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Sector update: Automobiles - CVs - early signs of stress?

We have been seeing a sharp uptick in M&HCV volumes on the back of strong infrastructure demand, stricter implementation of overloading ban and easy availability of finance. While these factors would drive volumes in the near term, our analysis of a set of recent data points – rise in early delinquencies, oil price-linked pressure on operator profitability and a visible slowdown in new capex announcements - point to potential build up in pressure points on M&HCV volumes over the medium term. When juxtaposed on high M&HCV volume growth expectations (the street is factoring in 12-15% CAGR over FY18-20E), we see a high probability of disappointment. While we reiterate our Outperformer rating on Ashok Leyland, given the strong near term outlook, we will carefully monitor the stress points.

Oil prices affect profitability: The last few months has seen a slower increase in freight index compared (+11% YTD) with pace of rise in diesel prices (up ~30% YTD, 45% in 18 months), which has had a bearing on profitability/repayment power of fleet owners. Weakening operator profitability may have been exacerbated by the build-up of excess capacity in the transportation system (+30% growth in estimated tonnage in FY18). In 2012-2014 when fuel prices jumped over 40% (similar to the current phase) financiers saw 2-3x rise in 90-day delinquencies. This led to stricter lending norms that contributed to a cumulative 45% decline in M&HCV volumes over FY12-14. While we expect GDP growth (+7.5% in FY19E versus 6.8% in FY12) to be more stable, a curtailment in lending norms/higher interest rates could hurt M&HCV volumes. 

Vehicle delinquencies have increased: We believe lower profitability of operators may have already impacted delinquencies. As per India ratings, even as 90-day weighted average delinquencies for CVs are steady; 30-day delinquencies (or early delinquency index - EDI) is sharply up yoy (from 6.87% in Feb 2017 to 7.89% currently). Also, the 2016 vintage performance has continued to see a spike in delinquencies, in lines with the stressed vintages of 2012 and 2013. Further, UP and Karnataka have higher stress levels compared to other states. The higher stress levels in UP holds significance as it was one of the fastest-growing markets (42% growth in FY18) and accounted for ~23% of the total FY18 M&HCV volume growth.

Signs of weakening capex cycle: High infrastructure spending is one of the key drivers that has driven M&HCV volumes in the recent past. However, we note early worrying signs with respect to capital expenditure in H2FY19E: (a) CMIE data shows continued weakness in new project announcements, which fell 22% yoy and 35% qoq to Rs2.05trn in Q1FY19. Project announcements by government declined 79% yoy to Rs245bn (the lowest in over a decade) while private project announcements (excluding a Jet Airways order) declined ~70% yoy. Project completion fell 21% yoy to Rs686bn. Lower project announcements impacted capex (and consequently CV demand) with a 6-12 month lag (b)  new project announcements, particularly in road construction (key driver of M&HCV volumes) too fell to Rs60bn (down 87% yoy) in the current quarter – lowest since June 2005 (barring Q12014, when there was a change in the government). (c) Recent media articles suggest that road construction projects awarded under the Hybrid Annuity Mechanism (funded 40% by government) too seem to be facing financing pressures – higher interest rates would be a further dampener).

While we expect the M&HCV cycle to remain strong in the near term, stress signs could potentially lead to disappointment, on high expectations. Additionally, a regulation that mandates increasing load per axle could be a negative. Given the strong near term outlook, we reiterate our Outperformer rating on Ashok Leyland (though we cut our target multiple to 9x FY20 EV/EBITDA from 11X previously for a TP of Rs 145). However, we would continue to monitor the stress points.