The Tata Motors Ltd stock has been among the major beneficiaries of the liquidity-induced rally in the stock markets. The shares have more than trebled compared with the lows earlier in the year. It’s true investors were too pessimistic early in the year, but at current levels, there seems to be far too much optimism.
Investors have been enthused about the strong margins of the domestic business in the June quarter, the fact that the company has been cutting costs at Jaguar-Land Rover (JLR) and also that there has been some ease in the acquired firm’s financing situation lately.
But are these factors good enough reasons to justify the firm’s current valuations? The optimistic analysts on the Street expect JLR to break even in the next fiscal year because of the company’s current cost-cutting measures. But this is also based on the assumption that volumes will pick up next year.
Currently, volumes continue to fall at a fast pace. In a recent report, India Infoline Ltd’s institutional equities desk points out that JLR’s volumes have fallen by 40% between January and July this year. There hasn’t been any recovery in volumes in recent months.
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Even if one were to go with the assumption that JLR’s volumes will pick up next year and come back to levels that will support a break-even, it must be noted that the firm will still be burning significant cash for a few more years. Based on thenumbers the firm reported in May this year, JLR was burning cash at an annualized rate of $479 million (around Rs2,330 crore today).
Now, even though the domestic business is doing better than it did in the second half of the previous fiscal year, it will be a while before performance comes back to the levels the company had attained in FY08. Back then, the domestic business had thrown up free cash flow of about Rs1,700 crore. (In FY09, even the domestic business burnt cash at a high rate owing to the slowdown.)
With JLR expected to continue burning cash for a prolonged period, the company would very likely have to raise more debt or would have to dilute its equity. From a current equity shareholder’s point of view, that’ll clearly be negative.
But investors seem to be ignoring these concerns because of the high beta the Tata Motors’ stock enjoys. Beta is a measure of a stock’s volatility; the higher it is, the more volatile a stock.
In a liquidity-led rally, high beta stocks do much better, and Tata Motors’ shares have indeed delivered superior returns in the past few months.
But the reverse is also true and when the market reverses, losses are the highest in high beta stocks. Considering that valuations are rather stretched, (the stock trades at about 33 times estimated earnings for FY11, according to India Infoline estimates), the pain could be considerably high.
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