Fitch Upgrades Jaguar Land Rover to 'BB+'; Outlook Stable

Fitch Ratings-Singapore : Fitch Ratings has upgraded Jaguar Land Rover Automotive plc's (JLR) Long-Term Foreign-Currency Issuer Default Rating (IDR) and senior unsecured ratings to 'BB+' from 'BB-'. The Outlook is Stable.

The two-notch upgrade reflects JLR's delivery on its commitment to widen and strengthen its product portfolio, increase geographic diversification, and expand capacity outside of the UK. This should provide it with greater flexibility and resilience over the medium term, which the agency considers to be commensurate with a 'BB+' rating for an automotive manufacturer. Notably the success of its entry models into new segments (specifically the Jaguar XE and initial indications for the F-PACE) while maintaining robust profitability, positive free cash flow and a strong financial profile, are considered instrumental as it transitions to become a higher-volume premium manufacturer.

We expect JLR's launch of more new and refreshed models to continue to support its sales volumes and profitability, even as it faces challenges on several fronts, including increased competition and margin pressure in the premium market in China, and continued uncertainty around the fall-out from the UK's vote to leave the EU.

KEY RATING DRIVERS

Stable Profitability: We expect JLR to maintain EBIT margins of 7%-8% in the financial year ending 31 March 2017 (FY17) and FY18. We expect profitability to be supported by JLR's core Land Rover products, continued robust sales of the Jaguar XE (compact sedan), the global roll-out of new and refreshed products including the Evoque convertible, Jaguar F-PACE (crossover), and in China the release of Jaguar XF L (luxury sedan).

In FY16, EBIT margin narrowed to 8.5% (FY15: 12.4%) on a weaker product mix and declining sales volumes in China due to a slowing economy. A drop in EBIT margin to 5.2% in 1QFY17 was mainly attributable to negative FX effects from the Brexit vote - the sterling's sharp depreciation caused an unfavourable revaluation of the company's euro-denominated payables - which more than offset the positive effects of a stronger product and volume mix. EBIT margin, adjusting for this FX effect, was 7.4% (1QFY16: 10.1%).

Strong Demand Drives Volumes: We expect JLR's Land Rover products - mainly luxury SUV's - to continue to benefit from robust demand in both developed and developing markets. JLR's successful launch of the all-new Jaguar XE and F-PACE are filling important segments where the company has previously not had a product presence.

Under our base case scenario, we expect JLR's retail volumes to increase by around 10% in FY17 from FY16. In 1QFY17, JLR enjoyed double-digit unit volume growth in all regions including China, with total retail volumes up 16% from 1QFY16. In FY16, retail volumes increased by 13% from FY15 to 521,571 units with double-digit volume growth in Europe, UK, and North America more than offsetting a decline in China (down 16%).

Capex to Remain High: We expect JLR's investments in capacity expansion, engine manufacturing, vehicle architecture and new technologies to meet carbon emission requirements to contribute to negative FCF in FY17, despite strong cash flows from operations. However, we expect the company to post positive FCF in FY18. Investments include a new manufacturing facility in Slovakia with an initial capacity of 150,000 units that is targeted for completion by 2018.

Robust Financial Profile, Liquidity: We expect JLR to maintain a strong financial profile and ample liquidity buffer in FY17-FY18. FFO-adjusted leverage will remain at or below 1.0x and FFO-adjusted net leverage at or less than 0.0x (FY16: 0.8x and -0.1 respectively). At 1QFY17, JLR had strong liquidity, with cash and cash equivalents of GBP2.4bn (FY16: GBP3.4bn), short-term liquidity deposits of GBP1.3bn (FY16: GBP1.3bn) and committed undrawn facilities of GBP1.9bn maturing in 2020.

Limited Scale, Product Diversity: JLR's scale and range of products are smaller than its premium-segment peers, which raise the risk of volatility in earnings and cash flow, and constrain the business profile. However, JLR's recent heavy investments are increasing its product breadth and volume, thereby helping to diminish this business risk.

Geographic Diversification: JLR's efforts over the last five years have helped it to achieve a more balanced geographic mix, with around 60% of retail sales volumes outside of UK and Europe. JLR's growth in China has been rapid and it is the fourth-largest automaker in the premium segment by volumes after Audi, BMW and Mercedes.

Fuel Efficiency Requirements: Tightening carbon dioxide 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. However, a further broadening of its product line to include more compact, fuel-efficient models would reduce its exposure to the risk of evolving environmental legislation.

KEY ASSUMPTIONS

Fitch's key assumptions within our rating case for the issuer include:

- Retail sales volume growth of around 10% in FY17
- EBIT margin of 7%-8% in FY17-FY18
- Capex of GBP3.7bn in FY17 and GBP3.2bn in FY18 (FY16: GBP2.8bn)
- Dividends remain modest at GBP150m per year in FY17-FY18 (FY16: GBP150m)

RATING SENSITIVITIES

Positive rating action is unlikely in the medium term given the need for a substantial increase in scale to achieve a transition to investment grade. However, a positive rating action may result if the company materially increases the volume and breadth of its products, while maintaining profitability and a strong financial profile.

Negative: Future developments that may, individually or collectively, lead to negative rating action include:

- Deterioration in key credit metrics including FFO-adjusted net leverage above 1.0x on a sustained basis (FY16: -0.1x) and a material weakening of JLR's liquidity position;

- Problems with operational execution and/or decreasing market share