RoCE likely to double for tyre companies; Apollo Tyres and Balkrishna Industries could give 12-20% return, Auto News, ET Auto

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After witnessing hyperinflation in its key input cost over the last 15-18 months, the tyre industry is seeing moderation in natural rubber as well as crude prices with a lag in synthetic rubber and carbon black prices.

This augurs well for a margin recovery from 2HFY23.

Since the breakout of geopolitical issues and tightening of interest rates, tyre makers were largely focused on sweating assets and controlling capex.

This is reflected in capacity utilisation of 80-90% across players in 1QFY23. Key input prices had seen an incessant increase over 50% since 1HFY21, with the average RM basket costing around Rs 180/kg, resulting in an over 10pp fall in gross margin.

But now the natural rubber prices appear to have peaked out in mid-June 2022. Spot prices for natural rubber (Thailand spot/RSS4 Kottayam) fell 34%/12.5% from its 1QFY23 average.

Synthetic rubber and carbon black prices are still 6-7% higher over its 1QFY23 average but it’s a reflection of the delayed impact of crude oil price inflation in 1HCY22.

Since underlying crude oil prices have corrected by 22% from its 1QFY23 average, it should reflect with a lag in both synthetic rubber and carbon black prices.

A sharp correction in natural rubber and crude prices to drive a sharp margin recovery from 3QFY23 and EPS upgrades. We expect margin to recover from 2HFY23, with a softening in underlying RM prices.

As per our estimates, for every 10% change in natural rubber/synthetic rubber/ carbon black prices (over its FY22 average), EBITDA margin will change by 160bp/80bp/100bp.

On an FY22 base, we expect blended gross margin to expand by ~190bp in FY24 (+300bp over FY23E). Our gross margin estimate implies a mean reversion to ~36.8% (its 10-year average) by FY25

While demand from OEMs improves across categories, replacement demand has been a mixed bag.

Replacement demand is holding up well for the PCR and 2W segments. However, replacement demand is relatively weak for truck and bus (T&B) and tractors.

Our interactions with the industry participants suggest that T&B demand should see a recovery from 3QFY23 onwards as the noise around inflation tapers off.

After two years of deep pain in a hyper-inflationary environment, we see these headwinds abating, thus driving a margin recovery from 2HFY23 and an earnings upgrade.

We expect a sharp improvement in FCF generation, a reduction in financial gearing, and an improvement in return on capital employed (RoCE). We expect RoCE for mainstream Tyre players is expected to more than double over FY22 to ~11% (v/s an average of sub-9% over the last five years).

Apollo Tyre is our preferred play on tyres as it offers the best blend of earnings growth and cheap valuations:

Apollo Tyres: Buy | LTP Rs 289 | Target Rs 325 | Upside 12%
Apollo Tyre is well placed, with a strong competitive positioning as well as ready capacities to benefit from the strong recovery in truck, bus and radial tyres (TBR) and passenger car radial tyres (PCR) in the OEM and replacement segments.

Driven by strong growth across its Indian and European operations, it is likely to deliver 10% revenue CAGR over FY22-25E. We estimate 8% volume CAGR over FY22-25 and 4% CAGR in price realisations.

As compared to its peers, Apollo Tyre offers the best blend of earnings growth and cheap valuations.

Balkrishna Industries: Buy | LTP Rs 1,918 | Target Rs 2,300| Upside 20%
We expect BIL’s outperformance to the specialty tyre industry to continue, driven by expansion of its product portfolio and ramp-up in the Off the Road tyres (OTR) segment, with scope to strengthen its competitive positioning.

We estimate revenue/EBITDA/PAT for BIL to grow at 15%/16%/13% over FY22-25E.

(The author is Head – Retail Research, Motilal Oswal Financial Services. Recommendations, suggestions, views and opinions are his own. These do not represent the views of Economic Times)

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