The minority shareholders and analysts tracking Tata Motors Ltd would not be pleased that the company has decided to fund the Jaguar-Land Rover (JLR) purchase primarily through the issuance of fresh equity.
One problem is that a large chunk of the equity issuance would come through the issue of equity shares carrying differential voting rights—holders of these shares will have only one vote for every 10 shares held, so as to protect the interests of the promoter group. But that would not be their biggest concern.
More important is the fact that the company’s equity capital will dilute between 30% and 35% in less than a year and another 12% between three and five years later.
On the positive side, the company reported that JLR managed a healthy pre-tax profit of $421 million in the March quarter, about a tenth of its revenues of $4.15 billion. This comes as a surprise, especially since Ford Motor Co., which agreed to sell JLR to Tata Motors, reported a firm-wide pre-tax margin of less than 2%, and JLR was supposed to be the segment dragging the firm’s profitability.
In any case, few expect the reported profit to translate into free cash flow, given the large capital expenditure needs for a luxury car maker. Analysts were disappointed that the company didn’t share details on cash flow and recurring capital expenditure needs of the acquired firm. But most of them seemed to be disheartened by what they heard on the equity dilution plans.
Many had assumed that the company would rely mainly on debt for funding the JLR purchase, since this was the approach followed by other group companies such Tata Steel Ltd for its acquisition of Corus and Tata Tea Ltd for the Tetley buy. While Tata Steel also diluted equity, it was to a much lower extent.
As Tata Motors’ management points out, interest rates have risen considerably and if the acquisition was mainly funded through debt, a high interest burden would wipe off JLR’s profit entirely. But now shareholders have to contend with lower earnings per share, thanks to the dilution.
As for the results for the quarter ended March 2008, even though volume growth of the core commercial vehicles business was much higher than in the previous three quarters, margins continued to be under pressure owing to cost inflation. Operating profit fell by 15% as margin fell by 230 basis points (one basis point is one-hundredth of a percentage point).
According to an analyst, results were more or less in line with expectations, but the more critical issue was that of high equity issuance. Although Tata Motors shares have underperformed after the JLR acquisition and trade at relatively low valuations, it wouldn’t be surprising if there’s a further correction owing to the nasty surprise at the dilution.
Mahindra & Mahindra: value creation by subsidiaries
The stand-alone profits of Mahindra and Mahindra Ltd before exceptional items and tax fell to Rs290.94 crore in the March quarter against Rs308.34 crore in the year-ago period. That’s no surprise—the company was in any case expected to show a decline in net profit during the quarter and the impact on the stock was minimal on Wednesday.
Earnings before interest, depreciation, tax and amortization increased by 12.4% on the back of a 16.4% rise in net sales. Higher interest costs impacted profits. The company’s debt-equity ratio went up to 0.60 at the end of fiscal year ended 31 March, compared with 0.46 a year ago, so there’s potential for further leverage, needed for its ambitious expansion plans.
As expected, margins were under pressure, with operating profit margin dipping to 10.9% in the fourth quarter from 11.3% in the third.
The management points out, however, that the lower margin was not because of rising raw material costs,but on account of exchange rate fluctuations during the year.
In the automotive segment, revenues rose by 16.3% in the fourth quarter and by 17.7% for all of FY08. The tractor segment saw a volume de-growth during the year, as well as other problems such as rising non-performing assets and material inflation.
Growth in exports, however, was 13.4%. Together with strong growth in power generating equipment and engines, that helped the segment show positive profit and revenue growth in the single digits for the year. Combined sourcing with subsidiary Punjab Tractors Ltd helped keep costs down. Inventories have been cut down drastically from six months to one at Punjab Tractors, while there has been a significant decrease in receivables.
Net profits at Punjab Tractors have been around the same level as in the previous year. The company expects a growth of 5% in the tractor segment this year.
The management was at pains to emphasize, however, that the value created in group companies has been higher than that created in the stand-alone company. There’s little doubt about that—for the full year, while profits before tax and exceptional items of the stand-alone company fell 5.6%, profits before tax and exceptional items for the consolidated entity rose by 20.9%. Another way of looking at that is to consider the growth in investments—in the FY08 balance sheet, for example, investments have increased from Rs2,237 crore to Rs4,215 crore.
The management points out that out of the stock’s current value of around Rs645, as much as Rs400 is on account of the subsidiaries, which means that only about Rs245 is on account of the automotive and tractor business.
That gives a price-earnings multiple of 5.9 on trailing stand-alone earnings, which shows the concerns about low growth, higher raw material prices and a large capital expenditure programme are already discounted.