Tyre Stocks Not Tired Yet

The size of the Indian automobile tyre industry is around Rs 50,000 crore and six major tyre companies command a market capital of about Rs 37,000 crore. The tyre stocks created a phenomenal wealth in 2014. For example, the stock price of JK Tyre moved up by 770 per cent from Rs 92 in 2013 to Rs 800 and that of CEAT went up by 1,119 per cent from Rs 82 to Rs 1,000. In fact, the share price of MRF has gone up by ~2,600 per cent or 27 times in the last seven years from a low of Rs 1,535 to Rs 42,500.

So what helped such wealth creation from the tyre stocks? The unprecedented run in the tyre stocks can be attributed to the benefits which they received due to the steep fall in the core input prices such as natural rubber and crude oil which in turn helped the companies to expand their operating margins substantially. The natural rubber prices fell 31 per cent from its peak of Rs 164 per kg in January 2014 to Rs 114 per kg in December 2014. Similarly, the crude oil price fell 47 per cent from its peak of USD 101 a barrel in January 2014 to USD 53 a barrel in December 2014, a fall of ~47 per cent from its peak. This crash in the raw material prices helped tyre companies to post phenomenal rise in their profits, which in turn resulted in solid gains for the investors of tyre stocks. The stock prices moved up as high as 1,000 per cent despite automotive sales remaining subdued in 2014.

Under Pressure in 2015

After this extraordinary run-up, tyre stocks came under pressure and got corrected by around 25 per cent to 50 per cent in 2015. Smart investors booked profits in December 2014 or early 2015 as both the prices of natural rubber and crude oil started firming up and reports of Chinese dumping tyres into India started making the rounds.

• Rubber prices moved by as much as Rs 19 per kg or by 17 per cent from the year’s bottom of Rs 114 per kg to trade at the year’s peak at Rs 133 per kg during the summer. Rubber prices in our view always move up significantly during the summer period as rubber tapping gets affected and there is a supply constraint. 
  Crude oil prices also recovered as high as 42 per cent from the bottom of USD 47 a barrel to USD 67 a barrel in 2015.
• After the US implemented restrictions on Chinese tyre imports, the Indian and the African markets got flooded with Chinese tyres. Import of truck and bus radials (TBRs) surged 60 per cent in FY15 to 7.8 lakh units compared to 4.9 lakh tyres in FY14 and of these China accounted for 70 per cent of them. About 25 per cent of the domestic replacement demand of TBRs is met from imported tyres from China as China’s manufacturing capacity for TBR is 120 million units while its domestic demand is 60 million units. 

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Tyre Stocks to Create Wealth Again
In our view, these steep corrections in the tyre stocks provide an opportunity to revisit them for investments. Our conviction to revisit the tyre stocks comes from the following reasons: 

• The market for the tyre industry is characterized as oligopolistic – i.e. practically the tyre market is controlled by about top four leaders. They account for about 3/4th of the total market. Due to the oligopolistic nature of the markets and brand positioning, the tyre majors would be able to avoid any steep erosion in the product prices. We believe that the government may also impose some restriction on cheap import of tyres into the country.
• Crude oil prices are still down by ~40 per cent from its peak and even benefit of cheap oil is expected to continue for at least the next two years as the Energy Information Administration of the US expects the oversupply of crude oil to continue till 2017. In fact, many international analysts predict that the oil glut could be permanent as the energy-intensity (amount of energy needed to generate a unit of GDP) of developing countries is falling rapidly. For example, China’s energy-intensity has halved over the last 30 years. Hence, in our view tyres makers will enjoy the benefit of low crude prices in terms of low cost for the procurement of synthetic rubber and other petrochemical inputs, which are derived from crude oil.
• The natural rubber prices firmed up recently due to summer as the tapping of rubber gets affected in this season. However, with the onset of good monsoon they have again started falling. After reaching its recent peak of Rs 133 per kg, prices have fallen by Rs 5 per kg and currently trade at Rs 128 per kg. On a YoY basis, the natural rubber prices are still down by 9 per cent from Rs 141 per kg in July 2014 while it is down by 22 per cent from 2014-year peak price of Rs 165 per kg. We expect the rubber prices to fall significantly during the monsoon period.
• In the last two years the tyre companies benefited by cheap raw materials while the automotive sales remained poor. In our view, in the next two years the tyre companies would be benefited by the renewal of growth in the automotive sector. In fact, the global rating agency Moody’s has recently indicated that the Indian companies, particularly those from the transport, metals and automotive industries, are well-placed to benefit from economic recovery in the next 12 to 18 months which would be enabled by the government’s push for reforms, lower interest rates and weaker commodity prices.

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Two Top Picks in the tyre space

We suggest JK Tyre, the cheapest tyre stock and MRF, a leader in the industry for wealth creation in the future.

MRF Ltd:

MRF has emerged as the largest player in the domestic tyre industry - its topline has grown bigger than that of Apollo Tyres. MRF enjoys a dominant position in the replacement market with replacement sales attributing to about 75 per cent of its revenues. We believe that the replacement market will continue to be strong over the next couple of years and this is also apparent from the fact that almost 70.72 lakh passenger vehicles (cars and utility vehicles) and nearly 19 lakh commercial vehicles (medium, heavy and light) have been added to the Indian roads during FY11 to FY13 whose tyres will be due for replacement (as car tyres are replaced on an average every third year) in the near future, thus giving tyre manufacturers a decent business opportunity. In case, the automotive industry doesn’t recover, there is still some comfort for this company. However, if the automotive sector improves along with the economy, then MRF can get good short-term triggers from sales to OEMs.

In the last six years its revenue has grown from Rs 8,000 crore in FY09  to Rs 15,000 crore in FY15 (September ending, estimated) – a jump of 87 per cent and trades at around 10x its FY15E EPS of Rs 3,300, which is quite attractive. Now MRF is even planning to invest over Rs 4,500 crore in two of its tyre factories in Tamil Nadu. The investment will be made at its factories in Perambalur and Arakonam over the next seven years as part of its expansion plan. This is a substantial investment in its own history.With the new capacity, if it grows its revenues even by just 12 per cent per annum, its revenue base can double to Rs 30,000 crore in the next six years. It had a net profit margin of 9.6 per cent in the first half of the current year. Despite economies of scale benefits, if we assume lower net PAT margin of say 8.5 per cent in 2021, the net profit should be around Rs 2,550 crore and the same would give an EPS of Rs 6,071. Assuming 12 PE, one may hope for a target price of Rs 72,000 in six years

However, we see a larger scope for PE expansion for MRF in the next six years:

• The stock exchanges might advise the promoters to dilute the equity considering the base price of the stock as at the current market price of MRF is not affordable to many retail investors.
• A tyre major, and that too a branded company, crosses a turnover of Rs 20,000-25,000 crore, it will start commanding much higher PE. A good example is Ultratech Cement – its consolidated revenue for FY15 is Rs 24,000 crore and it commands a PE of 39 on its FY15 consolidated EPS. Investors would not have believed this story of PE expansion about five years ago for a commodity business like cement! Just imagine, if MRF also crosses Rs 25,000 crore of turnover and has its PE expansion to 20 in the next six years, the price can go up as high as Rs 1,21,000. We are not projecting this kind of price of MRF – we are only projecting our sensitivity analysis.

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JK Tyre Ltd:

JK Tyre, India’s market leader in truck and bus radial tyres (TBR), commands a ~34 per cent share in the segment. Its focus on the TBR segment results in ~80 per cent of its revenue accruing from the commercial vehicle tyre sub-segment. It has a network of 138 selling locations and 4,000 dealers which are served by six plants in India and three plants in Mexico through its subsidiary JK Tornel. With state-of-the-art modern production facilities in all its nine plants, JK Tyre has a total production capacity of over 20 million tyres per annum.

Here are some salient factors in its favour:

• The stock price of more than the five-decade-old branded tyre company trades at a mere 5.7x FY15 consolidated EPS of Rs 15. The stock price has corrected by 47 per cent from its 52-week high.
• The net profit for the quarter ended March 31, 2015 has gone up by 136 per cent to Rs 105.96 crore as compared to Rs 44.96 crore in the same quarter previous year. However, net sales for the quarter were down by 6 per cent to Rs 1,789.49 crore as compared to Rs 1,895.62 crore.
• Operating profit of the company grew 43 per cent YoY to Rs 212.86 crore from Rs 149.2 crore aided by low raw material costs. The management has indicated that it has improved operational efficiency, including power conservation.
• While the segment profit from its India operations has gone up 41 per cent YoY, the same from Mexico has gone up 35 per cent YoY.
• The expansion at JK Tyre’s TBR and PCR categories at the Chennai tyre plant, at a cost of Rs 1,430 crore, is progressing as planned. This expansion is slated for completion by mid-2015. In our view, this domestic capacity expansion is coming at an appropriate time of anticipated turnaround in the automobile sector.
• Demand in Mexico for replacement market tyres is poised to grow at nearly 7.5 per cent a year over the next three to five years, according to a new market study from Frost & Sullivan Inc. Strong local vehicle sales and a growing economy have increased the size and purchasing powers of Mexico’s middle-class population, Frost & Sullivan said, and are driving the aftermarket tyre market growth. Poor road conditions in some areas of the country also help to increase the tyre replacement rate. JK Tornel’s expansion of PCR capacity by 50 per cent is also on its way to completion and the company shall have the benefit of increased production in the coming months. Hence, we believe that JK Tyre’s Mexican business will improve significantly going forward.

JK Tornel, Mexico: Impressive Performance Continues

JK Tyre acquired JK Tornel, a Mexico-based tyre company, in 2008 at a cost of about Rs 270 crore. At the time of its acquisition, Tornel had a turnover of Rs 800 crore – the same has gone up more than two times in FY14 at around Rs 1,700 crore. Quite interestingly, the segment profit from this Mexican operation in the last 24 months (FY14 and FY15) alone stands at Rs 354 crore as compared to its acquisition cost of Rs 270 crore! With penetration into OEMs like Nissan, Chrysler and Volkswagen, the business profile and market share are likely to improve in both Mexico and North American export markets. Mexico remains one of the largest export hubs for the North American market. Tornel is thus increasing capacity by ~25 per cent (45 TPD PCR).

The CV tyre segment is clearly witnessing a secular radicalization trend with the share of radial tyres in the M&HCV segment increasing from 4 per cent in FY07 to ~29 per cent in FY14. Penetration of truck and bus radial tyres in the OEM segment is ~55 per cent while the replacement segment radicalization currently stands at ~25 per cent. JK Tyre’s market share in India in the M&HCV TBR segment is greater than 30 per cent and in the passenger car radial segment greater than 12 per cent. Going forward, as radicalization in the truck and bus segment increases rapidly, we believe JK Tyre would be a major beneficiary leading to higher capacity utilisation levels in the TBR space.

With net debt levels appearing to have hit a peak and likely to ease downwards, we believe the major concern on leveraging is likely to be alleviated. Post FY16E, strong free cash flow generation makes us positive on the business as the next phase of growth begins. In the last two years, tyre stocks played out mainly on account of fall in input prices as the automotive sales in the country remained subdued.

The stock price of JK Tyre has come down by ~48 per cent from its 52-week high of Rs 163. This correction provides some added comfort on tactical ground. At the current market price of Rs 86, the stock trades at 4.9x FY16E EPS of Rs 17.5 and 4.3x FY17E EPS of Rs 20. Hence, we recommend a ‘buy’ on the stock with a target price of Rs 170 (conservatively assuming 8.5x FY17E EPS of Rs 20) in the next two to three years.