Rating Methodology for Auto Component Manufacturers

Transcription

1 June 2016 June 2016 ICRA Rating Feature Rating Methodology for This rating methodology updates and supersedes ICRA's earlier methodology note on the sector, published in August While this revised version incorporates a few modifications, ICRA's overall approach to rating issuers in the sector remains materially similar. Overview The auto-components industry currently accounts for 3.8% of India s Gross Domestic Product (GDP) and 25.6% of manufacturing GDP, providing employment to 1.5 million people. According to the Automotive Component Manufacturers Association of India (ACMA), the Indian auto-components industry is expected to register a turnover of US$223 billion by 2026, backed by strong exports ranging between US$80- US$100 billion by 2026, from the current US$11.2 billion. The industry can be broadly classified into the organised and the unorganised sector. The organised sector caters mostly to the original equipment manufacturers (OEMs, the vehicle manufacturers) and consists of high-value precision instruments while the unorganised sector comprises relatively lower value addition products and caters primarily to the replacement market. Demand for the Indian auto component industry can be classified into OEM sales (55% of revenues), aftermarket or replacement (17% of revenues) and exports (28% of revenues). In terms of product segments, manufacturers of engine parts and the drive, transmission and steering parts are the largest contributors, accounting for 31% and 19%, respectively, to the auto components industry s total turnover. The objective of this note is to help investors, issuers and other market participants understand ICRA s approach to analysing the creditworthiness of issuers in the auto component industry. While assigning ratings for auto component manufacturers, ICRA evaluates the industry risk in the context of the prevailing economic scenario, apart from analysing various issuer specific factors. The rating methodology broadly highlights the quantitative and qualitative risk factors that are likely to influence the rating outcomes in the auto component industry, including, but not restricted to: 1. Business Risk Analysis a. Scale and market position b. Revenue mix c. Diversification across segments, products, geographies and customers d. Technology and product complexity 2. Financial Risk Analysis a. Revenue growth b. Profitability c. Working capital management d. Tenure mismatches, and risks relating to interest rates and refinancing e. Debt-servicing track record f. Foreign exchange risk g. Accounting Policies and Contingent liabilities/off-balance sheet exposures h. Leverage and Coverage indicators i. Financial policies j. Adequacy of cash flows and liquidity position k. Event risk 3. Promoters and Management Quality

2 Business Risk Analysis Scale & market position An entity s revenue base and market position are key factors in determining its business strength and operating flexibility. Large scale of operations generally reflects greater market penetration and higher purchasing efficiencies while enhancing the business attractiveness for various stakeholders including employees, customers and investors. Effectively, a large scale and strong market position enable better cost absorption and greater ability to offer competitive pricing to buyers. An auto component manufacturer earns revenue from three primary sources i.e. 1) OEMs who manufacture or assemble vehicles 2) the aftermarket or replacement market in India and 3) exports to overseas OEMs or the aftermarket. While analysing an entity s market position, ICRA evaluates its overall market share and also its share of business (SoB) with its key OEM customers. Generally, OEMs have multiple vendors for same components which restrict the pricing power of component suppliers. A vehicle platform has its own lifecycle which OEMs generally extend by regular refreshes and new model launches on a periodic basis. A healthy SoB across different vehicle platforms, coupled with the regular addition of new platforms helps an auto component manufacturer withstand the revenue impact of transition from a sunset (outgoing model) to a sunrise (newly launched) vehicle model. In ICRA s view, a strong market position with an OEM is usually a good proxy of the entity s relative bargaining strength with the OEM, bolstering its ability to withstand cost pressures. To assess the market position of an auto component manufacturer, ICRA not only evaluates its market position vis-à-vis competition, but also takes into account the performance and market share of its customer OEMs from whom it derives a large share of its revenues. A well-established market position of the OEM typically provides a stable revenue base and a platform for sustainable earnings and cash flow generation for its Tier I and Tier II suppliers 1. OEMs are increasingly outsourcing activities to Tier I suppliers and co-developing products with inputs from their suppliers. Some of the large auto ancillaries globally like Denso (for Toyota), Faurecia (for PSA), Delphi (for General Motors) or Visteon (for Ford) were begun as captive units of their respective OEMs. There are instances where the OEMs have provided direct (loans/equity infusion) as well as indirect (favourable credit period) support to Tier I suppliers with whom they have strong relationship or have a high dependency. Consequently, strategic importance and strong order book share with OEMs is considered a credit positive. In certain components like automotive batteries and tyres, replacement demand is larger than the OEM market size. In order to establish a strong replacement footprint, auto component manufacturers have to invest in 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 OEMs. A widespread franchise or distribution network, technological prowess and brand reputation play a crucial role for auto component manufacturers in establishing a strong position in the aftermarket. In some cases, Tier I suppliers do not sell components directly to the aftermarket channel but rely on the OEMs distribution network to cater to the aftermarket requirements. In such a scenario, their aftermarket reach is linked to the OEMs network and generally their operating margin is relatively lower than those of their counterparts, deriving sizeable share of business from the replacement market directly. Revenue mix A balanced mix of OEM and aftermarket business is a positive typically a strong aftermarket presence provides greater revenue stability and higher operating margins, as compared to concentration on OEMs. However, ICRA has observed that a healthy OEM business is often the precursor for a strong presence in the aftermarket, given the brand visibility and loyalty, particularly from a first time replacer. Further, the aftermarket business is a relatively more stable revenue source and mitigates the impact of cyclicality in OEM demand to an extent. A strong aftermarket presence benefits auto component manufacturers during volatile commodity prices and could result in improved profitability during a declining commodity price 1 Tier I companies are direct suppliers to OEMs. Tier II companies are the key suppliers to tier-i suppliers without supplying a product directly to OEM companies. However, the same entity may be a tier-i supplier to an OEM and a tier-ii supplier to another entity; or the same entity may be a tier-i supplier for one product and a tier-ii supplier for a different product line of the same OEM. ICRA Rating Services Page 2 of 8

3 scenario, as bulk of the benefits from raw material price decline can be retained. During an economic slowdown, an auto component manufacturer with a strong presence in the aftermarket is able to withstand pressure on top-line and profitability much better than those supplying predominantly to OEMs because of relatively lower revenue volatility. Diversification across segments, products, geographies and customers ICRA views business diversification in product segments, customer base or geographies as a credit positive. An auto component manufacturer with a product portfolio catering to multiple automotive segments (commercial vehicles, passenger vehicles, two-wheelers, tractors etc.) is in a better position to withstand the vulnerabilities arising from the decline in volumes in any particular segment. For instance, an auto component supplier catering only to the highly cyclical commercial vehicle (CV) industry could potentially witness higher volatility in its earnings and cash flows, as compared to a diversified component supplier. Business diversification could also refer to exposure to non-automotive engineering segments such as locomotive, marine and defence, among others. ICRA views such non-automotive diversification as a positive rating factor, provided the revenues derived from such diversification are material. Within the OEM business, auto component manufacturers with higher client diversity tend to enjoy greater stability in revenues and profitability over a longer time horizon. However, each individual segment of the Indian automobile industry is currently characterised by a few OEMs accounting for the majority of the market. Thus, auto component manufacturers could achieve meaningful client diversity, largely by catering to multiple segments of the industry. Most of the Indian auto component manufacturers, however, have a relatively narrow product line compared to global majors, which restricts their presence to a particular segment. A company with multiple product offerings will be able to cater to a wider client base and would be able to outperform the underlying industry growth by improving content per share in a vehicle. In order 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. ICRA also takes into account the revenue mix in the context of domestic and export contributions. A balanced mix offers diversification benefits. For example, a demand slowdown inflicting one segment may get offset by growth in the other. However, sizeable exports also expose an entity to foreign exchange risk. Meaningful geographic diversification is achieved when an entity supplies to OEMs or Tier 1 suppliers across different countries. In India, currently there are only a handful of auto component manufacturers who have been able to achieve such geographical diversification. Apart from a diversified geographical revenue mix, physical 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 critical 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. Indian auto component export is often targeted at the overseas replacement market, which is relatively diversified and stable compared to exports to global OEMs or their Tier I suppliers. However, with regard to exports to the Tier I/ OEM segment, auto component manufacturers are often dependent on a few customers (owing to high demand), which results in client concentration risk in certain cases. The risk of bankruptcy filings by auto manufacturers and Tier I suppliers in developed markets had increased sharply during period, highlighting client concentration as a critical risk factor for exporters. Technology & product complexity An auto component manufacturer, with a high value-added product portfolio, with high entry barriers on account of technology and capital intensive operations, tends to enjoy better pricing flexibility compared to manufacturers of low value-added products with low entry barriers for competition. With the automobile industry moving towards shorter product lifecycles and common platforms, the ability of a supplier to meet an OEM s product development requirements continues to remain critical for sustained business growth. ICRA Rating Services Page 3 of 8

4 With increasing pressure on product pricing, an entity s efforts towards product engineering to reduce costs and enable product differentiation also play a critical role in strengthening relationship with the OEM. Spends on research & development (R&D) are an indicator of an entity s commitment towards product development and innovation. R&D expenses in the Indian auto component industry remain fairly low (~0.6% of revenues) as compared to developed markets, where some of the larger players invest ~10% of their revenues towards 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 be able to meet the OEMs technical requirements. Suppliers that have proprietary knowledge, tend to enjoy superior profitability metrics, relative to those that cater to customer-provided designs. 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 counterparts of their global customers. Apart from technological capabilities and product complexity, application of best manufacturing practices and adherence to global quality standards are getting increasingly important for entities to get orders for new platforms and new customers. Over the years, overseas acquisitions have also helped Indian component manufacturers gain technological knowhow and add new customers, apart from expanding their geographical footprint. Financial Risk Analysis While assessing the financial position of an auto component manufacturer, ICRA evaluates the profitability and cash-generating ability of the business, its balance sheet strength and sources of financial flexibility. ICRA reviews the accounting policies followed by the issuer, the notes to accounts, and auditor s comments that are part of the annual report. Any deviation from the Generally Accepted Accounting Practices (GAAP) is noted and the financial statements of the issuer are adjusted to reflect the impact of such deviations and also to ensure meaningful comparison against peers in the industry. Other factors, which cut across industries, while rating issuers, include the regulatory framework, group support and promoter and management quality. Revenue growth Sustained volume and revenue growth above the industry average, especially in comparison to its principal OEM is a strong positive. Such growth typically reflects an increase in market share and/or improved geographic and/or customer diversification. On the other hand, a declining revenue trend during a period of robust industry growth could be indicative of contracting market share, failing business models or product lines of the ancillary or OEMs. ICRA analyses growth on account of volumes and realisations. An increase in realisations, attributable to a price increase by OEMs to offset higher input price, however, does not reflect real growth and can be typically captured in a flat or declining operating margin. Nevertheless, improved realisation on account of higher value addition and better product mix is a positive from the credit perspective and could result in sustainable improvement in profitability. Profitability In addition to revenue growth, an entity s ability to sustain profitability through a business cycle is one of the key factors that ICRA incorporates in its analysis to differentiate between issuers. Raw material cost accounts for a considerable portion of an auto component manufacturer s cost structure. Therefore, the ability to pass on raw material price changes to the customers in a timely manner can influence profitability. 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. Further, since most OEMs stipulate periodic price reduction through the life of their supply contracts, auto component manufacturers have to continuously work at improving operational efficiencies and undertaking value analysis and value engineering projects to optimise product costs. A lean operating setup, characterised by low fixed overheads, provides an issuer the ability to flex costs and expenses during a down cycle, thereby protecting its profitability. The two primary measures of profitability are: (i) Operating profit before interest, depreciation and taxes margin (OPBDIT margins) and (ii) Return on capital employed (RoCE). Apart from the proportion of ICRA Rating Services Page 4 of 8

5 variable and fixed costs, one of the other key factors that influence OPBDIT margins of an auto component manufacturer relates to the proportion of revenues derived from aftermarket and exports (a higher proportion typically signifies better margins, ceteris paribus). Higher asset sweating and a lean working capital cycle drive RoCE. Overall, healthy profitability metrics lead to adequate cash flow generation to support debt servicing, margin funding for working capital borrowings, and capital expenditure needs linked to expansion. Working capital management Working capital levels are also a key indicator of the financial and operational health of an entity. 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. At the same time, an inventory build-up can also result from one-time events to support scheduled product launch by OEMs in the immediate future; being considered a necessary investment. While extended credit periods from suppliers is an indication of bargaining power and a substitute for working capital borrowing, stretched creditor days, over and above contractual creditor terms, could be an indication of liquidity strain. ICRA makes adjustments to an entity s receivables and debt for the bills discounted off-balance sheet (on recourse basis) to appropriately assess an entity s working capital cycle. Also, for entities that discount vendor bills but classify them under creditors; total outstanding liabilities are analysed along with debt to assess the indebtedness. ICRA compares the working capital intensity of the entity to be rated with its peer group to gauge its ability to negotiate credit terms with customers and suppliers; this also serves as a proxy of their business strength. Tenure mismatches, and risks relating to interest rates and refinancing Large dependence on short-term borrowings to fund long-term investments can expose an issuer to significant re-financing risks, especially during periods of tight liquidity. The existence of an adequate buffer of liquid assets, undrawn bank lines and drawing-power backed unutilised working capital limits to meet short-term obligations, is viewed positively. Similarly, the extent to which an issuer could be impacted by movements in interest rates is also evaluated. Debt-servicing track record The debt-servicing track record of an entity is an important input for any credit rating exercise. Any delays or defaults in the past in the repayment of principal or interest payments reduce the comfort level with respect to the auto component manufacturer s future debt servicing capability and willingness. Foreign exchange risk The extent of exchange risk that an entity faces would be determined by its net exports/imports position. ICRA looks into the import/export mix of the company to assess its exchange risk, the hedging strategy it has adopted, and the implications of such a strategy, while evaluating the entity s performance. Un-hedged foreign exchange liabilities could pose a significant risk to the balance sheet, unless covered by a natural hedge from exports or backed by foreign currency liquid assets. Accounting Policies and Contingent liabilities/off-balance sheet exposures In assessing the accounting quality of an entity, the accounting policies, notes to accounts, and auditor s comments are reviewed. Any deviation from the Generally Accepted Accounting Practices is noted and the financial statements of the issuer are adjusted to reflect the impact of such deviations. In addition to the financial statements, ICRA also evaluates the impact of devolvement of contingent liabilities and offbalance sheet exposures on the credit profile, in case such liabilities devolve. Leverage and coverage indicators ICRA assesses the ability of a manufacturer to generate healthy cash flows to reinvest in the business and meet its debt-servicing obligations in a timely manner. Leverage ratios are an indicator of the degree of financial flexibility an entity enjoys in terms of its ability to raise funds from alternative sources in times of ICRA Rating Services Page 5 of 8

6 financial stress. Such flexibility is reflected in the entity s gearing (Total Debt-to-Tangible Net worth) and Total Debt-to-Operating profit before Interest, Depreciation and Amortisation (OPBITDA) multiple. A strong Total Debt-to-EBIDTA multiple is a credit positive as it reiterates the ability of the manufacturer to service its debt obligations, fund growth opportunities and improve its competitive position without being overly reliant on external sources. High leverage leads to significant stress during cyclical downturns. The entity s ability to contain its leverage and thereby its future interest expenses and repayment obligations to levels comfortably serviceable during times of low accruals are critical to the rating. However, the extent to which an entity can leverage its balance sheet is subjective and is determined primarily by the philosophy of the management. The interest coverage indicator reflects the entity s ability to service the cost of external borrowings after meeting all operating expenses. It is an important rating consideration as a weak EBIDTA-to-interest multiple indicates the entity s inability to generating adequate operating profits to meet its interest and may signal a default risk. The Debt-Service-Coverage ratio (DSCR) indicates the entity s ability to service its interest and repayment from cash flows generated from the business. Strong free cash flows indicate the ability of an entity to fund investments, pursue organic and inorganic growth opportunities, and make timely debt repayments. Financial policies Financial policies are key rating inputs that help in evaluating the risk appetite of the management and its impact on the performance of the manufacturer. Entities that pursue an aggressive financial policy, including heavy reliance on debt financing, are likely to be more vulnerable to cyclical downturns than companies that employ a lesser degree of financial leverage. ICRA takes into account the financing pattern of long term and short term assets. 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/ OEMs. Most acquisitions by Indian auto component manufacturers in the past have been in the high-cost and low-growth regions in Europe and North America, aimed at technology and marquee customer acquisition. ICRA in its analysis examines the impact of the acquisition on an entity s consolidated profitability indicators, capital structure and debt coverage indicators. Ability to draw quick synergies, turning around the global operations and rationalising costs are critical to integrating an overseas acquisition. Adequacy of future cash flows The user industry for auto component manufacturers operates in a cyclical environment, leading to periods of financial strain. Most auto component manufacturers also do not enjoy adequate bargaining power with their much larger OEM customers. While most OEMs extend support to their key suppliers to meet liquidity requirements through schemes like supplier bills discounting; during periods of downturns, credit periods could be stretched. Stretched working capital cycle can lead to weak/ negative fund flow from operations and weak debt coverage indicators. Auto component manufacturers are also expected to invest in capacity expansion and product development in line with the plans of their OEM customers. The capital intensity for auto component manufacturers has gone up over the years, as OEMs increasingly move to a leaner structure with modular assembly. Such investments typically have a gestation period and carry risks, especially if it involves supplies to new platforms. Strong operating cash flows enable auto component manufacturers to undertake these critical investments, without stretching the balance sheet significantly. Large project expenditure, however, can lead to a period of negative free cash flows, even in entities with a relatively stronger business model. ICRA ascertains the adequacy of cash flows to meet future repayment obligations and capital investment requirements. Since the objective of the rating exercise is to assess the debt-servicing capability of the entity, ICRA draws up projections of the likely financial position of the entity, based on the expected movement in operating performance factoring in capital expenditure and investment requirements as well ICRA Rating Services Page 6 of 8

7 as the upcoming debt obligations. ICRA also looks at the funding requirements of the entity and the funding options available. Undrawn lines of credit, ability to roll over lines of credit cost-efficiently and drawingpower backed buffer in working capital limits are credit comforts. Ratios are adjusted for unencumbered cash to take cognisance of the liquidity buffer. Retained cash flowsto-debt is an indicator of cash available for reinvestment in the business and servicing of repayment obligations, after interest payouts, working capital adjustments and taking into consideration shareholder interests through dividends. Event Risk ICRA also recognises the possibility of events that can have a material impact on the credit profile of auto component manufacturers. Examples of such events include unrelated diversification; mergers and acquisitions; business restructuring, asset sales and spin-offs; capital restructuring; and litigations. ICRA evaluates the entities risk appetite for acquisitions and for related or unrelated diversification. This can become a rating concern if the acquisition or diversification has a long gestation period or is funded mainly through debt, which can adversely impact the capital structure and profitability. Adverse regulatory changes (such as the ban on diesel vehicles having engine capacity greater than 2000cc in Delhi) could also impact the performance of the principal OEM, which in turn could have a material impact on the credit profile of its vendors. Product recalls by OEMs, who in turn may have back-toback warranty provisioning with auto component manufacturers, could also have a material impact on the credit profile of auto component manufacturers. Promoters and Management Quality All debt ratings necessarily incorporate an assessment of the quality of the issuer s management, as well as the strengths/weaknesses arising from the issuer s being a part of a group. Also, of importance are the issuer s likely cash outflows arising from the possible need to support other group entities, in case the issuer is amongst the stronger entities within the group. Usually, a detailed discussion is held with the management to understand its business objectives, plans and strategies, and views on past performance, besides the outlook on the industry. Some of the other points assessed are: Experience and commitment of the promoter/management in the line of business concerned Attitude of the promoter/management to risk-taking and risk containment The issuer s policies on leveraging, interest risks and currency risks The issuer s plans on new projects, acquisitions, expansion, etc Strength of the other entities belonging to the same group as the issuer The ability and willingness of the group to support the issuer through measures such as capital infusion, if required. In case of groups consisting of companies with strong financial and operational linkages, various parameters such as capital structure, debt coverage indicators, and future funding requirements are assessed at the consolidated/group level. Summing Up ICRA s credit ratings are a symbolic representation of its opinion on the relative credit risk associated with the instrument being rated. This opinion is arrived at following a detailed evaluation of the issuer s business and financial risks, its competitive strengths, likely cash flows over the life of the instrument being rated, and the adequacy of such cash flows vis-à-vis its debt-servicing obligations. As the note has highlighted, in case of auto component manufacturers, special attention is also paid to the market position, scale of operations, cost competitiveness, diversification, besides the management s strategies for managing cyclical downturns and approach towards investment and growth. ICRA Rating Services Page 7 of 8

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