INVESTMENT IDEAS IN INDIAN AUTOMOBILE SPACE FOR ASSET MANAGEMENT COMPANIES

Alaknanda Lonare and Aditya Kamat. Mukesh Patel School of Technology Management & Engineering, Narsee Monjee Institute of Management Studies (Deemed-to-be University). ...................................................................................................................... Manuscript Info Abstract ......................... ........................................................................ Manuscript History Received: 11 September 2018 Final Accepted: 13 October 2018 Published: November 2018

The Indian automobile sector contributes to 7.1% of the Gross Domestic Product (GDP). Between the facts that India is one of the fastest growing economies in the G20 and India"s under-developed public transportation system, the industry is expected to grow rapidly and offer multiple investment opportunities in both the private and public markets. This paper follows a top down approach to find investment opportunities in the publicly traded equities from the automobile sector. This paper examines 2-wheelers, passenger vehicles and auto-ancillary sub-industries to identify the most attractive sectors. On finding the most attractive sub-industry, a comparative analysis is performed on the major stocks in the given space to look for undervalued stock(s) in the given industry while staying wary of value traps. A fundamental approach is taken while studying the financial performance as opposed to a technical approach. Once an under-valued stock is identified, the paper studies the company"s prospects, cause for undervaluation and comparison of financial performance with its peers. Based on this data, projections are made for the company and accordingly 3 cases of valuation using Residual Income valuation model to evaluate the attractiveness of the investment.

…………………………………………………………………………………………………….... Introduction:-
The technological revolution of the 20th century in the United States was a phase of rapid economic growth. The wealth created however, was concentrated in the hands of a few industrialist given the ownership structures prevalent. As a result, people like John D. Rockefeller"s, Andrew Carnegie"s and Henry Ford amassed large amounts of wealth much to the disdain of the others. In modern day India however, most large organizations are publicly listed allowing almost anyone to participate in the wealth creation process. The sector studied in this paper is the automotive industry. The sector directly contributes to about 7.1% of the nation"s GDP and almost 49% to the nation"s Manufacturing GDP. India is expected to become the 4th largest automobile producer globally by 2020 after China, US & Japan. India"s auto component industry is also expected to become the 3rd largest in the world by 2025. This paper attempts to identify the factors contributing to the growth in the automotive industry and identify the companies, and therefore stocks, most likely to benefit from the economic tailwinds.

ISSN: 2320-5407
Int. J. Adv. Res. 6(11), 876-885 877 The Indian automobile sector enjoys advantages such as growing demand, innovation opportunities, rising investment and policy support. As a result, India has emerged as a global R&D hub. (Indian Brand Equity Foundation, October 2017) The components sector is in a strong position to cash-in on India"s cost-effectiveness, profitability and globallyrecognized engineering capabilities. (KPMG, 2010) There are 4 major factors that favor the strong Indian autocomponents industry, namely: (1) Robust demand (2) Export opportunities (3) Policy advantage (4) Cost effective manufacturing base. (India Brand Equity Foundation, September 2017) Booz & co."s identified India as a key pillar of global automotive market. Indian automotive sales were likely to exceed the US market by mid 2030s. The global automotive game would be decided by the twin forces of India and China. (Booz & co., 2011) AT Kearney"s report identifies how the auto industry in India could build momentum for growth. The automobile industry contributes to several important dimensions of nation building, namely (1) Generation of government revenue (2) Creating economic development (3) Encouraging people development (4) Fostering R&D and innovation. The report also lays out the role stakeholders can play in industry growth. (AT Kearney, 2013) Another paper attempts to understand the trends, overbought and oversold situations of the selected auto stocks in automobile sector in Indian stock market context. (Srivastava, 2014) RC Bhargava, the chairman of Maruti Suzuki, expects the passenger car segment to grow at a rate of 8%-12% annually in the long term (CNBC TV18, 2017) Another interesting trend is the rise of the "scooterization" phenomenon. The share of scooters is likely to increase to~40% of the overall 2W market in the next 2-3 years (from 33.7% in YTD FY18), overtaking entry-level motorcycles to become the single-largest segment. (Guleria, 2017) One of the hurdles India may face is the stifling of innovation by regulatory agencies which will turn "Made In India" into "Mad In India." (Bajaj, 2017) Domestic hedge fund Avendus Alternate Strategies is concerned about valuations of the market in general which they believe are due to high liquidity. They do however believe that selective automobile stocks along with private banks, FMCG and affordable housing can be attractive purchases. (Holland, 2017) Nilesh Shah, principal of Kotak Mahindra AMC, is bullish on Automobile as well as Auto-ancillaries because he believes that the demand for automobiles will stay strong since public transport in India is poor and the global changes in oil prices are not reflected in Indian fuel prices. (Shah, 2017) Prakash Diwan of Altamount Capital believes that value can be found by latching on to select automobile players. (Diwan, 2016) Deven Choksey of KR Choksey Investment managers said India is emerging from the shock treatment of demonetization and signs of recovery are now visible in sectors such as cement, auto and capital goods. (Choksey, 2017) India manufacturers a new car every 10 seconds and a new bike every 2 seconds. The automobile industry contributes 7.1% to GDP and employs 19 million people directly. It has been identified as a lead indicator of the economy. (CNBC TV18, 2016). NOVONOUS estimates that the organized auto component industry in India is expected to grow at a Compound Annual Growth Rate(CAGR) of 12.5% by 2020. This sector supplies mainly to the OEMs. The 2-Wheelers business which has 77.5% of market share is expected to grow at a CAGR of 8% by 2020.

Gaps in Existing Literature: -
The existing literature has identified the Indian Automotive Industry as a potential growth engine for the economy. It has also identified the favorable prospects for the industry. Several researchers and market experts have pointed 878 out the investment opportunities in the sector may be restricted to selective stocks at that point in time. With that being said, the following are the gaps in the existing literature: 1. Perishable nature of information on the stock market: Valuations in the stock market are subject to change based on new information and macroeconomic events. Therefore, it is important that the information is continuously checked. 2. Low guidance as to which stocks are likely to generate value: While existing literature identifies major growth opportunities in the automotive space, it does not provide guidance to individual investors or institutional investors about the potential winners in the space 3. Lack of rigorous fundamental analysis of individual companies: A significant amount of literature is dedicated to technical analysis which focuses on short term investment strategies. However, the transaction costs are likely to be significant

Research Methodology: -
This study is predominantly descriptive. The analysis is based on secondary data collected from annual reports, databases, websites and interviews. The Indian automobile industry has been divided into three main sub-industries for the purposes of this study, (1) 2-wheeler manufacturers (2) Passenger car manufacturers and (3) Auto-ancillary manufacturers. Commercial vehicle manufacturers have been omitted since they have a significantly lower market share. Some of the companies in this study may sell their products in more than one sub-industry. In such cases the company has been classified under the sub-industry responsible for most of its revenue. A top-down approach has been taken in order to identify attractive investment opportunities. The following are the steps taken to identify investment opportunities: Studying the characteristics of the sub-industries:-Warren Buffett once said "When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact." The economics of each sub-industry has been identified on the basis of: The 2-wheeler Industry delivers the greatest return on shareholders" equity. The sub-industry"s significantly higher RoA enables it to do so even with modest leverage. The sub-industry has higher profit margins and asset turnover compared to the other sub-industries.
Comprising of nearly 80% of the automobile industry as well as having the most favorable financials, the 2-wheeler space is the most attractive space in the automobile industry by a significant margin.

Bull Case Bear Case Minimal debt
Choppy revenue and profit growth High RoA and high RoE by general standards Lack of a strong product in the scooter, entry level and premium market The "Bear" case made for Bajaj auto is much stronger than the "Bull Case." Therefore, buying Bajaj Auto stock does not seem like a strong investment idea.

Eicher Motors
Bull Case Bear Case Highest RoE among its peers and high RoA Extremely high multiple which may not be justified by net income growth Highest operating margins and net profit margins Growth rate limited to the growth rate of Niche market Niche market with loyal customer base The bull case for Eicher Motors is pretty strong. However, the P/E multiple for the company is too high and therefore the company is likely to suffer from a time correction which could destroy value for investors that enter into a long position at this stage.

Bull Case
Bear Case Producer of the highest selling bike in the country, Splendor.
Stiff competition in the rapidly growing scooter market from Honda"s Activa and TVS" Jupiter. High RoE and Highest RoA 881 Lowest P/E ratio in comparison to its peers Suppressed demand from rural India due to demonetization could mean that the earnings are suppressed and that the current P/E multiple is misleadingly inflated. At its current price levels, Hero MotoCorp appears to be an attractive investment opportunity. Hero MotoCorp mainly caters to the rural and agriculture segment. Supressed earnings in the past two years due to poor monsoons and demonetization could also mean that the company is poised for growth. The upside and downside in an investment is therefore worth examining.

Bull Case
Bear Case High RoE and Highest Asset Turnover Low RoA in an industry characterized by high RoAs Low interest burden despite high equity multiplier Heavy reliance on high gearing to produce RoE Highest revenue growth rate in the industry and consistently high net profit growth rate

Lowest Operating and Net Profit Margins in the industry
Astronomically high P/E Multiple  Hero MotoCorp has consistently generated a high return on its shareholder"s equity. The company has seen a decline in its asset turnover however it has been able to counter this by improving its un-levered net profit margin year after 882 year. A boost in operating margin has been a main contributor to the overall net profit margin expansion of 519 bps in 3 years.  The company has historically had high returns on asset and capital employed. A drop in RoCE in FY17 was because the capital employed grew at a higher rate than income. This could be because the company unsuspectingly had invested money in the capital block expecting a high demand from the market. The demand however was killed as a result of demonetization. The company"s RoA has been in the low to mid-twenties over the past 4 years Possible tailwinds Possible risks Aggressively growing 2-wheeler sector Hero"s top selling models are all motorbikes, a segment which is under siege due to "scooterization" of the Indian Market. Accommodative Monetary policy Possible failure of Hero Maestro which is Hero"s venture in the scooter market.

Ratios
New financing options for the consumer thanks to the rise in the Non-banking financial corporations(NBFCs) Suppressed demand from rural India in the past two years which is finally released.   Table 12 shows the assumptions made during valuation. The discount rate taken into consideration is 500 bps over the yield of the Indian 10-year bond. A fast growth period of 5 years is expected. Total Asset Turnover is conservatively taken at 3x. The proprietary ratio is assumed to be ~0.96x, which has been the average over the past 4 years.  In the base case it is assumed that the supressed demand in FY16 and FY17 will manifest in a spike in sales in FY18, FY19 & FY20. Hero"s record breaking 3 lakh unit sale on Dhanteras and the fact that Sales in Q2FY18 have grown 11% over Q2FY17 support this claim. The assumption that revenue would have grown at 7.5% in absence of these two extra-ordinary events means that we should expect a spike of 13.20% in FY19 and FY20 followed by 3 years of 7.5% revenue growth. The long-term growth rate is expected to be at 4%, slightly lower than the revenue CAGR over the past 4 years. We expect that Hero will be able to expand its margins by 50 basis points annually and 883 250 basis points over the next 5 years. This is about half the margin expansion the company has been able to achieve in the past 4 years. The company is not expected to take make significant capital structure decisions to affect the proprietary ratio.    The optimistic case makes the same assumptions regarding supressed demand as the base case. The growth rate after FY20 is assumed to be 10% which is slightly higher than we witnessed in FY15. Net profit margin is expected to expand by 100 basis points annually as witnessed in the preceding three years. The long-term revenue growth rate is 5%    The pessimistic case assumes that the company"s revenues will grow faster than the yield on the 10-year for just another year and enter its slow growth period. We are also going to do away with the assumption that there was any supressed demand in the market veiling the true earnings capacity of the company or that there is scope for margin expansion.

Conclusion:-
After a thorough analysis of the automobile sector and Hero MotoCorp, we can conclude that Hero MotoCorp is a great business that is undervalued by the market right. At a market cap of ~Rs. 750 billion, large asset management firms can add the company to their portfolio with low impact cost while at the same time contributing significantly to the firms returns