Chart Fun | The Curious Case of the Indian Auto Industry
The first principle is that you must not fool yourself, and you are the easiest person to fool.
— Richard P. Feynman (RPF)
Birth anniversaries provide an excuse to pause and ponder at the life and times (and quotes) of your idols. The above quote by Nobel winning physicist R. P. Feynman seemed apt for a topic that I have been pondering lately.
The Indian Automobile industry.
Within the microcosm of the Indian equity markets is a fast growing polarization between two camps of thoughts concerning the long-term prospects of the Indian auto industry.
The Bears, look at the negative price performance for the industry pocket as evidence of diminished prospects for Indian automobile manufacturers.
The Bulls, look at the same negative price performance as evidence of emergence of value among automobile stocks. They contend that the Bears are overestimating the negative consequences of industry change.
Who’s right?
This post does not aim to provide definitive answers. Instead it provides an Outside-In view (What future is realistically possible?), and an Inside-Out view (What are automobile stock prices implying?) of the Indian auto industry over the next decade.
(Unlike earlier harmless Chart Fun editions, this will be longer. Settle in.)
I) The Outside-In View
I would rather have questions that can’t be answered than answers that can’t be questioned. — RPF
The Indian auto industry has experienced stupendous growth over the past 2 decades. Industry revenues and after-tax profits for the listed universe have grown at a compounded rate of just under 20% annually. The growth industry status has translated into strong stock market performance. Industry market cap has grown at over 20% annually over the past 2 decades.
Can this pace sustain over the next decade?
India automobile buying behavior has evolved over the past 2 decades. Improving roads infrastructure, rising wealth, and access to cheaper sources of finance have fueled volume growth. For many Indians, owning an automobile is a status symbol. These behavioral pull factors, like habits, have taken time to gain root, and are likely to persist for extended periods. Faster wealth migration also encourages faster replacement rates for auto ownership. However, at a basic level, automobiles — much like human beings — occupy space.
Wealth levels bear a positive relationship with auto ownership (enabling force), physical space is limited (constraining force).
A decade from now India will be wealthier, but is there enough space to sustain vehicle growth?
“Vehicles” include cars, vans, buses, freight and other trucks; but exclude motorcycles and other two-wheelers.
Left chart depicts GDP/capita (x) against vehicle density (y).
Right chart depicts human population density (x) against vehicle density (y).
India’s GDP/capita estimates a decade from today rests on these assumptions: Inflation = 4%. Real GDP growth = 7%. Population growth = 1%.
A Lower Middle country today, India will join the Upper Middle income group a decade from now. However, India features high on the world population density pecking order.
What are India’s prospects as it makes the transition to a higher income level?
The average Upper Middle country’s vehicle population is 182/1,000 people. The highest vehicle density in this group is 500/1,000 people.
As always, India specific factors make things interesting.
Two-wheelers
The cross country comparisons exclude motorcycles and two-wheelers. Within the stock of Indian vehicles, two-wheelers form the largest category. India Road Vehicle Registration data indicates that the stock of two-wheelers would be around 180 million today, out of around 250 million total registered vehicles. Including two-wheelers pushes India’s vehicle penetration to 186/1,000 people. India has hit the average Upper Middle income group vehicle penetration levels, while being in the Lower Middle category.
Replacement demand
At an average vehicle replacement cycle of 10 years, around 25 million units are likely to come up for renewal annually. Apart from new vehicle demand, this will support volume growth, and unit pricing improvement since most buyers upgrade to a higher category vehicle. Faster replacement cycles could support faster volume growth but may push India into the High income category in terms of vehicle penetration.
India vehicle penetration forecasts, and implied unit volume growth.
At 5–8% volume growth and 3–5% pricing growth, can Indian auto industry deliver 8–13% growth in revenue over the next decade?
II. The Inside-Out View
What are stock prices implying today?
From observable market values of listed auto manufacturing companies I reverse engineer the operating performance that would need to be delivered by each company, in order to potentially provide a required return of 13%.
For the listed auto manufacturer group, current equity prices imply a revenue growth of 12% annually over the next decade.
This will come through a mix of volume growth and pricing. Taking us back to the big question from the previous section.
At 5–8% volume growth and 3–5% pricing growth, can Indian auto industry deliver 8–13% growth in revenue over the next decade?
There will be winners and losers within the group.
Who are they likely to be?
Indian Auto — A Maturing Industry?
The Indian Automobile industry has the hallmarks of an industry in transition. From a high growth, consumer staples-like industry of the past two decades to the global auto industry character of a mature, cyclical industry, with reasonable but moderate growth rates.
This transition has important implications for competitor behavior within the industry, industry value chain and stock price behavior for the group.
Who will win/lose?
The above transition is likely to be characterized by greater fight for market share, lower margins and consolidation pressures. There is also likely to be greater manifestation of discounting behavior, and a desire to focus on export markets. Companies are likely to encourage buyers to migrate to higher price points. Niche manufacturers and lowest cost/capital efficient operators are likely to fare better than neither-here-nor-there counterparts. Dealer economics are likely to come to the fore, and vehicle manufacturers may have to step up dealer support in an effort to sustain the value chain. A uniqueness in the current situation —the potential rise of electric vehicles —will imply greater reinvestment intensity, leading to lower profitability and returns on capital.
The sum total of these effects, by nature, will be gradual. But stock prices will react in advance; as they have done in the recent past. Some companies’ stock prices have been beaten down to levels where they discount a rather modest picture of the future. Others continue to project history’s high-growth, consumer staple-like version of the future.
Electric Vehicle Threat?
For a successful technology, reality must take precedence over public relations, for nature cannot be fooled. — RPF
Electric Vehicles pose one of the biggest threats/opportunities for the Auto industry today. The first EVs were made in the late 19th century. The rise of oil tilted the scales of commercial viability in internal combustion engine’s favor. After a century, we are witnessing a return of the EV/Oil debate.
India aspires to put 7 million EVs on the road. China, after spending $60 billion in subsidy, sold 1.2 million EV in 2018. China is cutting back on subsidy already. India’s FAME program has an outlay of $3–4 billion, which pales in comparison to what China has already spent subsidizing the industry. India has one of the highest population densities in the world. It may be solved one day; but India’s lack of innovation leadership means it is likely to be a later-stage replicator. So this represents a timing problem (far future).
The other problem around consumer usage concerns behavioral shifts that may negatively impact volume growth. Wide adoption of superior public transport (including electric bus fleets), and ride sharing represents potentially interesting opportunities/threats to the industry. Squaring off against these forces is the Indian penchant for ‘idle’ ownership of automobiles as a status symbol.
Which force will dominate?
Which category of automobiles is likely to ‘electrify’ the fastest? Two-wheelers, three-wheelers, light commercial vehicles, tractors?
What could alter outcomes?
On the negative side, lower-than-expected volume growth could be a primary dampener. High population density, slower replacement cycles could curtail volume growth, even though easier financing and increasing wealth offer reasons for optimism.
On the positive side, if the markets are content with a lower Cost of Capital/Required Return, lower levels of operating performance would be enough to justify current prices. A similar scenario played out in Indian Consumer Staples universe over the past decade; where progressively lower hurdle rates (“multiple expansion”) drove price performance.
What do you think will happen?
I’m curious to hear from you.
