Wednesday, December 16, 2009

[Investors] BUY Apollo Tyres @49 Target 60, BUY JK Tyre @ 150 Target 192

Tyre Sector

 

Pricing discipline - The differentiator 


We expect a re-rating of the tyre sector over the next few quarters, as concerns on the earnings front are put to rest. The current valuations of tyre companies indicate expectations of a sharp earnings decline (atleast 40%) in FY11E due to concerns on rising raw material prices (rubber prices only 7% below its previous peak) and capacity additions (affecting pricing power). The markets seem to be factoring in a repeat of the FY03-05 period, where profitability was significantly affected due to the above factors. EBIDTA margins declined by 410 bps to 6% and net profits declined by a CAGR of 22% during FY03-05.

 

While we share concerns on the rising raw material prices, we believe that pricing discipline will be the biggest differentiator. The industry has shown good pricing discipline since FY06. It should be noted that during FY06-FY08, the EBIDTA margins expanded by 500 bps to 11% and net profits increased at a 77% CAGR. This was despite a sharper increase (1.1x) in the rubber and oil prices during FY06-FY08 vis-à-vis FY03-FY05. Even in FY09, when there was a drop in volumes, (resulting in lower capacity utilization), pricing witnessed an uptrend.

 

We do not expect the ambitious capex plans during FY09-FY13 (gross block to increase by ~58%) to adversely impact tyre pricing as the expansion is more of a necessity than an option. Capacity addition during FY09-FY13 is mirroring long term growth trends. More importantly, capacity additions will happen in a phased manner and can be curtailed if the situation so warrants.

 

We consider 1HFY10 profitability as abnormal and hence, are factoring in a drop in earnings of 15% to 25% for domestic business in FY11. Barring a further spike in rubber prices, we believe that earnings would surprise positively.

 

While all the tyre companies will benefit from pricing discipline, we expect Apollo Tyres (ATL) and JK Tyre (JKT) to outperform as the contribution from their recent international acquisitions become more visible in FY11 and FY12. We are initiating coverage on ATL (BUY) and JKT (BUY). We like ATL for its thirst for market leadership with a clear focus on profitability. We like JKT purely from a valuation view.

 

 

Reco

Company

CMP (Rs)*

TP (Rs

BUY

Apollo Tyres Ltd.

49

60

BUY

JK Tyre & Industries Ltd.

150

192

* CMP as on 14th Dec-2009

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