Alice’s Dialogue

Lucas’ Dialogue

Your Thoughts

Lucas, please share your thoughts with the committee.

I’ve been doing work on Tonda Motor Company for the past 3 months and have decided to initiate coverage with a buy rating. My $30 price target is 20% above the stock’s $25 closing price. I get to my target by applying a 10x P/E multiple on my forecast of $3.00 for next year. The reason for the upgrade is based on a meeting I had with the company’s management about a month ago. I went to their headquarters with a sell-side analyst and a few other buy-side analysts, where we heard management tell us it’s comfortable with the consensus estimate for this year and next, which are currently $2.77 and $2.98, respectively. During the meeting, they reiterated points made during their last investor day, by showing us some of their upcoming new car and truck models and saying their preliminary research suggested they are going to be hot sellers.

Thank you, Lucas. What are the critical factors that will move the stock from $25 to $30?

I suspect the market doesn’t believe in the $2.98 EPS consensus estimate, or maybe it doesn’t understand how well the new models are going to sell.

What research have you done to confirm these views?

I’ve read all of the company’s regulatory filings for the past 3 years and reviewed the quarterly transcripts from the past 4 quarters.

Have you spoken to anyone about your view? Specifically, this notion you have that the market doesn’t believe in the $2.98 estimate?

No. But I have a gut feeling I’m right.

What are the catalysts that will bring the market around to your thinking and drive the stock from $25 to $30?

Hmmm…maybe when the new models start selling really well, the market will get excited.

Can you show us your earnings model?

Yes, I’ve printed copies of the basic earnings model that shows my forecast for everyone.

Lucas, this model is formatted like those I see from Morningstar. Did you create this on your own?

I used Morningstar’s model but made a few changes.

Such as?

I have Tonda’s pricing improving slightly more than their forecast.

How does the pricing assumption relate to your investment thesis that Tonda’s cars are selling better than expected?

I guess if the cars are selling hot, that will lead to better pricing.

Lucas, where could you be wrong?

I’m sorry, I don’t understand the question.

What part of your thesis could turn out to be incorrect, and thus lead the stock to be dead money or even drop from current levels?

Well, I can’t imagine the stock going down from here, because management said on its last quarterly call that it’s comfortable with consensus expectations. Also, valuation levels seem low.

How do you draw this conclusion?

The stock has been trading between a 9x and 10x forward earnings multiple for the past two years, and right now it’s at 9x.

Is there anything else you would like to share with us?

No, that sums up my work.

Thank you, Lucas. Please stop by my office later so we can discuss.

Alice’s Dialogue

Lucas’ Dialogue

Your Thoughts

Lucas, please go ahead and present your thoughts.

Thank you. First, I want to apologize for being unprepared for my last stock call. I hope you’ll see that I’ve done quite a bit of additional work. I would like to initiate coverage of General Bavarian Motors, ticker GBM, with a buy rating and a one-year price target of $75, which would be 18% upside from last night’s close of $63.50. The buy-rating is based on the stock maintaining its current 11x forward earnings on my estimate of $6.80 per share for next year, which is about 15% above consensus expectations. I’m assuming the stock continues to trade at a 20% discount to the market’s multiple.  Based on three conversations I’ve had with sell-side analysts and three other buy-side analysts, I believe the market is overly concerned with two issues:

• Potential labor unrest by GBM’s unionized employees in Europe, who have their labor contract coming due in four months; and
• Competitive pressures in emerging markets such as China and India
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Have you done any work on these issues?

Yes. Here’s what I’ve discovered: The European labor union suffered a bad defeat five months ago when it went on strike at another company’s plant that was subsequently shut down and all of the employees lost their jobs. The union leaders are potentially going to be voted out of office by their members because so many jobs have been lost. Based on our conversation with two labor consultants, the union leadership is much more concerned about improving its members’ job security than trying to increase wages above inflation.

How does your estimate differ than consensus?

As you can see on row 35 of my earnings model, my $6.80 EPS estimate assumes labor costs rise only 4% next year, whereas most sell-side analysts have it increasing 6-7%.

And what about competition in the emerging markets?

As for China and India, we’ve read a number of trade journals that explain that lower-cost domestic start-ups are struggling to maintain quality levels as they expand, which is allowing GBM to capitalize on its higher quality products. We confirmed our thesis by speaking with two industry consultants who specialize in the emerging market auto sector. As you’ll see in row 18 of my earnings model, my forecast does not have any decline to pricing in those markets, but the average sell-side model expects it to drop 3%-5%. Under my upside scenario, the company’s higher quality could allow it to raise pricing 3%-4%, similar to levels over the past four years.

Why is the market missing these two points?

The company’s management says it’s comfortable with next year’s consensus estimate of $5.90 per share, but we believe the company is taking a conservative stance because it’s about to begin labor negotiations and doesn’t want to appear too profitable. We went back and looked at the last three rounds of labor negotiations over the past 12 years, and each time, after the negotiations are settled, the company beats numbers, presumably because management kept a lid on sell-side expectations during the negotiations.

So, what’s going to bring the market around to your thinking?

I believe once the labor agreement is reached, the company will be more vocal about putting to rest concerns about competitive pressures in China and India. Based on my estimates, the company should start to beat current EPS expectations in about two quarters and should significantly beat estimates four quarters from now. I also expect J&J Auto Quality awards to be released in three months, which should show the quality challenges of GBM’s competitors in China and India.

What are the risks to your thesis?

My $75 price target is my base-case scenario, whereas I have a downside scenario of $60 and an upside scenario of $85. The biggest risk to my thesis is if the labor negotiations deteriorate and the company experiences much higher wage inflation. There’s also the risk that the competition in China and India cut prices, which could have a negative impact, but only if the competitors can close the quality gap. For a down-side scenario, I assume labor costs rise to the company’s 10-year average and auto pricing drops 3% in China and India, which lowers my $6.80 EPS estimate to $5.75. If I apply the 10-year average relative multiple of a 25% discount to the market’s multiple on my $5.75, I arrive at a downside of $60. I’m still relatively new to this business, so I can’t say that I have 100% conviction, but I’m much more confident with this call than I was with my earlier Tonda call.