India’s growing auto market will drive a healthy 9% compounded annual growth rate (CAGR) for the tyre industry in the ensuing years, in spite of changing business economy (rising input cost) for the industry.
Raw material prices (rubber) are increasing, but we do not expect a repeat of significant damages on the operating front. This is supported by the fact that the Indian tyre industry has been operating at around 90% capacity utilization levels over the last three-four years. This typically implies either very strong demand or constraints on the supply side, both of which should push product prices up.
Further, the tyre makers are fairly confident of a sustained improvement in demand, owing to which they have planned higher investments over the next two-three years. Consequently, higher capital requirements will help protect margins from upward bound input costs, as the business model evolves bearing in mind the final return on equity (RoE) rather than margins.
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With the sector set for a structural shift (higher investment needs in radialization) and apparent pricing flexibility, this will result in an improvement in the return on capital expenditure (RoCE) and RoE of tyre manufacturers.
The Rs22,500 crore Indian tyre industry registered a volume CAGR of 8.5% over the last five years with a production of 1.18 mt in FY09.
Strong demand for vehicles across segments, to be aided by an overall recovery in macroeconomic factors and underlying structural demand drivers, will propel robust growth in tyre demand.
Profits of around Rs4,062 crore (including dividend payout) would be required over FY2010-12 estimates to meet reinvestment needs, implying around Rs1,557 crore of profit in FY2012 estimates compared with Rs360 crore at present.
Margins are set to increase on the back of high investment in radials. Manufacturing radial tyres is far more capital intensive than cross-ply tyres. Selling price of radial tyres are around 20% higher than cross-ply tyres. Taking into account the difference in capital requirements and consequent impact on asset turnover, interest cost and depreciation, to generate similar RoCE and RoE. Tyre companies would need to earn earnings before interest, taxes, depreciation and amortization (Ebitda) margins of around 22% compared with around 9% being earned on cross-ply tyres.
Higher capital requirements will help protect margins from upward-bound input costs.
A high-return profile justifies higher valuation. Greater pricing flexibility has led to significant increase in return ratios of the tyre manufacturers over the last three-four years. Profitability of tyre manufacturers over the next couple of years would continue to be determined largely by higher demand.
The industry, which is operating at 90% capacity utilization levels with apparent pricing flexibility, offers an improvement in RoCE and RoE going forward.
Owing to the apparent structural shift the industry is going through, tyre companies would fetch higher valuation.
Entering stocks in the sector at current valuations would fetch good returns.
Graphic by Yogesh Kumar / Mint