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INITIATION
Apollo Tyres (APLO.BO)
Neutral Equity Research
Earnings downgrade cycle, valuation support; initiate with Neutral
Investment view
We initiate coverage on Apollo Tyres with a Neutral rating and 12-month
FY12E P/B-based target price of Rs63. We believe: 1) increase in per unit raw
material costs during FY10-FY12E is likely to be the highest in a decade (21%
CAGR), driven by rising natural rubber and crude prices; 2) earnings
downgrade cycle is likely to continue despite a favourable pricing
environment—our FY11E-FY12E EPS is 12%-17% below Bloomberg
consensus; 3) stock is currently trading close to its 5-year historical valuation
support of 1.0X P/B and 0.5X EV/GCI, assuming no further downward
revisions to earnings expectations for the company.
Core drivers of growth
We expect 15% FY10-FY12E revenue CAGR driven by strong industry
demand and ramp-up of new capacity in Tamil Nadu. However, we
project a 16% CAGR decline in net income during the same period due to
a 4.1 pp contraction in EBITDA margins driven by material cost inflation.
Risks to the investment case
We believe Apollo’s valuation is highly leveraged to margins—1 pp change
in EBITDA margin could lead to 11% potential impact on P/B-based implied
valuation. Further, key risks include higher/lower than expected natural
rubber prices, and pricing in the replacement tyre market.
Valuation
We believe the stock is pricing in the best in terms of a favourable product
pricing environment, and the worst in terms of raw material cost outlook.
Our 12-m P/B-based TP of Rs63 is based on historical average P/B of 1.2X.
Industry context
We prefer Bosch India (BOSH.BO, Buy, on CL) as an upstream exposure
to Indian auto demand, as its technology leadership in fuel injections
leads to higher pricing power and margin stability, in our view.
Earnings downgrade cycle, valuation support; initiate with Neutral
1) Further downward revisions to consensus expectations likely…
Apollo Tyres’ FY11E/FY12E Bloomberg consensus EPS has been revised down by
18%/10% since Sept 30, 2010. We believe this earnings downgrade cycle will continue,
with yoy growth in per unit raw material costs during FY10-FY12E at the highest in a
decade (21% CAGR vs historical average of 7% yoy). This cost inflation is driven by
shortages in the natural rubber market and rising crude prices. Our FY11E-FY12E EPS is
12%-17% below Bloomberg consensus estimates (see Exhibit 1).
2) …but valuations close to historical support could limit downside risks
Our analysis suggests that historically valuation finds support at one-year forward 1.0X
P/B and 0.6X EV/GCI (see Exhibits 2-3), and the stock is currently trading at 1.25X FY12E
P/B and 0.7X EV/GCI. So while downward revisions to consensus expectations would cap
stock price outperformance, we believe that significant and sustainable stock price decline
also appears unlikely over the next 12 months given balance sheet based valuation
support, in our view. We believe that a key source of risk to our view on valuation is
steeper than expected downward revision to earnings expectations (driven by higher than
expected rubber costs, or lower price hikes).
3) Trading at historical average, in line with peers—P/B is our primary valuation metric
Apollo Tyres is currently trading close to its historical average on earnings multiple based
valuation parameters of P/E and EV/EBITDA (see Exhibits 5-6), and balance sheet-based
parameters of P/B and EV/GCI (see Exhibits 2-3). It also trades in line with domestic
automobile peers on relative returns based valuation parameter—Director’s Cut (see
Exhibit 4). Our 12-m target price is based on historical 5-year average P/B of 1.2X. We use
P/B-based methodology to value Apollo Tyres (vs an earnings multiple based approach
for other automobile stocks under our coverage) because: a) higher historical volatility in
earnings growth due to a conversion business model, and b) balance sheet based
valuation metrics such as P/B have lower sensitivity to earnings revisions enabling a more
consistent approach to valuation.
Key risks: High leverage to margins; rubber, crude and tyre prices
We believe Apollo Tyres’ valuation is highly leveraged to margins—our sensitivity implies
11% potential impact on our P/B-based implied valuation for every 1 pp change in EBITDA
margin (see Exhibit 9).
Key risks to our view include: -
1) Higher/lower than expected natural rubber prices, which are driven by production in
the key rubber producing regions of the world namely Thailand, Indonesia, Malaysia and
the Indian rubber producing state of Kerala. We note that rubber costs were 34% of Apollo
Tyres domestic revenue in FY2010 (see Exhibit 10), and estimate an 18% CAGR in per unit
rubber costs during FY10-FY12E
2) Higher/lower than expected crude oil prices through 2011E-2012E. We note that prices
of fabrics (such as Nylon Tyre Chord or NTC) used in the manufacture of tyres closely
track crude prices. Our energy team forecasts Brent crude price of US$100/bbl in 2011E
and US$110/bbl in 2012E (US$79 2010E average) (see Exhibit 12). We note that fabric
costs were 11% of Apollo Tyres’ domestic revenue in FY2010 (see Exhibit 10), and
estimate a 12% CAGR in per unit fabric costs during FY10-FY12E.
3) Higher/lower than expected tyre pricing particularly in the domestic tyre market,
driven by momentum in replacement demand. We believe there are downside risks to
margins if the domestic market is unable to absorb a 10% FY10-FY12E CAGR in prices.
Catalysts: Record cost increases, partially offset by price hikes
Significant rise in raw material costs driven by natural rubber, oil prices
We believe natural rubber prices are likely to rise at the fastest pace in a decade with an
18% FY10-FY12E CAGR (see Exhibit 11). Since June 30, 2010, natural rubber prices have
risen by about 30% in the international markets due to weather related disruptions and
extended wintering season in key rubber producing countries such as Thailand, Malaysia
and Indonesia.
Supply-demand dynamics in global natural rubber market are likely to have undergone a
structural change, in our view. Our Tokyo auto team expects supply/demand for natural
rubber to stay tight in 2011E on China/India growth and a recovery in N. America,
absorbing the higher rubber production volumes in Thailand and Indonesia on a yoy
basis. We note that before 2009, China was a consumer of natural rubber and an exporter
of tyres. From 2009, it became a consumer of both natural rubber and tyres. China has
roughly a 40% weighting in global natural rubber demand and its consumption is likely
to sustain high growth. We believe supply is unlikely to grow substantially at this stage
due to falling yields as trees age as well as the fact that many farmers in the key rubberproducing
regions are shifting from rubber to palm oil. Our Tokyo auto team does not
expect supply to increase by a significant degree until 2013E-2014E, when trees planted in
2006-2007 start to contribute. (Refer to the report Rubber supply/demand still tight, price
hikes likely – we say wait, dated November 15, 2010).
We note that rubber costs accounted for 34% of Apollo Tyres domestic revenue in FY2010,
and estimate an 18% CAGR in per unit rubber costs during FY10-FY12E. Further, our
global energy team estimates crude prices are also likely to rise by 25% during CY2011E
and a further 10% in CY2012E driving higher cost of fabric (11% of domestic revenue in
FY2010) used in tyre manufacture. Thus, yoy increase in raw material costs for Apollo
Tyres is likely to be the highest in a decade, in our view (see Exhibit 13). We estimate an
absolute impact of about 25 pp on EBITDA margins of Apollo Tyres over FY10-FY12E on
account of raw material cost inflation, assuming other factors such as pricing remain
constant.
Price hikes to partially offset the impact of raw material cost inflation
We believe that price hikes in the Indian tyre industry will help to absorb much of the raw
material cost inflation, with a 10% CAGR in pricing during FY10-FY12E. As a result, we
estimate a relatively limited impact of rising raw material costs on EBITDA margin of
Apollo Tyres (decline of 4.1 pp during FY10-FY12E).
In general, there are two reasons why we think this magnitude of price hike is likely:
1) We believe that the demand environment remains conducive, improving the market’s
ability to absorb price hikes (see Exhibit 14). Apollo Tyres has already effected more than
10% price hike in the replacement market during 1HFY11, according to the company. We
believe the pricing environment is likely to be favourable with end of the seasonally weak
monsoon and calendar year-end period. We note that there has been a similar magnitude
of price increases during FY07-FY08 period
2) We believe that the Indian tyre industry has limited financial ability to absorb further
raw material cost increases, and may need to partially pass them on through price
increases: a) Apollo Tyres net debt-to-equity is likely to worsen and reach an all-time high
during FY11E before improving in FY12E, in our view, due to ongoing capex and lower
operating margins (see Exhibit 16), b) Most other competitors in the industry are in a
similarly weak position considering their financial leverage and /or operating margins
We note that the stock is currently pricing in an optimistic tyre price outlook for FY10-
FY12E. The street appears to be taking the view that raw material cost increases will be
partially passed on as described above. There could be downside risks to margins and
valuation in case these price increases do not come through, in our view.
Industry profile: Volatile earnings growth, lower relative returns
We make the following brief observations on the Indian tyre industry:
1) About 65% of tyre demand was driven by the replacement market, with 24% driven by
the OEM market (see Exhibit 18). This lends a greater degree of stability to the demand
cycle for the tyre industry relative to OEMs, in our view.
2) On a segmental basis, in tonnage terms trucks and buses account for 69% of demand
with cars accounting for 13% of tyre demand (Exhibit 19). This is in comparison with
developed markets where cars contribute about 38% of demand because of higher levels
of passenger car penetration, in our view.
3) We believe that the industry has relatively less control over major raw material cost
components (accounting for 50%-60% of revenues) such as natural rubber and NTC as
prices of these materials are driven by market supply-demand factors. This is in contrast
to Indian OEMs under coverage that have greater negotiating power with vendors and
parts makers, in our view, and actively collaborate with them to bring down material and
processing costs over time.
4) We note that the tyre industry is relatively less consolidated with top two competitors
accounting for about 42% of the overall market (see Exhibit 20), compared with 60%-70%
for Indian 2-wheeler, passenger car and truck segments.
We believe that as a consequence of 3) and 4) above, Apollo Tyres’ earnings growth tends
to be more volatile through the cycle relative to OEMs under coverage, and the company
also enjoys lower relative cash returns
Company profile
Apollo Tyre is India’s second-largest manufacturer of tyres, with eight manufacturing
plants located across India, South Africa, and Europe. Its main brands include Apollo,
Dunlop in South Africa, Maloya, Regal and Vredestein. It operates through a network of
multi-brand outlets and independent distributors. We estimate Apollo Tyres’ domestic
operations to contribute 63% of consolidated revenue (see Exhibit 21) and 75% of
operating profilts in FY11E. The company is currently the market leader in the domestic
Medium and Heavy Commercial Vehicle tyre segment with about 28% market share,
followed by MRF with 19% market share. About 80% of revenues of the company are
exposed to the replacement market, as of FY10 (compared with 65% for the industry). The
promoter group owns about 40% of equity, followed by Foreign Institutional Investors at
29% and mutual funds at 11%
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