Wednesday, 12 March 2008

Company Focus – TATA Motors – Leaning on a Hybrid Leverage?

Ratan TATA and Ravi Kant have impressed both the investment community and auto-industry in the successful 3 phase turnaround of the company, the last step of which revealed the ambitious plans set out that have led Indian conglomerate to relieve Ford of 2 of its once ‘jewels in the crown’ of a bygone PAG.

Pitched against a number of PE firms throughout 2007, the TATA win was announced late in the year, the recent months concerned with hammering-out details of the deal, most important of which, beyond price and payment structure, the agreed technical, production and administration support agreements so critical to a smooth transition in this typically complex ‘carve-out’ deal.

Timing however has been less than auspicious relative to capital markets sentiment. The continued fall out the credit crunch demonstrates that worries go beyond the boundaries of sub-prime, near-prime becomes more shaky and the accompanying CDOs are continuing to hit blue-chip investment bank balance sheets, so reigning in lending and raising credit stipulations. Whilst obviously felt greatest by the US institutions (including cornerstones like Freddie Mac and Fannie May) the global credit-risk shockwave – even in arguably decoupled Asian regions – has raised the ratings sensitivities from the big 3 credit agencies. As the TATA – JLR deal was progressing we saw Moodys start to twitch about the expected TATA leverage needed to not only pay the $2bn price-tag, but also the, as then, unknown costs of integrating the 2 western automakers into the industrial fold.

Since January TATA has announced its additional funding ambition, to the tune of $3bn. That obviously well supersedes the $2bn Ford agreement, and is far higher than any basic amalgamation costs to be incurred. So the markets are asking “how exactly will the extra $1bn be used”, whilst Tata and Kant will be asking “how can we best structure the leverage and who will be most amenable?” Acting as the all-important intermediaries in finance structuring and financial instrument buyers will be Citigroup and JP Morgan. Newswire reports mention that much of the borrowed amount will be in the form of short-term bridging loans, which if is the case, is theoretically obviously expensive to TATA, especially so under present liquidity conditions, and may reflect lender’s present cautiousness in staking a greater claim in TATA here and now, though that’s not to say that longer term arrangements won’t be made as and when TATA proves its case (ie giving greater transparency) or when market nerves settle. In reality all exposed lending parties will want to:

a) spread their risk
b) maximise short term rewards and
c) create a longer-term fixed income revenue-stream
d) seek to probably use transferable & hybrid loan instruments (ie convertible bonds and income securities)

The importance and use of such dual-character hybrid securities will probably play an ever important role in what are still considered jittery equities markets and relatively illiquid money markets. Given the value extraction TATA Motors sees in Jaguar-Land Rover in addition to normative car and truck operations, it will seek to maintain as much in the way of preference shares and ordinary shares as possible, but given the present financing climate that will be hard. Hence the undoubted employment of convertible bonds; providing satisfactory fixed income (reportedly at 2pp over LIBOR in the short-term) and the requirement for a debt swap when TATA shares look set for an upturn.

Now, if we take a look at who the Citgroup and JP Morgan Book Runners are targeting as debt underwriters we can see a definite pattern emerging as the $3bn loan is split evenly in terms of the number of US & Japanese companies (if not in direct loan value terms), the remainder going to a French and (expectantly) an Indian bank:

1. Citigroup
2. JP Morgan
Additional Underwriters
3. Standard Chartered
4. Mitsubishi UFJ
5. Bank of Tokyo
6. Mizuho Financial Group
7. Calyon
8. State Bank of India

The numbers in the consortium aren’t surprising, but perhaps what is interesting, is the number of Japanese concerns that have taken the opportunity to back TATA. Given a lack of opportunity to invest into China – due to political and commercial issues - India has for many years been seen as a natural home for Japanese investment, especially so the motor-cycle and auto-industries, in which the Japanese managed to use their inherent industrial strengths in these sectors ‘re-play’ their own economic histories via the likes of Kenetic-Honda, Hero-Honda, Suzuki India, Maruti-Suzuki etc.

Beyond the historical aspect, it’s clear that within the effectively stagnant Japanese economy that Japanese institutions are keen to gain exposure to external economic stimuli, none more so than India at present. Beyond the direct financial benefits of under-pinning TATA, investment-auto-motives’ believes that there may also be a diplomatic angle that could serve to align TATA and Japanese VMs and Tier 1s & 2s, so complementing the gains made by Suzuki in its JV with Maruti and assisting the Japanese supply-base to create transplants in India for local production and export back to homeland assembly plants in Nagasaki, Prefecture 1 etc.

But what of TATA’s use of that additional $1bn?

The TATA Motor’s group spans many vehicle divisions, which themselves are broadened more so by the Jaguar-Land Rover acquisition. Without repeat the outlook provided with the pre-Christmas posting that evaluated TATA’s J-LR intentions (18.12.08), senior management has a broad remit indeed in building-up a Motors Group that operates (now) in every vehicle segment.

Integration of J-LR was never going to be as immediate as some industry commentators first thought, Ratan Tata’s recent Geneva Show comments ratifying the fact. However there will be 2 main foci for the Indian management team interfacing with J-LR and they will be:

1. Re-sourcing of low-value J-LR components from the lower cost TATA supply chain
2. Re-allocation of transferable engineering development work to TATA Technologies Ltd to exploit lower cost ‘bums on seats’ in India
3* Complete vehicle line transfer of Defender 4x4 to India

This last initiative will not have been aired for politically sensitive reasons, but the reasons to do so are powerful and alluring:

A. To act as the Iconic corner-stone in competing against Mahindra for light 4x4 Military commissions, in India and beyond
B. To provide an intermediary product between the lower-duty TL 4x4 and medium truck range, gaining parts sharing efficiencies where possible
C. To reduce Defender Bill of Material and Production Costs dramatically.
D. Free-up production space and capacity at Solihull for other vehicles.

Point C will be one of the first ‘quick wins’ for TATA, since the vehicle is essentially a 50 year old simple design that constitutes basic engineered and fabricated parts (esp BIW with high aluminium content) and possibly the most intensive hand-built labour production process in the developed motor industry. Defender in reality would have been outsourced to a low-labour cost region years ago had it not been for the military significance of the product and threat of disruption.

Beyond J-LR, the TATA cars division will need re-capitalisation as a new generation of small & medium vehicles start their R&D and engineering development process. With the Fiat marketing JV underway, it would be feasible that both companies are seriously assessing the possibility of further sharing powertrain, other high-cost modules, and very probably evaluating complete sub-structures. Such synergies could assist the development of eventually a shared Indian production base for TATA-Fiat. And given the Fiat-Ford small car connection, and the recent TATA-Ford relationship, that alliance network could grow larger still. Lastly of course the new Nano ultra-small car will require ongoing production launch and additional plant capitalisation.

Additionally, the commercial vehicle and truck ranges – spanning LCVs, MCVs and HGVs - will need updating to meet market competition, fleet operators demands and ever-pressured CO2 demands from a growing contingent of domestic lobbyists.
And as with cars, there will probably be an ongoing programme of transference of the TATA Daewoo Commercial Vehicles engineering and low-value production work into Indian facilities, lead by (and the expansion of HV Transmissions and Axles divisions)

And fittingly, given mention of voracious lobbyists, the Alternative Propulsions division has promised to deliver 2,500 AP vehicles through 2008/9. Various options are being developed and reviewed, and we suspect the 2,500 vehicles will be essentially test-bed products used by Green government and private sector fleet, many of which will be adaptions of the Ace Mini-Truck and Nano Car, whether air-propelled, ULEV forms or complete EVs using ‘compromised’ but stable battery technology (ie Ni-Hy not L-ion).

So, given the expansive ambitions of TATA Motors, the additional $1bn that markets are querying will be directed toward a plethora of evolutionary product, project and organisational needs.

Though Ratan Tata and Ravi Kant have historically provided only ‘teasers’ of their intentions, preferring big block-buster announcements as seen with J-LR and Nano, it may now be time for them to discretely metaphorically ‘open the books’, so as to demonstrate in detail the mid-long term intentions of the Group. For at the moment as far as the outside world is concerned they are sky-high aspirations, and at that level they are rather cloudy.

Provide more detail and the probability of gaining less expensive borrowing in the short term and a greater influence on the underwriting conditions of convertible bonds or such swap-based instruments could assist in putting the Group on a better financial footing. Of course that puts greater pressure on TATA to deliver, but that hasn’t been a problem over the last 5 years. “More of the same” investors will be calling, even if credit ratings agencies are perhaps being over zealous in there risk of default reporting. As ever, the role of the Chairman and CEO is to maximise the investor enthusiasm and reduce their retractable coverage to gain the best cost of borrowing, but relative to other auto-firms TATA's WACC should be lower than many.