Near-term Headwinds

Tata Motors is India’s largest automobile company in terms of revenues. Of the total revenues earned by leading auto companies such as Maruti Suzuki India, Mahindra & Mahindra, Bajaj Auto and Apollo Tyres, Tata Motors alone accounts for a revenue share of around 53 per cent. It is the market leader in commercial vehicles, with around 60-65 per cent share in major segments. It is the third largest player in passenger cars. The company acquired the commercial vehicle business of Daewoo in 2004 and Jaguar Land Rover (JLR) in 2009. In India it has an industrial joint venture with Fiat. Through subsidiaries and associates, the company has operations in UK, South Korea, Thailand and Spain.

Headwinds for auto sector
The auto industry faces multiple headwinds in the short run. In recent times, manufacturers have increased the sales price of vehicles in order to at least partially pass on the higher cost of raw materials. Vehicle owners’ cost of ownership has also gone up owing to a 28 per cent increase in the price of petrol and a 7 per cent increase in the price of diesel over the last one year. Moreover, auto loans have become costlier by 150-200 basis points over this period due to the interest rate hikes undertaken by the Reserve Bank of India.
As a result, volume growth in the auto space is slowing down while inventory levels are going up. This holds especially true for the passenger segment and the medium and heavy commercial vehicles (M&HCVs) segment. However, two wheelers, utility vehicles (UVs) and light commercial vehicles (LCVs) continue to record strong volume growth.

Commodity costs have started easing now. However, their higher costs in the first half of FY12 put pressure on profitability in Q2. Moreover, competition has become stiffer in certain segments, and this has restricted the pricing power of players in those segments. According to a recent report by Motilal Oswal Securities, automobile companies are undertaking cost-reduction measures, productivity improvement programmes, and utilising high operating leverage in order to lessen the impact of higher raw-material costs. Nonetheless, analysts at this brokerage house estimate that EBITDA margins will remain muted.
Over the long-term, however, the sector’s volume outlook is positive due to rapid economic growth, easy availability of finance, and an improvement in export outlook.

Positives
Market leader. As mentioned above Tata Motors is India’s largest automobile company and is the market leader in commercial vehicles. It is the world’s fourth-largest truck manufacturer and third-largest bus manufacturer.
JLR’s contribution. JLR contributes 57 per cent of Tata Motors’ consolidated sales. The acquisition of JLR has upped the ante for the parent company. From being a predominantly domestic player, it now competes with the likes of BMW, Daimler and Audi.
Moreover, in Q2FY12, Tata Motors’ standalone performance was disappointing. But its consolidated sales grew 26 per cent year-on-year (y-o-y) in this quarter owing to JLR’s strong sales performance (volume growth of 23 per cent y-o-y). JLR’s performance offset the impact of adverse currency movement and input cost pressures.

Opportunities
Ramp up of Jaguar volumes. Management expects Jaguar’s sales volumes to rise in the coming quarters after the launch of a new model called XF, further enhancement of dealer network, and increased marketing efforts. Also, most of the inventory backlog has been cleared up; hence wholesale dispatches are likely to improve in future. Management expects JLR to register strong growth in China, Russia and North America. According to a report by IDBI Capital, models like XF and Evoque are expected to contribute meaningfully from Q3 onwards, with presence in more geographies. Evoque has an order book of around 20,000 units after supplying 8,000 units in Q2FY12. The company has a target of 40,000 units in China for FY12. Evoque will be sold in China from November 2011 onwards.
New launches. Jaguar plans to roll out new models such as XJ and XF, while Land Rover plans to launch Evoque in other markets, including China. This should help in sustaining JLR’s volume momentum. In order to combat competition in different segments, Tata Motors plans to launch new models and variants across segments in FY12: variants of the Prima range, world LCV range, Nano variants, Vista variants, Manza limited edition, and the New Safari.
New engine plant. The company plans to invest 355 million pounds over the next three years on setting up an engine plant at Wolverhampton, UK, where it will manufacture new, advanced technology, low-emission engines. This plant will manufacture four-cylinder petrol and diesel engines. Currently, it sources these engines from Ford, which is, however, facing constraints in meeting this demand. Tata Motors invested around 710 million pounds in H1FY12 in JLR and around `11.6 billion in its standalone business.

Negatives
Adverse currency movement. JLR has exposure to both euro and US dollars as its non-Europe sales are in US dollars (around 50 per cent of sales). Both sales and input cost expenditures in Europe are in the euro. Hence, a weakening US dollar and an appreciating euro are negatives for the company.
Domestic business outlook. Tata Motors has been losing market share in the domestic passenger car market. Demand outlook remains bleak, especially in the passenger car segment, owing to rising costs, higher interest rates, and expectations of lower economic growth. Further, margins are expected to remain under pressure due to limited pricing power, inflationary pressures, and low operating leverage.
LCVs could face intense competition. Competitive intensity has increased in the fast-growing LCV market with M&M and Piaggio making inroads into this segment and gaining share at the expense of Tata Motors. New entrants Ashok Leyland, Hindustan Motors and Force Motors have also recently entered this segment.
Economic problems in Europe and U.S. The U.S. and the European economies, which are the main markets for JLR, have been witnessing sluggish growth of late. The outlook of these economies is bleak with the possibility of a double-dip recession looming large in the U.S. and the Euro zone suffering from the problem of high sovereign debt.

Financials
After taking a huge hit in its profitability, wherein it posted a negative profit and a nearly zero return on capital employed (RoCE) and a negative return on net worth (RoNW) in FY09, Tata Motors’ profitability numbers have shown a significant improvement. Over a period of five years, the company has exhibited good growth numbers. Its total income has registered a five-year compounded annual growth rate (CAGR) of 38.8 per cent and its net profit posted a five-year CAGR of 40.1 per cent.
The company has seen some moderation in its total debt which has declined 7.1 per cent in FY11 over FY10. Its debt-to-equity ratio has declined to 1.72 times in FY11 from 4.4 in FY10. The company’s free cash flow stood at `7,442.06 crore in FY11.
It has a healthy track record of paying regular and attractive dividends to its shareholders. Its dividend pay-out ratio currently stood at 70.05 per cent in FY11.

Valuation
The stock is currently trading at a price-to-earnings (P/E) ratio of 5.17. It is trading at a discount to its five-year median P/E of 8.73 times. Over a period of five years, its earnings per share has grown at a CAGR of 27.3 per cent. This gives it an attractive price-to-earnings to growth (PEG) ratio of 0.2.
The stock has good prospects in the long-term. However, the near-term prospects are not very good. A positive surprise could come from the roll out of Evoque in geographies outside Europe and US, which could result in significant jump in JLR’s monthly sales volumes and improve Tata Motors’ overall performance. Investors with at least a three-year investment horizon may buy this stock.