We explore the business of India’s leading tyre company and discuss the opportunities and challenges it faces going forward.
Statutory Warning: This is NOT an investment advice to buy or sell shares. Please make your own decision, as blindly acting on anyone else’s research and opinions can be injurious to your wealth. I do not own the stock, but my analysis may be biased, and wrong. I have been wrong many times in the past. I, Vishal Khandelwal, am a registered Research Analyst as per SEBI (Research Analyst) Regulations, 2014 (Registration No. INH000000578).
About CEAT Ltd.
Established in 1958, CEAT is India’s leading tyre manufacturer, and part of the RPG Group (promoters own 50.8% stake in the company). The company got its name from its predecessor Cavi Elettrici e Affini Torino SpA (translated as Electrical Cables and Allied Products of Turin) that was established in Italy in 1924.
CEAT offers tyres to all segments and manufactures radials for heavy-duty trucks and buses, light commercial vehicles, earthmovers, forklifts, tractors, trailers, cars, motorcycles and scooters.
Before we get deeper into the company, let’s first look at the lay of the land i.e., the tyre industry.
Indian Tyre Industry
It is estimated that the world tyre market is likely to reach US$276 billion in 2017. The centre of gravity in world trade has been shifting from mature markets to emerging economies. As a part of this broader trend, many emerging economies are likely to become manufacturing hubs, and the tyre industry is no exception.
The Indian tyre industry is estimated to be of a size of around Rs 50,000 crore at the end of March 2016, and is dominated largely by the commercial vehicle segment consisting of heavy, light and small commercial vehicles (around 55% of total tyre volumes). The next largest segment is passenger vehicles constituted by cars, SUV’s, motorcycles and scooters. The Farm & Off the Road (OTR) segments consisting of the tractor front and rear tyres, tractor trailers and large tyres for earth-moving and other construction and mining related equipment are the other important segments in the market.
Traditionally, tyres are classified as cross-ply (bias) and radial, based on the technology deployed in their manufacture. In India, the commercial tyre segment continues to be dominated by cross-ply tyres due to road conditions, loading patterns and the high initial cost of radials. There is however a steady growth in radialisation across segments in recent years with the highest in passenger cars at almost 100% followed by heavy commercial vehicles at 33% and light commercial vehicles at 30% in 2015.
The tyre industry, which is a derived demand business, is also directly affected by the performance of the vehicle manufacturing sector which in turn is dependent on the overall economic growth. The industry consists of three distinct markets namely Replacement, Original Equipment Manufacturer [OEM] and Exports. By value, replacement market accounts for approximately 60% of the industry with OEM and Exports making up to 22% and 18% respectively. While in the Commercial and Farm segments, replacement sales form a major chunk, in the passenger segment, both OEM and replacement sales hold an almost equal size.
The Indian tyre industry has grown at an average annual rate of around 4% – in terms of tonnage sold (stands at around 1.7 million tonne currently) – during the five-year period of FY11 to FY16. The commercial vehicle industry forms around 55% of these volumes, but it has been sluggish with a five‐year annual average growth of just about 2%. This has been a direct consequence of not only subdued economic activity that has meant weaker OEM sales, but also due to lower movement of trucks that has led to low wear and tear and thus slower replacement demand. Passenger vehicle tyres have seen strongest demand offtake with an 8% annual growth over the past five years, while two-wheeler tyres demand has grown at 6%.
One of the biggest worries for Indian tyre manufacturers in recent times has been the consistent growth in tyre imports over the past two years. Truck Bus Radial (TBR) and two-wheeler tyre segments primarily witnessed a sharp rise in imports in the first nine months of FY 2015- 16. Market share of TBR imports moved up to ~35% in the replacement market in FY16. Imports in the two-wheeler segment remain less worrying for Indian manufacturers, as imports here have a market share of only 4% at present.
China has been the biggest contributor to imports into India. This was on account of three main reasons namely India’s anti-dumping duties on Chinese tyres ended in early 2015, the U.S. imposed anti-dumping duty on Chinese tyres and the devaluation of Yuan made Chinese tyres cheaper. This has resulted into excess supply into Indian and global markets.
Currently, with the slowdown in China, the country is facing a problem of plenty in the tyre sector due to large installed capacities. The Chinese tyre manufacturers are desperately seeking other markets to push their products, whatever be the cost. Without any regulations to check these large-scale imports, the Chinese low cost tyres are having a run in the Indian market. According to estimates, China accounts for nearly 90% of truck radial imports and 46% of passenger car tyre imports. The Chinese truck radial imports constitute close to 27% of the Truck Bus Radial (TBR) replacement market and are cheaper by 25% to 40%, making them even cheaper than Indian bias tyres.
However, the picture isn’t entirely bleak for Indian tyre companies, especially with their profit margins at an all- time high – thanks to lower natural rubber prices (which have risen of late). Economic upturn has also helped companies see increased demand for tyres from the OEM and replacement segments, even as exports remain under pressure. Balance sheets of most key players in the industry has improved considerably over the years, and things are looking brighter.
With an annual revenue of Rs 5,700 crore, CEAT has emerged as one of the leading tyre brands in India. The company’s capacity is more than 900 metric tonne/day (MT/day), or around 95,000 tyres per day. The sales split across market segments is in line with industry.
1. Has the company done well in terms of sales and profit growth over the past few years?
CEAT’s sales have grown at an average annual rate of 12% over the past ten years, and 10% over the past five years. Now these growth numbers do not seem great. However, we must put things in perspective while looking at such growth numbers before drawing conclusions. Like most Indian tyre companies, the commercial vehicles (CV; truck and bus tyres) segment formed the largest part of CEAT’s total sales (around 60% of sales in FY11). As compared to this, sales of 2/3-wheeler and passenger and utility vehicle (PV+UV) tyres formed less than 15% of sales.
Now, if you were to see the company’s FY16 numbers, while CV tyre sales formed just around 38% of sales, the 2/3-wheeler and PV+UV tyre sales has moved up to an equivalent 38%. This is even when the Indian tyre industry as a while still sells around 57% of tyres to the CV industry.
In other words, CEAT has gone against the industry trend and has consciously brought down the share of CV tyre sales in its total business while increasing its focus on the 2/3-wheeler and CV tyres space. So, while the overall sales of the company has grown at just around 12% between FY11 and FY16, sales from the 2/3-wheeler segment and PV+UV segments have grown at rates of 32% and 34% respectively.
This has helped CEAT increase its market share in the 2/3-wheelet tyres and PV+UV space from 8% in FY11 to over 25% in FY16 (second only to MRF that has 35% share).
Now the question is – why has the company done this i.e., move away from the CV tyre space and focus on the low priced 2/3-wheeler and PV+UV tyres?
Profitability is the answer. 2/3-wheeler and PV tyres command better margins as compared to CV tyres (branding works better, and thus its benefits accrue, here than in CV tyres), and this is clearly seen in the way CEAT has grown its margins and profits over these years.
While gross margin has improved from 25% in FY12 to 45% in FY16, net profit has seen an average annual growth of 75% during this period. Subsequently, net profit margins, that were less than 0.5% in FY12, stood at around 8% in FY16.
If the company continues to maintain its focus on high-margin areas going forward – as the management has outlined in its latest presentation – one may expect the margin and profit growth to remain robust.
Now, one metric that must be tracked here is what the competition is also doing in the 2/3-wheeler and PV+UV space. If it’s a high margin business that we know as investors and analysts, CEAT’s competitors (especially those already having an entrenched position in this space, like MRF and TVS Srichakra) know it better, and thus one may expected increased competition in this space going forward.
Anyways, with such growth in the high-profitability passenger vehicle tyres business, CEAT has embarked on capacity expansion. It plans to increase its capacity from 900 metric tonne per day (MT/day) to 1,245 MT/day by FY18. As per the management, around 70% of this incremental capacity will be catering to the 2/3-wheeler and PV+UV tyres spaces.
CEAT is also looking to venture into the high margin off-highway tyre (OHT) business, where BKT is the current leader. Towards this, the former is setting up a capacity of 40 MT/day (which will be further ramped up to 100 MT/day, and this when it comes onstream and adds to CEAT’s sales, is likely to help its margins even further.
As far as the CV tyre space is concerned, despite CEAT’s reduced focus, the company is expected to benefit from increased ‘radialisation’ (even today, around 70% of this industry uses archaic bias tyres; radialisation is expected to cover approx. 80% of the industry by FY20).
Radialisation may have a beneficial impact on pricing and profitability of the business. This is because radial tyres generally command a 30‐50% pricing premium over bias tyres.
And given the fact that around 15.7 million passenger vehicles and nearly 4.2 million commercial vehicles have been added to Indian roads during the past six years (see table below), there is expected to be strong demand coming from the replacement market, as this existing population of automobiles will be due for replacement over the next 2-3 years.
2. How profitably have retained earnings reinvested?
CEAT’s business has undergone a major shift over the past few years, and thus ‘average’ ROE number doesn’t look rosy if you were to see a ten-year picture for instance.
However, owing to this shift in the company’s business towards high margin streams (as discussed above), ROE moved up from 2.7% in FY12 to a high of 30% in FY14 and was at 24% in FY16.
Now, here’s an interesting insight that you may get by breaking up CEAT’s ROE using the Du Pont framework. As you may see from the chart below, the company’s ROE has very closely tracked its net margins.
Thus, we can assume that ROE to be a direct beneficiary of the company’s move towards high margin 2/3-wheeler and PV+UV tyres segments. Going forward, if you were to take a call on where the ROE may head, you need to keep a close track on the company’s margins. And to assess the margins, look at what competitors are doing in CEAT’s core segments, how the raw material costs are moving, and if they are moving up, is the company able to pass on the hike to consumers (which it has been able to do in the past).
3. Does the business have a durable competitive advantage?
Tyre companies were traditionally considered as commodity businesses – buying rubber and selling tyres. Even when companies like MRF and CEAT were spending some money on brand building, the benefits were not seen in the numbers. Focus on the CV business and OEMs (automobile companies) where these companies did not have much bargaining power was a reason their brand building exercise did not pay much.
However, things seem to have changed over the past few years. With a greater focus on direct consumers, many of these companies – especially the larger players – have shown the attributes of consumer companies. Nothing else justifies their margins to get into double digits, earnings rising at considerable rates, rising dividend payments, and 20%+ return on equity.
One thing that has helped these companies over these years has been rising spends on brand-building exercise. CEAT, for instance, has seen its advertisement and sales promotion expenses rising at an average annual rate of 21% over the past five years (as against sales growth of 12%). The company, in FY16, spent 2.1% of its sales on brand-building (1.8% for MRF), the benefits of which are going to accrue over the next few years.
Such spending, as we know, if done sensibly can help a business create a moat around itself. But this only happens when consumers are willing to pay a higher price for the given brand. This seems to have been the case with CEAT as seen from its rising gross and net margins over the years. So, certainly CEAT has built a deeper moat around itself, but its sustainability is what you need to constantly watch out for. So, as I mentioned above, keep an eye on its net margins, which has a direct bearing on its ROE.
4. How has the management fared?
CEAT’s management has done well to steer the company away from competition in the low-margin CV tyres market into the 2/3-wheeler and PV+UV spaces. This, as we read above, has caused sharp improvements in margins and return ratios. This talks highly about the management’s capital allocation skills. Moreover, the total management compensation was less than 3% of the net earnings in FY16, which is comfortably within reasonable limits and tells that the management isn’t overpaying itself. The company’s 34-year old MD, Anant Goenka, for instance draws a salary of around Rs 3.2 crore, which is small compared to the size of business he is heading. He has in fact been instrumental in spearheading the CEAT brand over the past few years since he took over as MD in FY12. The benefits, as we have seen, have started to flow in.
5. What are the risks to the business?
CEAT’s business, despite is growth potential, faces some big risks. Notable among them are two. First is economic slowdown that has an indirect impact on tyre demand (as automobile sales slow down). The second issue the tyre industry, including CEAT, faces is that of dumping by Chinese manufacturers. There has been a huge influx of imported tyres in the last few years in India, which has had an adverse effect on Indian tyre producers. The import of truck and bus radial tires from China rose 65% to US$ 123 million in the 10-month period of April to December 2015 from US$ 75 million during the corresponding period the previous year (Source – India’s Ministry of Commerce and Industry).
Indian tyre producers have been demanding higher duties on imported tires for some time. Most of the domestic producers were expecting the government to take some steps in the Union Budget 2016-17 to impose an anti- dumping duty of about US$ 25 per tyre or raise the import duty from 10 to 30%; however, the Indian government did not take any action on the huge imports of tyres. Such continued and large scale dumping from China poses one of the big risks for Indian manufactures like CEAT, and may impact margins and return ratios which are currently at historically high levels.
Another probable risk is that of a resurgence in natural rubber prices and the impact on margins of tyre companies including CEAT (material costs, mostly rubber, form around 55-60% of a tyre company’s sales). Now, India imports a huge amount of natural rubber for tyre production, but in a major blow to tyre producers, the Indian government banned imports of rubber for use in goods for re-export and initiated an anti-dumping probe into synthetic rubber imports from the European Union and South Korea, which compete with natural rubber. The government also placed restrictions on imports of natural rubber through two of India’s major ports (Nhava Sheva and Chennai).
The government acted after the Indian Rubber Growers Association called for an immediate government intervention, saying that domestic rubber prices had plunged to an eight-year low of US$ 1.4 a kilogram.
The association called for an additional safeguard duty on rubber imports beyond the amount required by Indian industry, seeking to drive demand to Indian producers. According to the association, imports of natural rubber had exceeded 400,000 metric tons in the first nine months of the financial year (April 2015 – Dec 2015), compared with 442,130 metric tons during the preceding 12 months.
Restrictions on natural rubber imports, which account for up to 52% of India’s overall consumption, are likely to raise its prices. This increase may have a negative effect on the cost of production of tyre companies, including CEAT, thereby possibly impacting their margins and returns in case they are not able to pass on the higher costs to consumers (which, by the way, they have been able to do so far).
CEAT’s stock is currently trading at around Rs 1130 (as on 17th Feb. 2017), which implies a P/E multiple of around 12x its trailing 12-months consolidated EPS of Rs 96 per share. Also, over the past five years, CEAT has earned average free cash flow (FCF) of around Rs 1,800 crore. At the current market cap of around Rs 4,500 crore, it implies a FCF yield (FCF divided by Market cap) of around 40%.
While these valuations may look cheap on an absolute basis, one needs to understand the nature of the tyre stocks that have always commanded valuations in high single digits or low teens. For instance, the highest P/E MRF’s stock has seen in the last few years is 18x, and the number for CEAT stands at 15x. Of course, as we discussed earlier, these companies are shifting for being commodity-type businesses to consumer brands (which command higher P/E multiples then the former), you must ensure that you don’t end up overpaying.
And then, please consider both sides of the case – opportunities and risks – plus ensure sufficient margin of safety in the stock’s price, before making any investment decision.
Statutory Warning: This is NOT an investment advice to buy or sell shares. Please make your own decision, as blindly acting on anyone else’s research and opinions can be injurious to your wealth. I do not own the stock, but my analysis may be biased, and wrong. I have been wrong many times in the past. I, Vishal Khandelwal, am a registered Research Analyst as per SEBI (Research Analyst) Regulations, 2014 (Registration No. INH000000578).[/show_to] [hide_from accesslevel=’almanack’]
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