Costly ride

The auto industry was one of the worst hit during the recent global financial crisis. Auto stocks underperformed sharply during the period. A steep drop in demand led to lower sales volumes. Demand was impacted due to tight liquidity and higher interest rates.

Higher raw material costs hit operating profit margins and overall profitability.

However, with the domestic economy improving, the auto industry got much-needed relief. Sales volumes have picked up and stocks outperformed. Since the beginning of this year, the BSE Auto index rose 186.1% compared with a 68.8% gain in the BSE Sensex.

Having said that, some analysts feel current valuations are stretched despite the decent long-term outlook. Sandeep Pandya of Goldman Sachs says the market appears to be factoring in optimistic scenarios of strong domestic demand growth and export potential of most auto companies. Increasing international exposure poses return and valuation multiple risks, and limits upside surprise potential on margins over the near term, he says.

“We initiate coverage on Maruti Suzuki India with a Sell rating and a 12-month FY2011 price to earnings based target prices of Rs 1421, implying 10% potential downside,” wrote Pandya in a note to clients on December 17, 2009.

At Rs 1548.55, Maruti’s currently trading at about 18 times its estimated earnings for 2011. This is very close to its historical peak of 21 times. Analysts feel Maruti’s current valuations do not reflect business risks emerging from increasing export share in revenues and rising competition in the domestic compact car segment.

The Goldman Sachs analyst has a neutral rating on Tata Motors. “We also initiate coverage on Tata Motors with Neutral and a 12-month sum of total parts (SOTP-based) target price of Rs 674, implying 5% potential downside,” wrote Pandya. Tata Motors high financial leverage is a concern for the stock. Execution risks are anticipated in the global luxury car business on the back of potential headwinds of higher cost structure, poor economies of scale and greater environmental regulations.