Auto Dealerships in Overdrive: CRISIL

Focus on improving liquidity and capital structure will boost dealer credit profiles

Vasudevan R, Head, CRISIL Ratings

Executive Summary

Upgrades outnumbered downgrades in CRISIL's portfolio of its rated automobile (auto) dealership entities during the 12 months through January 2011; CRISIL upgraded seven of its outstanding ratings in the auto dealership sector, and downgraded one. This reflects healthy improvement in the credit quality of CRISIL-rated auto dealers, buoyed by a surge in business volumes and the resultant improvement in their business risk profiles. The improvement in business risk profiles was accompanied by enhancement in their capital structure and liquidity, driven by improved efficiencies and stronger cash accruals.

 
CRISIL believes that auto dealers will maintain the uptrend in their business risk profiles over the medium term, on the back of healthy demand and a relatively stable and secure business model, marked by minimal inventory and receivable risks. However, their financial risk profiles may remain constrained by their leveraged capital structure and stretched liquidity, reducing much of the benefits of improved business prospects. Only those auto dealers that strengthen their capital structure and liquidity position, backed by improved profitability and efficient working capital management, are, therefore, likely to witness rating upgrades over the next 12-18 months.

CRISIL-rated dealers account for 23 per cent of India's auto sales

CRISIL has rated 126 entities in the auto dealership sector. These entities posted consolidated sales of around Rs. 220 billion in 2009-10 (refers to financial year, April 1 to March 31), or around 23 per cent of the total commercial vehicle and passenger car industry revenues. Chart 1 presents the segment-wise breakup in CRISIL-rated auto dealers' portfolio.

Auto dealers have secure business models, but limited bargaining power

CRISIL believes that auto dealers will continue to benefit from their secure business model—one that is marked by minimal inventory and receivable risks. The dealers' business risk profiles will, nevertheless, remain constrained by low bargaining power with their principals/ original equipment manufacturers (OEMs), and their greater vulnerability (than the principals) to vagaries in business cycle.

Auto Dealership: An overview   ▪  Auto dealers are the final link in the automobile industry value chain, connecting the original equipment manufacturers (OEMs)/principals and end customers.   ▪  Auto dealers create showrooms and workshop infrastructure and typically deal in products of single OEMs.   ▪  Multi-vehicle/multi-brand dealership is more an exception, and typically will be for different classes of vehicles (say, four- and two-wheelers) that do not compete with/cannibalise each other, or the result of agreements between the OEMs (as in the case of the FIAT-Tata deal).   ▪  Dealership agreements with OEMs are for a fixed period, and are renewable.   ▪  Dealers get commission on sale of vehicle, and additional commission for achieving/exceeding periodical targets.   ▪  Other income sources, which contribute on an average 4-5 per cent to the topline, fetch relatively higher margin - sale of spares (15-20 per cent of operating margin); services (30-40 per cent of operating margin).

 
The business model of auto dealerships is relatively stable and secure, supported by price protection extended by the principals. While significant price revisions are rare, adverse movements, if any, are typically supported by the principals, to a large extent. Moreover, the price protection also covers discounts offered by dealers to sell non-moving inventory or new products, thus substantially protecting the dealers' bottom-line. Hence, despite the trading nature of their business, auto dealers have limited inventory risk. In addition, the bulk of sales are paid for through vehicle loans contracted from banks and financial institutions, while the remainder is paid for in cash. Thus, the auto dealers to a large extent are protected from receivable risks, as is evident from the low average debtor days of 18 (representing the receivables from vehicle financiers), for CRISIL-rated players between 2007 and 2010.

On the flip side, auto dealers have limited bargaining power with the OEMs. The dealers' agreement with the principal restricts the dealer from selling the products of competitors, but allows the principal to have non­exclusive agreements with multiple dealers. The OEMs also enjoy the flexibility to add dealers once the existing dealer's business volumes become significant. The scale of operations, therefore, remains small for most auto dealers, with showrooms in no more than a couple of regions. This constrains the dealer's ability to negotiate on price or avail of credit for purchases from the principals. Further, dealers are also more vulnerable than the OEMs, to vagaries in business cycle and changes in customer preference. Thus, the low bargaining power and small scale of business, in conjunction with the trading nature of operations, restrict profitability of dealers; the average operating margin of CRISIL-rated players was 2.7 per cent between 2007 and 2010.

CRISIL, however, believes that dealers will continue to benefit from their stable business model, backed by their limited inventory and receivable risks, despite their small scale of operations and limited bargaining power.

Despite buoyant demand, sustainable improvement in profitability will be critical

CRISIL expects auto dealers to benefit over the medium term from the expected surge in demand for both passenger cars and CVs. CRISIL believes that sustainable improvement in profitability, complemented by better economies of scale and an increasing share of high-margin businesses such as sale of spares and services in the overall revenue pie, will be key differentiating factors for auto dealers, and support enhancement in their business risk profiles.

 
The demand for passenger cars is expected to grow at a compound annual growth rate (CAGR) of 15 per cent (by volume) over the medium term, spurred by increasing spending power, and launch of new products, resulting in turn, in a revival in consumer interest. Likewise, sustained growth in economy and increasing commercial and industrial activity will drive the demand for commercial vehicles, which is expected to grow at a healthy CAGR of 15 per cent (by volume) over the medium term. Thus, surge in demand, across the urban and rural areas, in conjunction with improved penetration in the Tier II and III cities, is likely to result in a sustainable scale-up in the dealers' operations over the medium term.

Profitability in the auto dealership business is low, but has been improving, albeit marginally. Driven by the significant increase in sale of vehicles in the past couple of years, the share of revenues from high-margin spares and services in the revenue pie of CRISIL-rated players has been on the rise; the revenue contribution from such businesses increased by 11 basis points to 3.69 per cent in 2009-10, from 3.58 per cent in 2006-07. Moreover, dealers also benefit from economies of scale, supported by growing business volumes. The average operating margins of CRISIL-rated entities have, therefore, improved to 3.01 per cent from 2.33 per cent during the same period (refer to Chart 2).

While CRISIL believes that the profitability of players may remain range-bound at between 3.0 and 3.25 per cent, concerted focus on improving the share of revenues from high-margin businesses such as spares and services, and on optimising the economies of scale will be differentiating factors for auto dealers over the medium term.

Better working capital management key to improving liquidity and capital structure

The financial risk profiles of auto dealers remain constrained by their stretched liquidity, highly leveraged capital structure, and weak debt protection metrics. CRISIL believes that efficient working capital management and capital infusions enabling improvement in liquidity and capital structure will enhance the financial risk profiles of auto dealers over the medium term.

 
The liquidity of auto dealers is weak, owing to limited cash accruals and reliance on external funding for inventory purchases. Although the average inventory holding period is moderate at around 43 days, lack of credit from the OEMs, low levels of capital support from the promoters, and substantial funding needs for supporting growth in business, have resulted in liquidity constraints for most dealers.

Auto dealers depend heavily on external debt to meet their working capital funding requirements for inventory purchase. Despite small size and concentration risk in the dealership business, lenders extend working capital (channel financing) at high loan-to-value ratios of 85-90 per cent to auto dealers (as against 75 per cent to manufacturing entities), drawing comfort from the relatively liquid nature of the inventory, and the price protection that dealers derive from their principals. As a result, the short-term debt accounts for 76 per cent, on average, of the total debt of CRISIL-rated players. However, the heavy reliance on external debt for working capital requirements and low networth have resulted in a highly leveraged capital structure for players, with the total outside liabilities to tangible net worth (TOL/TNW) ratio remaining high at around 5.44 times on average during the four years through 2009-10 (refer to Chart 3). Their debt protection metrics remain weak due to low profitability and high financing costs; the average interest coverage ratio at around 1.74 times for CRISIL-rated players during the period 2007-2010. CRISIL has observed that businesses with weak debt protection metrics and high leverage are more vulnerable to the adverse impact of fall in sales owing to business cycles, or intensifying competition, which can add to the players' liquidity pressures.

Nevertheless, the players' TOL/TNW ratio improved to 5 times as on March 31, 2010 from around 6 times as on March 31, 2007, backed by scale-up in operations, and improvement in accruals owing to economies of scale and improved profitability. CRISIL believes that players that rationalised their inventory holdings were able to manage their working capital requirements better, and report significant improvement in their capital structure and liquidity. For instance, the CRISIL-rated players, whose ratings were upgraded over the past 12 months, had average inventory holdings of 30 days in 2009-10, improving from 40 days during the three years through 2008-09. As a result, their TOL/ TNW ratio also improved to 4.2 times as on March 31, 2010, from 5.3 times a year ago, indicating improved working capital management, which enhanced their liquidity as well.

CRISIL believes that as auto dealers' business volumes surge on the back of healthy demand, their working capital requirements will increase correspondingly. Players that manage their working capital requirements efficiently, and strengthen their capital structure and liquidity, are more likely than others, to witness improvement in their financial risk profile, over the medium term.

Conclusion

CRISIL expects the credit risk profiles of auto dealers to improve gradually over the medium term, driven by a surge in demand for both passenger cars and CVs. While buoyant demand drives growth in sales, it will also raise the working capital requirements of dealers, further weakening their already-leveraged financial risk profiles. Players that strengthen their capital structure and liquidity by improving their profitability and working capital management on a sustainable basis are more likely than others to have their ratings upgraded over the next 12 to 18 months.