Fitch Revises Jaguar Land Rover’s Outlook to Negative; Affirms at ‘BB+’

Fitch Ratings - London - 13 September 2018: Fitch Ratings has revised Jaguar Land Rover Automotive plc's (JLR) Outlook to Negative from Stable, while affirming the Long-Term Issuer Default Rating (IDR) and senior unsecured rating at 'BB+'.

The Outlook change reflects Fitch's projections of further negative free cash flow (FCF) in the next two years before gradually recovering to positive from end-financial year ending 31 March 2021 (FY21). The ratings may be downgraded if Fitch has reason over the next six to 12 months to believe that JLR's FCF is not improving according to our projections.

KEY RATING DRIVERS

Falling Profitability: Higher production and labour costs burdened JLR's profitability but margins were particularly impacted by rising depreciation costs from recent investments. Adjusted EBIT margin fell further in FY18 to 1.6%, from 4.8% in FY17 and 12.4% in FY15 despite increasing revenue. Depreciation will continue to weigh on profitability but we expect this to be partly offset in the medium term by improvements in productivity and savings in the manufacturing process.

We project the EBIT margin to increase moderately to around 2% in FY19 and to recover gradually to 5%-7% through to FY22.

Investment Burdening FCF: The expected benefit on profitability from lower investment in the next two to three years dedicated to production expansion is being offset by JLR's increased focus on electrification, autonomous driving and shared mobility. In particular, the recently-launched I-Pace has gathered positive reviews and customer interest, but it is a drag on group profitability and cash generation. FCF fell significantly in FY18 to negative 4.2% and we expect a further decrease to around negative 6% in FY19.

Higher spending in 2019-2021 than in our previous assumptions will keep FCF in negative territory until at least 2020 in our projections. Nonetheless, Fitch expects these investments to bolster the group's business profile by improving the manufacturing footprint outside of the UK and by enhancing JLR's agility to respond to key sector trends.

Material Brexit Risks: The group sells about 20% of its vehicles in both continental Europe and the US, but builds them quasi-exclusively in the UK, making it particularly exposed to Brexit issues and risks related to potential increased global tariffs. New assembly plants in Slovakia and Brazil and the use of a subcontractor in Austria should somewhat ease the production imbalance in the medium term but the group remains heavily at risk in the short-term. A disorderly Brexit may significantly disrupt the group's supply chain and ability to manufacture and then sell its vehicles, in turn putting additional pressure on earnings and cash generation compared with our current projections.

Robust But Weakening Financial Metrics: The combination of declining funds from operations (FFO) and higher debt led JLR to move to an adjusted net debt position at end-FY18 from an adjusted net cash position at end-FY17. FFO adjusted net leverage was 0.1x at end-FY18, compared with negative 0.2x at end-FY17 and we expect further deterioration to around 0.5x-0.6x in the next two to three years. However, although such levels are weak they remain commensurate with the ratings.

Limited Scale and Product Diversity: JLR's scale and range of products are smaller than premium- segment peers', which raises the risk of volatility in earnings and cash flow, and constrains the group's business profile. However, JLR's recent heavy investments are increasing the group's product breadth and volume, thereby helping to diminish this business risk. The group also benefits from its brands' solid reputation and history and, notably, Land Rover's undisputed market position and track record in the booming SUV segment.

Geographic Diversification Improving: JLR's efforts over the last five years have helped the group achieve a more balanced geographic mix, with over half of retail sales volumes outside of Europe. JLR's growth in China has been rapid and the group is the fourth-largest automaker in the premium segment by volume after Audi, BMW and Mercedes.

Fuel Efficiency Requirements: Tightening emission requirements in both developed and developing countries remain a challenge for JLR as its product portfolio is currently weighted towards larger, less fuel-efficient SUVs. JLR's product portfolio is also heavily biased towards diesel, which accounts for just less than 90% of JLR's sales in Europe, while sales of diesel powertrain are falling in Europe. The group is increasing flexibility through its new modular platform and is broadening its product line to include more compact, fuel-efficient models but material uncertainty remains about the speed and extent of powertrain shift, notably in Europe.

DERIVATION SUMMARY

JLR competes in the profitable premium segment with Daimler AG's Mercedes (A-/Stable), BMW AG and the multi-brand Volkswagen AG (BBB+/Stable), notably Audi, but it lacks the scale of its much larger German peers. The limited product portfolio and lower diversification of JLR are a constraint on the ratings, but its model range is expanding and JLR has been building up its product track record in the past three to five years.

Profitability and cash generation have historically been stronger than its mass market peers' - Fiat Chrysler Automobiles N. (FCA, BB/Positive), Peugeot S.A. (PSA, BB+/Positive) and Renault SA (BBB/Stable) - and have been in line with German premium manufacturers'. However, the profitability decline in FY17-FY18 is putting JLR at a disadvantage compared with its main peers as JLR is currently undergoing a period of challenges and significant expansion, both with respect to capacity and product range, resulting in negative FCF and lower margins than its through-the-cycle average.

JLR's capital structure is solid with consistent FFO adjusted gross and net leverage in recent years of around 1x and breakeven, respectively, comparable to Daimler's and VW's. Renault's and PSA's leverage have declined to similar levels as JLR's, after significant debt increases following the 2008- 2009 industry crisis and 2010-2012 recession. However, Fitch believes JLR's capital structure has been more stable and consistent through the cycle.

KEY ASSUMPTIONS

- Revenue falling by around 5% in FY19, notably from deterioration in the product mix, before recovering by mid- to high-single digits through to FY22

- Moderate increase of the EBIT margin to around 2% in FY19 and gradual recovery to 5%-7% through to FY22

- Capex maintained at GBP4 billion-GBP4.5 billion

- Pay-out ratio remaining at 25%

RATING SENSITIVITIES

Developments That May, Individually or Collectively, Lead to Positive Rating Action

- Further product diversification and an increase in scale towards GBP30 billion-GBP40 billion revenue,

combined with additional positive track record in maintaining robust profitability and financial structure

- Operating margin above 6%

- FCF margin around 1.5%

- FFO-adjusted net leverage below 0.5x

- Refinancing of maturing bonds for a higher amount to compensate for the expected negative FCF Developments That May, Individually or Collectively, Lead to Negative Rating Action

- Deterioration in key credit metrics including FFO-adjusted net leverage to above 1x on a sustained basis

- Material weakening of JLR's liquidity position

- Problems with implementation of new product introduction and production footprint expansion or decreasing market share

- Sustained negative FCF

LIQUIDITY AND DEBT STRUCTURE

Healthy Liquidity: At end-June 2018, JLR reported cash and cash equivalents of GBP1.3 billion, short-term liquidity deposits of GBP1.5 billion, and committed undrawn facilities of GBP1.9 billion maturing in 2022. Total reported debt at end-June 2018 was GBP3.9 billion, including GBP0.7 billion of short-term maturities, before adjustments of GBP0.7 billion for operating leases and GBP0.5 billion for restricted and cash deemed not fully available to account for intra-year working capital volatility.

SUMMARY OF FINANCIAL STATEMENT ADJUSTMENTS

Fitch adds an 8x multiple of lease payments to debt, resulting in a GBP0.7 billion debt adjustment in FY18.

Fitch treats GBP0.5 billion of cash (equivalent to 2.5% of sales) as restricted for working capital and operating needs.

Fitch adjusts debt by GBP41 million to reflect the fair value of debt.

Additional information is available on www.fitchratings.com