal Mission. While this will, to an extent, help stem the current volume decline, Fitch believes that a recovery in freight rates will remain more critical for the CV sector, which is likely only over the medium term. Better credit availability will, however, partly offset the current impact of the slowdown for both cars and CVs.

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