Beginning of earnings downgrade cycle in domestic tyre sector?: IIFL Capital Services

26 Sep 2023 , 10:56 AM

Since August 2022, the domestic Tyre sector has been in an earnings upgrade cycle, coinciding with the peaking of RM basket and subsequent moderation. In recent quarters, tyremakers have clocked higher-than-average Ebitda margin and ‘Ebitda per MT’ (all-time high, in some cases). A few months back, analysts of IIFL Capital Services had downgraded their sector view to Neutral as they did not expect above-normal levels of profitability to sustain over the medium-term. In recent months, prices of Crude and natural rubber (international) have risen substantially; this is likely to hurt margins starting Q3FY24. As the margins are currently above normal, analysts of IIFL Capital Services do not expect tyre-makers to increase prices. Analysts of IIFL Capital Services cut FY25/FY26 EPS estimates of domestic tyre-makers by 5-10%, to account for the rise in input cost. Analysts of IIFL Capital Services earnings estimates now factor normalised levels of margins across companies. In the past, margins have dropped below ‘normal’ when cost pressures were intense and persistent; this scenario may result in further EPS downgrades.

Margins to come off as input costs rise: 

In recent months, prices of crude and international rubber have moved up substantially. Crude price is up ~17% in $ terms vs the average of Q1FY24. International rubber price has moved up ~10% from Q1FY24 average. Although the price of natural rubber (India) has come off ~6% from Q1FY24 level, analysts of IIFL Capital Services estimate the net impact to be adverse. Analysts of IIFL Capital Services expect these to hurt the Tyre sector margins starting Q3FY24, as the benefit of low-cost inventory wears off.

Above-normal margins and Ebitda per MT unlikely to sustain: 

The current margins and ‘Ebitda per ton’ of domestic tyre-makers are significantly above historical average. For Apollo (standalone) and CEAT, Ebitda per MT in Q1FY24 were at all-time highs. Tyre-makers are forthcoming in hiking tyre prices when margins are sub-optimal. However, when profitability is above normal, they are unlikely to raise prices even if input costs rise, for the fear of competition. This causes natural up-cycles and down-cycles in margins of tyre-makers, despite the improvement in pricing discipline seen in recent years.

Cut FY25/FY26 EPS by 5-10%: 

Analysts of IIFL Capital Services trim their margin assumptions for Apollo (standalone), CEAT and MRF to account for the rise in input costs. This leads to ~10% cut to FY25/FY26 EPS for Apollo and CEAT. In case of MRF, EPS cut is ~5%. Their margin estimates assume Crude at $85. As commodity prices have been volatile, MTM of earnings to commodity prices may result in frequent upgrades/downgrades to EPS estimates. Analysts of IIFL Capital Services revised estimates build in margins closer to their view on normalised profitability.

Revenue growth likely to be muted in FY24/FY25; Expect nearzero earnings growth in FY25: 

Tyre industry revenue grew at 22% Cagr over FY21-23, supported by growth in both volumes and pricing. Analysts of IIFL Capital Services expect the sector revenue growth to taper down to 10% or lower in FY24/FY25. The OE segment is seeing significant moderation after high growth in FY22/FY23. After-market growth is also relatively muted. Analysts of IIFL Capital Services do not expect tyre-makers to increase prices, especially since FY23-exit margins were at above-average levels. With revenue growth of 10% or lower and Ebitda margins expected to come off from FY24 highs, analysts of IIFL Capital Services expect EPS growth for domestic tyre-makers to be near-zero in FY25.

Low capex, higher FCF & ROCE are structural positives; may support higher valuations vs history: 

Analysts of IIFL Capital Services expect industry capex to average 6% of revenue in the coming years, vs historical average of 9%. This is due to the end of ‘high capex phase’ as well as sharp rise in industry revenue in recent years (rev up 1.5x over FY21-23, supported by rise in realisations). As a result, analysts of IIFL Capital Services expect FCF generation to be strong. Low capex and high FCF (debt repayment) will also keep a lid on ‘growth in capital employed’, thereby supporting ROCE of 13-15% vs single-digit in recent years.