Tyre Stocks in limelight giving double digit intra-day returns yesterday

Yesterday, Sensex and Nifty lost about 0.7% each as a lack of fresh triggers and subdued global cues weighed on the sentiment. Yet tyre stocks went on to show resilience and surged with heavy volumes despite overall markets being in red. Some of the prominent ones include CEAT, MRF, Apollo Tyres, JK Tyres & Goodyear India. All of them are in limelight currently.

All of these stocks—JK Tyre, CEAT, Goodyear, MRF, and Apollo—have been trading near their 52-week highs. A select few of them broke that high yesterday. This increase can be attributed to the relief brought about by falling raw material prices. Especially those for natural rubber, carbon black, and other derivatives derived from petroleum. While Brent crude oil prices have decreased, the costs of both natural and synthetic rubber have fallen from their most recent heights. These elements account for a sizeable share of the sector’s total input costs. Given this, cost softening may provide the much-needed boost for the tyre industry’s sluggish operating performance.

However, more importantly, the sector’s improved pricing power is said to be the main driver of excitement around tyre stocks, along with bright future outlook.  Let’s analyse fundamentals of few of them and see where the sector is headed towards.

Improving Demand Outlook and gross margins going forward in Tyre Stocks

After experiencing challenges with COVID and other market barriers, the demand prognosis for the sector is anticipated to remain strong. The domestic original equipment manufacturers (OEMs) and the replacement segments are expected to rebound in FY23, which would likely improve volumes. Additionally, the reduction in the shortage of semiconductors could boost OEM sales and revive replacement demand for tyre companies in H2FY23.

The recent quarters have seen significant pressure on the gross margins of tyre manufacturers. Companies have therefore implemented a number of price increases in order to stop further margin erosion. Given the delay in passing on the burden of high input costs, margins should gradually start to increase. The margins might continue to decline in Q2FY23, but starting in Q3FY23, they should start increasing steadily.

It’s interesting to note that the industry’s pricing discipline is being aided by the market leader MRF Ltd.’s declining sales and profit disparity with other companies. Due to its greater exposure to two-wheelers (2W) and market dominance in the TBB (truck, bus, bias tyres) area, MRF has historically enjoyed a large margin advantage over peers, according to IIFL Securities Ltd. So, it would be interesting to keep a track of further updates in this sector from hereon.

“Earlier, there used to be under-cutting of prices by leaders in each tyre category and the price trend was set by the leader. But, in the last one year or so, we have seen significant price action by all listed companies,” said Varun Baxi, an analyst at Nirmala Bang Institutional Equities. This is good for the margin outlook and a double-digit margin growth will lead to multiple re-rating for tyre stocks, Baxi said.

Companies in Tyre sector aiming higher free cash flows to lower their debts

Investors in tyre stocks should keep an eye on the sector’s leverage capital expenditure trends. For the time being, a significant portion of the tyre industry’s capital expenditure is likely to be delayed. Tyre firms are anticipated to use free cash flows to repay debt as their profitability improves. With this one prominent and preferred tyre stock in the industry is Apollo tyres.

“We expect Apollo Tyres to deliver average FCF of Rs 1500 crore/year in FY23-FY25E. As compared to negative mean FCF of Rs 600 crore during FY17-FY22. With the focus on pricing discipline and capital allocation, we expect it to become gross debt free over the next 5 years. As against around Rs 6000 crore gross debt on books in FY22”, added the ICICI Securities.

Another brokerage HDFC Securities in its report last month gave an ‘Add’ call on the stock. It gave a target price of Rs 260 per share. The brokerage said it expects the stock to emerge as a major beneficiary of the favourable industry dynamics in India. Further, it will continue to outperform Europe, given its lean cost structure.

Moreover, the Apollo Tyres has given stellar performance in Q1FY23 and managed beat expectations domestically. Further, the management of the company aims to generate higher free cash flows rather than incurring expenditure on unnecessary capex in next two-three years. This is done to achieve better debt to operating profits levels, which is more sustainable and can improve shareholder’s gains.

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