Tata Motors: Time to Hit the Brakes?

| About: Tata Motors (TTM)

In looking at Tata Motors (NYSE:TTM), the first thing that jumps out is the poor condition of the balance sheet. On 31 March 2009, the debt on the balance sheet was Rs 392.134 billion ($8.7 billion); that is an astounding Rs 763 per share ($17). After reducing cash and cash equivalents, the net debt comes in at Rs 683 per share ($15). Shareholder equity was Rs 59.406 billion ($1.3 billion) or Rs 116 per share ($2.6). The net debt to net debt plus equity ratio is 86%. This is well over debt levels I consider prudent.

My tolerable net debt to net debt plus equity ratio is 30%. For a car maker, a slightly higher than 30% is okay in some circumstances; they typically use a quasi financial services business to drive sales growth through financing buyers. For instance, when I last looked, Honda Motor Company (NYSE:HMC) has a ratio of 48%.

But in the case of Tata Motors the debt is not so high on vehicle finance; a significant part is to finance the acquisition of JLR. A recent corporate presentation shows Tata Motors debt incurred in respect of Vehicle Finance at Rs 76 billion (1.7 billion); which is only 21% of the total net debt.

In my view, the capital structure is weak; very weak. Such high debt levels will limit access to capital and can lead to muted future growth prospects. There also remains considerable confusion about what portion of the company truly belongs to shareholders – the threat of a highly dilutive capital raising event is ever present.

The good thing about a bad capital structure is that the risk is very visible and in times of crisis the risk gets mispriced; Tata Motors traded down to Rs 124 ($2.76) during the bear market and at those price levels the risks were mispriced. The question to ask is: What is Tata Motors worth with its structural risks fully priced?

I have a high level of confidence in the stand alone Indian operations being capable of delivering long term earnings of Rs 39 per share ($0.87) before interest; this can be expected to grow in line with India’s nominal GDP growth of 12%. This amount is adequate to service debt; the interest is expected to be approximately Rs 25 per share ($0.56). The per share numbers are based on share count after the recent capital raising exercise assuming full conversion of convertible notes; see later in this post for additional details.

This provides a very low interest cover. In addition, it does not provide any real ability to pay-down debt. For simplicity I will assume the debt is embedded in the long term capital structure (i.e. it will be permanently carried); and I will go with an expectation of rising long term interest rates.

The consequence is an assumption that interest expense too shall increase at 12% per year. Rs 14 ($0.31), growing at 12% annually, for an investor with a 16% annual return expectation and a notional payout in perpetuity expectation of 40% returns a value of Rs 235 ($5.22).

To this we need to add the valuation attributed to the long term contribution we can expect from JLR. JLR’s contribution is difficult to estimate; visibility on historic data is low and forward expectations are difficult to form particularly when you consider the growth impetus which will arise once the brands aggressively entry India.

In my view a very conservative long term earnings expectation from JLR, is Rs 16 per share ($0.36); this does not include the cost of the debt burden which has been included as what the long term India earnings will generate. This Rs 16 ($0.36) growing at 6% annually for an investor with a 10% annual return expectation and a notional payout in perpetuity of 40% returns a value of Rs 255 ($5.67). This puts a value of Rs 490 ($10.89) for Tata Motors.

The Rs 16 ($0.36) JLR estimate does not include growth potential for India; in my view Rs 26 ($0.58) is not an unrealistic long term earnings expectation for JLR. This Rs 26 ($0.58) growing at 6% annually for an investor with a 10% annual return expectation and a notional payout in perpetuity of 40% returns a value of Rs 415 ($9.22). This puts a value of Rs 650 ($14.44) for Tata Motors.

Because of the poor capital structure, I view the level between Rs 490 ($10.89) and Rs 650 ($14.44) {Average Rs 570 ($12.67)} as a good target at which to book profits or exit positions. With a strong capital structure, these targets would be considered the upper end of a buy limit. The capital generated should at this stage of the cycle move towards quality and away from risk; Tata Motors would only come back on my buy radar if either:

(a) Its capital structure is cleaned up; price targets would be evaluated at that time

(b) it trades down to a level of Rs 250 ($5.56) where I would consider it a buy as all risks associated with the poor capital structure are largely priced; this is a bear target and I would buy and accumulate if it fell further.

(c) pricing excessively negative sentimental in addition to poor fundamentals as a result of the bad capital structure would create a buy point at Rs 115 ($2.56); this is a bear bottom target.

(d) Short term horizon investors might consider buying at Rs 410 ($9.11) level. This is what I see as fair value and believe gains to Rs 650 ($14.44) levels are possible provided that risk aversion does not return and sentiment remains possible.

Above conversions to $ have used a long term Rs/$ rate of Rs 45=$1.

Notes on capital structure and growth prospects

Growth Prospects

Tata Motors deals in a wide variety of vehicles. Buses are a great growth area; Indian public transport is an absolute mess and Tata buses help making it get better. Part of the Indian fiscal stimulus is geared towards investment in this area. Tata trucks are also beneficiaries of massive growth opportunities; with GDP expected to grow at 12% nominal over the coming years, logistics and the movement of goods will create incremental demand for road transport.

Tata passenger vehicles also operate in a growth area; at the bottom end of the market, the Nano, recently added to the passenger vehicle portfolio, provides a wonderful growth opportunity. At the top end of the market, bringing the JLR brand into India will open up a significant premium vehicle market for the group. The middle end of the market has a decent product portfolio, which can in my view benefit greatly from the introduction of acquired technology and intellectual property to improve quality.

The mid end can also benefit from JLR brand “rub off”; but here, care is needed so as not to taint the JLR brand with the non premium product portfolio. The problem is that to benefit from this huge opportunity, Tata Motors must have access to finance; and with the terrible capital structure, access to incremental finance is unlikely to be available.

Because of this albatross, I would use in line growth expectations to value the company. In line growth represents a long term growth rate of 12% for the group ex JLR and 6% growth for JLR; these growth rates represent long term nominal GDP growth expectations in India and overseas respectively.

Capital Structure

A significant chunk of the debt went towards the acquisition of JLR. On question which arises repeatedly is whether that was a good buy. In my view it was a good long term buy. No doubt I would have been happier with a lower price, but it was a good buy. Success does depend largely on execution; part of the acquisition benefits will come from future JLR income streams (including bringing the brand to India), but that is a small part of the story; the real success will come from brand positioning and from the acquired technology and intellectual property being applied to Tata Motors wider business.

At this point in time, I do not believe Tata Motors has successfully leveraged the acquisition in any manner.

Now for the good news. Tata Motors is part of the Tata Group, which enjoys high investor confidence in India. The access to debt is good even during periods of distress. The ability to refinance means that Tata Motors can carry the high level of debt embedded in its capital structure.

Even through this crisis, Tata Motors has been able to refinance debt and improve its debt maturity profile; there is no reason to expect this to change. This is very important; it means that a dilutive capital raising exercise will not be necessary during a period of distress when shares are deeply under-valued. Any capital raised to pay down debt and improve the capital structure will be an active management decision.

Improving the capital structure is something I believe is both highly desirable and inevitable. Access to incremental finance will be required to drive growth and capture higher market share and the management will ultimately recognize this; an effectively managed company will face a compelling force which will draw it towards a responsible capital structure consistent with good business practice.

In my view, a responsible capital structure will maintain a net debt to net debt to equity of no more than 30%. Incremental long term debt can then be accessed to drive the net debt to net debt to equity to a 50% level; but this incremental debt should be productive and profitable debt – that is debt undertaken to drive sales growth through the financing of vehicle buyers in the consumer and commercial segments.

My view as expressed in the prior paragraph is supported by Tata Motors' recent and successful capital raising exercise. Tata Motors raised $750 million; $375 through the issuance of global depositary shares, which valued each share at $12.54 (approximately Rs 580), and an additional $375 million from 4% coupon convertible notes (due 2014) to be converted at $13.48 (approximately Rs 625) per share. Share count at 31 March 2009 was 514 million; if all convertible notes are converted, the share base will rise to approximately 572 million – this is dilutive but it is an important first step towards improving the capital structure. After this transaction, I expect the net debt to net debt plus equity to improve from 86% to 74% assuming the hybrid notes are treated as equity. In my opinion this should be the first of further capital raising exercises to be conducted as confidence improves and the share price strengthens.

Disclosure: Indirect long positions in Tata Motors