Will Tata Motors' outperformance sustain?

Tata Motors has seen strong upgrades in volume, top line and profit estimates, after reporting an unexpectedly superlative quarterly global volume performance for Jaguar Land Rover (JLR). It was led by strong demand for the Evoque SUV from the Land Rover stable.

Demand was strong in China and Russia and relatively stable in other markets. There is a waiting period of six weeks for JLR models and two to three months for the Evoque, according to IDBI Capital analyst Bhaumik Bhatia.

This suggests near-term demand prospects for JLR, which contributes 67 per cent of Tata Motors' consolidated revenues and 90 per cent of profit, remain healthy.

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In the medium term, the stated five-year capex plan of about ٟ.5 billion annually for JLR is expected to ease capacity constraints and support growth. This and buzz about a JLR Initial Public Offer (IPO) have fuelled a 72 per cent outperformance of the Tata Motors stock vis-a-vis the broader Sensex, despite the relatively muted prospects at home, where growth is mainly expected on the commercial vehicles (CV) front, with a modest margin expansion.

The question that begs answering is whether this outperformance (up 40 per cent in the past three months, including 13 per cent in the last fortnight) prices in the higher volume growth fully and if the stock would continue to so perform.

Bloomberg data indicates there are 41 buys, 12 holds and four sell ratings on the stock, with a consensus price target of Rs 315.

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Among the naysayers is UBS analyst Sonal Gupta, who, while raising volume growth estimates for FY13 to 25 per cent from 13 per cent year-on-year and earnings per share (EPS) estimates for FY13 and FY14 by 23 per cent and 17 per cent, respectively, feels the strong volume growth is priced in at current valuations. A BRICS Research price target estimate of Rs 307 set on April 17 has been achieved already.

However, Jeffries Research believes Tata Motors still has meaningful upside and Macquarie has an outperform rating on the stock, based on a 16 per cent increase in EPS estimates; it has raised its price target for the stock by 12 per cent to Rs 370.

Broadly, while the sentiments are largely bullish, stock outperformance may be difficult to sustain, given that at Rs 314, it is trading at the higher end of its three-year price to earnings (PE) range of four to eight times.

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Healthy JLR outlook

The Chinese market is central to the growth outlook for JLR; it offers strong growth with robust profitability. This market is expected to become larger than the US one, to about 19 per cent of total JLR volumes by FY13 (Macquarie estimates), while growing at about 18 per cent.

In the near term, Macquarie sees Ebitda (earnings before interest, taxes, depreciation and amortisation) margins expanding by 35 basis points to 16.1 per cent in 2012-13, propped by this change in geographic mix and operating leverage as volume growth kicks in.

Domestically, though, Tata's growth is expected to be more subdued, driven mainly by light commercial vehicles (LCVs), according to IDBI Capital. The brokerage quotes management as indicating a 22 per cent LCV volume growth in FY13, even as M&HCV and car volume growth expectations are muted at about eight per cent.

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Product pipeline, capex

For JLR, growth will get support from the four launches in its pipeline in FY13, including a two-seater Jaguar sports car (F-type), an XF station wagon and two new Range Rovers (including a sports variant) on a premium lightweight architecture platform.

According to IDBI Capital, the company doesn't envisage any constraints on capacity or engine supply from Ford, which is contracted till 2020.

In the medium term, JLR plans to invest �� million on two engine plants, one in the UK (�� mn) by late 2014 (calendar year) and in India after that.

Moody's analyst, Falk Frey, sees investment also targeted towards enhancing growth by expanding its portfolio of models, as well as research and development towards new launches, alongside expanding dealer networks in emerging markets.

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In addition, it will face costs for achieving European carbon dioxide emission standards. The company also plans to invest 𧸯 mn as equity in a 50:50 joint venture with Chery in China, and the final investment here will depend on government approval and percentage of localisation required, according to IDBI Capital.

Key issues, triggers

The large capex appetite for JLR, however, will impact the free cash flows for the company and be negative over the medium term, according to a Moody's rating note. Given the nature of the business, this will be an ongoing expense and Moody's doesn't see debt levels (about Rs 44,000 crore at end-September 2011) coming down from an absolute level in this timeframe.

Additionally, the company has been capitalising 84 per cent of its total product development expenditure, which has also boosted Ebitda margins.

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The company, though, intends to reduce this to 40-45 per cent by increasing the amount expensed through the P&L by 2015-16. While such a move will bring its accounting norms in line with peers, it will impact profitability.

Forex-related risks (positive as of now) stem from the larger environment, while discounting driven by competitive or growth pressures in specific target markets like China (where the broader auto market isn't growing) are other potential risks.

Positively, JLR's IPO is the key trigger. A bullish Bloomberg survey of three analysts valued it at $14 billion versus the $2.3 bn paid by Tata Motors to acquire it in 2008. While successful listing is a function of the global environment and risk appetite, it will unlock value for shareholders and perhaps provide added fizz for the stock from current levels, wherein it trades at a one-year forward P/E of 7.7 times consensus consolidated earnings estimates.