Worst of auto down-cycle behind us, says MOSL; lists M&M, Tata Motors among top picks

After consistently underperforming in the last 5 years, the auto sector is likely to break this cycle. On the back of improving demand, earnings upgrade, rise in investor allocation, and strong earnings outlook, domestic brokerage house Motilal Oswal believes the worst of the auto down-cycle is behind us even as valuations are reasonable. 

Its top picks in the sector are M&M, Tata Motors, Motherson Sumi and Ashok Leyland.

"Given the improving narrative on demand, supply, and margins, we expect the auto sector’s earnings to grow significantly on a flat base of five years. A sharp 26 percent earnings upgrade for Nifty Auto in 3QFY23 and positive management commentaries offer a stronger outlook for the sector," said the brokerage.

The report observed that the NSE Nifty Auto index has underperformed the Nifty over the last five years by a compound annual growth rate (CAGR) of 700 bps (Auto index up 3 percent CAGR v/s 10 percent CAGR of Nifty). The profits of auto companies in the Nifty have also declined from ₹28,000 crore in FY18 to ₹25,000 crore in FY23E vs the 13 percent CAGR in Nifty’s earnings over a similar period, it further informed.

The auto sector’s weight in the Nifty has also been consistently declining from 10.6 percent in FY18 to 5 percent in FY22 but has now inched up to 5.6 percent, highlighted MOSL.

"The Auto sector has seen a storm of headwinds over the last 4-5 years, which resulted in a higher cost of ownership, lower affordability and restrictions in vehicle supplies (due to chip shortages). Thus, domestic volumes declined for 2-wheelers (2W) (-14 percent CAGR over FY19-22), 3-Wheelers (3W) (-28 percent), passenger vehicles (PV) (-3 percent) and commercial vehicles (CV) (-11 percent)," mentioned the report.

Headwinds Receding

However, the brokerage pointed out that now most of the headwinds are receding, aided by: 1) the absorption of cost inflation at the customer level, 2) the realization of pent-up demand, and 3) improvements in the supply chain, further showcasing that this was evident in better consumer sentiment and volume recovery in 9 months of FY23 for all the segments viz 2Ws/3Ws (+13 percent), PVs (+31 percent), CVs (+40 percent) and tractors (+14 percent).

The brokerage expects growth in all segments over FY23-25, with a 10 percent CAGR in 2Ws, 12.5 percent CAGR in PVs, 13 percent CAGR in CVs and 7 percent CAGR in tractors.

The brokerage also said that the improving demand is supported by receding cost tailwinds (key input material costs down 12-24 percent since Mar’22), a favorable mix (premium segment doing better than entry segment) and favorable forex (for exporters). As a result, it estimates gross margins/EBITDA margins to improve by 110bp/180bp over FY23E-25E for the Nifty Auto universe (except Tata Motors). 

It also estimates the Nifty Auto profit pool to see a 47 percent CAGR to ₹54,300 crore over FY23E-25E. As a result, the auto sector’s contribution to the Nifty50 earnings is expected to improve from the low of 1.3 percent in FY22 to 6 percent by FY25E (similar to FY19), but still lower than the 10 percent contribution witnessed during FY14-18, predicted the brokerage house.

Earnings upgrade after a prolonged downgrade cycle

MOSL further stated that after witnessing consistent downgrades in earnings over the last 3-4 years due to incessant headwinds, the December quarter (Q3FY23) was the first quarter of big upgrades. In Q3FY23, Nifty Auto earnings saw a 26 percent upgrade in earnings for FY23, one of the biggest upgrades in the last five years (excluding one-quarter of post-Covid opening up), it noted.

All the Nifty Auto stocks have witnessed sharp earnings cuts in FY21/FY22. M&M fared somewhat better than other Nifty Auto stocks, with only a 9 percent/4 percent earnings drop in FY21/22 (as opposed to double-digit earnings cuts for other Nifty Auto stocks), due to its presence in the outperforming tractor category and recent SUV launches, further mentioned the brokerage.

Investor’s allocation increasing in the sector: The sector also witnessed a rise in allocation by the top-20 mutual funds in India, which has increased to 8 percent in January 2023, the highest in the last four years, informed the report. This has led to an overweight position by 210 bp, the highest in the last six years, it added.

PAT to jump 2.2 times: Net profit for the Nifty Auto pack is expected to surge 2.2x to ₹543b in FY25 (v/s ₹25000 crore in FY23E), predicted the brokerage. In Q3FY23, auto businesses within MOSL's Nifty Coverage Universe posted an earnings upgrade of 26 percent for FY23E, one of the biggest revisions in the previous five years (excluding one-quarter post-Covid).

"The higher gross margin and regulated other operating expenses, driven by cost discipline and operating leverage, led to this above-anticipated result. This coupled with a stable demand environment and opportunity for growth in the exports market should drive earnings over the next couple of years," said MOSL.

Sector outlook: On the mend as the majority of the headwinds are behind now, the outlook is bolstered by easing supply chain challenges and stable domestic demand, the brokerage anticipates the healthy growth in domestic volumes to continue across all categories throughout FY23–25.

Core commodity prices have seen some stabilization since Q2FY23 and commodities such as steel/aluminum/rubber/ polymer have corrected 10-23 percent from their peaks. Even though commodity prices are still on the rise, MOSL believes the price hikes taken so far will offset the impact of raw material inflation to a great extent.

The brokerage further stated that while operating leverage benefits are likely to be fueled by expectations of healthy volume growth and cost control measures, raw material price stability will further boost profitability for the auto industry.