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Pakistan Automobiles: Sector Earnings Revised Downward

• The worsening macroeconomic environment has cast a doubt on the previously estimated strong demand growth. We have revised our macroeconomic assumptions which include a) revision in GDP growth forecast, b) higher PKR devaluation and c) tighter monetary policy led slowdown in financing.
• Despite deteriorating macroeconomic environment and law restricting non-filers from purchasing cars, we maintain our market-weight stance on auto sector. We believe, that on average 28% YTD decline in auto stocks (HCAR, PSMC, INDU) compared to 5% YTD rise in KSE-100 index indicates that market has priced in most of the unfavorable sector outlook. However, we downgrade PSMC to a ‘Hold’, while maintaining our ‘Hold’ stance on INDU and HCAR.
• We expect GDP growth at 4-4.5% for FY19 compared to 5.8% in FY18 as fiscal austerity measures, rupee depreciation and monetary tightening are expected to curtail overall aggregate demand. Moreover, we also take into account slowdown in Auto financing due to faster than anticipated interest rate hike wherein we now expect policy rate to reach 8.5% by Dec-18. It must be noted that outstanding car financing declined in June 2018, which is a first such fall after a period of 18 months, pointing towards a potential slowdown.  
• More importantly, law passed in budget FY18-19 barring non-filers from purchasing cars is estimated to lead to a decline in volumes next fiscal year. As per news sources, approximately 40% of Auto clients are non-filers. However, the impact on demand will vary across companies due to differences in their respective client base.
• Based on the aforementioned factors, we expect overall demand for motor vehicles to contract in FY19. We estimate unit sales of the local OEMs to decline 11% YoY in FY19 from the twin effect of changing macroeconomic landscape as well as impact of regulatory change. Resultantly, our forecasted 5-Year (FY19-23) forward CAGR of unit sales for the 3 existing local OEMs is 2% and takes into account heightened competition from new players post FY20.
• Accordingly, we revise down our Topline auto universe earnings estimate on average by 34% for 2019 and estimate 5-Year (FY19-23) sales and profitability CAGR at 12% and 5% respectively. The change stems from downward revision in volumetric growth from previous estimated forward 5-Year (FY19-23) CAGR of 10% to 2% and downward revision of gross margin from on average estimate of 12% to 9% during the same period owing to aforesaid factors.
• We downgrade PSMC to ‘Hold’ and maintain ‘Hold’ on INDU and HCAR as the companies will face tough demand conditions as well as falling GP margins.
• Key risks to our thesis: 1) higher than expected PKR Depreciation, 2) volatility in steel prices, 3) delayed roll out of new models, 5) higher than anticipated interest rates and 6) regulatory changes.