India Ratings and Research (Ind-Ra) expects tractor volumes to grow at around 17 percent in financial year 2016-17 (financial year 2015-16: negative 8.9 percent on a year-on-year basis), driven by the improved growth prospects of the agriculture sector as well as a low base effect. Ind-Ra expects agriculture gross value added (GVA) to grow at 2.9 percent in financial year 2016-17 (financial year 2015-16: 1.2 percent; financial year 2014-15: negative 0.2 percent). Ind-Ra observes that currency demonetisation has impacted farmers’ seeds and fertiliser purchases. If the cash crunch prevails for a longer time, it may lead to lower agriculture GVA and may have a more pronounced negative impact on tractor sales volumes in financial year 2016-17.
Ind-Ra’s analysis indicates that out of the 10 major states accounting for around 85 percent of the industry volumes, eight have received normal-to-excess rainfall this season. Overall southwest monsoon situation in 2016 was much better than the previous two years and is likely to aid volume growth for the industry. However, Ind-Ra expects that the overall volume growth could be lower in the second half of financial year 2016-17 (around 14 percent).The currency demonetisation would have a negative impact on the tractor sales in next couple of months, post which demand is likely to normalise aided by the governments focus to boost liquidity in the rural areas on a priority basis.
EBITDA Margins To Expand By Around 300 Basis Points In FY17
Sector companies are likely to see a margin expansion of up to 300 basis points due to operating leverage benefits. Sector companies have around 20 percent of the costs fixed in their cost structure and thus volume growth could lead to a margin expansion. Volumes for sector companies have already started picking up from the fourth quarter of financial year 2015-16 on a yearly basis, due to the low base effect as well as in anticipation of a favourable monsoon. In the first half of financial year 2016-17, EBIT margins of companies such as Mahindra & Mahindra Ltd. (‘IND AAA’/Stable), Escorts Ltd. (‘IND A-’/Stable) in the agriculture segment have already reached the highest levels seen in the last three-four years. However, around 75 percent of the raw materials consumed are derived from steel and iron, and thus profitability could be impacted by volatility in these commodities.
Higher Growth In Upper Segment Of 41-50 Horsepower
Ind-Ra expects the higher horsepower (HP) segment to grow at a higher rate than overall industry. Tractors of 41-50 horsepower capacity accounted for around 49 percent of the industry volumes in the first quarter of financial year 2016-17. The share of the segment has been gradually increasing over the years. Volume in the segment grew at a CAGR of 15.8 percent over fiscal 2010-16 against the industry CAGR of 3.4 percent. This is due to increasing usage of tractors for running agriculture implements requiring higher power and usage of tractors for heavy loads transportation. Shift towards the higher HP segment is likely to aid the profitability of sector companies as it generates better margins.
Robust Balance Sheet, Minimal Capex Needs
The credit profile for major players is marked by low leverage and high interest coverage. Most sector companies have adequate capacities to grow over the next two to three years, resulting in low capex requirements primarily for new product launches as well as maintenance capex. Thus, the credit profile is likely to remain strong and further improve in fiscal 2017. Improvements in revenue and operating margins would result in higher cash flows for sector companies in fiscal 2017.
Larger Availability Of Financing Likely To Aid Growth
The expected better agricultural output as well as renewed focus of the government towards rural infrastructure should increase the repayment capacity of tractor loan borrowers. This should aid the asset quality in the segment where delinquency levels have shot up and currently is among the highest, the sector has witnessed in last two decades. While the normalisation of asset quality is likely to be a prolonged affair, given the severity of problem, the trends should be encouraging. The improved prospects should persuade larger participation from banks and non-banking finance companies (NBFCs), increasing the finance penetration and thereby aiding sales.
Structural Factors To Drive Long-Term Growth
Long-term drivers of the sector demand include gradually increasing farm mechanisation, increasing penetration of tractors, government impetus on increasing farm productivity and increasing usage of tractors for non-farm activities. Increasing affordability of tractors for small and marginal farmers through government initiatives as well as innovative approaches such as tractor on rentals could significantly increase tractor demand. However, adequate rainfall especially in predominantly rain-fed areas will remain a key factor impacting tractor demand over the near- to medium-term. Government’s focus on increasing irrigation intensity is likely to reduce volatility in the sector demand in the medium- to long-term.
Key Industry Trends
Rural Growth To Boost Sector Demand In FY17
Ind-Ra expects industry volumes to grow at around 17 percent in fiscal 2017 with rural growth on the back of a favourable monsoon. Domestic tractor volumes have historically shown a strong relationship with agriculture growth, and heavily depend on monsoons due to inadequate irrigation intensity. According to the end of season report of India Meteorological Department, out of the 20 meteorological sub-division within the 10 states (accounting for around 85 percent of industry volumes), 16 have received normal-to-excess rainfall. The overall rainfall situation in 2016 during Southwest monsoon was much better than 2014 and 2015 and is likely to aid volume growth for the industry. The two major states with deficient rainfall – Punjab and Haryana – have higher irrigation intensity and thus unlikely to see a major impact on tractor demand.
The other indicators such as area sown under kharif crops as well as advance estimates of food grain production have also seen an improvement, indicating improved agricultural production this year. However, currency demonetisation has affected farmers in terms of their seeds and fertiliser purchases. Ind-Ra believes, if cash crunch continues for a longer time, it may impact rabi production and may have an impact on tractor sales in the second half of financial year 2016-17.
The expectation of stronger growth in domestic industry volume, nearly 4 times of the CAGR in sales of 4.9 percent over fiscal 07-16, is also driven by the low base effect. This is because industry volumes in financial year 2015-16 were more than 20 percent below the historical peak. Domestic tractor sales declined 13 percent and 11 percent over fiscal 2015 and fiscal 2016, respectively, driven by successive sub-par monsoon. Ind-Ra analysis indicates that industry volumes have seen a strong rebound, following a decline in preceding years.
During April-September 2016, the domestic tractor sales grew around 20.3 percent, while exports declined by 0.6 percent. Ind-Ra expects that the overall volume growth could be lower in the second half of fiscal 2016-17 (around 14 percent). The currency demonetisation would have a negative impact on the tractor sales in next couple of months, post which demand is likely to normalise. The key risk to the growth assumption is that the industry growth has not been uniform across the country with southern and western India seeing high double-digit growth while growth in northern and central India has been muted during April-September 2016. Thus, a strong uptick in growth in the northern and central markets could lead to a higher growth rate for the year.
Commercial usage of tractor in non-farm activities is also likely to boost demand for the sector in fiscal 2017. Tractors are being increasingly used for haulage applications, as farmers look for the optimum utilisation of their invested capital throughout the year. In addition, tractors’ ability to navigate in rough terrain and carry heavy loads has contributed to this usage. Increased spending on rural infrastructure development by the government is also likely to support tractor demand. Tractor companies have specifically launched products to explore this growing segment within the industry.
Gradual Shift In Volumes Towards Higher Horsepower Segment
Demand for higher HP tractors has been gradually increasing over the years. Mechanisation of agriculture, requiring tractors to run agriculture implements, and increasing usage of tractors for non-farm purposes including excessive loading have contributed to this change.
Ind-Ra expects growth in the 41-50 horsepower and above 50 horsepower segments to be higher than that of the overall industry. Companies have launched several products to capture the higher HP segment. Over fiscal 2010-16, volume in the 41-50 horsepower segment grew at a CAGR of 15.8 percent against the industry CAGR of 3.4 percent. The shift in mix is likely to aid the profitability of sector companies as high HP tractors generally have better pricing.
Strong Credit Profile, Cash Flows To Improve In FY17
A majority of the sector players are debt free or have limited debt on their balance sheets due to their low working capital cycle requirement and limited capex in the past three to four years. The credit profile for major players thus is marked by low leverage and high interest coverage. Most sector companies have surplus capacity to grow over the next two to three years. Thus, the sector is unlikely to witness major capex in the next two years and the credit profile of sector companies will remain strong in financial year 2016-17.
Ind-Ra also expects an improvement in the cash flows of sector companies in fiscal 2017, driven by an improvement in revenue and operating margins.
Operating Leverage To Drive Margin Expansion
Volumes for a majority of sector companies in financial year 2015-16 were 20 percent-25 percent below the historical peak. However, volumes have started to pick up from the fourth quarter of fiscal 2016 on a yearly basis, due to the low base effect as well as in anticipation of a favourable monsoon. This is likely to improve capacity utilisation for sector companies. Improvements in capacity utilisation are likely to aid margins of sector companies due to operating leverage benefits. While raw materials account for around 75 percent of cost structure, fixed cost is around 25 percent of cost structure. Thus, companies could see a margin expansion of up to 300 basis points with increase in volumes. In the first half of financial year 2016-17, EBIT margins the agri segment for companies such as Mahindra & Mahindra and Escorts have already reached the highest levels seen in the last three years.
Around 75 percent of raw materials consumed are derived from steel and iron and thus profitability is highly sensitive to volatility in these commodities. Domestic steel prices have largely remained flat on a year-on-year basis. However, a spike in raw material prices could negate some of the margin benefit derived from operating leverage for sector companies.
Increasing Credit Availability For Farmers
Tractor financing, which was largely the preserve of public sector banks till last decade, is increasingly witnessing large participation from private sector banks and non-banking finance companies. NBFCs have been increasingly exploring this segment for growth. Nevertheless, the extent of participation from NBFCs has been modest till now, expect for Mahindra Finance and L&T Finance, which together constitute most (30 percent-35 percent) of the financing in the new tractor domain. Part of the reason for the limited participation has been the limited reach and volatile asset quality performance of the sector. Asset quality pressure has been building up in wake of borrowers’ poor cash flow, resulting in a spike in delinquencies. However, participation from other players would increase as NBFCs increase their reach and delinquencies become more manageable as prospects of the sector improve. Moreover, since NBFCs generally finance weak borrowers, a large proportion of this lending is likely to be incremental sales and not cannibalisation of bank customers. Furthermore, increasing revenue from non-farm sources could help in reducing volatility in borrowers’ cash flows, reducing the risk perception of borrowers and increasing availability of finances.
Structural Factors To Drive Long-Term Industry Demand
Irrigation availability and rainfall remain key drivers for agricultural growth. The tractor demand over the near to medium term will show a rising trend however with some fluctuations. However, there are several long-term drivers of sector demand including gradually increasing farm mechanisation levels and increasing penetration of tractors, government focus on increasing rural income, irrigation coverage as well as increasing usage of tractor for non-farm activities.
High Growth Potential As Tractor Penetration Remains Low
Tractor penetration level in India remains low; while mechanisation of farming activities is low. However, a higher focus on increasing farm productivity as well as lower availability of labour for farm activities is likely to push farm mechanisation in the country.
According to the Economic Survey 2015-2016, the overall level of mechanisation in farming is below 50 percent in a majority of farming operations in India, while the overall tractor penetration also remains low.
The lower penetration of tractors among a vast majority of farmers signifies the potential growth rate for the sector. Although small and marginal farmers have less ability to purchase tractors, Ind-Ra believes government initiatives to improve mechanisation as well as innovative approaches such as providing tractor on rentals could significantly increase tractor demand. Tractor companies such as Mahindra & Mahindra have launched tractor and farm equipment rental services such as Trringo. Centre and state governments such as Punjab, Madhya Pradesh, and Karnataka have also launched initiatives for providing tractors on rentals to bring down the cost of mechanisation for marginal farmers.
Government Push To Drive Rural Income
Rural income is likely to benefit significantly from the government’s recent initiatives. The government is targeting to double the rural income by 2022. Several new initiatives have been announced or are in the pipeline; while spending on rural economy has also been increased. The same is likely to increase the affordability of tractors and drive long-term industry growth. The central government’s budgeted expenditure on agriculture, rural development, water resources, river development and Ganga rejuvenation increased by almost 27 percent over fiscal 2016-17 to Rs 1.4 trillion.
Government initiatives such as distributing soil health cards, setting up a national agriculture market, and increasing spending on irrigation are meant to make agriculture more remunerative for farmers. Increasing irrigation intensity would lower the dependency of agriculture on monsoons and hence would result in a more stable agriculture output and tractor demand.
(India Ratings and Research a wholly owned subsidiary of Fitch Group is a SEBI and RBI accredited credit rating agency operating in the Indian credit market.)