India Ratings and Research opines that the continued spread of coronavirus (COVID-19) would negatively impact the domestic auto industry in the near term, because Wuhan (China), the epicentre of the outbreak, is a major manufacturing hub for automobile and auto parts. Furthermore, the agency believes the sector would face pressure not only from the supply side but also the side and exports, if the spread of COVID-19 domestically and globally persists for more than two months.
Indian auto ancillaries and original equipment manufacturers (OEMs) have about 27% import dependence on China for key parts and accessories. The extended production halts in China after the Chinese New Year due to a substantial rise in COVID-19 affected population have created supply-side risks for domestic auto companies. Against a backdrop of falling domestic sales and continuing margin pressure, any supply-side shocks could affect the credit metrics of sector companies under further strain. Under Ind-Ra's base case estimates, a sustained supply chain issue could increase the median net leverage of domestic producers by at least 0.3x due to the potential margin contraction and asset turnover pressure.
Heavy Reliance on China for Key Auto Parts: Wuhan domiciles the manufacturing plants of certain leading global auto component manufacturers supplying to OEMs. Being the epicentre of the pandemic, a major supply chain disruption for key auto components is likely across vehicle segments, i.e. passenger vehicles, commercial vehicles and two wheelers. Furthermore, the transition to Bharat Stage VI and constant premiumisation of vehicles has increased the reliance of OEMs on the import of technologically advanced products. This could be seen from a 10% yoy increase in imported components such as steering and braking systems, engine parts, electronic components, fuel injection parts, and alloy wheels.
Importantly, any disruption related to a single component being exclusively or largely imported from China would significantly affect the entire chain of OEMs, Tier I suppliers and Tier II suppliers. With over 80% of the imported components in two wheelers and truck-trailers are from China, the reliance on imported content is higher in the segment than other auto segment and hence it is likely to be impacted more. In other segments such as cars, buses and commercial vehicles, Chinese import concentration ranges between 17%-25% of the total imports.
Tyre, the only Component to Benefit: In case of tyres, imports from China constituted 25% of the total imports during FY19 with a higher proportion particularly in truck and bus radial. A supply shock in case of tyres will be positive for domestic tyre manufactures, especially those catering to the segment. Furthermore, many domestic tyre manufacturing companies have expanded their capacity during FY19-FY20; hence, an import gap would improve the capacity utilisation of these companies. However this is likely to be somewhat offset by the challenging situation in the domestic market if there are more shutdowns not just by OEMs leading to lower volume intake, but also by other industries limiting the movement of vehicles, and hence the demand for tyres.
Alternatives are Expensive and Scarce: In a scenario of disruption in the supply of key components the industry could look at sourcing them either locally or from other countries such as Germany, South Korea, Japan and Thailand, currently accounting for around 33% of the total imports. However, the change in procurement channels could be costlier and the supply could be insufficient to meet the demand.
Double Whammy - Challenging Macroeconomic Environment and COVID-19: The SARS outbreak, which also originated in China during FY03, led to around 100bp margin contraction among Indian auto parts manufacturers on an aggregate basis. However, the intensity of COVID-19 is much greater than that of SARS and China's position in the global automobile market has also become more prominent now than in FY03. Hence, if the containment of the spread remains elusive, then the margin impact could be over 100bp in 4QFY20-1QFY21 and subsequently the credit metrics could come under further pressure.
Disruptions could Aggravate if Outbreak Intensifies in North America & Central Europe, especially Germany: The issuers in the agency's rated portfolio the issuers have adequate inventory until March-April 2020 for key imported items; hence, any near-term issues stemming from supply related challenges are limited. However, the volume offtake of auto ancillaries may decline due to an overall decline in the vehicle production as OEMs take production cuts due to supply-side challenges of certain components. Furthermore, as the COVID-19 outbreak has now spanned all continents excluding Antarctica, the global consumption is likely to be affected at least in the near term, posing challenges to export-oriented auto ancillary companies as well. If the virus spread is not contained timely, imports from other key geographies as stated earlier and exports to countries such as the US and UK could also be impacted.
Impact on Ind-Ra rated issuers: Ind-Ra analyses the impact of virus outbreak on its rated portfolio in four dimensions. First, the import-related risk arising due to the COVID-19 outbreak in China; secondly, the import-related risk arising out of the spread to other key countries such as Germany, South Korea and Japan; thirdly, the exports-related risks arising due to an outbreak in other countries, and lastly, the domestic OEM related risk. Ind-Ra opines the impact to be limited in the near term, given the adequate stock of imported raw materials. However, any significant production cut by OEMs due to unavailability of components may have an indirect impact on ancillaries as well. Furthermore, if the intensity of the outbreak increases in other geographies such as Germany and US, which are also the key export markets for these companies, then the impact could be material from both demand and supply sides.
To understand the dimensional impact, Ind-Ra has segregated its outstanding ratings above the BBB level in 2x2 matrix on the basis of diversification and existing leverage levels. The liquidity position of this sample remains adequate and hence the agency stress tests the impact on net leverage basis a 5% shock in the top line due to supply chain disruptions and dented demand coupled with a 100bp margin contraction due to possible higher procurement costs. We note that the companies with high leverage levels and low diversification in the A category could witness a 0.35x-0.40x increase in the net leverage under sensitivity while those with moderate levels of debt and low diversification could see a 0.25x-0.30x increase in the net leverage. Since some of issuers in these categories have thin buffer with respect to their leverage levels and hence are more vulnerable to the current situation, the agency may consider appropriate rating action from time to time. On the other hand in AAA and AA rated issuers, most of the companies have diversified portfolios and moderate levels of debt with established market position; hence were not materially impacted under our analysis.
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