Due to the different business characteristics, the IT services has been able to weather the volatility in revenues pretty well compared to the auto sector.
The domestic auto industry is reeling from a cyclical slowdown and many auto companies (both original equipment manufacturers (OEMs) and auto component players) — especially in the medium and heavy commercial vehicles (M&HCV) and passenger cars space are expected to report a drop in revenues.
Although most industries end up bearing the brunt of a weak economy, some such as the auto industry are hurt more than others. Why is that so?
AUTO OEMS
Below are a few factors that make auto OEMs susceptible to high volatility in revenues and consequently profits:
Discretionary spend-oriented (private and public): When the going gets tough, the first items to get knocked off the shopping list of consumers are the discretionary spend items and passenger cars and two-wheelers largely fall in this category.
Similarly, when business activity slows down, the need for the wheels of commerce (that is, logistics) takes a hit — and new CV sales is the first victim.
Lack of accretive growth and low annuity income: Every month, OEMs needs to hunt for customers and make a new sale to clock revenues. Just because they made record sales in the previous month, they cannot take it easy in the current month.
It’s almost like the case with the daily wage labourer.
The only portion of revenues that is accretive and somewhat of an annuity in nature is the sale of spares. The more entrenched an OEM is in the marketplace (that is, the more the number of its vehicles on the road), the higher the prospects of spares sale.
However, sales of authorised spares continue to be a very small portion of total sales of OEMs, thanks to a large grey market — so there’s not much to cushion OEM revenues during times when new vehicle sales slowdown.
Long replacement cycle: The replacement cycle for automobiles ranges from around three years for two-wheelers to about 15 years for HCVs.
Longer the replacement cycle, the less predictable the repeat sales, unless the buyer is a fleet operator or grows into one.
Low customer loyalty: With increasing number of car manufacturers entering the market, the propensity for customers to change the brand of car that they buy is also increasing, which further impacts the smoothness and predictability of revenues.
High dependency on hunting (new customers) vs harvesting (existing customers): The bottom of the pyramid in a country like India — be it for two-wheelers, cars or CVs consists of first time users.
This makes it necessary to constantly acquire new customers since it is not sufficient to merely harvest i.e. sell additional vehicles to existing customers.
High fixed costs: The typically high fixed costs of the industry (high operating leverage) causes disproportionate impact on the bottomline for any change in topline — something that works like magic during growth but turns into a pain during contraction.
This is why OEMs start offering discounts to ensure break-even.
Not only auto OEMs, any company/industry that displays similar business characteristics, be it capital goods or housing and construction, are prone to high volatility in revenues and profits.
AUTO COMPONENTS
The degree of volatility in revenues for auto-component companies is a function of how much they cater to OEMs versus after-market.
Those that cater to OEMs have a much higher volatility due to direct correlation of demand and the bullwhip effect (disproportionately large swings in inventory in response to change in customer demand), while after market players are somewhat cushioned, because, after all, if a car battery is dead it needs to be replaced —slowdown or no slowdown.
From a bottom-line standpoint, auto component companies are also significantly impacted by the fluctuation in underlying commodity prices, which they are unable to fully pass on to OEMs.
IT SERVICES
Let’s step back and consider another industry at the other end of the spectrum that has weathered the economic slowdown pretty well actually — IT services. How many times have we heard of a significant drop in revenues of IT services companies?
It almost seems that the worst that could happen is zero growth.
On closer introspection, one can see that many of the business characteristics of IT services are quite opposite to those of auto OEMs:
Longer horizon projects that phases out revenues;
Accretive growth and annuity income in the form of application maintenance and support, infrastructure management, and so on;
High share of revenues from existing customers — high switching costs for customers;
Less dependency on hunting vs harvesting — better prospects of growing existing accounts;
Non-discretionary spend-oriented: IT has become essential to the functioning of organisations (a fact that finally hit upon Warren Buffett, leading him to become one of the largest shareholders of IBM). To think about it, IT can both help save costs (which are relevant during slowdown in client industries) and scale up their business (which is applicable during growth phase in client industries).
High variable costs: Salaries is the largest cost head and can be tweaked through selective retrenchment during tough times.
