Tyre sector margins to peak in June quarter: IIFL Capital Services

11 May 2023 , 10:52 AM

Tyre stocks are inherently cyclical, generating high returns when margins recover from sub-normal levels to above-normal. Once margins are above average, they revert to mean or even lower over time, as input costs rise or as players cut prices to pass on cost benefit and/or to gain volumes/market-share. Analysts at IIFL Capital Services believe that the margin normalization and earnings rebound story in the current cycle have largely played out. Margins and EBITDA/ton are currently above average and most likely to peak in the June quarter. EPS estimates have been upgraded to accommodate the higher-than-average margins. Stocks are looking relatively cheap on cyclical high earnings projections; they always do till industry dynamics lead to EPS cuts.

Analysts at IIFL Capital Services have been very positive on the sector since their August 2022 report and they now turn Neutral on the sector. They have downgraded Apollo Tyres from Buy to Add. Ceat stays at Add and MRF at Reduce.

Tyre industry has been secular, but volume growth alone is not attractive enough

Tyre industry volumes have grown at 6% CAGR over the past 20 years. The secular growth has been driven by the aftermarket segment, which in turn has been the result of a continuously increasing vehicle population. In FY22 and FY23, industry revenue grew at 20% CAGR, with more than 10% volume growth (on COVID base) and 10% expansion in realization. The sharp increase in realization in FY22 and FY23 came after near-zero growth in realizations for almost 10 years. Heading into FY24/FY25, analysts at IIFL Capital Services expect industry revenue growth to settle at 10% or lower, with single digit volume growth and very little pricing gain.

Earnings rebound and stock performance linked to margins more than volumes

Given that steady-state revenue growth would be 10% or lower, the industry has generated high earnings growth and superior stock performance, only when margins have improved from sub-normal levels to normal or above-normal. During such phases, earnings growth has outpaced revenue growth by a wide margin.

Current industry margins above average; may peak in June quarter

Tyre-makers clocked 750-800 basis points gross margin expansion in Q4FY23 versus Q2FY23 due to fall in inputs costs (Crude, rubber). There is a possibility of some more margin expansion in the June quarter (Q1FY24). Natural rubber has inched up more than 10% from lows. In its Q4FY23 investor call, Ceat management highlighted that the RM basket may inch up towards the end of Q1FY24. Q4FY23 margin for Ceat and Apollo are above historical average. EBITDA/ton are also at multi-year highs. MRF is still lower due to structural issues (market-share loss). History tells us that above-normal margins have not sustained for long. Margins have reverted to mean or lower over time, as input costs rose or as players cut prices to gain volumes/market-share.

Earnings growth beyond FY24 may be lackluster

As analysts at IIFL Capital Services build in higher-than-average margins in FY24 and given low probability for margins to go up further in FY25, earnings growth in FY25 would be lackluster, largely mirroring single-digit revenue growth. If margins mean-revert due to industry dynamics (input cost increase, price cuts), FY25 EPS may hurt even more.

Downgrade Apollo Tyres from Buy to Add

Apollo has been one of IIFL’s top mid-cap picks. Analysts at IIFL Capital Services now believe that the earnings revival story has played out. The structural improvement in FCF profile is well-appreciated by the market, as evident in the re-rating from 11-12x PE (on sub-normal earnings) to 14x PE (on above-normal earnings). Analysts at IIFL Capital Services have downgraded the stock from Buy to Add with a Target Price of Rs. 410 (11% upside). They expect Apollo to bring down debt at a fast pace, due to the structural improvement in its FCF profile. However, reported earnings growth may be muted post FY24.