India Ratings expects moderate demand growth for automotive suppliers during 2013, borne out by the continued slow economic growth and weak signs of recovery in export markets. Aftermarkets can only help weather the impact of sluggish growth in original equipment manufactures’ automotive sales to some extent. However, an expected pick-up in demand in the second half would likely ease the pressures on the overall auto sector. India Ratings believes that the auto supplier industry is better positioned to handle the current slowdown compared with the 2008 position.
The export competitiveness of automotive suppliers, arising out of the weak INR, could only slightly benefit them as global automotive sales would remain weak in the near term. A further weakening of INR could impact auto suppliers’ profitability as cost increases for imported components may be only partially compensated by OEMs and with a lag. Besides, firm commodity prices would stress cash flows. However, a thrust on localisation would drive growth and profitability over the medium term.
International trade agreements, aimed at reducing trade barriers and promoting free trade across partner countries, could intensify competition in global as well as domestic auto sectors. The EU-Korea free trade agreement (FTA), effective from July 2011, could hurt the Indian auto suppliers’ exports to Europe which are already under pressure. Besides, a number of India’s trade agreements with other economies, particularly in Asia, would increase competition in the domestic industry over the medium term.
Focus on product innovation
Many domestic automotive suppliers are focused on developing new products both for existing and new customers to keep up the growth momentum amid intense competition. This has been driven both by domestic capacity constraints in technology-oriented products and significant competition faced by suppliers in simple commoditised offerings from cheaper imports. These innovations, though entail major investments for suppliers in the medium term, can be a key differentiator in the long run.
A focus on enhancing capacity and technical capability has kept investment needs high for auto suppliers, whose weak operating cash flows have necessitated reliance on external funding sources. Besides, the liquidity stress faced by OEMs could be passed down the value chain leading to longer payable period and higher working capital needs. This would drive up debt and prevent improvement in credit profiles in 2013.
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A sharper and sustained fall in domestic automotive sales may stretch the already weak credit metrics of auto suppliers beyond 2013 and could cause the outlook to be revised to negative. Also, with key export markets, particularly Europe, showing weak signs of revival in the near term, aftermarkets can provide only little support for a sustained period.
A revision in the outlook to positive for the auto suppliers sector is unlikely in the short-to-medium term on account of its significant capex requirements for seizing long-term opportunities. This would prevent a sustainable improvement in credit profiles of auto suppliers.
Growth to mirror OEM sales
Demand for auto suppliers would remain moderate, reflecting pressures likely to be faced by OEMs both in India and globally during 2013. With price increases being announced by most OEMs and interest rates continuing near peak levels, domestic automotive sales are not likely to see a meaningful recovery unless economic growth improves. The suppliers who had expanded capacities to support export demand, assuming it to be counter-cyclical to the domestic cycles, would remain under pressure with weak demand persisting in key export markets.
The companies that had focused on the commercial vehicle market are likely to be more severely impacted than those with more diversified product and customer profiles. The suppliers who had focussed on increasing their share of business in a single vehicle rather than on growing volumes would tend to benefit. Aftermarkets can provide limited shield to auto suppliers with significant competition from cheaper imports.
While a decline in the rupee-dollar exchange rate will enhance the cost competitiveness in international markets, India Ratings does not believe that the impact will be sufficient to boost export demand. A large part of the investments made over the last couple of years towards capacity building are not fully utilised, and may impact the financial flexibility of auto suppliers in the absence of a recovery in demand during the latter part of 2013.
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Rising integration with global markets
The multi-tiered and highly fragmented domestic auto supplier segment is becoming integrated with the global industry due to the presence of global OEMs. This not only makes way for their global components suppliers to enter the domestic market but also forces domestic suppliers to adopt global standards and practices. The standardisation of vehicle platforms fosters this integration. As a result, many global auto suppliers are entering into technological tie-ups or JVs with domestic suppliers. But a sheer number of these global players from varied regions such as Japan, Europe, and the US intensify competition.
Besides, international trade agreements, which aim to foster co-operation between trading partners, could alter the competitive landscape for domestic auto suppliers as they involve trade linkages with other global economies. Since most of these agreements aim to reduce trade barriers over a period of time, India Ratings does not expect an imminent alternation but remains concerned about domestic auto suppliers’ ability to withstand their impact over the medium term.
Technology focus adding to capital intensity
Auto suppliers have made significant investments in technology, organically or inorganically. Competitive pressure in domestic and global auto markets has forced suppliers to innovate new techniques for existing components as well. Since input cost increases are difficult to pass on to OEMs completely and cheaper imports in commoditised offerings impact earnings, auto suppliers have to work towards productivity gains to protect their operating profitability which adds to capex requirement.
Domestic auto suppliers are focussing on enhancing their technical capabilities for innovating new products and localising components which are currently being imported through acquisitions or in-house developmental efforts. Besides, compliance with stricter safety and environmental standards adds to capital intensity.
As a result, the agency believes that capital intensity for domestic automotive suppliers would remain high in 2013 and beyond, for them to develop a long-term competitive edge. This would necessitate significant funding requirements which the current operating cash flows may not support. The long-term growth prospects for the Indian auto supplier sector may attract private equity investments in the sector in 2013, though many of these could be aimed at providing an exit to the existing investors in the wake of weak capital markets, as was seen in 2012. The agency expects that borrowings would remain the mainstay for funding capex in a majority of cases.
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Working capital cycle could remain stretched at the current levels due to sluggish offtake and pressure on OEMs’ operating cash flows in the initial period. Many OEMs have undertaken production cuts in H212 and may also do so during the initial half of 2013 to manage their inventory levels. The multi-tiered value chain may make it difficult for auto suppliers to completely synchronise their production to meet OEM demand, thus stretching their inventory holdings at times.
The offtake by OEMs may bring down the inventory levels; though resuming the higher scale of operations would add to the receivable cycle, thereby keeping working capital requirements high in absolute terms in 2013. Firm raw material prices would further put pressure on working capital requirements. As a result, working capital requirements, coupled with capex, would keep total borrowings high and prevent any improvement in the credit metrics of auto suppliers. However, this is likely to remain compatible with the agency’s sector outlook.
2012 review
The year 2012 saw a significant erosion in profitability margins of most of the auto suppliers on account of raw material price increases, which partly were driven up by INR depreciation and a rise in other input costs such as labour, power and fuel and general overheads. The single-digit growth in revenue could only provide a limited hedge against cost pressures.
India Ratings observed that though overall growth for most of the automotive segments remained subdued, some OEMs grew faster than the industry average which supported higher growth for their suppliers as well during 2012. However, continued capex aimed at developing and commercialising newer products was largely funded through borrowings. This, along with lower profitability, led to weaker credit metrics in 2012 as envisaged by the agency in its 2012 mid-year review.
The credit profiles of most auto suppliers, though weakened in 2012, have remained within the agency’s tolerance levels leading to rating affirmation for most of the suppliers. Negative rating actions were taken in some cases where the deterioration was significant and was expected to sustain over a longer period.