Tata Motors Inc. – A Growing Margin of Safety

Tata Motors Inc. (TTM, Financial) is incorporated and domiciled in India and, since 1954, has been involved primarily in the manufacturing of automotive vehicles and parts. TTM offers a broad portfolio of automotive products, ranging from sub-1 ton to 49 ton GVW, trucks (including pickup trucks) to small, medium and large buses and coaches to passenger cars, including the world’s most affordable car –Â the Tata Nano –Â as well as premium luxury cars and SUVs. TTM ranks as the eighth largest truck manufacturer globally in the 6 ton plus category according to Automotive World, as measured by volume of vehicles produced.

TTM's most substantial presence is in India, while it does have global operations in connection with the production and sale of its Jaguar and Land Rover premium brand passenger vehicles. TTM is the largest automobile manufacturer by revenue in India, the largest commercial vehicle manufacturer in terms of revenue in India and among the top four passenger vehicle manufacturers in terms of units sold in India. It is estimated that there are over 8 million TTM vehicles on the road today. As of March 31, 2014, TTM's operations included 70 consolidated subsidiaries, 2 joint operations, 3 joint ventures and 18 equity method affiliates. Production is handled through six principal automotive manufacturing facilities in India and 3 facilities in the United Kingdom (for its Jaguar Land Rover business) as well as two advanced design and engineering facilities. TTM has approximately 68,889 permanent employees

Purchase considerations and reasons for caution

One thing we like about TTM is its specialization in selling low-cost vehicles; cars (specifically under the Tata brand) are sold at basement bottom prices for their condition in a fairly easy-to-finance environment. TTM has won consumers' minds as the low cost seller of automotive vehicles and, combined with cost efficiencies derived from its scale of operations, provides it with a strong cost advantage over much of the competition. A point of caution, however, is that to maintain its cost advantage it must maintain market dominance in India, helping maintain pricing and per vehicle costs. Intensified competition has led to diminished market share in the passenger and utility vehicle lines, and this must be reversed.

What we also like about TTM is its growing presence and strength in the luxury vehicle market through its acquisition and transformation of Jaguar Land Rover. Not only does it now offer products in the premium performance car and premium all-terrain vehicle segments with well-recognized luxury brands, its geographic presence has also expanded significantly and become more diversified across markets and product segments. Total sales of Jaguar Land Rover vehicles increased from 314,000 units in 2012 to 432,000 units in 2014. We think that TTM is well positioned for organic and geographic growth by capturing increased market share from Mercedes and BMW.

What we don't like is TTM's vulnerability to economic cycles, signs of tightening in Indian credit markets (with increasing loan defaults) and intensified market competition. While India’s GDP growth continues to outpace the Western world, at about 5%, industrial production is expected to slow. On the back of tightening monetary policy, declining fiscal spending, rising inflation and slowing net national investment, fiscal 2015 and 2016 will present challenges as households are spending more on essentials and less on discretionary goods, including vehicles. Diminished vehicle sales to the mining and quarrying, manufacturing, infrastructure and transportation sectors are also expected and will hurt profits.

Financial highlights

About $39,051M in revenues moved through TTM's door in 2014. TTM’s revenues for the March 2005 to March 2014 period clocked in at an average annual rate of growth of 27%. Revenues grew at an annual rate of 12% over the last 3 years and by 23% annually over the last 5 years. Year over year TTM continues to make substantial sums of money off revenues after subtracting costs of goods sold, with gross profits reaching $14,955M in 2014. Gross profits have grown by 36% per year over the last 10 years and 15% per year over the last 3 years.

TTM's production costs appear well under control, with COGS rising by 23% per year over the last 10 years against revenue growth of 27%. TTM does not appear to be experiencing any difficulties passing on the cost of inflation to consumers. Gross margins have increased from 21% in 2005 to 38% in 2014. The level of gross margins is also reasonably strong. As a general rule, we want to see consistent gross profit margins above 30% for firms in the sector. TTM has met this requirement in 7 of the last 10 years. This is, in our opinion, indicative of a firm with a reasonably strong competitive advantage and with reasonable pricing power.

TTM spends about 74% of gross profits on hard costs associated with selling expenses, advertising, management salaries, payrolls, advertising and legal fees. We consider spending above 65% of gross profits on SG&A a poor result. Cost of SG&A, have been increasing at a decreasing rate, rising by 50% per year over the last 5 years and 17% per year over the last 3 years. We still consider this a negative sign, however, when viewed against annual revenue growth of 23% and 12% over the same periods respectively.

TTM has shown reasonable strength but definite volatility in its operating earnings picture, falling by 7% per year over the last 3 years but rising by 160% per year over the last 5 years. The long-term trend in operating income has been upward, rising steadily from $434M in 2005 to $1,229 in 2014. TTM has earned on average about 5% in operating earnings on total revenues over the last 10 years--a moderate result. TTM carries a sizeable amount of debt on its books and, consequently, pays out about 72% of operating income on interest payments annually. This is much higher than desired.

Bottom line results show a strong long-term trend in earnings, with some volatility, growing at an average annual rate of 24% over the last 10 years. Earnings are expected to tick upwards in 2015 and 2016 as demand for low-cost and luxury vehicles continues to grow in Asian, European and North American markets. TTM’s strong low-cost position in the Indian market and growing competitive presence in the international luxury market has allowed it to maintain net margins of 4% over the last 10 years in an incredibly competitive industry. We do expect to see some margin expansion moving forward as income levels in emerging markets rise.

Diluted EPS have grown from $0.81 per share in 2005 to $3.31 in 2014. We dislike seeing that earnings growth has lagged revenue growth by 3% per year over the last 10 years and by 2% per year over the last 3 years. While not terribly concerning, we are treating these as minor signs of earnings quality weakness.

We dislike that the firm's share-base continues to grow, with diluted shares outstanding rising by about 250M since 2004. TTM's ROE performance has been strong, averaging 23% over the last 10 years. Its ROA performance has been moderate, averaging 6% over the last 10 years.

Multiple-based valuation

As a market-based approach for evaluating TTM, we have assembled the 15-year historical record of the company’s Price/Sales, Price/Earnings, Price/Free Cash-Flow and Price/Book Value ratios as shown below.

Historical multiples, distributional properties and forward projected SPS, EPS, FCFPS and BVPS

After reviewing the distributional properties of the multipliers around their respective means, we are confident about using multiplier values of 0.65, 11, 12, and 3 respectively. Each expected multiplier is multiplied by the corresponding variable for the company’s expected average 10-year forward sales, earnings, free cash-flows and book value per share. Based on our experiences with the industry we then decided to overweight free cash-flows and book value as they have been particularly effective predictors of company value. Applying the weights shown below we derived a weighted-average fair value estimate for TTM of $58.35. Following Tata's recent drop in price, this implies a margin-of-safety of about 26%. Not outstanding for a speculative play but definitely not bad either.