Will The Tyre Juggernaut Tire Down Or Keep Rolling?BloombergQuintOpinion
Auto stocks are running. Auto-ancillary stocks are doing one better than them, and have put on skating wheels. Lately, the segment that seems to be in the fast lane on an express highway is tyre stocks. The reasons are familiar. The last couple of years have been challenging for the Indian auto sector. Tyre industry growth has been decelerating since Q2FY19 and had gone into negative territory in Q2FY20.
Tyre companies had embarked on an aggressive capex programme during this period, resulting in a double whammy of sub-optimal capacity utilisation and increased financial gearing. But things have improved with the better outlook for autos, and a return to normalcy has propelled these stocks ahead in the last few weeks. The question is, can this continue? Let us study the factors.
Higher demand will be seen across all automobile segments over a pandemic-hit low base of FY21, amid expectations of Covid-19 vaccines and an improvement in the demand cycle amid improving economy and consumer sentiment. There is arguably already a ‘V’ shaped recovery in most auto segments and if, as is widely expected, OEM demand growth from passenger vehicles, two-wheelers, and tractor segments in the medium term stays strong, then the reported sales numbers would look strong because of the base effect.
For the very near term, Q4 FY21 and Q1 FY22 have a very low base in terms of volumes (down 10% and 30% respectively), which means growth will look strong. If we widen the time frame a bit, the last three years have seen volume growth in low single digits, because of which just a normal upcycle can bode well for FY22E and FY23E, as the base cyclical recovery would look accentuated, as happens in cyclical industries.
Replacement demand for tyres has been strong even as OEM sales have been tepid for the last 18-24 months. This replacement demand is expected to remain strong in the near term and eventually may normalise in the medium to long term period. Also, the markets have not rewarded the players much during the last three years, which works in favour of tyre stocks when it comes to valuations.
Lower Competition And Market Share Gains For Listed Players
One thing that has happened in the last few quarters is, as most people know, that all tyres are now made in India, and in the words of one dealer, are ‘fresh’. Thus, overall competitive intensity/differentiation by quality/geography is moderate.
On the back of this, some companies would have had market share changes recently. Ceat Ltd. said that it has gained market share. A lot of imports were in the higher end of the product mix, imported from Michelin, Bridgestone, and other Asian players. Apollo Tyres Ltd. would have benefitted, with its product portfolio most suited to step in.
In fact, a few days back, Michelin India Pvt. wrote a letter to the dealers of passenger vehicles about the inability to supply tyres, which points towards some market share shifts, as the space vacated by Michelin would have arguably been taken by some of the incumbents.
Also, in each individual segment like passenger vehicles, commercial vehicles, and two-wheelers, the top three-four players hold nearly 70-80% market share. However, no tyre company has a dominant position and pricing power. Go to any large tyre store, as I did, and the manager would tell you how options for the tyres on the same car are available with a price difference of 10-25% between companies.
Favourable Policy Period
The government’s production-linked incentives scheme for automobiles has sops of over Rs 57,000 crore over a five-year period and focuses on making Indian companies globally competitive by driving exports. While that may be the poster boy of incentives, the government has also been taking steps to stem the dumping of imported tyres. In 2017, the government had imposed anti-dumping duty on imports of truck and bus radials. In June 2020, it restricted the import of tyres across segments and geographies, and the Michelin India letter mentioned earlier speaks of that move as one key reason for not being able to supply tyres. But the larger point is that the domestic industry does not have to deal with ‘dumped’ tyres to the extent it had to, and that can only augur well for volumes.
Raw Material Inflation: Scary Or Not Really?
I don’t know of too many other industries that are so commodity price-dependent. Of the total raw material consumption, nearly 80-85% would be dependent on commodity prices – rubber and crude oil derivatives. Both rubber and crude prices have been on the rise in the last six months. Usually, tyre companies have a pass-through clause with the OEMs, and in the replacement market the costs are passed on to consumers easily when demand is strong. For the time being, demand is strong, and thus it might be easier to pass on costs.
Ceat, in its call, said that it took price hikes of about 3% in December, across segments (except two-wheelers) and would need to take more price hikes to offset the impact of higher raw material costs. Shareholders will be pleased to see companies able to increase prices at will, as it means that raw material prices moving up hasn't been more than a minor irritant.
Most investors would now start building in an earnings upgrade for FY22E earnings, since there would be twin factors of an expected increase in volume growth, plus operating leverage upticks. The capacity additions and further capex plans from companies like Ceat would provide ample headroom for meeting demand over the next two-three years. And if the companies can pass on the raw material price increases easily, it will help them maintain the operational metrics, which should help in sustaining return ratios and improving multiples.
However, a look at the current valuations versus the long term averages suggests that there is only one company, Ceat, where investors can find valuation comfort.
As per a Motilal Oswal note, it has:
the highest headroom to grow due to substantial capacity additions;
higher operating and financial leverage; and
a pure India focus.
For a stock that has underperformed the most since the last three years, maybe the next few quarters can see it burn the rubber relative to peers, and absolutely, driven largely by the valuation comfort.
So What Happens Going Ahead?
The commentary from some of the companies gives us a glimpse into the near term. JK Tyre Ltd., after reporting its best operational quarter in the last two years, said that all of its nine plants in India operated at close to 96% capacity utilisation in Q3FY21 and that it foresees sustained sales and profitability during the coming period.
Ceat, earlier in January, spoke about inventory levels continuing to remain low despite higher production, indicating higher demand. In an investor call, Ceat mentioned how replacement demand remains strong due to pent-up demand and the need for personal mobility and that demand from OEMs has also picked-up. According to the company, economic activity—as reflected in toll collections—has increased, boosting replacement demand for CVs.
The utilisation is at very high levels and all new capacities are ramping-up well for most companies too, and most of them have embarked on capex plans, signalling their vision about the medium term. If they can improve the sales mix, if the raw material cost uptick doesn’t play spoilsport and if the global economy turnaround stays strong in 2021, these stocks may just have found the wheels to continue their joyride.
Niraj Shah is Markets Editor at BloombergQuint.