Updated: Sep 19, 2020
Note: This article is only for informational/educational purposes and in no way meant to be a stock recommendation or financial advice. Please conduct your own analysis or consult a SEBI registered investment advisor before you undertake any investment action.
The auto sector has been seeing encouraging recovery since July, with major auto makers reporting an improvement in year on year sales degrowth numbers.
For instance, the auto sales plummeted 42 per cent in June 2020 compared to the same month last year – remember, when analyzing financial numbers, it is customary to compare year-on-year figures since businesses face seasonality.
This disparity was reduced in July 2020, when the auto sales registered a decline of 36% compared to July 2019.
In August, the sales de-grew by 26.81 per cent. In fact, the passenger vehicles sales in August 2020 were lower by only 7 per cent compared to August 2019, indicating the recovery may be in pace.
To be sure, some of this could simply be pent up demand as car dealers stock up diminished inventories and consumers proceed with pending bookings. Also, we must consider the low base of last year – the passenger car segment had degrown by 32 per cent in August 2019 over August 2018, while the two-wheeler segment in August 2019 had degrown by 22 per cent over August 2018.
To evaluate whether this auto sector recovery is sustainable going forward, it may help to look at supportive, leading macro indicators that signal a rebound in the economy to pre-Covid levels.
For instance, data reviewed by CNBC TV18 recently showed that daily toll collection via FastTag has reached 98 per cent of pre-Covid levels. This includes toll collection at national highways, highways under state governments, and the transport ministry.
Furthermore, there’s an interesting phenomenon: The share of passenger vehicles in FastTag toll collection has increased to 41 per cent on September 4 compared to 38 per cent in the pre-lockdown phase. The share of commercial vehicles has declined to 59 per cent from 62 per cent earlier.
Keep this data point in mind for the specific small-cap company we will be discussing below. This company has a higher share of revenues from passenger vehicles.
CRISIL Research analysed toll data for over 600 national highway toll plazas and found that the vehicular traffic in June-July reached 80 per cent of pre-Covid levels.
This can also be corroborated through data on e-way bill generation in July, which as per an ICICI’s research report reached 88 per cent of pre-Covid levels of 5.5 crore bills. E-way bills generation is a prominent indicator of economic activity as it suggests a momentum in the movement of goods – these bills are required for transportation of goods with a value greater than Rs 50,000.
Furthermore, as per the report, daily vehicle registrations were at 72 per cent of pre-Covid levels during the week ending August 20. All this is to say that the factors supporting auto sector recovery, at least in shorter term, could be in place.
For this recovery to be sustainable in the long run, however, several factors need to be in sorted out, starting first with taxes.
For instance, the GST rate on automobiles is at 28 per cent, in line with luxury goods. The auto sector has long demanded a 10 per cent reduction in GST. Remember, the government had reduced the GST on electric vehicles (EVs) from previous 12 per cent to 5 per cent earlier, and this led to a rise in EV sales by over 20 per cent – from 1.3 lakh to 1.56 lakh units – in FY20 compared to FY19.
Other factors such as passing the benefit of lower crude prices to consumers or finalizing the long pending vehicle scrappage policy (which mandates scrapping vehicles older than 15 or 20 years) could boost new vehicle sales.
These policy measures are triggers that could lead to a major rerating in auto OEMs (original equipment manufacturers) and auto ancillary stocks.
LUMAX INDUSTRIES – A BET ON THE AUTO SECTOR
One such auto ancillary company, which is a supplier to all major OEMs, is Lumax Industries. The company provides comprehensive lighting solutions to the automotive sector.
Specifically, it manufactures technology-advanced and high-quality lights ranging from head lamps, tail lamps, fog lamps, sundry lamps to auxiliary lamps.
Through one of its associate companies SL Lumax, it also manufactures motorcycle chassis, molded parts, exhaust/emission parts, seating mechanism, frames to parking brakes, gear shifters and many more, but that comprises less than 10 per cent of its total revenue.
As much as 92 per cent of its revenue comes from lamps.
Lumax has been on my radar for quite some time now, primarily because of its moats as well as superior financials – both of which we will discuss below.
But first . . . let’s take a look at the industry dynamics.
As may be obvious, the automotive components sector, including lighting, relies heavily on the performance of the Original Equipment Manufacturers (OEMs), meaning auto makers. Any slowdown in the broader auto sector directly impacts the auto components industry.
As of FY20, India’s automobile industry was the 4th largest in the world. It is the largest tractor manufacturer, second largest bus manufacturer, and third largest heavy truck manufacturer.
While the automobile industry contributes to 7.5% to India’s gross domestic product (GDP), employing close to 80 lakh people directly and indirectly, the auto components industry contributes to 2.3 per cent to GDP, employing approx. 15 lakh people.
INDUSTRY GROWTH DRIVERS
In the long run, the auto sector has significant potential to grow. This is evident from the fact that in India, the per capita usage of car stands at a meager 32 people per 1000, compared to 192 globally. The pandemic may increase the demand for personal mobility, but even otherwise the growth of the shared mobility model had made manufacturers optimistic on the demand.
POTENTIAL FOR LOCALIZATION
Among the other growth drivers for the auto component industry, the potential for higher localization – specifically the shift of value chains from China to India – in the wake of the pandemic may score at the top.
Notably, this is easier said than done. In the absence of import restrictions and domestic manufacturers who can match their offerings to their Chinese counterparts on not just the pricing front but also quality, one would be better off discounting this possibility for now.
COST AND AVAILABILITY OF CREDIT
In the shorter run, the cost and availability of credit impacts automobile demand. Higher interest rates make it tougher to own a car, which directly influences automobile sales.
Besides, the new safety and emission Bharat VI norms have also increased the costs of car ownership in the short run. In the medium to longer run, however, these norms may lead to an increase in the demand for auto components that enhance safety and emission.
THE STRUCTURAL SHIFT FROM TRADITIONAL HALOGEN BULBS TO LED LIGHTING
One such component that enhances safety is, of course, lighting – specifically LED lighting. Under the Bharat VI regulation, both 2 wheelers and 4 wheelers will have to use oxygen sensors to reduce energy consumption.
This in turn will trigger the shift from conventional incandescent halogen lamps to LED lighting solutions. The demand for EVs and safety norms such as Daylight Running Lamps are also gradually redefining the automotive space in India.
To Lumax’s credit, the company was ready for Bharat VI norms even before they became effective.
For the automobile industry, the increased demand for LED lights stems not just from stringent regulation, but also because LEDs are more energy efficient – their luminous efficacy is 80-110 lumen per watt, while traditional halogen bulbs have 11-20 lumen per watt. LEDs also last longer – 50,000 hours versus 3000 hours for halogen bulbs.
This is longer than the average life of a car.
From a safety perspective, halogens LEDs reduce glare for drivers of vehicles, increases illumination in dark areas, improve night time visibility. An added advantage is the design versatility that LEDs provide. As per Lumax’s management, with the transition to LEDs, it is now possible to customize light designs as per the need of the specific auto maker.
Lumax has been a first mover in the LED lamps technology. As early as FY 2018, the company earned 25 per cent of its revenues from LED lights, with the rest coming from conventional lights. The company has since guided for a transition to a greater share of revenues, as high as 50 per cent, from LED lamps by 2022-23.
In August 2020’s quarter’s concall, the company indicated that it is on track to reach this goal, with the latest revenue share between LEDs to conventional lamps being 30:70. Even this is a one-off anomaly, as in the quarters preceding the pandemic, this ratio was 34:66.
The company further indicated that even farm equipment makers, with greater presence in the rural economy, have been seeking LED lamps.
VULNERABLE TO MACROECONOMIC VOLATILITY
The auto sector, and by extension auto component makers, are heavily dependent on the performace of the broader domestic as well as global economy.
For automakers disproportionately reliant on the rural economy – Escorts, M&M, Hero, to an extent Maruti Suzuki, and others – factors such as monsoon, irrigation, reservoir levels, MNREGA spending, minimum support price (MSP) policies, inflation, and pay commission payouts matter significantly.
Furthermore, even currency fluctuations may lower their margins through increasing competitive pressures. Say, for instance, a depreciation in the Chinese currency yuan may make their exports to India cheaper, flooding the Indian markets with cheap Chinese goods – in the absence of import restrictions.
Similarly, an appreciation in the rupee may make Indian goods less competitive globally – keeping other factors constant. This may put pressure on the export revenues of the domestic auto component makers. A stable rupee is therefore favorable.
With that in mind, let’s dig into the company’s business model and financials.
The scale and economic advantage of Lumax Industries stems from the fact that 90 per cent of four wheelers, two wheelers, bus and truck makers, farm equipment manufacturers, earth movers in India – you name them – are its customers. A total of 32 of them.
The company exports to as many as 18 countries, but domestically it commands more than a 50 per cent market share in automotive lighting industry.
A bulk of its revenue, almost 66 per cent, comes from four-wheeler manufacturers, mainly Maruti Suzuki which makes up for 36 per cent of its overall revenues, and 29 per cent comes from the two-wheeler segment, mainly Hero and Honda.
PRODUCT CATEGORY BREAKUP
Within product category, the company focuses heavily on front lighting, which contributes 66 per cent of its sales. The rear lighting and others contribute the rest.
The reason for this has to do with the fact that front lighting, unlike rear lighting, normally requires more technologically advanced and innovative features to aid clear visibility and road safety – these features include, for instance, the auto on-off, bending or curve lights, cornering lights, headlight levelling, and high beam assist.
In an answer to a question during the August conference call, the management also indicated that front lighting comes with higher profit margins.
INVESTMENT IN RESEARCH AND DEVELOPMENT
As you may guess, these features keep evolving through the years as auto makers frequently launch new models with better road safety and design enhancement features to boost sales. To help fulfill their requirements, Lumax invests heavily in research and development (R&D) every year. The infographic below shows the company’s R&D spends as a percentage of revenues.
COLLABORATIONS WITH GLOBAL LEADERS
What makes this investment in R&D fruitful is the fact that it comes on the back of a three-decade long partnership with Japan’s leading automotive lighting solutions provider Stanley Electric Co.
Lumax’s partnership with Stanley began in the year 1984 with the latter providing technical assistance to the former. Lumax went public in 1985-87, following which Stanley also participated financially in Lumax in the year 1994. As of today, Stanley is mentioned as a foreign promoter with 37.5 per cent ownership in the company. Another 37.5 per cent is owned by the DK Jain Group – Dhyanesh Jain, his two sons Anmol and Deepak and some other family members, for a total promoter ownership of 75 per cent.
Stanley’s technical assistance helps the company not only maintain superior quality of products – which in turn helps retain customers – but also lead innovation in the automotive lighting industry.
Besides Stanley, the company, either directly, or indirectly through subsidiaries and its associate company SL Lumax – in which it owns 21.28 per cent stake – has also formed joint ventures with six other global manufacturers of auto components. These include Mannoh (from Japan), Austem & SL (from Korea), Cornaglia and Sipal (from Italy), and Gill Group (from the USA). These collaborations have helped the DK Jain Group to expand operations and customer base and gain market leadership.
LUMAX’S RAW MATERIALS
The company’s primary raw materials include glass, tungsten, molybdenum, phosphorus, silicon, niobium, polymers, tantalum, and a mixture of inert gases. In addition to the volatile prices of these commodities, the company is also exposed to steel and rubber prices as they are key inputs used in manufacturing automobiles.
LUMAX & PORTER’S FIVE FORCES
Even so, the company attempts to mitigate the pressure on gross margins caused as a result of volatile raw material prices through not only keeping a diversified vendor base but also continuing to build long-term relationship with them. This moderates the bargaining power of suppliers – one of the five forces of the strategy guru Michael Porter.
As per FY 20 annual report, the company has 226 vendors and the average relationship with them spans about 10 years. Furthermore, the company often engages in back to back contracts with vendors in an attempt to mitigate procurement costs.
Furthermore, in 2019 the company also backward-integrated by manufacturing Printed Circuit Boards (PCBs), which are an essential component used in making LED lamps.
It also aims to include a vast range of advanced electronic components available with its partner Stanley Japan, including but not limited to HVAC (Heating Ventilation Air Conditioning) panel.
On a structural and long-term basis, it seems the power of substitutes to automobiles, and therefore automotive lighting, is also low given the poor public transport infrastructure in India and the need for personal mobility.
he transition to electric vehicles (EVs) – though in my view would be gradual -- is also expected to benefit Lumax since this would spur the transition to energy efficient LED technology in automotive lamps. As we’ll see further below, Lumax is heavily focusing on increasing the revenue share from LED lamps versus the conventional halogen lamps used earlier.
The one major challenge that Lumax faces, in addition to volatility in raw material prices, is the competitive pressure from Chinese imports. As per Mint, quoting ICRA Research and Acma, as much as 27 per cent of automotive components in India are sourced from China.
What works in favour of Lumax, however, is the fact that Its relationship with key customers – the largest of them being Maruti Suzuki – spans a period of over three decades. Besides, its technical and financial partnership with Japan’s Stanley Electric helps the company ensure high quality product and service.
The coronavirus pandemic could further help Lumax in the long run – which commands a 50 per cent market share in domestic automotive lighting market – if the government’s localization initiatives are successful.
On the customers’ front, as mentioned previously, Lumax supplies to more than 90 per cent of India’s vehicle manufacturers. This comprises 32 customers in total, with the average customer relationship spanning more than two decades. Lumax continues to add more customers – for instance, in 2018 it added Morris Garage and TVS Motors.
But being in a cyclical industry where sales depend heavily on the performance of the domestic economy and consequently the discretionary spends of people, Lumax’s bargaining power with customers may be constrained.
A combination of high taxes on automobiles combined with slowdown in the economy means auto makers scramble to cut costs aggressively. This is reflected in the company’s stock price – since the beginning of the slowdown in auto industry, Lumax’s share price has fallen from a high of mid-2000s to Rs 1400 now.
And lastly, the domestic entry barriers to this industry, seem quite low. Automotive lighting is fast becoming a niche market that increasingly requires technological expertise. This is especially relevant given the policy shift to stringent Bharat VI safety norms, preference for energy efficient LED lighting in vehicles, and increasing demand for innovative light design.
The threat from Chinese imports, unless the incremental demand shifts to locally manufactured products continues to loom.
A WORD ON CORPORATE GOVERNANCE
The company is headed by the DK Jain Group, with Mr DK Jain being Chairman Emeritus, and his two sons Deepak and Anmol being Chairman/Managing Director and Joint Managing Director respectively.
As per annual reports and exchange filings, the company has 12 board of directors with half of them being independent (and one, woman director). Since Stanley Electric is a financial partner, two among the twelve directors are nominated by Stanley.
The audit committee is chaired by an independent director and a majority of the members are also independent. The nomination & remuneration is fully composed of independent directors, as it should be -– to avoid conflicts of interest.
Since my study of the related party transactions of the company, as mentioned in the annual report, shows no irregularity, I’m skipping that section here. These transactions seem to have been conducted on an arms-length basis and done as part of the normal course of business operations.
The company took no fixed deposits in the last five years and does not have pledged shares or have given guarantees.
A deep dive into Lumax’s financials demonstrates a classic case of the company’s stock price responding strongly to changes in key financial as well as macroeconomic variables. Let’s first look at the company’s stock price trajectory. Before 2015-16, as you may notice in the chart below, Lumax’s stock price stayed below Rs 350.
Here’s what triggered the spectacular rally in the company’s stock price from the lows of Rs 315 before FY16 to a high of mid-2000s by the end of FY 20118.
The year FY16 was a turning point for the company. As you may notice below, the company’s reported profit after tax or PAT jumped from Rs 16 crores in FY 15 to over Rs 52 crores in FY16. This was a stellar growth of 213 per cent in a year.
FACTORS THAT BOOSTED LUMAX’S STOCK TILL 2018
This rise in profit was owing to a number of factors.
One, a rise in gross profit margin from 31 per cent to 33 per cent – as raw material costs reduced from 69 per cent of revenue to 67 per cent of revenues. Two, a similar rise in operating margin from 5.6 to 7.3 per cent. Three, an even greater rise in net profit margin from 1.4 per cent to 4.1 per cent. Four, a reduction in long term debt from Rs 37 crores in FY15 to Rs 10 crores in FY16.
The debt to equity ratio, as a result, reduced from 0.5 in FY15 to 0.2 in FY16. This helped the company reduce finance costs in subsequent years. Five, an improvement in return on capital employed (ROCE) from 10 per cent to 16 per cent over the year.
Here's a detailed look at several key financial metrics of Lumax for the last 6 years:
What’s more, the rise in profit was accompanied by a rise in net operating cash flows (CFO) as well, from Rs 59 crore at the end of FY15 to Rs 87 crore in FY16. This was against a profit before tax of Rs 41 crore, suggesting that the company maintained its earnings quality. In other words, the company was able to turn net profits into actual cash flows.
Clearly, the market noticed this improvement and rewarded the shareholders with a steep rise in share price from Rs 315 at the end of FY 15 to Rs 442 at the end of FY16, and then to Rs 1441 by the end of FY17.
SECTORAL HEADWINDS HIT LUMAX’S FINANCIALS AFTER 2018
This journey continued until mid-2018, when the auto sector as a whole began facing cyclical headwinds. These headwinds occurred as a result of a mix of factors: high credit costs (interest rates) owing the NBFC crisis spurred by the IL&FS crisis, high insurance costs (bumping up the cost of owning a vehicle), and high crude price fluctuations.
As we may notice, this hit the auto makers and auto ancillary companies dearly. Lumax’s net profit declined by 5.3 per cent in FY19 over FY18, working capital cycle faced pressure – as evident in the working capital cycle days increasing from 103 to 108 days.
By the end of FY20, the company was compelled to take on some debt, mainly to fund the working capital requirements during these tumultuous periods. Over FY18-20, the company’s interest coverage ratio reduced from 19 to 7.5.
Remember, the interest coverage ratio demonstrates the company’s ability to pay interest expenses out of operating profits. A ratio of 7.5 implies the company has operating profit equal to 7 times the annual interest expenses. This, in my view, is a comfortable level for a manufacturing company.
EARNINGS QUALITY AND WORKING CAPITAL PRESSURE AFTER 2018
The company’s earnings quality, as determined by EBITDA to CFO ratio, also deteriorated during this period. Ideally, we want to have net CFO at least equal to or greater than EBITDA.
A lower net CFO may suggest higher working capital pressure as the company either faces delay in receiving proceeds from the sale of products from customers (this is normally implied by the fall in receivables turnover ratio) or fails to sell inventory fast (this is implied by a lower inventory turnover ratio), suggesting a build-up of inventory.
In Lumax’s case, the company was able to get payments from customers on time, as the receivables turnover ratio has been steady to improving. The inventory turnover ratio, however, reduced from 7.65 in FY18 to 5.13 in FY20.
Due to COVID-related disruptions, the company continues to face pressure on working capital. To its credit, however, the company has been consistently successful in optimizing costs through these years.
When sales reduce, the primary option for any company is to reduce fixed costs as much as possible – this fact assumes greater importance for companies in capital intensive industries such as auto or auto ancillary.
In an attempt to optimize its costs, Lumax has guided for reducing employee benefits expenses – mainly taking salary cuts, progressively increasing through the hierarchy with the management taking a 100 per cent while those in the lowest rung taking a 5 per cent cut during the quarter.
The company had also taken moratorium from banks for the payment of loans.
WHAT DOES THE FUTURE HOLD?
Given this fact, the company’s performance in the September as well as December quarter would need to be monitored. In the August conference call, the management indicated a “better than expected” rebound, though gradual, to normalcy in demand as well as capacity utilization.
This matches our analysis of improving macroeconomic factors at the beginning of this post.
But will it sustain beyond a year? The chances will increase if policy measures such as GST rate reduction, vehicle scrappage policy, and easing vehicle financing costs for consumers are implemented.
Special thanks to Gargi Purohit (Twitter: @PurohitGargi) for extensive help with data inputs and infographics.