- Sector downgraded to NEUTRAL from OVERWEIGHT: This follows a recent round of visits and our downgrades of Tan Chong (TCM) to SELL (from HOLD) and MBM to HOLD (from BUY). The auto sector has underperformed expectations for 2 consecutive quarters, except for BAuto and DRB. Our 2014F TIV is unchanged at 680,090 units (+3.7% YoY), implying 0.65x GDP-TIV multiplier, below the 10-year average of 0.9x. However, our aggregate sector CY14F/15F/16F earnings were revised down by 18%/14%/12% in the past month. Average sector pretax margin is now expected to contract to 10% in CY14F from 10.7% in CY13 and 10.9% in CY12, reflecting our view that the current TIV is driven by discounting rather than actual demand strength.

- Approval rates fall, applications stall: Loan applications for passenger car purchases have seen gradual deterioration since Nov 2013, contracting by up to 28% in recent months (see Chart 2), reflecting weaker demand and rollback of bank financing. Loan approval rates have seen a sharp reversal falling to as low as 49% in June 2014 (See Chart 3). Low-segment buyers are most at risk, given stricter loan approvals going down the income curve. Tighter lending guidelines in Jan 2012 saw Perodua Viva’s volume falling 19% immediately, as an example. We foresee conversion of bookings into sales becoming more challenging. More importantly, the knock-on effect on the 2nd hand market means lower trade-in values, which eventually impacts new car sales.

- Developing macro risk: From a macro perspective, we see developing demand risk from stricter credit access, potential inflationary pressure from subsidy rationalisation and GST, as well as HP rate hikes. Major launches have been/are focused on the A/B segments (i.e. Toyota Vios, Honda City/Jazz, Mazda 2, Perodua Axia, Proton Iriz), where buyers are sensitive to changes in disposable income and credit access /cost. Despite heavy discounting activities, passenger car TIV has fallen for 2 consecutive months (See Chart 1); underpinning our view of difficulties converting bookings into actual sales as well as outright demand deterioration. More importantly, this spells a double whammy (volume and margin hit) to earnings going forward.

- TIV is now less of a profit indicator: TIV is increasingly masking underlying demand trend as auto players have become more volume-focused at the expense of pricing. Margin erosion was the central theme in the 1Q14 earnings season and this worsened in 2Q14 - both TCM and UMW autos saw earnings affected by margin contraction given:- (1) excessive channel inventories; (2) higher overtrades; and (3) B-segment competition. The stiff price competition is unlikely to abate in the near term, based on feedback from our recent visits. Induction of incremental 700K/annum capacity over the next 5 years (or a massive 117% growth) based on the EEV program targets, compounds the situation, particularly for non-EEV models, given the cost advantages that EEV models enjoy.

- Excessive valuations: Average sector CY14F PE of 17x is stretched, relative to a 12% EPS contraction. This is particularly inflated by TCM’s (SELL, FV: RM3.30/share) and UMW’s (HOLD, FV: RM12.40/share) valuations of 33x/18x and 16x/15x CY14F/15F PEs, respectively. Peaking earnings revision cycle and excessive valuations are likely to cap sector upside in the near term.

- Our BUY calls revolve around EEV beneficiaries: We are still positive on the EEV drive which can lower cost significantly, but beneficiaries are still selective. Of the companies under coverage, BAuto (BUY, FV: RM3.70/share) and Honda (34% owned by DRB Hicom - BUY, FV: RM3.60/share) are most aggressive in introducing EEV-qualified models. BAuto is our top BUY for its:- (1) potential acquisitive growth; (2) best proxy to the EEV program; (3) Aggressive new model introductions driving strong 23% 3-year EPS CAGR; and (4) resilient margins given its niche in higher-end segments. TCM is our top SELL for excessive valuations at 18x FY15F PE, a sharp reversal in earnings momentum, and a deteriorating balance sheet.

Source: AmeSecurities