Until 28 May, Tata Motors Ltd’s shares were slightly better off than the rest of the market. They had declined by 17% since January, while the National Stock Exchange’s Nifty index had dropped 20%. That, of course, needs to be seen in the backdrop of the stock’s performance in 2007, when it fell by 20%, even while the Nifty rose by more than 50%. Still, Tata Motors’ shares did rather well for the large part of this year, despite rising interest rates, escalating costs of the Tata Nano project and the daunting task of integrating the Jaguar-Land Rover (JLR) business acquired by it.
(FUNDING ISSUES) On 28 May, Tata Motors announced that it would be diluting equity significantly to fund the JLR acquisition, rather than raising most of the funds through debt. The markets haven’t taken kindly to this and as a result, Tata Motors’ shares have dropped 37% since, more than double the rate at which the Nifty has dropped.
The stock’s massive underperformance since 2007 is more or less being justified by the company’s financial performance. Last year, operating profit fell by 9% and things seemed to be getting progressively worse, going by the 15% drop in operating profit in the March quarter.
The company’s recently released annual report gives little reason for cheer. Cash generated from operations jumped 140% to Rs6,471 crore, but only because of a large drop in receivables in the financing business and a huge jump in trade payables (creditors). According to an analyst, these factors aren’t sustainable, which means cash flow from operations could revert to FY07 levels. There was a large 79% increase in capital expenditure to Rs4,411 crore and, but for the unusual decrease in working capital, Tata Motors would have ended up with negative free cash flow. (Free cash flow is defined as cash flow from operations minus capital expenditure.)
JLR has much higher capital expenditure requirements than Tata Motors and could strain free cash flow going forward. Needless to say, negative free cash flow will necessitate fund-raising. Note that the Tata Motors’ stock has shed 37% in value since the announcement that it will raise Rs7,200 crore through rights issues and another $500-600 million (Rs2,160-2,590 crore) through an international offering of equity/equity-linked instruments. At the time of the announcement, the dilution was estimated at 30-35% in the current fiscal year and another 12% in three-five years’ time.
With the current traded price being much lower, the dilution could end up being much higher, hurting sentiment further. In that sense, Tata Motors seems to be in a vicious circle, where its falling share price is making funding more expensive, which in turn is further hurting sentiment for the stock. It’s no wonder the shares are near a three-year low.
The 1970s’ oil shock plus additional risks
It’s not only this column that’s increasingly becoming obsessed with drawing parallels with the oil shock of the 1970s that reverberated into the 1980s. Lehman Brothers’ Global Strategy Weekly dated 27 June points out that if oil prices continue at around $140 (Rs6,048) a barrel for the rest of the year, “the world will once again spend nearly 7% of aggregate GDP on oil, a return to the peak levels of expenditure seen in the early eighties”. Stung by high prices, developed nations took several steps to reduce their dependence on oil, as a result of which their oil consumption per unit of GDP fell. Now that most of the demand is coming from emerging markets, oil consumption as a percentage of global GDP is back to the level of the 1980s.
What’s interesting is that level proved to be a tipping point for global growth in the 1980s and is proving to be the same this time around.
The research note goes on to say: “If we examine the 1980s’ analogue, given that the overall effect of higher crude prices (as a percentage of global GDP) is on a par with the current environment, then it is clear to us that the rise in crude between 1978 and 1980 was accompanied by higher stock markets, but once growth slowed, stocks fell by 17% (peak to trough), between April 1981 and March 1982, subsequently recovering as growth resumed.” The reason: valuations were low relative to the risk-free rate, or, in other words, the equity premium was low. This time too, the initial rise in oil prices was accompanied by higher stock prices and it is only in the past few months that higher oil prices have led to slower growth. The note says that this time, although the impact of high oil prices is unlikely to be of the same magnitude, the equity markets are pricing in a similar shock.
But surely it’s clear to everybody that the difference is that this time we have more than high oil prices to worry about. It’s a bit unusual that although Lehman Brothers is in the middle of a credit markets storm, the note does not raise the possibility that the credit crunch and the housing downturn in several countries are additional risks that didn’t exist in the 1980s and hence are supplementary reasons to be bearish on equity markets.
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