New Delhi, Jan 12 (IANS): The automobiles sector is expected to face commodity cost inflation which will be offset by price hikes, lower discounts, cost cutting, and operating leverage, according to a report by Motilal Oswal Institutional Equities.

The report said spot prices of base commodities saw a sharp increase (15-40 per cent) 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," the report said.

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 per cent/70 per cent over 1HFY21/FY20 on an average.

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

"Putting all negatives and positives together, we expect EBITDA margin to improve to 13.3 per cent by FY23E (v/s 10.5 per cent in FY20 and 12.7 per cent 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," the report said.

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

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.