The investment thesis of the Tata Motors stock

By Morningstar Analysts |  17-02-20 | 
 

Tata Motors has been in the news for the right reasons.

They had launched new models like Altroz and Nexon EV and updated BS6 engines in the existing models.

To develop unified connected vehicle platform for Nexcon EV range of electric cars Tata Elxsi has partnered with Tata Motors in developing their unified Connected Vehicle Platform that powers the Nexon EV range of electric cars.

Tata Motors owns iconic brands Jaguar and Land Rover, while offering a broad product line of motor vehicles including compact passenger cars, sport utility vehicles, luxury passenger vehicles and large semi trucks. At 45%, it holds the largest market share of commercial vehicles in India.

Senior Equity Analyst Richard Hilgert shares his view on this stock.

Despite continued weakness in the Indian market, Tata Motors Ltd. stand-alone, or TML, cut losses versus the second fiscal quarter and the third fiscal quarter a year ago.

We expect the rough road to turnaround will continue, especially due to the unexpected plunge in India demand. The shares represent compelling value for long-term investors relative to our expectations for cash flow and returns on invested capital.

Tata Motors premium Jaguar and Land Rover brands have fallen on hard times due to increased spending for electrified powertrains and autonomous technologies plus a substantial decline in China demand. However, since fiscal 2009, when Tata acquired the luxury automaker, JLR’s revenue has risen at a CAGR of 14%, with global volume growing 8%.

Over the past 10 years, competitors have entered the Indian commercial vehicle market and Tata's share of commercial trucks has retreated to 45% from a peak of 64% in 2010. This was driven by Tata taking longer to introduce new models versus its peers, deregulation of diesel prices compromising its diesel range, new competitors entering a rapidly growing market (6% CAGR since 2008).

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.

JLR confirmed guidance that consolidated EBIT margin would remain in the low-single-digit range through fiscal 2021. We expect the rough road to turnaround will continue, especially due to the unexpected plunge in India demand, but we think the 5-star-rated shares of Tata Motors represent compelling value for long-term investors relative to our expectations for cash flow and returns on invested capital. The stock currently trades at a discount to our Rs 465 fair value estimate. However, our fair value estimate may be negatively affected by an increased share count as TML announced an equity warrant sale to parent Tata Sons.

So far, our forecast that JLR margin degradation troughed in fiscal 2019 has held. We expect fiscal fourth-quarter margins to be hurt by U.K. factory shutdowns in preparation for the Jan. 31 Brexit, similar to the shutdowns in the fiscal second quarter for the previous October Brexit preparation. Restructuring has delivered GBP 2.9 billion out of a GBP 4.0 billion targeted savings, including lower capital spending, improved working capital, and cost reduction. However, we forecast JLR cash burn (cash flow from operations less capital expenditures and capitalized development) as the automaker continues higher spending for powertrain electrification and autonomous technologies.

Why it gets a Narrow 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 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.

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.

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