How to do Business Analysis of Auto Ancillary Companies

Modified: 26-Apr-21

Auto ancillary or auto component sector is one of the important sectors for both the economy as well as investors. There are hundreds of companies from auto ancillary listed on Indian stock exchanges. Many of them have achieved big scale with manufacturing plants located all over the world.

As a result, many investors have submitted their analysis of auto ancillary companies for our inputs on the “Ask Your Queries” section of our website. We have analysed many of these auto ancillary companies and provided our views as “Analysis” articles.

Over time, after an in-depth analysis of many auto ancillary companies, we have noticed quite a few common characteristics, issues and challenges faced by these companies. We have noticed various steps that different companies took to solve their challenges.

This article is an attempt to summarize our learning from the analysis of many auto ancillary companies. In the current article, we aim to highlight the key aspects of the business model of auto ancillary companies, how it becomes challenging for new players to get business from large auto manufacturers (OEMs), how the large auto manufacturers put continuous pressure on their suppliers, how profits of auto ancillary companies get squeezed between large customers and even larger raw material suppliers (metal producers).

We aim to highlight to an investor how various auto ancillary companies aim to become an indispensable partner for the original equipment manufacturers (OEMs), which are large automobile manufacturers. What steps the auto ancillary players take to establish their market position, diversify to protect their profit margins, tie-up with foreign players to gain additional business and at the same time face the risk of becoming obsolete if they do not upgrade their technology continuously.

This article will help every investor who is thinking of investing in the auto ancillary sector or is analysing any company from this sector. After reading this article the investor would be able to determine where any auto ancillary companies stand in the industry, whether the company is taking the right steps to establish itself as a long-term player or it is going in a direction that may cause problems down the line.

We have provided real-life examples of auto ancillary companies along with details of their business decisions in the article so that an investor may understand the discussions better.

Let us now highlight the key characteristics of the business model of auto ancillary companies.

 

1) Cyclical business performance:

When an investor analyses an auto ancillary company, then she would notice cyclicity (fluctuations) in its business performance. The cyclicity is present in sales i.e. periods of increasing sales would be followed by periods of declining sales. The cyclicity is present in the profit margins as well i.e. periods of increasing profit margins are followed by periods of declining profit margins and vice versa.

This is the norm for most of the auto ancillary companies analysed by us. In case, an investor comes across any auto ancillary company, which has a long history of continuously increasing sales and profit margins, then she should recognize that it is an exception and not the norm.

Moreover, out of the many different segments of auto ancillary companies, the companies that primarily depend on the commercial vehicles segment show a higher level of cyclicity.

 

1.1) Real-life examples of cyclical business performance of auto ancillary companies:

An investor may see the cyclicity in the business performance of Jamna Auto Industries Ltd, which produces springs/suspension parts for commercial vehicles.

In the below table showing the sales and operating profit margin of Jamna Auto Industries Ltd from FY2011 to FY2021, an investor would notice the periods of declining sales as well as profit margins FY2012-FY2014 and FY2019-FY2021. The cyclicity in the business performance of an auto ancillary player comes out clearly in the performance of Jamna Auto Industries Ltd.

Jamna Auto Industries Ltd Sales FY2011 2021

To take another example, an investor may observe the financial performance of India Nippon Electricals Ltd, a TVS group company, manufacturing electrical ignition systems for automobiles and gensets (portable generators).

An investor may notice that the operating profit margin (OPM) of India Nippon Electricals Ltd has followed a cyclical pattern. The OPM declined from 14% to 9% over FY2012-FY2014, then increased to 14% over FY2015-FY2018 and then again declined to 9% from FY2019-FY2021. An investor may also notice the decline in sales of the company during FY2019-FY2021.

India Nippon Electricals Ltd Sales FY2011 2021

From the above two examples, an investor would be able to appreciate the cyclicity in the business model of auto ancillary companies. Cyclicity reflects in the pattern of the rise and fall of the profit margins as well as sales.

 

1.2) Reasons for the cyclical business performance of auto ancillary companies:

When an investor tries to understand the reasons for cyclicity, then she notices that out of three key customer segments served by auto ancillary companies, the largest segment is original equipment manufacturers (OEMs), whose performance fluctuates cyclically in line with economic phases.

CARE Rating Methodology for auto ancillary companies by the credit rating agency, CARE, July 2020, page 1:

The industry’s sales to OEM segment contributed to 56.4% of its total turnover, while exports and replacement market contributed to 26.7% and 16.9%, respectively.

The OEM segment of the automobile industry represents the production and sale of new vehicles. An investor would appreciate that purchase of a new vehicle is not an emergency/essential purchase and any customer can defer the purchase in times of economic downturns.

An auto ancillary company, Minda Industries Ltd, a leading Indian auto component manufacturer producing switches, horns, lighting, alloy wheels and other auto ancillary products, highlighted this aspect in its FY2020 annual report, page 94:

Auto industries are discretionary in nature. Amidst slowdown, spending on new vehicles is often curtailed or postponed by user, making the industry a cyclical.

Another credit rating agency, ICRA, highlighted the cyclical aspect of the business of auto ancillary companies, especially those commercial vehicle segment in its rating guidelines for the sector in Oct. 2020, page 2:

The auto industry operates in a cyclical environment, leading to periods of low profitability and revenues for auto component manufacturers. This is more pronounced in ancillaries catering to the CV segment.

Therefore, an investor would notice that the dependence of the automobile industry on the general economic environment for its sales leads to cyclicity in the auto ancillary companies. The discretionary nature of automobile purchases is one of the key reasons for the cyclicity in its demand and thereby the business performance of all the dependent sectors.

In addition, there is one very important factor, which leads to cyclicity in the profit margins of auto ancillary companies. This factor is very low, almost nil negotiating/pricing power of auto ancillary companies with their customers (OEMs) as well as their suppliers (large metal producing companies).

Advised reading: How to do business analysis of a company

 

2) Very low bargaining and pricing power of auto ancillary companies with their customers and suppliers:

While analysing the business of many auto ancillary players, an investor notices that the automobile component manufacturers do not enjoy a high pricing power on their customers, which are much larger original equipment manufacturers (OEMs). Also, most of the auto component manufacturers do not have high bargaining power over their suppliers, as the suppliers are also large metal players.

ICRA rating guidelines for the auto component sector, August 2018, page 2:

Most auto component manufacturers, moreover, do not enjoy adequate bargaining power with their much larger OEM customers or with their large raw material (metal) suppliers.

As a result, the automobile component manufacturers find it very difficult to protect their profit margins whenever the raw material prices increase or when the demand slows down. This is because, when raw material prices increase, then they are not able to pass on the costs to the OEMs. The OEMs are very large companies compared to auto component manufacturers who have multiple suppliers for each component that they purchase.

In addition, the auto component manufacturers face intense competition among each other as well as from the unorganized sector.

CARE Rating Methodology for Auto Ancillary Companies, July 2020, page 1:

With most auto ancillary companies being smaller in size and largely dependent on OEMs, they have limited bargaining power. Furthermore, competition has been intense due to the sizeable presence of unorganised players.

Therefore, the auto component manufacturers can’t get a price increase each time the raw material costs increase. In fact, as per ICRA, the margins earned by auto ancillary players from the Indian OEMs is the least when compared to other segments of aftermarket and exports.

ICRA rating guidelines for the auto component sector, Oct. 2020, page 1:

Margins from the domestic OEM segment are the least as ancillaries do not enjoy adequate bargaining power with their much larger OEM customers.

Also, the auto component manufacturers buy raw material like steel, aluminium, plastic etc. from suppliers like steel plants, refineries etc. who also are very large when compared to the auto component manufacturers. Therefore, the auto component manufacturers are not able to enjoy any bargaining power from their suppliers as well.

As a result, during tough times, the profit margins of the auto component manufacturers are squeezed between the increasing cost of raw material from metal suppliers and the pricing pressures from the OEMs. This is the key reasons for the cyclical fluctuations in the profit margins of auto component manufacturers.

It is said that the OEMs keep a track of the operating margins of all their vendors and whenever there is an increase in operating margins due to any reason e.g. lower raw material cost etc., OEMs demand a price cut/discount from vendors. Such tough business dynamics with intense competition is one of the main reasons for muted operating margin levels of almost all the auto ancillary players except a few.

As any improvement in the profitability margins of auto ancillary companies is commonly followed by requests for discounts by OEMs; therefore, auto ancillary companies find it difficult to have high profitability margins.

 

2.1) Real-life examples of auto ancillary companies with low pricing power:

While reading the annual reports of different auto ancillary companies, an investor would come across multiple instances where companies have highlighted the continuous pricing pressure from customers and their inability to get price hikes even when raw material prices increase.

Let us see the example of India Nippon Electricals Ltd, a TVS group company, manufacturing electrical ignition systems for automobiles and gensets (portable generators).

While analysing the financial performance of India Nippon Electricals Ltd, an investor would notice that over FY2011-FY2021, the operating profit margins of the company showed a cyclical pattern with periods of decreasing profit margins followed by periods of increasing profit margins.

India Nippon Electricals Ltd Sales FY2011 2021

While analysing the annual reports of the company, an investor comes across multiple instances where the company highlighted its inability to get price increase from its customers (OEMs) leading to a decline in profit margins.

FY2013 annual report, page 11:

Profit before tax and exceptional items, as a percentage of sales, dropped by around 1.70% over the previous year mainly, due to increase in material and conversion costs given to suppliers not recouped, in full by the customers.

FY2013 annual report, page 12:

Although metal prices are softening, costlier imports due to weak rupee as well as increase in power cost are pushing up the cost of production which is not adequately compensated by customers.

The profit margins of the company are always at the discretion of the large automobile manufacturers. The automobile manufacturers enjoy the benefits of multiple suppliers for each product creating intense competition among the suppliers. In addition, OEMs have the option of importing components from overseas suppliers from China or South East Asia etc.

ICRA rating guidelines for the auto component sector, Oct. 2020, page 3:

Competitive Intensity: Often, the OEMs have multiple vendors for same components, which restrict the pricing power of component suppliers. Moreover, imported components, particularly for bought-out components and child parts, could act as alternate sources of supplies for the OEM and limit pricing flexibility for suppliers. Organised players witness intense competition from the unorganised segment and spurious parts in the replacement segment.

As a result, the company always finds it difficult to pass on the increase in production costs like cost of raw material, wage etc. to the customers.

FY2010 annual report, page 9:

Likewise, prices of steel and products made of steel went up. To recoup the cost increases fully from the customers is becoming increasingly difficult due to competitive pressures.

An investor may believe that the above competitive landscape of the industry may represent an old picture of FY2010, which marked the end of a difficult business period for the company (FY2005-2009). However, reading the later annual reports also indicates the similar business position of India Nippon Electricals Ltd where it finds it difficult to pass on the full extent of the increase in raw material costs to the customers due to intense competition.

FY2015 annual report, page 7:

While on one hand the input costs are going up, the intensifying competition for the range of products manufactured by the company on the other hand creates pressure on customer pricing. These pose challenges to maintain the profitability, as customers may not fully offset the cost escalations.

Auto ancillary companies face tough competition. This is because every OEM prefers to keep multiple suppliers for each component. In addition, they face competition from imports from China and other South-East Asian countries, many startups as well as the unorganized sector.

FY2019 annual report, page 18:

Risks and concerns: Protectionist measures adopted by few countries, global trade war and entry of startups in providing efficient engineering solutions continue to haunt the industry. Similarly, rising trend in raw material prices in steel, copper and petroleum products result in increasing product costs. Minimum wages policy pushes the cost of operation up. It poses challenge to maintain the profitability as customers may not fully offset the cost escalations. Frequent changes in emission norms make the customer postpone their purchases and makes few existing products obsolete.

As a result of such intense competition, the only way available for an auto ancillary player to gain a higher market share is to reduce prices, which impacts its profit margins.

FY2014 annual report, page 4:

The cost increases on account of costlier imports and other cost increases like diesel price increases, power cost etc. have not been adequately compensated by customers. On the other hand the competitive intensity of the market is forcing lower selling prices to gain new business.

And if a company wants to increase its profitability, then the only way available to it is to reduce its costs because it cannot expect the OEMs to give it a higher price without the risk of losing business to other competitors.

FY2019 annual report, page 18:

Your Company is focusing on development of newer range of products which offer customers good value propositions, improving productivity and cost reduction in every possible area of operation to protect the bottom line.

(An investor may read our detailed analysis of India Nippon Electricals Ltd in the following article: Analysis: India Nippon Electricals Ltd)

The credit rating agency, CRISIL, has also highlighted in its rating guidelines for auto ancillary companies (April 2016, page 5) that OEMs know that auto component suppliers are dependent on them for business. Therefore, there is hardly any pricing power left for auto component manufacturers. As a result, the only way to improve profitability, at times, is to control the costs.

The fortunes of auto component suppliers are linked to those of the auto OEM industry. This constrains the supplier’s bargaining and pricing power. The key to improving profitability, is, therefore, cost (especially raw material cost) control.

Therefore, an investor would appreciate that the auto ancillary companies operate in a very tough business environment where they do not have pricing power over their customers, which are much larger automobile OEMs. Simultaneously, they do not have pricing power over their suppliers who are also very large metal producers (steel, aluminium, copper etc.).

As a result, auto ancillary companies face a challenge to maintain their profit margins and in turn, face cyclicity in their business performance where periods of poor performance follow periods of good performance.

 

2.2) Impact of low bargaining power of auto ancillary companies on the working capital:

While analysing auto ancillary companies an investor realizes that apart from the profit margins, the low bargaining power of auto ancillary companies impacts many other aspects of their business as well. For example, auto component manufacturers find it very difficult to manage their working capital especially the inventory position.

OEMs prefer to maintain an asset-light business model. One of the approaches that OEM follow to stay asset-light is the “just-in-time” approach. Under this approach, OEMs ask the auto ancillary company to deliver its products just before it is about to be used by the OEM. Such an arrangement ensures that OEM keeps only very minimal inventory with itself (sometimes only for one shift of operations) whereas the auto ancillary company has to keep a lot of inventory to ensure that it is able to deliver the goods to OEM whenever demanded. Any failure by an auto ancillary company to deliver goods “just-in-time” may involve loss of market share as well as financial penalties.

Minda Industries Ltd, a leading Indian auto component manufacturer producing switches, horns, lighting, alloy wheels and other auto ancillary products, highlighted this aspect of the business of auto ancillary players in its prospectus for QIP in March 2017, page 39:

We typically commit to order raw materials and sub-assembly components from our suppliers based on our customer recommendations, forecasts and orders. Cancellation by customers or any delay or reduction in their orders can result in a mismatch between the inventory of pre-constructed components, raw materials and the manufactured product that we hold. This could also result in excess inventory and increased working capital.

In addition to the working capital intensive business model due to the “just-in-time” approach of OEMs, the auto ancillary companies also have to enter one-sided agreements favouring the OEMs while doing their production planning.

The almost complete dependence of auto component manufacturers on the OEMs for business exposes them to many risks with respect to inventory management as the OEMs can order less than contracted quantity leaving the auto component manufacturer with excess inventory. Moreover, due to their higher bargaining power, usually, OEMs do not face any financial penalty for ordering a lesser quantity of products.

QIP prospectus of Minda Industries Ltd, March 2017, page 39:

In most instances, our OEM customers agree to purchase their requirements for specific products but are not mandatorily required to purchase any minimum quantity of products from us. Further, such conditions provide flexibility to our customers to place order for a lesser quantity of products in the purchase orders in spite of a higher number being specified in the contract.

An investor should note that the presence of a high amount of inventory with the auto ancillary company is a problem as it may increase the costs for the company.

ICRA rating methodology for auto component companies, Oct. 2020, page 7:

High levels of receivables and inventory may be reflective of poor quality earnings, which may require write-offs in the future. A high inventory level increases the holding cost and working capital requirements while inadequate inventory might lead to a market share loss.

Therefore, an investor would appreciate that the lack of bargaining power of auto ancillary companies puts them in a very tough business position both with respect to profit margins as well as inventory planning.

Nevertheless, even in the challenging business environment, auto ancillary companies compete with each other to become a preferred partner for the OEMs. Each of the companies attempts to become a dependable partner for the OEMs where they aim to get deep integration in OEMs’ operations, new product development etc. The auto ancillary companies do this to make the OEM dependent on them. This, in turn, provides them preferred treatment in the form of reasonable price increases and also makes it tough for the OEMs to switch any of business away from them.

Let us now see what steps auto ancillary companies take to become a dependable supplier to OEMs who get preferred treatment.

Advised reading: How to Analyse New Companies in Unknown Industries?

 

3) Grow big. OEMs prefer large suppliers. In auto ancillary sector, big becomes bigger:

While reading about the factors influencing the business of auto component manufacturers, an investor notices that increasingly the OEMs are trying to reduce the number of suppliers they deal with i.e. the OEMs are consolidating their supplier base. OEMs prefer to deal with a few suppliers who can give them a lot of products rather than negotiating with many suppliers who give them one product each.

As a result, large suppliers get better bargaining power over OEMs and in turn, they also better purchasing power over their suppliers.

The following observations by the credit rating agency ICRA in its rating guidelines for auto component manufacturers (August 2018) would help an investor in this regard.

To improve operational efficiencies and strengthen the overall supply chain network, OEMs are increasingly focusing on consolidation of their vendor base. Consequently, a supplier of multiple products could benefit as it will be easier for an OEM to manage a single vendor with multiple product offerings rather than negotiate with several small vendors with single products.

Large scale of operations generally reflects greater market penetration, improved bargaining power and higher purchasing efficiencies,

The size of an auto component manufacturer is crucial as larger suppliers typically receive preferential treatment from OEMs, which generally results in a relatively superior wallet share with OEMs as compared to their smaller peers.

The credit rating agency, CRISIL has also highlighted in its rating methodology for auto component suppliers, April 2016, page 4 that the OEMs are trying to reduce the number of suppliers they source from.

Auto OEMs have significantly pruned the number of component suppliers they source from, in line with the global trends. Tier-I suppliers, on account of their direct interface with OEMs and larger number of value-added offerings, have better bargaining power and operating margins than other suppliers do.

Another credit rating agency, CARE, has also highlighted that large auto ancillary companies that supply directly to OEMs (i.e. tier I suppliers) get a higher bargaining power over OEMs as compared to smaller players or tier II (supply to tier I) and tier III suppliers (supply to tier II). Large suppliers have a strong relationship with OEMs and enjoy better profitability than the smaller suppliers.

entities with large scale of operations reflecting greater market share, higher bargaining and purchasing power. A strong market position is a reflection of strength of its relationship with OEMs and a key driver of operational flexibility. CARE Ratings also analyses whether the company falls into Tier I auto component manufacturer or Tier II or III auto component manufacturer.

On account of direct relationship with OEMs and higher degree of inter-dependence for supply of components in addition to being engaged at product development stage, Tier I companies enjoy higher profitability and are considered superior over Tier II and III companies.

 

3.1) Real-life example of auto ancillary companies benefiting from large size:

The auto ancillary company, Minda Industries Ltd, a leading Indian auto component manufacturer producing switches, horns, lighting, alloy wheels and other auto ancillary products, provides a good example of this case. The company has 62 plants located around the world.

When an investor analyses the financial performance of Minda Industries Ltd over the last decade, then she notices that during FY2011-FY2014, the OPM of the company declined from 9% to 5%. However, after FY2015, the OPM of the company has increased significantly from 5% to 11%.

Minda Industries Ltd Sales FY2011 2021

While analysing the business performance of Minda Industries Ltd, an investor would notice that during the last decade, the company has increased the size of its business by multiple aspects. The company did capacity expansions in its existing line of businesses like switches. In addition, it increased the size of its offering to the OEMs by acquiring the horn and lighting business of European companies, and starting new lines of businesses like alloy wheels and fuel caps etc.

Currently, Minda Industries Ltd is the largest supplier of switches and horns and the third-largest supplier of lighting in India.

ICRA credit rating report of Minda Industries Ltd, October 2018, page 1:

In the domestic automotive market, the company is positioned as the largest player in switches (both in passenger vehicles or PV and two wheelers or 2W) and horns in terms of market presence and in PV alloy wheels in terms of installed capacity, and the third largest player in lighting products.

Advised reading: Credit Rating Reports: A Complete Guide for Stock Investors

The company had continuously kept on investing in making one manufacturing plant after another as well as expanding its existing plants to increase its size of operations so that it could become a reliable partner for the OEMs. The following information will help an investor to understand the continuous project execution work done by Minda Industries Ltd.

  • In FY2010, the company completed a lighting project at Chakan, Pune (FY2010 annual report, page 30).
  • In FY2013, the company completed a switches plant in Hosur, TN and a fuel caps plant in Manesar, Haryana (FY2013 annual report, page 16).
  • In FY2015, the company expanded the capacity of the lighting division at Manesar, Haryana (FY2015 annual report, page 25).
  • In FY2016, the company completed alloy wheel and rubber hoses plants at Bawal Haryana (FY2016 annual report, page 4).
  • In FY2018, the company under JV Minda Kosei started production at another alloy-wheel plant in Gujarat (FY2018 annual report, page 91).
  • In FY2021, the company completed the sensors plant (June 2020 presentation by the company, page 7) and 2-wheeler alloy wheels plant completed (August 2020, Q1-FY21 press release).

The presence of plants in multiple auto clusters of India like Gurgaon (Haryana), Pune (Maharashtra), Hosur (Tamil Nadu) and Gujarat enables the company to supply to multiple OEMs quickly with a lower lead time i.e. fulfil the requirements of OEMs to send the products just-in-time with a minimal idle inventory.

The credit rating agency, ICRA has highlighted the benefits of having multiple plants in the auto-clusters near OEMs in its rating guidelines for the sector, Oct. 2020, page 5, like competitive advantages, flexibility, just in time supplies etc.:

location diversification of manufacturing units, closer to the OEMs’ manufacturing units, results in lower overhead logistics and reduced lead time for supplies which can lend a competitive edge. Multiple manufacturing units also provide the flexibility to shift production to another manufacturing unit in case of disruption in one unit (could be due to a labour strike or any other force majeure event). This is important in cases where an auto component manufacturer is a just-in-time supplier to an OEM and any delays in supplies could lead to production line stoppages.

Many times, an investor would notice that auto ancillary companies have to chase the OEMs whenever the OEMs decide to open a new plant whether it is at another location within India or in a foreign country. The auto ancillary companies have to put up a plant at the new location whenever the OEM decides to do so.

Moreover, at times, when the OEMs change their plans at a later stage, then the auto ancillary companies end up with unused investments at the new location.

 

3.2) Decisions of chasing the OEMs’ manufacturing plants gone wrong for auto ancillary companies:

An investor may look at the example of an auto ancillary company, India Nippon Electricals Ltd, which had to buy land in Indonesia as well as Uttarakhand when its OEM customers decide to put up their plants in these locations. However, later on, the plans of the OEMs did not work out and India Nippon Electricals Ltd was stuck with unused land at these locations.

The company had to create a subsidiary in Indonesia when its largest customer, TVS Motors, started its production facility in Indonesia. However, the production volumes of TVS in Indonesia did not reach sufficient numbers. As a result, India Nippon Electricals Ltd did not start to create any plant in Indonesia and instead, it supplied products to TVS Indonesia from its Indian manufacturing units. Currently, the company only has the land parcel in Indonesia that it had purchased to create the plant there.

FY2013 annual report, page 13:

Your company acquired land in Indonesia through its subsidiary company, PT Automotive Systems Indonesia, with a view to establish manufacturing operations to support TVS Motors. However, as the volumes have not reached our expectations, we cannot proceed with the same.

The investment by the company in Indonesia did not yield any results, as TVS Indonesia does not have the required production volumes. Moreover, local automobile manufacturers have their own supplier networks. As a result, India Nippon Electricals Ltd has decided to liquidate the subsidiary company.

FY2017 annual report, page 10:

However, as mentioned in the previous report, the manufacturers of two wheelers in that country have their own sources for the products in the subsidiary’s range of manufacture and it has been decided to take necessary steps to liquidate the subsidiary.

Advised reading: How to read the annual report of a company

On similar lines, India Nippon Electricals Ltd purchased land in Uttarakhand in the last decade when one of its customers planned to open up a manufacturing plant there. However, in FY2010, the company intimated its shareholders that it had to defer the plans to start manufacturing in Uttarakhand due to a change in the customer’s plans.

FY2010 annual report, page 9:

Your Company has deferred commencement of manufacturing at Uttarakhand due to changes in the customers’ plans. Manufacturing will commence at an appropriate time depending on volumes. Meanwhile, your Company is meeting customers’ requirements from its unit at Rewari.

Therefore, an investor would notice that many times, auto ancillary companies have to make investments in locations where later on they might not manufacture products because either the OEM customers change their plans or the customers could not do well.

Coming back to the example of Minda Industries Ltd, an investor would notice that to grow bigger, it is on a continuous lookout to increase the range of products that it can supply to OEMs. In its quest to widen its product basket, it announced the acquisition of Harita Seating in February 2019, which is still under process. If successful, the acquisition would further add scale to the business operations of Minda Industries Ltd.

FY2019 annual report, page 43:

The Board of Directors of your Company had its meeting held on 14 February 2019, approved acquisition of Harita Seating Systems Limited (“Harita”), by way of composite scheme of amalgamation, which is the leading manufacturer of seating systems in India

The increasing size of the business of Minda Industries Ltd has acted as an important factor where it could get preferential treatment from its customers (OEMs) in terms of additional business leading to an even larger scale of operations and better pricing power. This is another factor leading to the increased profit margins of the company during FY2014-FY2019.

An investor would appreciate that a large auto component manufacturer benefits from economies of scale. They can purchase from their suppliers at cheaper prices and can produce goods more cost-effectively in their plants. As a result, they can offer their products at very competitive prices to OEMs. This, in turn, makes things further difficult for new and small players to gain scale in the industry.

ICRA rating methodology for auto component companies, Oct. 2020, page 3:

Effectively, a large scale enables better cost absorption and greater ability to offer competitive pricing to buyers. The size of an auto component manufacturer is crucial as larger suppliers typically receive preference from the OEMs during source selection, which generally results in a relatively superior wallet share with them compared to their smaller peers.

The credit rating agency, CRISIL has also highlighted the benefit of big size/market share for auto ancillary companies in its rating guidelines (April 2016):

A strong market share generally translates into larger business volumes, thus helping players benefit from economies of scale (through a better coverage of overheads) and thus, to compete better on prices.

As a result, an investor would notice that in the case of auto ancillary companies, it is the big who have a higher chance of getting bigger in future.

Read: In-depth fundamental analysis of Auto ancillary Companies

Let us see what are the other factors that help auto ancillary players get preferential treatment from OEMs.

 

4) Technology, Research and Development:

In the auto ancillary businesses, the products vary from simple products like sheet metal parts to technologically complex and critical products like engine/drive transmission system and fuel systems. The companies producing technological complex products are more important for the OEMs and in turn, get preferential treatment.

While reading about the dynamics affecting the business of auto component manufacturers, an investor gets to know that, the players who manufacture technologically advanced products benefit in many ways. These companies get better attention from OEMs in terms of intensive coordination on product development, preferential treatment in orders, better pricing terms etc.

Credit rating agencies ICRA and CARE have highlighted the technological superiority of the products as one of the key features for any auto component manufacturer.

ICRA rating guidelines for auto component manufacturers, Oct. 2020:

Auto component manufacturers producing technology-intensive products where competitive pressures are benign are relatively better placed for passing on raw material price increases to customers compared to players with the presence in relatively lower value-added components.

Suppliers that have proprietary knowledge, tend to enjoy superior profitability metrics, relative to those that cater to customer-provided designs.

CARE rating guidelines for auto component manufacturers, July 2020:

The more critical, complex and technology-intensive the product is, higher is the extent of coordination called for between the auto ancillary and the OEM, and higher is the pricing power enjoyed by the ancillary.

The credit rating agency, CARE as well as CRISIL, also highlighted many other aspects of auto ancillary companies producing technologically advanced products. Technology acts as an entry barrier for new companies. Technology also lowers the substitution risk. Technologically complex products also enjoy higher profit margins.

CARE rating guidelines for auto component manufacturers, July 2020:

companies manufacturing technologically-intensive products face lesser substitution risk as the technology acts as an entry barrier. Thus, companies with a strong in-house R&D team or access to new technology or foreign technical collaborators / parent and producing products in the higher end of the value chain are viewed favorably.

CRISIL rating guidelines for auto ancillary companies (April 2016):

Product complexity also limits the risk of price erosion and discourages new entrants, thus strengthening the supplier’s market position.

Moreover, OEMs realize that the auto ancillary companies producing technologically complex and critical products are essential for uninterrupted operations of the OEM plants. Therefore, they strengthen the relationship with such auto ancillary companies by taking an equity stake in them, investing money in their manufacturing plants or giving them favourable credit terms etc. All these steps make it difficult for the OEM to switch to other auto ancillary companies.

ICRA rating guidelines for auto component manufacturers, Oct. 2020 (page 5):

There are instances where the OEMs enjoy a strong relationship or have high dependency for supplies of critical components. They may have an equity stake in the suppliers in certain cases. In certain cases, the OEMs have also made sizeable investments in tooling and other processes along with vendors, resulting in high switchover cost for the OEMs and consequently stable wallet share for vendors.

Therefore, an investor would appreciate that those auto ancillary companies that spend money on R&D and attempt to improve the technology of their products get better pricing for their products and favourable treatment from the OEMs and in turn enjoy improving, higher margins.

 

4.1) Real-life example of auto ancillary companies benefiting from technology and R&D spending:

An investor may again look at the example of Minda Industries Ltd, which continuously increased its spending on research and development over the last 10 years.

Minda Industries Ltd Research And Development Expenditure 2011 2020

The expenditure on R&D in the standalone entity increased from ₹15 cr in FY2011 to ₹91 cr in FY2019. In the last 10 years (FY2011-2020), the company spent a total of ₹491 cr on R&D, which is about 2.9% of its standalone revenue.

The company also entered into many technological tie-ups for technological improvement of its products like lightings (AMS, Korea), horns (FIAMM, Italy), fuel caps (Toyoda Gosei), alloy wheels (Kosei, Japan), high-end sensors (Sensata, USA), speakers (Onkyo, Japan), printed circuit boards (Katolec, Japan) etc.

Additionally, Minda Industries Ltd acquired many companies to get access to the superior technology of these companies like horns (Clarton, Spain), lighting (Rinder group of Spain and Delvis), ECUs and controllers (iSYS RTS), Telematics AIS 40 technology (from KPIT Engineering) etc.

While analysing the business of Minda Industries Ltd, an investor comes across many instances where the preferential treatment of the company by OEM customers becomes evident. At times, the company has received minimum offtake commitment for its products from OEMs and at other times, the OEMs gave it confirmed orders even before its manufacturing plant became operational.

In 2017, when the company increased the capacity of its alloy wheel plant at Bawal, Haryana, then it had confirmed orders from its largest customers, Maruti Suzuki India Ltd (MSIL).

ICRA credit rating report of Minda Industries Ltd, September 2017, page 4:

many of the newly incorporated companies like Minda Kosei scaled-up on the back of confirmed off-take from its customers

Minda Kosei is exposed to business risks, though mitigated to some extent by the confirmed business orders from MSIL.

Later on, in 2019, when the company was setting up another alloy wheel plant for 2-wheelers, then it had a confirmed order from another 2-wheeler OEM.

ICRA credit rating report of Minda Industries Ltd, September 2019, page 4:

Though the investment in setting up the alloy wheels facility is sizeable, the business risk is mitigated partially by a confirmed order from a leading 2W OEM.

An investor would appreciate that confirmed orders even before the plant is operational indicate the special treatment large players like Minda Industries Ltd get from OEMs. Such confirmed orders help the companies to do better production planning leading to the best utilization of resources and thereby better profit margins.

(An investor may read our detailed analysis of Minda Industries Ltd in the following article: Analysis: Minda Industries Ltd)

 

4.2) Loss of revenue if auto ancillary companies do not upgrade technology:

Moreover, an investor also needs to keep in mind that a strong focus on technological development is required by auto component manufacturers to maintain their competence as well as profitability. This is because; the OEMs include periodic price reduction clauses in their contracts with auto component manufacturers.

ICRA credit rating guidelines for auto component manufacturers, August 2018, page 5:

Further, since most OEMs stipulate periodic price reduction through the life of their supply contracts, auto component manufacturers must continuously work at improving operational efficiencies and undertaking ‘value analysis and value engineering’ projects to optimise product costs.

Therefore, if an auto component manufacturer does not continuously upgrade its technology on time, then it will miss the high profit-margin new contracts from OEMs and the supplies on the existing contracts would become less profitable as those vehicles models become old.

As a result, auto ancillary companies are under continuous pressure to improve their technologies.

An investor would appreciate that technological developments are expensive investments and may require significant spending in the form of research & development (R&D) spending. Every auto component manufacturer may not afford a high R&D budget or the long-time it may take to develop a product. Therefore, many times, auto ancillary companies do technical tie-ups with global players, which already have the technology.

 

5) Technical tie-ups with global players and acquisitions:

An investor would appreciate that in the automobile field, the technology in the vehicles advances at a very fast pace. Many times, global innovator companies bring in new advancements, which are highly value-adding for the customer comfort that all the OEMs demand their suppliers to upgrade their products.

At times, the govt. forces OEMs to upgrade the technology of their products by regulatory changes e.g. Indian govt. forced all the automobile manufacturers to meet BS-VI norms directly by upgrading from BS-IV norms. As a result, the automobile industry had to take a big jump in technological advancement as it had to skip BS-V norms altogether.

At such times, if any auto ancillary company is not able to upgrade its products to meet the required advancements like meeting BS-VI norms, then it faces the risk of losing a significant amount of business.

An investor may look at the example of an auto ancillary company, Gandhi Special Tubes Ltd, a manufacturer of welded and seamless steel tubes, cold-formed tube nuts and fuel injection tube assemblies for automobile and other industries.

While analysing Gandhi Special Tubes Ltd, an investor notices that one of the components made by the company, the fuel injection tube, is a critical component of the engine of the vehicle. Therefore, the company must upgrade it to meet the new norms, if it plans to retain its market share.

However, an investor notices that the company does not have the required technology to make parts meeting the new technological requirements.

FY2018 annual report, page 41:

Threats: Tightening of emission norms could see change in technology and could impact demand for Company’s one line of products i.e. fuel injection tubes only .With the introduction of BS IV standards from 1st April, 2017, there is a major change in specifications for high pressure fuel injection tubes which is one of the applications for which company’s products are used. Technology to manufacture CRDI TUBES is currently not with the Company.

(An investor may read our detailed analysis of Gandhi Special Tubes Ltd in the following article: Analysis: Gandhi Special Tubes Ltd)

On the contrary, companies, which have already developed the technology to upgrade their products as per new requirements feel much more confident about maintaining their market share.

An investor may look at the example of another auto ancillary company, Sharda Motor Industries Ltd, which could develop BS-VI compatible versions of its products by research and development. The company would be able to sell these products to OEMs at a higher price and earn good profits.

Credit rating report of Sharda Motor Industries Ltd by CRISIL, February 2017:

Continued focus on R&D, process automation, and value engineering: Substantial investment in research and development (R&D) infrastructure has enabled the company to achieve significant improvement in the production process, and launch products that match the stricter emission norms of Bharat Stage-VI. This has led to improved operating efficiency and various OEMs have placed orders for exhaust systems for new launches, scheduled over the next 12-18 months. These high value-added products will be sold at a significant premium over the existing ones.

(An investor may read our detailed analysis of Sharda Motor Industries Ltd in the following article: Analysis: Sharda Motor Industries Ltd)

Therefore, an investor would appreciate that keeping up the technology of the products is essential for auto component manufacturers. However, most of the Indian auto ancillary companies are not able to spend a large amount on R&D.

As per credit rating agency, CRISIL, Indian auto component manufacturers spend less than 1% of their revenue on R&D whereas auto component manufacturers in the developed countries spend 8% – 10% of their revenue on R&D. Therefore, many times, when the companies are not able to develop the technology in-house, then they plan to tie-up with global players in order to get access to the new technology.

The credit rating agency, ICRA, highlighted the benefit of such tie-ups with global companies for Indian auto ancillary companies in its rating guidelines (Oct. 2020, page 4):

Research & development (R&D) expenses in the Indian auto component industry remain low (<1% of revenues) compared to the developed markets, where some of the larger players invest ~8–10% of their revenues in R&D. In India, several auto component manufacturers have entered into technical collaborations with international Tier I manufacturers for the transfer of technical knowledge; or have formed equity partnerships with foreign players to meet the OEMs’ technical requirements.

At times, the steps to gain technology by a tie-up with global players also help the companies gain additional business. This is because, global OEMs, which have their manufacturing plants in India look favourably at those Indian auto ancillary companies, which have tie-ups with global auto ancillary companies that supply to the global plants to these OEMs.

The credit rating agency, CRISIL has also highlighted the benefit of such tie-ups with global companies for Indian auto ancillary companies in its rating guidelines (April 2016, page 5):

Technology partners have greatly influenced OEM decisions in finalising auto component vendors, especially when the former are suppliers to the concerned OEMs’ international operations, making validation easier.

ICRA, rating guidelines for auto ancillary companies (Oct. 2020, page 4):

The presence of a strong technology partner not only mitigates technology obsolescence risk to an extent, but in some cases also provides additional business opportunities to domestic establishments of the partner’s global customers.

 

5.1) Real-life example of auto ancillary companies focusing on technological tie-ups:

From the discussion on Minda Industries Ltd, an investor would remember that the company tied up with numerous other players to gain access to the required technology and strengthen its position in the Indian auto ancillary sector.

The company entered into many technological tie-ups for technological improvement of its products like lightings (AMS, Korea), horns (FIAMM, Italy), fuel caps (Toyoda Gosei), alloy wheels (Kosei, Japan), high-end sensors (Sensata, USA), speakers (Onkyo, Japan), printed circuit boards (Katolec, Japan) etc.

However, an investor would appreciate that in such technological tie-ups, the foreign partners usually share their existing technologies with Indian auto ancillary companies. Such tie-ups do not force the global partner to develop technologies as per the need of Indian companies. Therefore, at times, Indian auto ancillary companies find that the tie-ups are not fulfilling their needs.

In such a situation, many times, the Indian auto ancillary companies have to resort to outright acquisitions of foreign companies with the required technology.

Minda Industries Ltd faced such a situation when one of its technological partner from South Korea did not perform as per expectations and the company had to look for other places to gain the required technology. It found a company in Europe, which met its requirements. As a result, it acquired the European company (Delvis) to improve its in-house design and development capabilities.

October 2019 conference call on the acquisition of Delvis, page 7:

Sunil Bohra: …there has been dependency in terms of specifically LED lamps on one of our TLA partner and to be very honest we wanted them to do lot more, but obviously it was since they are not a partner or a JV partner you cannot force them right, so information development use to happen but then we could do much more and we could sense that opportunity, which you could not capitalize and I think with this acquisition and technology in-house we should be able to capitalize on the technology and we should see a faster growth in our lighting business.

The result of all these efforts to improve the technical aspect of its products seems to have led to Minda Industries Ltd becoming an important supplier for the OEMs. Therefore, it seems that the company could get frequent price increases from the OEMs whenever raw material costs increased and as a result, it could improve its profit margins over the years.

While analysing the acquisitions by Indian auto ancillary companies, an investor would appreciate that over the years, apart from access to the technology, companies have benefited by getting new products, customers and markets. In fact, as per credit rating agency, ICRA, acquisitions are a common way of growth by Indian auto ancillary companies.

ICRA, rating guidelines for auto ancillary companies (Oct. 2020, page 1):

Besides capacity expansion, acquisitions have been a common strategy for growth pursued by large Indian auto component manufacturers. Acquisitions typically help expand product lines and provide access to new markets/segments/customers. Acquisitions by Indian auto component manufacturers in the past were primarily in Europe and North America, aimed at technology and marquee customer acquisition.

 

5.2) Acquisition led growth strategy by auto ancillary companies: Challenges for investors:

One of the side-effects of the acquisition led growth strategy is that many auto ancillary companies end up having a very complex corporate structure with numerous subsidiary, associates and joint ventures.

If an investor looks at the auto ancillary company, Minda Industries Ltd, then she would notice that the company has 42 subsidiaries, associates and joint ventures. The presence of so many entities in the corporate structure presents a few challenges for the investors.

The biggest challenge of a complex corporate structure is that the investors are not able to assess the performance of the group as a whole. In many such instances, even the consolidated financials are not able to capture the overall group position leaving the analysis of investors incomplete.

In the case of Minda Industries Ltd, the consolidated financials for FY2020 show revenue of ₹5,465 cr. However, in the FY2020 annual report, on page 10, the company has declared that the total turnover of UNO Minda group is ₹7,200 cr.

In the case of complex corporate structures, another aspect that complicates an investor or analyst’s job is that the management uses a lot of discretion in determining what should be included in consolidated financials and what should be excluded. An investor would appreciate that most of the times; the management would tend to exclude loss-making companies from consolidation to present a better financial position to the investors.

In the case of Minda Industries Ltd, in the FY2012 annual report, the auditor highlighted that in the previous years, the management did not consolidate some JVs and associate companies in its financials. Had the company consolidated those companies, then its reported profit would have been lower.

FY2012 annual report, page 74:

Without qualifying our report, attention is drawn to note 50 of the Consolidated Financial Statements that during the previous periods, the management had not consolidated certain joint ventures and associates as part of their consolidated financial statements. Accordingly, during the current year, management has adjusted the effect of the same with the current year profits in accordance with Accounting Standard – 5 ‘Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies’. Had these joint ventures and associates been consolidated in the previous periods, the profit for the current year would have been lower by Rs. 340.20 lacs.

Therefore, an investor would appreciate that in the case of companies with a complex corporate structure, it is always a possibility that the consolidated financial statements presented to the investor may not represent the complete financial position of the company. If this is the case, then the analysis done by the investor or the investment decisions taken by the investor may be erroneous.

Advised reading: Standalone vs Consolidated Financials: A Complete Guide

In the case of companies that have a large number of subsidiaries, JVs and associates, investors face a problem that many times, there are investments done by the company in different entities that are present in the tables in the notes to financial statements; however, there is no explanation about them in the directors’ report or management discussion & analysis section. As a result, the investor is not able to judge the purpose of the investment done by the company in those entities. In such instances, the assessment of the investment decisions by the investor becomes mere guesswork.

Therefore, the strategy of auto ancillary companies to grow by making acquisitions and creating numerous subsidiaries, associates and joint ventures in the process, complicates the analysis process for the investors.

An investor would notice that in order to expand their business and also to protect themselves from the cyclical and tough business environment while supplying to OEMs, many auto ancillary companies take steps for business diversification.

 

Diversification by auto ancillary companies:

Companies attempt to diversify in terms of more clients in order to protect their business from risks and gain bargaining power.

CRISIL rating guidelines for auto ancillary companies (April 2016, page 3):

Diversity in clientele also strengthens bargaining power in negotiating supply contracts

However, many times, the diversification attempts do not provide desired protection because the Indian automobile market has a few large players dominating each segment like 2,3,4 wheelers and commercial vehicles.

ICRA, rating guidelines for auto ancillary companies (Oct. 2020, page 5):

However, each individual segment of the Indian automobile industry is currently an oligopoly with a few OEMs accounting for a major share of the market. Hence, auto component manufacturers can achieve meaningful client diversity, largely by catering to multiple segments of the industry or by having significant exports.

Therefore, the auto ancillary companies have to diversify across different product segment like 2, 3 & 4-wheelers, different geographies like exports, revenue segments like the aftermarket/replacement market.

Even in the case of exports, Indian auto component manufacturers primarily target the replacement market because it becomes very difficult for them to get a breakthrough into OEMs or tier-I suppliers of OEMs because global companies change their suppliers very infrequently.

ICRA, rating guidelines for auto ancillary companies (Oct. 2020, page 5):

Indian auto component exports are often targeted at the overseas replacement market, which is relatively diversified and stable compared to exports to the global OEMs or their Tier I suppliers. However, auto component manufacturers are often dependent on a few customers when the exports are to the Tier I/ OEM segment because of infrequent supplier additions/switches by the global OEMs

As a result, many auto ancillary companies attempt to build their presence in the aftermarket segment i.e. replacement market whether in India or overseas.

However, while analysing different auto ancillary companies, an investor notices that the aftermarket segment is highly challenging and not all the companies are able to achieve success in the replacement market.

 

6) Aftermarket or replacement market is not as easy as it seems:

While reading about the factors that strengthen the business model of an auto ancillary company, an investor notices that the aftermarket/replacement segment provides a much better opportunity to the companies.

The aftermarket segment has better profit margins. This is because when raw material prices come down, then unlike supplies to the OEM segment, in the case of the aftermarket segment, the auto ancillary companies can retain some of the benefits to themselves. Whereas in the case of OEMs, the purchase managers of the OEMs squeeze out all the benefit of reduction in raw material prices from the auto ancillary companies.

CRISIL rating guidelines for auto ancillary companies (April 2016, page 4):

The aftermarket (AM) segment is also more profitable, for it is less exposed to pricing pressure than is the case with supplying to the OEMs.

ICRA, rating guidelines for auto ancillary companies (Oct. 2020, page 4):

Strong aftermarket presence benefits auto component manufacturers during volatile commodity prices and cushions profitability during a declining commodity price scenario, as some benefits from raw material price decline can be retained.

The demand for products is less cyclical in the aftermarket segment than the OEMs where customers postpone the purchase of new vehicle during the economic downturn. In the aftermarket, people have to take care of the wear and tear of their existing vehicles.

ICRA, rating guidelines for auto ancillary companies (Oct. 2020, page 4):

During an economic slowdown, an auto component manufacturer with a strong presence in the aftermarket can withstand pressure on the top-line and profitability much better than those supplying predominantly to OEMs.

CARE rating guidelines for auto component manufacturers, July 2020:

Replacement market sales command higher margins and at the same time provide revenue stability as it is not correlated to the performance of the OEMs and production of vehicles, which can be volatile.

In addition, for some products, the aftermarket segment is even larger than the OEM segment.

ICRA, rating guidelines for auto ancillary companies (Oct. 2020, page 1):

In certain components like automotive batteries and tyres, replacement demand is larger than the OEM market size.

Looking at the benefits of a strong presence in the aftermarket/replacement segment, quite a few auto ancillary companies start to make investments for the distribution channel, sales & marketing teams anticipating that these higher expenses may be compensated by the higher profit margins in the aftermarket segment.

ICRA, rating guidelines for auto ancillary companies (Oct. 2020, page 1):

In terms of margins, the replacement segment is the highest, followed by exports.…To establish a strong replacement footprint, auto component manufacturers will require investments for setting up a distribution network and incur sales and marketing expenses, which may be compensated by relatively superior contribution margins, earned from replacement sales as compared to sales to the OEMs.

However, to be successful in the aftermarket segment, the investments required to create the large distribution channel and additional sales and marketing teams are substantial. Many times, these investments may not be economically viable considering that the margins in the aftermarket segment may not be high enough to recover additional investments. This is because, the aftermarket segment has very intense competition from the unorganized sector, imports as well as spurious/duplicate products. Moreover, most of the purchasers in the aftermarket are very price-conscious and may not choose to pay a premium for the branded products from organized players.

CARE rating guidelines for auto component manufacturers, July 2020, page 3:

However, a large distribution network is required to cater to the replacement market, so the costs incurred may not be justifiable at times, as the buyers in this segment are extremely price sensitive and may not be brand conscious.

Besides creating a significant presence in the aftermarket takes a large amount of management bandwidth as well as resources. Therefore, an investor may come across companies that could not establish a significant aftermarket presence despite making it a priority even for 10-years.

 

6.1) Real-life example of an auto ancillary company unable to achieve desired scale even in 10-years:

An investor may look at the example of Jamna Auto Industries Ltd, which produces springs/suspension parts for commercial vehicles. The company started to highlight its focus on the aftermarket segment in FY2009.

FY2009 annual report, page 5:

The company decided to increase its share in the domestic and export replacement markets. We are happy to inform that we have increased our share in the domestic replacement market.

In FY2012, the company again emphasized that growth in the aftermarket segment is essential for the future growth strategy of the company.

FY2012 annual report, page 14:

An aggressive ramping up of sales in the After-Markets – India/Export and a higher proportion of Parabolic sales is crucial to our growth strategy.

However, even more than 10-years after declaring its focus on the after-market segment, even in FY2020, the company has not yet achieved a meaningful scale in the aftermarket segment.

Credit rating report of Jamna Auto Industries Ltd by ICRA, March 2020, page 3:

Despite the management’s initiatives to develop a widespread network for the after-market segment, its ability to scale up its after-market supplies to a level that can offset any sharp decline in CV OEM volumes in case of any downturn, is yet to be demonstrated.

Advised reading: Credit Rating Reports: A Complete Guide for Stock Investors

Therefore, investors should appreciate that even though the aftermarket segment looks like a solution to many problems faced by auto ancillary companies in the OEM segment. However, establishing a presence in the aftermarket segment is not an easy task. Companies like Jamna Auto Industries Ltd despite being the largest producer of suspension springs in India, could not build the desired scale in the aftermarket segment even in 10-years.

 

6.2) Challenges of aftermarket business in the auto ancillary industry:

Apart from the difficulty to create the distribution channel, sales and marketing teams, the aftermarket segment has other challenges as well like a higher working capital requirement, prolonged receivables, and credit risk to recover the dues etc.

CRISIL rating guidelines for auto ancillary companies (April 2016, page 4):

Component suppliers selling largely to the AM segment, on the other hand, have larger working capital requirements, given the longer payment cycles involved.

On the contrary, auto component manufacturers which primarily deal with OEMs are better placed because the OEMs make prompt payments when it is due.

Typically, component suppliers that are predominantly dependent on the OEMs for revenue have lower working capital requirements. That is because the OEMs follow just-in-time practices in procurement, and make prompt payments.

In addition, most of the OEMs are known to clear their dues to the supplier on time and do not default on payments. As a result, at times, auto component suppliers have claimed that they have never suffered any loss of receivables.

An investor may look at the example of India Nippon Electricals Ltd, a TVS group company, manufacturing electrical ignition systems for automobiles (two-wheelers, three-wheelers), and gensets (portable generators).

The company gets 98% of its revenue from large customers like TVS Motors (63%), Hero Motocorp (25%) and Crompton Greaves (10%). In its annual report, the company highlighted that it had never lost any money on receivables.

FY2019 annual report, page 152:

The Group’s receivables are predominantly from its related parties and large Original Equipment Manufacturers. The Group has never experienced doubtful debts in earlier years, therefore, there is no credit risk and thus no allowance for expected credit losses have been made.

Therefore, an investor would notice that even though many times, auto component companies communicate to their investors that they plan to make a big business from the aftermarket segment, then the investor should be aware that it is easier said than done.

Establishing a significant aftermarket business comes with many challenges like:

  • Large investment to create a distribution channel
  • Significant expense on marketing and advertising
  • Intense competition with imports, unorganized players and spurious/duplicate/counterfeit products
  • Highly price-sensitive buyers who are not brand-conscious
  • Large working capital requirements due to inventory stocking and delayed payment cycles
  • Risk of non-recovery of trade receivables

In the light of the above discussion, an investor would notice that in the auto ancillary sector, a company needs to have a very strong relationship with the OEMs in order to gain good business terms. For any auto ancillary player, it might require large investments of money and management bandwidth in increasing business size, technological upgradation, R&D, technical tie-ups, acquisitions etc. in order to become an important partner for OEMs.

However, there is one segment of the auto ancillary industry, which automatically gets favourable treatment from OEMs without as much hassle as other players.

This segment of the auto ancillary industry is the companies belonging to the OEM group, either their subsidiaries or their promoter-group-companies, which supply products to the parent OEM. These companies get favourable business terms, assured business, access to new technologies, newer markets, distribution channel, aftermarket sales as well as help in sourcing raw material at the best prices from the OEM.

CARE rating guidelines for auto component manufacturers, July 2020, page 1:

Companies belonging to groups with established presence in the industry either as OEMs or ancillaries stand to gain because of the association. Strong parentage enables access to various aspects like new markets, technology, personnel, distribution networks, raw material sourcing, etc.

Therefore, the auto ancillary companies belonging to the OEMs or their promoter groups enjoy a lot of benefits because of the promoter linkages.

However, for all other auto ancillary companies, it is a tough business to stay relevant in the intensely competitive business characterised by low negotiating/pricing power, forever changing technology and regulations requiring significant investment to upgrade to new standards.

An investor would appreciate that the auto ancillary companies end up investing a lot of capital in their business in the form of multiple plants near OEM clusters, as large inventory holding for just-in-time delivery to OEMs, and extended payment terms. This creates a situation where most of the auto ancillary companies end up with a financial picture of low-profit margins, negative free cash flow (post-meeting capital expenditure) and increasing debt.

When we analysed the financials of numerous auto ancillary companies as a part of our exercise to analyse all (2,800+) companies with a market capitalization of more than ₹10 cr listed on Indian stock exchanges, then we noticed that most of the auto ancillary companies presented the following financial picture.

  • Most of the companies had an operating profit margin (OPM) in the range of 6-10%. In fact, 10% seemed to be the upper limit that original equipment manufacturers (OEMs) seemed to have set for their vendors. OPM of most of the auto ancillary players used to peak at 10% and then again decline in the cyclical pattern characteristic of the auto industry.
  • In almost all the cases, the CFO for the last 10 years for auto ancillary players was significantly higher than PAT. This was primarily due to high depreciation and interest on debt on their balance sheet.
  • In addition, almost in all the cases, the capital expenditure done by the auto ancillary players was higher than their CFO, which led to a negative FCF. These players, in turn, had to raise more debt to meet the capital expenditure requirements.

This was irrespective of the fact that the companies operated in such diverse segments like manufacturing steering wheels, suspensions, die-casting, locking system, fabrication etc.

Therefore, in our assessment of numerous auto ancillary players, we noticed that most of them had fluctuating OPM within the 7-10% range, negative FCF with capital expenditure funded by debt.

Though an investor would also find a few players that defy this trend with either higher OPM, low debt etc.; however, we noticed that it was an exception rather than a norm.

Advised reading: What I learnt from a brief analysis of 2,800 Companies

With this, we have come to the end of this article in which, we have attempted to put together all our learning from in-depth analysis of numerous auto ancillary companies listed on Indian stock markets.

 

Summary

To summarize, the business of almost all auto ancillary companies presents the following key features:

  • In most cases, the business performance is cyclical. Periods of increasing sales and profit margins are followed by periods of declining sales and profit margins.
  • Almost all auto component manufacturers have very low/negligible bargaining and pricing power with both, their customers (OEMs) and their suppliers (large metal producers). As a result, auto component manufacturers face low fluctuating profit margins, high working capital (high inventory and receivables), and even unused investments in land or plants.
  • In auto ancillary business, usually, the big gets bigger. OEMs like to deal with large players who can supply them with as many products as possible and as quickly as possible (just-in-time) in all of their multiple plants in various auto-clusters. OEMs give favourable pricing and credit terms to such players.
  • Auto ancillary players have to continuously upgrade their technology to stay relevant in the business and maintain their market share. The companies have to invest a lot of money in R&D or technical tie-ups or acquisitions in order to gain access to newer technologies.
  • However, despite all these efforts, auto ancillary companies face tough times with low profitability and return on their assets. In order to earn higher profits and safeguard themselves from business cycles, many auto ancillary companies look towards the aftermarket segment. However, establishing a large presence in the aftermarket segment requires large investments, which many times is not justified because the customers are price sensitive and indifferent to brands. Therefore, many times, companies have failed to create significant aftermarket business despite efforts of more than 10-years.

Most of the auto ancillary companies analysed by us seem to face the above-mentioned business features. We believe that keeping these learnings in mind while analysing any auto ancillary company would help an investor in her own analysis of companies from this sector.

The above key learnings would help an investor to focus on key aspects of the business model to understand how the company is performing with respect to auto ancillary companies in general. Therefore, she would be able to identify whether the company, which she is analysing, is doing something different from the rest of the sector or it is just following the well-trodden path being followed by numerous other auto ancillary companies.

By following the above learnings, the investor would be able to make a better and insightful opinion about any auto ancillary company.

Now it is your turn to let us know how you feel about this article. Let us know your feedback in the comments below. Please also share whether, during your analysis of auto ancillary companies, you have found any common feature across the industry. Please also share any other inputs that you feel may be useful for all the readers and the author.

All the best for your investing journey!

Regards,

Dr Vijay Malik

P.S:

 

DISCLAIMER

Registration status with SEBI:

I am registered with SEBI as an Investment Adviser under SEBI (Investment Advisers) Regulations, 2013.

Details of financial interest in the Subject Company:

Currently, I do not own stocks of the companies mentioned above in my portfolio.

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8 thoughts on “How to do Business Analysis of Auto Ancillary Companies

  1. Thanks for the great analysis of the Auto Ancillary players. I love reading your articles and it has definitely made me a better fundamental investor.
    I have also analysed Minda Industries Ltd. while I liked their business, I feel that it’s in a tough business and has to improve on its brand and corporate structure. One company, which I feel has a lot of great qualities is Bosch Ltd i.e., the advantage of size, technological prowess, aftermarket share etc.
    I would love to hear your views on Bosch Ltd.

    • Dear Prashant,
      Thanks for sharing your feedback. We provide our views to the analysis submitted by readers. You may share your detailed analysis of Bosch Ltd by doing an in-depth reading of all the available annual reports, credit rating reports, peer/competitor analysis etc. We will be happy to provide our inputs.
      Regards,
      Dr Vijay Malik

  2. Thanks, Dr Vijay. I was invested in some of the auto ancillary companies like Suprajit Engineering Ltd, Motherson Sumi Systems Ltd, Varroc Engineering Ltd. However, definitely, I need to apply your intensive study to them and think to come out soon. This study will surely help a lot of new investors like me to take decisions before putting their money into it; even at the cycle lower end (with tier 1).

  3. Sir, The article is very insightful and informative. I learnt a lot from it about the auto ancillary sector. I was personally studying about RACL Geartech Ltd and now plan to apply the learnings there. However, it’d have been very interesting to see Motherson Sumi Systems Ltd here along with Minda Industries Ltd. Thanks again.

    • Dear Saurabh,
      Thanks for your feedback. You may share your detailed analysis of Motherson Sumi Systems Ltd with us. We would be happy to provide our inputs to your detailed analysis.
      Regards,
      Dr Vijay Malik

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