The best bargain

Why would I pick an automobile manufacturer as my best pick when the sector itself appears to have hit a speed breaker in India’s currently potholed economy? It’s because the Tata Motors legend is one hell of a trip. It winds, coasts, struggles, dips and rises again in the manner of all great journeys. Investors have to ride Tata Motors with finesse and a light hand. The reasons for this faith follow. 

Tata Motors is the largest commercial vehicle (CV) and third-largest passenger vehicle (PV) manufacturer in India. Its subsidiaries and associate companies extend their operations to the UK, South Korea, Thailand, Spain and South Africa. Among them is Jaguar Land Rover (JLR), the audacious business of the two iconic British brands acquired by the Tatas from Ford for $2.5 billion in FY09. It’s a matter of national pride that JLR has undergone a dramatic transformation under Tata Motors’ ownership, with a sharp increase in sales and record profits. So, though the domestic business is not exactly blooming right now, I have reason to believe the difficult times at Tata Motors are bottoming out. In fact, I expect even the Indian market will contribute meaningfully to the company’s profitability as the macroeconomic scenario improves in FY14. Here’s a quick recap while we wait for that to come about. 

Jaguar roars

Tata Motors has, somewhat unexpectedly, become a play on the global luxury vehicle market with JLR contributing over half of the consolidated revenues and over 80% of FY12 profits. That’s because the worldwide luxury market has been relatively resilient despite the weakness in the global economic environment. What’s stopped things from going south is the strong demand from China, where JLR has expanded its network and launched the smallest Range Rover model, the Evoque — and FY13 year-to-date volumes are already up by 24%. I estimate JLR’s sales volume will keep up their momentum thanks to the significant product upgrades offered for the flagship Range Rover and Range Rover Sport models, and exciting variant launches like Sportsbrake, All-wheel Drive, and the 2.0 litre engine, which look set to keep buyers intrigued enough to reach for their cheque books.

JLR plans to introduce 30 new products over the next three to five years to meet what it reckons is the full global potential of the brand, and most of them will be replacements and platform upgrades (that is, moving existing systems into the latest tech platform) of its bestselling models. JLR also has interesting plans to enter newer market segments and price ranges with smaller and lighter vehicles. The smaller Jaguar will come out in late CY14 and mark JLR’s entry in an important, high-volume segment, currently dominated by the German triumvirate of Mercedes Benz, BMW and Audi. This happening market, which will surely expand JLR’s growth trajectory, has an annual size of 1.25 million units. 

I also expect JLR’s Ebitda margins to remain healthy over FY12-14. The volumes sold will be higher and the ramp-up of the Range Rover will fetch higher margins than the outgoing model. There’s also the positive impact of the expansion in the profitable Chinese market. Finally, by mid-FY14, the launch of Range Rover Sport should rev up profits too. 

Cost reduction is also on the anvil. The new modular platform strategy will enable JLR to have two models per platform by 2016, up from the current 1.3 times. For instance, Evoque and Freelander share the same platform. Similarly, the recently launched Range Rover model (built on an entirely aluminium platform against 50% steel and 50% aluminium earlier) and upcoming launch of Range Rover Sport will have the same platform. This strategy will up JLR’s margins by 1.5-2% on a sustainable basis because development cost will be lower and there will be savings on common parts. 

JLR’s £355-million engine plant investment in the UK will ensure a captive source of engines for its four-cylinder gasoline and diesel vehicles. This is a good move because JLR will be able to meet stricter emission norms, and it can compete better with its peers in the Chinese and Russian markets. Four cylinders will become JLR’s mainstream engines over the next three to five years with the introduction of all-aluminium models (but JLR will continue to source Ford’s V6 and V8 engines, both diesel and petrol, as part of a long-term agreement till 2018-19).

China has been one of the key drivers of the turnaround in JLR’s fortunes and its German peers already have a manufacturing base there. To compete more effectively in its largest and most profitable market, JLR has entered into an equal JV with China’s Chery Auto specifically for developing and manufacturing relatively low-end JLR vehicles in that country, cutting out high import duties and costs, and increasing the component sourcing from Chinese vendors. That’s another smart move for JLR’s future.  

India driving

Yes, Tata Motors’ domestic business has been under a lot of pressure and it’s a reflection of the worrying weakening economic activity in India. The sales volumes of heavy CVs declined by a substantial 22% from April to November 2012 but this was compensated by robust growth in light CV sales because consumption spending stayed stable and the hub-and-spoke model proliferated. However, there appears to be no end in sight for the struggling domestic passenger vehicle business hit by a triple whammy — Tata Motors’ brand perception is poor, competitive pressures are higher and demand has slowed down. Overall standalone performance is dragging under the weight of lower capacity utilisation and higher discounts and ad spends.

Steering through

JLR volumes are showering signs of recovery

Admittedly, the prospects of the near-term domestic performance don’t look good. Sure, the government’s recent reform initiatives have brightened things up a little and they could help revive the economy in FY14. We can only wait for that to happen. Macroeconomic variables influencing the heavy motor vehicles segment (interest rates, industrial activity and infrastructure development) are expected to improve as well. That surely bodes well for demand. Also, heavy CV sales could spring a surprising upside as pent-up demand — the deferred FY13 replacement — gets realised, which should drive recovery in the domestic business.

It is JLR’s strong performance over the last couple of years that has boosted Tata Motors’ flagging operational and financial strength — net automotive debt was only 0.3 times in September 2012. That’s why, even though Tata Motors has elevated capex programmes, JLR’s strong cash flows will turn it net cash positive at a consolidated level over the next two years.

So here’s what I expect: Tata Motors will report a consolidated net profit of ₹13,000 crore in FY14, thanks to JLR’s strong performance for all the reasons I have outlined above. Therefore, consider this: Tata Motors’ stock trades at 7.1 times estimated 2013-14 consolidated earnings at ₹278, and the auto major’s DVR (differential voting rights) shares, which were issued in late 2008, are available at a 40% discount to the company’s ordinary shares. In fact, I expect the gap between the ordinary shares and DVR shares, which carry one-tenth the voting rights and 5% more dividend, to narrow as the company’s growth prospects and liquidity improve. 

Tata Motors’ DVR shares trade at a very attractive price-to-earnings ratio of about 4.3 times earnings at ₹168 — and remember, the DVR shares come with an attractive dividend yield of 3%. I am expecting returns of 25% on the DVR shares. So there you have it, the reason why Tata Motors’ DVR, with a target price of ₹210, is my best pick.