Tata Motors: Driving a good bargain

India is a fascinating place to invest. The Bombay Stock Exchange (BSE) is the oldest stock exchange in Asia and has more than 6,000 listed companies. I have been investing directly in India for the past 15 years and have found it to be a stock picker's paradise – as an institutional investor.

Unfortunately, Australian retail investors can't access India's stock market at the company level. Even institutional investors have to go through a long, laborious, and expensive process to buy local shares. Now there are exchange traded funds (ETFs) that can give a broad exposure to the Indian market, such as iShares India 50 and iShares MSCI India. For stock pickers there are American depository receipts (ADRS) that trade in the US in US dollars, but the selection is quite narrow. There are also global depository receipts (GDRS) that trade in London in US dollars but, while there are a few more companies listed, liquidity can be a problem.

ADRs are a special security listed on a Wall Street which allow American and international investors buy shares in non-US listed global companies. BHP, for example, has ADRs on the American market. For all intents and purposes ADRs carry the same rights and obligations as ordinary shares. The Tata Motors ADRs are particularly useful since under existing legislation foreigners can not buy the Tata Motors stock on the Indian Stock Exchange.

My most successful Indian investments have been either small and midcap companies that were leveraged to positive trends in the domestic economy, or large well managed companies who moved outside of India to establish world class businesses on the global stage. IT service providers Tata Consultancy Services and Infosys are good examples, as is Sun Pharmaceuticals – now one of the world's largest players in generic medicine.

Recently, I've noticed that another Indian global player continues to do well – Tata Motors – which is my next candidate for inclusion in the Eureka global portfolio. Tata Motors' US-traded ADR  has the symbol TTM on the New York Stock Exchange and is currently priced around $US47.

Never heard of them? That isn't surprising. Indian auto makers haven't exactly covered themselves with glory in the export market except for one brand and that's Jaguar Land Rover (JLR).Tata bought Jaguar Land Rover from Ford in 2008 and it has been a smashing success. JLR is the first reason to own Tata Motors as its outlook remains strong.

The other two reasons come from India, where Tata Motors is the largest auto and commercial vehicle maker. In recent times, however, Tata's domestic businesses have been struggling. In spite of India being one of the world's largest car markets, Tata has struggled against the competition due to a lack of new models and the unqualified failure of the Nano, an entry-level car that was supposed to revolutionise the Indian car industry.

Developed in 2008, requiring most of the firm's engineering expertise, and priced at $US2500, the Nano was positioned to be the world's cheapest car – India's own Model T! However, sales proved disappointing (down 61% year-on-year to the end of March 2014) simply because Indian car buyers were more aspirational than Tata realized and didn't actually want a cheap entry level car. Concerns about safety and equipment levels also pressured sales. The Indian consumer, now with more disposable income, wanted something a bit more up market like a Suzuki Alto (made by Tata's arch-competitor Maruti Suzuki) or perhaps a Hyundai – bigger, flashier, better equipped, and safer for only a little more money. The Nano fiasco impeded any other new model developments and so Tata has struggled in the automotive space – up until now.

Last week the company announced it was launching its first new cars in four years, aimed firmly at India's growing middle class. Named the “Zest” sedan and the “Bolt” hatchback and selling for an estimated $US7500, they compete against the companies that have reduced Tata's market share from 10% to 4.2% over the last four years: Honda, Maruti Suzuki, and Hyundai.

Tata has totally revamped its design and production processes and this car has been developed in conjunction with many of the world's leading power train suppliers such as Bosch and Honeywell. JLR has advised on the engineering and production processes. On paper it looks like a winner with a turbocharged 1.2 litre “Revotron” petrol engine and also a diesel engine option sourced from Fiat. More importantly, Tata intends to introduce two new models a year for the next six years, including a compact SUV. Although it's early days, this could be an inflection point for Tata in one of the most dynamic auto markets in the world.

Tata's commercial vehicle business has also struggled as India's economy has stagnated and slowed over the last 18 months. This is an extremely important segment for Tata as it is India's largest manufacturer with a market share of over 50%. At its recent results conference, the company flagged the first positive signs – particularly in the medium and heavy vehicle segment – in nine quarters and guided to more recovery in the second half of 2014-15.

Mahindra and Mahindra, another commercial vehicle manufacturer, has confirmed the beginnings of a pickup in its business as well. This is good news and could be signs of stability, however, a sustained recovery in this segment depends on the direction of the Indian economy, interest rates, and the speed and duration of expected reforms from Narendra Modi, the recently elected PM, and his administration. His work is cut out for him, given India's economy is growing at only 4-5% (half the level at its peak), inflation is 9% and rising, industrial production is flat to trending downwards and public finances are messy. Still, I believe he has a good chance to turn the economy around given his successes in his home state of Gujarat and the mandate delivered to him by voters. Economists agree, and have forecast a rebound in economic growth to the 6-6.5% level in 2014.

Latest Results

Tata reported its consolidated results for the first quarter of 2014-15 on August 11, 2014. Revenues grew 38.3% year-on-year to INR (Indian Rupee)646.8 billion with an earnings before interest, tax, depreciation and amortisation (EBITDA) margin of 17.2% (a 4.5 percentage point improvement year-on-year). Profit after tax increased 212% to INR54 billion.

These results are spectacular when you consider the domestic businesses – auto and commercial vehicles – contribute negatively to EBITDA (a loss of RS 3billion or -3.9%) on revenues of INR77 billion. Weak volumes and excessive discounting were the culprits here.

Jaguar Land Rover is unquestionably the growth engine for this company. Sales of Range Rover, Range Rover Sport, Evoque, Jaguar X and the F-Type are growing strongly in all geographies including China. In the last quarter the company realised an average selling price (ASP) of $US73,000 and incentives remained at low levels.

New products such as the Discovery Sport (replacing the Freelander), Jaguar XE (luxury compact) and a Jaguar Crossover, along with existing products, firmly underpin revenue growth going forward. Local production will pick up in China with three models being manufactured locally – the Jaguar XF, Freelander and Evoque – and will enjoy much lower tariffs. Prices of some models will decrease by 20%. JLR plans to increase the dealership network there by 33% to cope with greater demand.

Financial Assumptions

My financial assumptions for Tata Motors are as follows:

• Tata Motors trades on 7.5 times 2014-15 earnings and 4.4 times its enterprise value to EBITDA multiple – a significant discount to the other global and Indian auto makers.
• Consolidated (group) sales are estimated to increase 47% from INR2,308,031 million in 2013-14 to INR3,400,000 million RS in 2016-17
• JLR's volume growth is 15.5% in 2013-14, 12% in 2014-15, and 16% in FY2015-16.
• JLR margins are 18.5% in 2013-14, 18% in 2014-15, and 18% in FY2015-16.
• Domestic (auto plus commercial vehicles) margins turn positive in 2014-15 to 5% and 7% in 2015-16 (they were -3.95% in 2012-13 and -1.5% in 2013-14), while sales increase 15% in 2014-15 and 18% in 2015-16 off a very low base.

Valuation

Tata Motors should command a price-earnings multiple of 9.5 times INR in 2015-16, which is still below the average of a blended global original equipment manufacturer (OEM) multiple and the other Indian auto manufacturers. With a 9.5 times 2015-16 earnings of INR647 million, there is a 25% upside from here.

Conclusion and Recommendation

Even though Tata is up 35 % this year in its local currency*, it is a BUY in the mid to high $US40s. As well as continuing momentum in JLR, I expect positive quarter on quarter progression in the commercial vehicle business and some positive news flow regarding the two new automotive offerings. That's not in the price.

Risks

Risks to my valuation and recommendation to Tata Motors are as follows:

• Market conditions for luxury vehicles deteriorates globally; discounting increases
• Indian economy remains stagnant
• Chinese growth doesn't eventuate due to regulatory concerns and demand slows down
• Adverse currency movements of its major transactional currencies versus the INR. JLR is a net exporter in US dollars and an importer in Europe.

*Note Tata Motors ADR trades at a premium to the local shares of 11%. This is not unusual for ADRS – particularly with those that are in favour with investors. Currency can also be a factor.

To see Tata Motor's financial summary and forecasts, click here.