We explore the business of India’s leading tyre manufacturer and discuss the opportunities and risks the company 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 Indian Tyre Industry
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 (OTR) 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, Institutional/ Original Equipment Manufacturer [OEM] and Exports. By value, replacement market accounts for approximately 60% of the industry with Institutional / 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 Institutional and OEM and replacement sales play an almost equal role.
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 57% 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%.
Tyre Industry Product Mix (in Volumes)
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 material prices. 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.
About MRF Ltd.
MRF is India’s largest tyre manufacturing company (29% market share, followed by Apollo and JK Tyres at 17% and 13% respective). The company started as a rubber balloon factory with a funding of Rs 14,000 way back in the 1940s. In 1952, the company forayed into tread rubber manufacturing and today it is the largest tyre manufacturer in the country, with 8 plants set up across India to cater to the entire spectrum of tyres, from passenger and commercial vehicles to industrial tyres.
The company has one of the most diversified portfolios in the industry and commands leadership position in various segments, including 2-wheelers, passenger vehicles and truck/bus tyres. In addition, MRF is the first and only Indian company that supplies aircraft tyres to the Indian Air Force. The company also has a strong presence in the replacement market. It also has a high brand recall among OEMs, as is indicated by the Original Equipment Tire Customer Satisfaction Index (TCSI) Study, which MRF has won for record 10 times in 13 years, making it the only Indian tyre maker to do so. Apart from this, the company has also won the JD Power Award for a record eleven times. The award is widely considered to be the automotive equivalent of the Oscar and is the highest recognition in the automobile industry. Anyways, apart from tyres, MRF also has small presence in paints and coats, toys, motorsports and cricket training.
During the eight-year period of 2006 to 2014, the company grew its net sales and profits at average annual rates of 17% and 35% respectively. The company changed its financial year ending to March in 2016, and thus the last financial statements have been prepared for 18 months, and therefore not comparable to the previous financial year.
Anyways, let me now analyse the company using a set of questions to test the underlying business and management quality.
1. Has the company done well in terms of sales and profit growth over the past few years?
From around 50 years that MRF took to achieve Rs 5,000 crore in revenue (by FY07), it took the company just the next eight years to almost triple it to around Rs 14,000 crore in 2014. In the 18-months period ended March 2016, this number crossed Rs 22,000 crore. It is worth nothing here that this revenue of Rs 22,000 crore was achieved on a fixed asset base of Rs 9,200 crore. The company is now planning to invest over Rs 4,500 crore in two of its tyre factories in Tamil Nadu to raise its capacity to meet increased demand. On its current base and given MRF’s history, this is a substantial investment, which is likely to have a positive impact on the company’s revenue growth. A positive impact on profit is also highly probable, but for the competition and pressure on pricing due to expansion by other tyre manufacturers too.
The management however believes that increased ‘radialisation’ in the commercial vehicle space (even today, around 70% of this industry uses archaic bias tyres; radialisation is expected to cover approx. 80% of the industry by FY20), is going to have a beneficial impact on pricing and profitability. This is because radial tyres generally command a 30‐50% pricing premium over bias tyres. The management also hopes for a strong growth in business from the replacement market, where MRF enjoys a dominant position. Replacement sales form around 75% of the company’s total revenue. 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.
Domestic Sales Trends (FY11-FY16)
Data Source: SIAM
As far as profit growth is concerned, things have looked up for MRF over the past five years thanks to lower rubber, crude oil, and other raw material prices.
The other side of lower raw material prices, however, is that sales growth for tyre companies including MRF could have been better over the past two years but for the passing on of softer material prices to consumers in the form of selling price reduction.
2. How profitably have retained earnings reinvested?
MRF has earned an average return on equity of 25% over the past five years, especially thanks to a surge in the eighteen-months period ended March 2016. Lower material prices combined with better cost controls has helped the company earn such margins, while also beating its peers.
Higher ROE for MRF has been helped largely by rising net margins, as discussed above. Going forward, while radialisation as a theme is likely to help margins and ROE further, there might be some weakness in the numbers in the medium term owing the capital expenditure the company will be incurring to raise its radial tyres capacity. It’s important to note here that manufacturing of radial tires is more capital intensive than their cross-ply counterparts.
3. Does the business have a durable competitive advantage?
MRF’s brand is surely an advantage that it has over competitors. That the company has a strong brand recall among OEMs (as indicated by the Original Equipment Tire Customer Satisfaction Index (TCSI) Study, which MRF has won for record 10 times in 13 years) adds tremendously to this advantage. However, and despite the fact that the tyre industry is concentrated among the top few players, steady dumping by China’s low priced tyres – thanks to soft natural rubber prices – has hurt companies like MRF on the pricing front.
So the hope for MRF to get its turf back from Chinese players is that rubber prices firm up, which will ultimately force the low margin Chinese manufacturers to also raise prices, which will reduce the price differential (and subsequently lead to a greater demand for better quality Indian tyres).
So, overall, MRF boasts of the brand moat, but how sustainable it is in light of rising competition from both Indian and Chinese players remains to be seen.
4. How has the management fared?
MRF’s management has a good track record – both in terms of managing the business across cycles (as seen from the sales and profit performance over the years), and compensation levels. The total managerial remuneration stands at Rs 67 crore, which is way less than the ceiling of 10% of the company’s net profit.
5. What are the risks to the business?
MRF’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 MRF, 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 MRF, 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. 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 is likely to have a negative effect on the cost of production of tyre companies, including MRF, thereby impacting their margins and returns.
Seeing the stock you are writing about run up 15-20% by the time you finish your report is a sad feeling, and I have been witness to the same several times in my career as an analyst. This time, however, I can take respite from the fact that this is not a recommendation I am making, but just a company analysis.
Anyways, MRF’s stock is currently trading at around Rs 41,065 (as on 15th Sep. 2016), which implies a P/E multiple of 10.2x its trailing 12-months EPS of Rs 4,045 per share. Now, just the stock price of MRF puts off a lot of people who look at the company. After all, Rs 40,000 will buy you just one stock in the company. But it’s important to note the underlying reason for such a high stock price (note that I am not talking about the stock’s valuation here, just the stock price). In MRF case, it is the low levels of outstanding shares that stand at just 0.42 crore (4.2 million). Multiplying this share count with the current stock price equates to a market capitalization of around Rs 17,530 crore. For comparison’s sake, let’s take a company with a higher market cap – Ashok Leyland. Its market cap is around Rs 24,000 crore or 37% higher than MRF’s, but its stock price is just Rs 85, or just 0.2% of MRF’s stock price. So you see, a higher stock price should not be a detriment for you to make a stock buying decision. Only consider what value you are getting from the business compared to the price you are paying. Of course, this is not a recommendation to buy MRF’s stock, but I thought I should clear any doubts you may have looking at the absolute stock price of the company.
Still, let’s use the expected return model to assess an approx. valuation for MRF. Assuming an exit multiple of 15x P/E on an estimated FY26 EPS of around Rs 11,370 (assuming 12% CAGR over FY16 EPS, as against around 30% CAGR the company has clocked over the past 5 and 8 years), the estimated stock price comes to around Rs 170,000 (assuming no bonus or stock split). From the current levels of about Rs 40,000, that’s an average annual return of around 15.5%.
Please note that like all valuations, the numbers I have approximately arrived at for MRF will certainly turn out to be wrong, and prove yet another time my inability to see the future. As such, you, as an investor, must use your own analysis and reasoning while making any investment decision in the stock. Also, please consider both sides of the case – opportunities and risks – plus ensure sufficient margin of safety in the stock’s price, before making any such 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’]
- Spotlight: Big ideas from Value Investing and why applying them in your investment decision making will be a great deal
- InvestorInsights: Interviews with experienced value investors, learners, and deep thinkers
- StockTalk: Thorough analysis of business models of companies (without any recommendations)
- Behaviouronomics: Deep analysis of human behaviour and how it impacts investment decision making
- BookWorm: Reviews of the best books on Value Investing and related subjects
- Free Course – Financial Statement Analysis for Smart People (otherwise priced at Rs 5,900)
- Archives: Instant access to our huge archive from the past three years