Our analyst's take on Tata Motors

By Morningstar Analysts |  13-11-19 | 

According to media reports, Tata Motors has approached China’s Zhejiang Geely Holding Group Co. and BMW AG as it seeks partnerships for investing in electric vehicles.

Meanwhile, Moody’s assigned a ‘Ba3’ rating to the proposed senior unsecured notes to be issued by Tata Motors; the rating outlook is negative.

RICHARD HILGERT, Senior Equity Analyst, admits that Tata Motors, India's largest commercial truck producer and owner of the Jaguar and Land Rover luxury brands, has hit a bumpy road. But is also convinced that the company is heading towards recovery.

Here are his views on the fair value, the moat and what he believes is the company's future.

Fair Value Estimate, FVE

In the first half of CY2019, we recently lowered our FVE to Rs 465 from Rs 580 after rolling our model to the new fiscal year.

The decrease was primarily due to:

  • Increased financial leverage which resulted in an above average credit risk rating
  • Change in capital structure resulted in an increase in our discount rate from 8.9% to 9.4%
  • Assumption of revenue growth of 7.5%, well below the trailing 10-year average revenue growth rate of 14.0%
  • 5-year adjusted EBITDA margin forecast averages roughly 13.3%, 120 basis points better than the trailing 10-year average of approximately 12.1%.

We took into consideration margin expansion from the Indian business as the domestic commercial vehicle market rebounds which were severally depressed from fiscal 2013 to fiscal 2017 plus recovery in JLR China joint venture volume and profitability due to the launch of new models.

During our 5-year forecast period, we estimate 5.9% JLR revenue growth in Indian rupees but only 4.8% in British pounds as the pound rebounds relative to the rupee. Our JLR volume growth assumption is 4% versus a 12.6% 10-year average, supported by continued demand recovery in Europe, recovering demand growth for luxury vehicles in China, and Brazil.

We believe the global market for luxury passenger vehicles will continue to grow at a healthier pace than the lower-priced mass market, which we peg at 3% annualized growth.

Morningstar's 2.25% long-term inflation outlook underpins our capital cost assumptions. Our assumed cost of equity is 14%, well above the 9% rate of return we expect investors will demand of a diversified equity portfolio. This incorporates above-average systematic risk and a 3-percentage-point India country risk premium. Our pretax cost of debt assumption is 8.0%, up from the prior model's 6.5%, incorporating a normalized long-term real rate environment while taking into account the spread creditors are likely to demand given Tata's credit risk.

We use a 56% debt weighting to reflect the long-term capital structure of Tata, which has ranged between a low of 30% and high of 97%. Our long-run effective tax rate assumption is 27.5%, in line with the company's 10-year historical median. Consequently, our tax-affected weighted average cost of capital for Tata is 9.4%.

Economic Moat

Tata Motors' narrow economic moat rating is driven by the strength and global recognition of its Jaguar and Land Rover brands. Brand strength enables premium pricing that results in solid margins and healthy economic profits. The low-cost advantage enjoyed by its Indian business is driven by low labor costs and the local tax structure that favors domestic manufacturers.

In our opinion, given capital intensity and lengthy product life cycles that a new startup would endure, it is more probable than not that Tata would maintain economic profitability for 10 years. Despite recent Jaguar Land Rover losses, the brand still enjoys premium pricing benefiting from its intangible asset moat source. However, for a mass-production luxury automotive brand, it is much more difficult to make the same claim about a 20-year period, during which, as management teams come and go and product turnover opens the possibility of a string of missteps, as is currently the case, the probability rises that the brand could destroy economic value for a period.

Luxury, ultraluxury, and exotic brand automakers do not necessarily have an economic moat just because of brand strength and premium pricing. Even though Bentley (owned by Volkswagen) is globally recognized as an ultraluxury brand that commands a commensurate price, the automaker has experienced inconsistent volume and revenue growth, poor margin performance, profit volatility, and erratic economic profits during the past 10 years. In contrast, over the same time frame, wide-moat-rated exotic sports carmaker Ferrari has generated stable, consistent revenue growth, wide profit margins, and high returns corresponding with other wide-moat-rated stocks like Hermes, Richemont, and Vuitton. The main difference between the two is Ferrari’s rich Formula One racing heritage and its ability to leverage this heritage with the regular development and sale to select clientele of ultra-exclusive, multi-million-dollar, limited-edition (and sometimes completely unique one-offs), exotic super and hyper cars.

While brands in these segments command high prices and are often purchased to make a personal statement, consumers can still easily switch to one of many competing products. Premium and luxury vehicle consumers can readily choose from brands like Acura, Alfa Romeo, Audi, BMW, Cadillac, Infiniti, Jaguar, Land Rover, Lexus, Lincoln, Mercedes, and Porsche. Ultra-luxury and exotic brands include Aston Martin, Bentley, Bugatti, Ferrari, Koenigsegg, Lamborghini, Maserati (which is shifting to a lower-price higher-volume strategy), McLaren, Pagani, and Rolls-Royce. These vehicle consumers have the financial wherewithal to simply add more cars to their personal fleet if they so desire.

However, based on Jaguar Land Rover's ability to price above mass-market models due to its brand strength, we think the luxury brands make a substantial contribution toward building Tata’s consolidated economic moat. Using just JLR financials, we estimate that over the past nine years, brand strength has enabled the group to average 6 percentage points of economic profit over an estimated 9.4% weighted average cost of capital.

With new facilities in China, Slovakia, and Brazil, Jaguar Land Rover will have a manufacturing presence in the world's top seven automobile markets. Global volume growth in luxury segment vehicles is bolstered by an increasing population of upper-middle-class as well as roughly 15 million high-net-worth individuals with investable assets of $1 million or higher. We expect 1%-3% average annual growth in overall global automotive demand, but because of the increase in the world’s wealthy population, we think luxury vehicle segment demand will grow at average annual rate in excess of 3%. We believe JLR will continue to roll out new products that sustain its luxury brand image and premium pricing, supporting our narrow economic moat rating.

Tata's domestic mass-market passenger vehicle and its commercial vehicle operations enjoy substantial growth potential and a low-cost manufacturing base. Global automobile manufacturers face a steep import duty in India ranging from 60% to 200% based on the price tag which, when coupled with insurance and domestic inland tax of 20%-30%, makes their products an unattractive option for domestic buyers. More than 40% depreciation in the Indian rupee over the past few years has further raised the prices for imported automobiles for the domestic market. In our view, this provides a competitive advantage to domestic manufacturers, including Tata Motors.

More global automobile manufacturers may choose to set up manufacturing plants or assembly lines in India, which could give them a level playing field versus domestic manufacturers. Still, it takes at least two years to select a site, apply for government permits, receive various approvals, build a plant, and start vehicle production. Also, immediate market acceptance is not guaranteed and usually requires more than one model. In addition, we believe Tata's efforts to export its small car Nano to Asian countries supports favorable operating leverage in its low-cost India manufacturing base. Given the time it takes for competitors to establish a presence, and because Tata is already well positioned to benefit from volume growth, we think the company will enjoy a moat from its cost advantage for at least 10 years.

The future

Tata is positioned to gain from the continued growth in Indian automotive sales and the expansion of luxury markets in emerging economies, especially China. Still, the imperative remains for Tata to keep investing in new models across brands and vehicle platforms. The Tata brand also needs to improve on its ability to execute vehicles at world-class quality levels. While improving, some JLR products still suffer from perceived poor quality. Growing industry overcapacity and domestic competition, along with capital-intensive operations and the industry's cyclicality, pose serious challenges to Tata's ability to consistently earn returns above its cost of capital.

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