Shift in diesel demand or higher scrutiny/stringent emission norms may lead to higher R&D cost for JLR: Diesel cars contribute c50% of global and c80% of European sales for JLR (Jaguar Land Rover) and the company is on track to achieve the 2020 CO2 emission targets. A decline in diesel demand may put pressure on this target as gasoline cars emit 15-20% higher CO2. This may lead to higher R&D spend and cost of compliance for JLR. Further, stricter emission tests to offset cycle-bypassing (if come into effect) may further add to the R&D intensity and may lead to higher cost of cars as well. This is an incremental risk for JLR’s already stressed cash flows.
Monthly volumes could easily ramp-up by c30% over the next few months: The management expects volumes of 500,000 in FY16 (vs 467,000 in FY15). This means a sharp pull up in volumes in 2H. Average monthly sales could improve from the current 35,000 per month to 45,000 as XE/XF launches ramp-up in US/China and local production of Discovery sports picks up in China, in our view. Management continues to believe Ebitda (earnings before interest taxes depreciation and amortisation) margins can be sustained in the range of 14-16% in the long term. We are currently forecasting 15% margins for FY16/17. The downside risk to these margins is sharp discounting on Range Rover or RRsports. However, the operating leverage benefit could be significant as well and therefore we are comfortable with the mid-range of the guidance (remember gross margins were near alltime high in Q1 suggesting the upside from operating leverage).
We revise downwards our FY16/17 Ebitda forecasts by c5% (largely driven by margin cuts), but remain Buy on undemanding valuations, even on the revised estimates. Impending product launches will be the stock trigger over the coming months.
In this note, we discuss the potential fall-out for JLR from structural dip in Diesel engine demand and a likely increase in scrutiny/ procedures for emissions (reduce the gap in the lab emission test results and the real-life on road emissions).
Diesel demise + Strict emission tests = Higher R&D for JLR
Have diesel engines lost the charm and will they slowly be wiped out in the long term?
The question if diesel powertrains will be totally displaced by EV (electric vehicles) is long drawn and outside the scope of this note. Eventually, there may be only EV cars in a decade or so but that would have happened anyway, despite the VW episode. Also, in the long run, more catalytic converters will have to be added (making a diesel car more expensive) and the gasoline engine will also become more efficient. Hence, we believe diesel penetration rates will decline in the future, although this should still take some time.
Strict testing procedures may also demand higher R&D resources and increase in cost of car as well
Assuming stricter regulations are introduced, this may lead to higher R&D cost for OEs like JLR as well, unless regulators relax the CO2 targets. This will impact all, but it is a bigger issue for JLR considering the already strained cash flows over the next few years. Based on our revised estimates today and the capex guidance by JLR, the company will have a negative FCF of cGBP700m in FY16 and may be just about break-even in FY17. Assuming R&D investments are increased by 20%, this will mean negative FCF of cGBP1 bn in FY16 and cGBP200m in FY17. This is a potential risk.
Positively, we feel the risk to overall capex is low even if R&D goes up
While higher R&D may be on the cards, we expect capex on plant and capacity expansion to come down. By the end of this year, JLR should have capacity, which suffices FY18/19 volume targets (even if we assume China capacity is not fungible). In the worst case, overall capex may remain the same (in absolute terms) and come down by c400bp as percentage of revenues in two years. In the past three years, the company has spent nearly GBP9.3 bn on capex (FY14/15/16). Nearly 55% of this is on plant and machinery (capacity expansion) and remaining 45% was on R&D.
By the end of this year, the total capacity of JLR will be around +700,000. At our current estimates this capacity will break even only by FY18/19 (even if we assume China capacity is not fungible).
Additionally, some of the one-time large investments like the engine plant (Ingenium) should come down gradually over the next 2-3 years as the company builds capacity across multiple engines. Consequently, capex on tangible assets should come down going forward. Worst case, absolute capex will remain flat but will still come down as percentage of sales in the coming years. We expect at least 400bp decline in capex intensity (capex to sales ratio) by FY18, from FY15. Further, just for reference, in the past 10 years, BMW has spent CEUR70 bn on total capex and of that 48% was for capacity expansion and 52% on R&D. Averaging across Daimler and Audi, on an average past 10 years, nearly 55% of the total capex has been invested in R&D. Compared to that for JLR in the past 2-3 years, c45% of the total capex has been on R&D, which means the spend on capacity expansion has been higher than usual, considering the high growth phase of JLR.
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