Apollo Tyres: Will It Go The Distance?

Duncan Fletcher, the current coach of the Indian cricket team, was appointed in 2011 right after the triumph of the team in the World Cup cricket championship. Fletcher replaced a highly successful Gary Kirsten. Naturally, the weight of expectation mounted on him. But what followed was that India forfeited its top spot in test cricket, met with crushing defeat in a series in England and was also whitewashed in Australia.

The pressure was now on the BCCI to remove the failed coach and bring back confidence in the squad. But what the board did was unexpected – it extended Fletcher’s contract by a year. The rest is cricketing history. The coach justified the faith reposed in him, and delivered the goods by leading India to a win in the prestigious Champions trophy. This story from the world of sports comes with an important lesson, that all things require time to deliver results.

At the current juncture, the management of Apollo Tyres would be feeling the jitters just like the Indian cricket coach felt in the earlier part of his stint. Recently, the stock has been hammered by 39 per cent within a period of just nine trading sessions. Brokerage houses are still busy downgrading the stock, while dealers are not tired of punching the sell orders. The stock’s downward spiral has not yet stopped, and no one knows where the bottom is. Some may be eyeing the possibility of bottom fishing in the counter, while many would be seeing an opportunity to short sell the stock. Already, Rs 1754 crore has been wiped out of the company’s market cap (including Rs 760 crore from promoters).

So, where does this stock stand at the moment? What went wrong and what does its future course look like?

The Cooper Acquisition

Ambition is the core of growth, and without ambition it is hard to even survive. Back in 2012, Apollo Tyres had set an ambitious target of figuring among the top 10 tyre makers in the world and achieve a revenue target of USD 5 billion by around 2017. This would require the company to achieve a CAGR of about 20 per cent in revenues, which looked difficult considering the sluggishness in the auto market worldwide. There seemed no other way but to grow inorganically.

To pursue this goal, Apollo Tyres had been looking to acquire the US-based Cooper Tire & Rubber Company, the 11th largest tyre manufacturer in the world. Its first attempt last year failed. The second attempt in June 2013, however, proved fruitful. To achieve its target, Apollo is paying USD 2.5 billion (Rs 14750) crore in cash to the shareholders of Cooper. This is at a 40 per cent premium on the weighted average price of the latter as on June 11, 2013.

The deal gives Cooper’s shareholders what they have probably dreamed of. On June 14, 2013, Rubbernews.com reported Roy Armes, Chairman and CEO, Cooper Tire as saying that the 40 per cent premium is a winning deal for the shareholders,who have endured years of undervalued share price. At USD 2.5 billion, Cooper has been valued at an EV/EBITDA multiple of 4.4x, which is expensive as compared to that of its international peers.[PAGE BREAK]

An All-Cash Deal

What has scared the street is that it appears the company is trying to bite off more than it can chew. Cooper’s revenues in fiscal year 2012 were USD 4.4 billion, twice that of Apollo Tyres. Its market cap of over USD 2 billion is also double that of Apollo.

The Cooper acquisition is an all-cash transaction and will be completed by raising debt. In an interaction with DSIJ, Apollo’s Vice Chairman & Managing Director, Neeraj Kanwar expressed his view saying, “We believe that this transaction has been financed in a prudent manner”. He further added, “Of the total USD 2.5 billion of additional debt, USD 450 million will be reflected on Apollo Tyres, which can be serviced by the cash flows of the company. The balance USD 2.1 billion will be raised as bonds and asset-based lending and will be on the books of Cooper Tire, which can comfortably service the interest out of its cash flows. The bonds will have a maturity of seven to eight years, and hence, will not see any annual outgo on principal”.

The debt-funded acquisition will see Apollo’s debt-to-equity ratio rising above 1.5x from the current 0.7x. So, why is the company taking this huge risk? What’s in Cooper for Apollo?

About Cooper Tire

Cooper Tire & Rubber Company was founded in 1914 in Findlay, Ohio. It manufactures and markets tyres for passenger cars, light and medium trucks, motorsports and motorcycles, which are sold globally. The company derives its revenues from the US, Europe and Asian markets. As of 2012, it had a topline of USD 4.2 billion split across the US markets (70 per cent), China (20 per cent) and Europe and the other Asian markets (10 per cent). The China business makes sizeable exports to Australia and Southeast Asia and also exports small quantities in North America. Recently, Cooper has started selling its products in China as well.

Earlier in a conference call, Sunam Sarkar, CFO, Apollo Tyres said that the company derives 90 per cent of its revenues from passenger car tyres, and that too in the replacement market. Revenues from Original Equipment Manufacturers (OEM) form a negligible proportion of its total revenues.

Cooper Tire has a manufacturing capacity of about 53 million tyres. It has nine manufacturing capabilities across the globe, which includes five in North America, two in Europe and two in China. In China, it has a joint venture named Cooper Chengshan, in which it owns 65 per cent stake. Cooper has a 14 per cent market share in USA. The company has been profitable over many years and has paid dividends regularly to its investors.

Reason For The Acquisition

Apollo has been driving its revenues from India and Europe. So far, the company has been absent in the two larger markets, i.e. US and China. China is a growing market with good margins and has low cost manufacturing capabilities. The US market provides steady business with stable margins. From the management’s interactions, though, it is clear that the company has been intending to enter these markets, which provide a combination of stability and growth.

With respect to the benefits of the acquisition, Kanwar said, “The deal gives both companies a footprint across new markets. The combined entity can sell its products in developed geographies like the US and Europe, and have a strong presence in emerging areas like China and India. Due to the complementary nature of the two businesses, this strategic transaction will enable Apollo and Cooper to sell brands and products in diverse countries with a negligible overlap.”

Cooper also has a strong distribution network in USA, which now will be available to Apollo Tyres. Kanwar mentioned that the acquisition has enabled the company to cross-sell the products across different territories. Apollo’s presence in commercial vehicle tyres will help it to sell tyres in USA and China, while Cooper’s dominance in the passenger car tyres will help it in the Indian market.

Moreover, Apollo also expects to derive synergy of USD 80-120 million in next three years at the EBITDA level. In this regard, Kanwar opines, “The combined entity will leverage its global presence in range of areas including supply chain, branding and distribution R&D and technology capability”. While the management remains upbeat, what is the reason behind the underperformance of the stock?[PAGE BREAK]

Why Did The Stock Skid?

The deal nevertheless is an expensive one and also funded by debt with duration of around seven to eight years. The interest rate of this loan will be around eight to 10 per cent with a bullet repayment schedule. This means that the company will only pay interest on the debt for the first six to seven years, and in the terminal year, it will either have to repay the whole debt or may have to negotiate with the bankers to extend the tenure.

The debt will also be raised through a complex mechanism. USD 450 million will be raised by its Mauritius-based subsidiary and will be serviced through the cash flows of Apollo Tyres. The remaining USD 2.1 billion would be raised by a new holding company comprising Cooper as well as Apollo’s European subsidiary, Vredestein. This debt will be on the books of Cooper and will be serviced through its cash flows.

The market is concerned over the huge rise in the risk profile of both the companies. It is no wonder that immediately after the deal, ratings agency Crisil downgraded Apollo from ‘AA’ to ‘A’ with a ‘Negative’ outlook. The company’s annual interest outgo will increase by around Rs. 1300 crore. The market is also expecting a fall in its EBITDA margins, which means that the combined entity may have problems meeting its interest obligations.

It also should be noted that Cooper’s margins have not been very stable, with fluctuation due to the instability in raw material prices. The margins showed remarkable improvement in 2012, but these do not seem to be sustainable going ahead. Any slight fluctuation in raw material prices or a crack in the US recovery may hit its financials.

As we have said already, Cooper has been paying dividends for over 40 years now. Once the acquisition is completed, this firm will be delisted, which means these dividends would be available to the company as cash. This will make for around Rs. 150 crore each year. Kanwar specified that this cash will be deployed to fund the capex and growth plans, besides to service its debt.

The street believes that the management of Apollo Tyres is treading on a very thin line, and even a slight change in dynamics may lead to major worries on its financials front. There is also a concern on the ability of the combined entity to service its debt in the future. At the moment, Apollo has declined any possibility of raising equity capital.

History On Its Side

So, why Apollo has taken this huge risk? Maybe it is taking cues from similar decisions in the past that worked for the company. In 2009, Apollo Tyres had acquired Dutch tyre maker Vredestein Banden in a combination of debt and internal accruals. Vredestein’s Russian parent had gone bankrupt then. At that point, Vredestein had revenues of 300 million Euros with 11 per cent EBITDA margin. Apollo has strongly grown this business, with its revenues touching about 425-430 million Euro and its EBITDA margins at 16 per cent. This would surely be a morale booster for the management.

Who does not remember Tata Motors’ acquisition of the iconic brand Jaguar Land Rover (JLR). The markets had over-reacted to the Tata Motors stock then, but eventually the Tatas were able to fund this acquisition through a Rights Issue. JLR is now the major revenue and net profit contributor for Tata Motors, and the company’s stock too has shown a fantastic recovery.

The management of Apollo may have taken a page out of Tata Motors’ case study. But it should be noted that Tata Motors reported a huge decline in its net profit one year after the acquisition. For Apollo, the margin for error remains nil. This is precisely what makes this deal a very risky proposition at the moment.

What’s In Store For Apollo?

The fall in the share price of Apollo itself is an indication that the market is expecting a decline in the profitability in future despite the management’s assurance that the deal is EPS-accretive. We believe that the net profit of the combined entity will be under pressure for the next one year. Some improvement could be seen in 2014. However, if the synergy does not work out, the company may have to take a write-off, which could be a huge setback.

Time will tell whether this is a gamble or a calculated risk and whether or not it will pay off for Apollo. As Cooper Tire is a profitable company, there seem to be fewer hurdles in generating good cash flows in the future. Apollo’s stock, however, seems set to continue its downward journey for some more time. We advise investors to avoid the stock at this time. We expect the clouds to clear on this counter over the next two quarters, and will provide a fresh call after that.