We downgrade Tata Motors to Neutral from Buy as JLR margin in Q1FY16 came inline with our previous bear case assumption of 15.2% (adjusting for one-off annual incentive) versus our estimate of 16.9%, driven likely by pricing pressure in China. We believe a strong margin recovery from the current levels is unlikely as the benefit of the Range Rover and RR Sport product cycle has largely played out and there is limited operating leverage in the system. We cut our target multiple for JLR to 4x from 5x as FCF (free cash flow) generation is likely to remain poor (negative in FY16) and downside risk to margins from deterioration in mix and further pricing pressure in China remains.
Limited operating leverage at JLR: We don’t see much case for operating leverage in the JLR business as in our view UK production is likely to grow at only 5% CAGR (compound annual growth rate) over the next three years despite a strong pipeline of new launches due to the transfer of China demand to Chery with the localisation of models. We believe operating costs are like to increase with the start of engine facility and model proliferation and so JLR Ebitda margins are unlikely to rise significantly. We cut JLR Ebitda margin from 17.2% for FY16/17 to 16.2%/16.6%. We cut our FY16/ 17 EPS by 16%/12%, respectively.
Improving India to be less of a drag: Standalone Ebitda margins at 4.7% in Q1FY16 were significantly ahead of our estimates driven by, we believe, lower support to financing subsidiary, falling commodity prices, and cost control. So we raise India Ebitda margins from 3.3%/6.2% to 5%/8.3%. However, the management has continued to significantly commit more and more capital to passenger vehicle product development which is unlikely to generate any returns over the medium term. According to the management, PV (passenger vehicle) volumes need to increase by 50% to reach Ebitda break even level. However, driven by CV (commercial vehicle) recovery we expect India to get close to FCF break even by FY17.
Valuation: Cut PT to R424 (from R545) on sum of the parts basis. We value JLR at 4x 1-yr fwd Ebitda (vs 5x earlier), while we value domestic business at 1-year fwd Ebitda.
Our previous view has been that Range Rover and RR Sport will continue to hold strong and therefore the mix will remain strong. However, we see growing evidence that the model cycle has largely played out. For example, China Q1FY16 retail volumes were down 4% year-on-year for Range Rover, RR Sport Sport and Discovery. US retail volumes declined 21%/17% y-o-y for Range Rover/RR Sport in July’15. RR Sport retail volume growth has been largely flattish for the last three quarters.
While we expect 12% CAGR growth in JLR global volumes (ex-China) over FY15-17, driven by new launches—Discovery Sport, Jag-uar XE, F-Pace and Jaguar XF—we expect only 5% CAGR growth in JLR global volumes (ex-Chery JV). We see limited operating leverage benefit to offset rising costs with new facilities expansion.