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Commodity cost inflation on the anvil…

* Spot prices of base commodities saw a sharp increase (15-40%) over 2QFY21. Considering 3-6 month contracts, we expect the impact of base commodity prices to reflect in the P&L from 3QFY21 onwards. Base commodity price inflation would have a 350-400bp gross impact over the next 2-3 quarters.

* Precious metals (platinum, palladium and rhodium) are facing a double whammy of a huge increase in usage due to BS-VI compliance and a sharp rise in prices. This is particularly true for rhodium where spot prices are higher by 28%/70% over 1HFY21/FY20 on an average.

* While cost inflation is fairly large, OEMs are focusing on more than offsetting the same through: a) price increases (of 1-6% in 2Ws, Tractors, and PVs), b) lower discounts (100-400bp across segments), c) cost cutting (80-100bp), and d) operating leverage (150-170bp).

* Putting all negatives and positives together, we expect EBITDA margin to improve to 13.3% by FY23E (v/s 10.5% in FY20 and 12.7% in FY19) as the impact of commodity cost inflation is more than offset by benefits of price increases, lower discounts, cost cutting initiatives, and operating leverage.

* With a likely pick-up in volumes (higher asset turns), margin improvement, and lower capex intensity, we expect a sharp improvement in FCF generation over FY21-23E. For our Auto OEM (excluding JLR) universe, FCF conversion (% of PAT) is estimated to be at 100-125% over FY21-23E (as against 20%/33% in FY20/FY19).

* Analysis of past cycles suggests that valuations expand as the cyclical recovery sustains, laying the foundation for the next upcycle. Current valuations reflect an early to mid-cycle recovery, with scope for a further rise if the volume expansion sustains. MM is our top OEM pick. Among Auto Components, we prefer ENDU and MSS.

Sizeable commodity cost inflation to reflect from 3QFY21 onwards…

* Spot prices of base commodities saw a sharp increase (15-40%) over 2QFY21. The following is the inflation in base commodities over its 1HFY21/FY20 average – steel (+45%/44%), aluminum (+24%/20%), rubber (+42%/45%), lead (+11%/7%), copper (+35%/44%), and polymer (+36%/33%). (same pg repition)

* Considering 3-6 month contracts, we expect the impact of base commodity prices to reflect in the P&L from 3QFY21 onwards. Base commodity price inflation would have a 350-400bp gross impact over the next 2-3 quarters.

* Precious metals (platinum, palladium and rhodium) are facing a double whammy of a huge increase in usage due to BS-VI compliance and a sharp rise in prices. While we have broadly seen an impact of this in 1HFY21, the price volatility may pose some risk. This is particularly true for rhodium where spot prices are higher by 28%/70% over 1HFY21/FY20 on an average.

* We expect price pass-through to be faster in Tractors (no BS-VI and precious metal impact) and 2Ws, followed by LCVs and PVs.

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