Will tyre stocks continue to enjoy the joy ride?
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Mumbai: Tyre stocks are on a roll, clocking new highs almost every day. From three months ago, Apollo Tyres Ltd has gone up by 48.3%, MRF Ltd by 36.9%, Ceat Ltd by 35% and JK Tyre Industries Ltd topped the list, surging 70.5%.
Investors were quick to take cognizance of the change in two key variables—sales volumes and rubber prices—that determine the fortunes of tyre firms. But will it stay this way?
Until a few weeks ago, the outlook for tyre firms for fiscal year 2017 was grim as analysts were cautious on auto sales on the one hand, and rubber prices had surged ahead on the other.
Suddenly, the scenario reversed. With the June quarter came hope that auto sales could be better than expected from the festive season of FY17. A good monsoon would bump up rural demand and the increase in disposable income as a result of higher salaries from the Seventh Pay Commission will propel urban demand too. Better auto sales implies a better chance for tyre companies to pass on production cost increases, if any, to consumers, particularly in the replacement market.
In any case, sales volumes and realisation had improved in the June quarter, though marginally. Fuelling this was the sharp 20% drop in rubber price (RSS-Grade 4) in the last six weeks putting the earlier five-month rally in reverse gear. The lower price of rubber, which accounts for two-thirds of the raw material cost in making a tyre, is a key variable that impacts profitability. The rubber price is now back to where it was about a year ago and with the tapping season ahead, the hope is that it will stay this way for some quarters. Also, low off take in China is likely to keep international rubber prices depressed for the medium term.
Meanwhile, some industry sources say there is hope of anti-dumping duty being imposed on imported tyres. Recall that Chinese tyres, which are about a third the price of domestic ones, had given the manufacturers a run for their money. It has hurt sales and profitability of domestic firms for many quarters.
That said, it is important for investors to steer clear of short-term changes in stock prices. Note that the stock price return is far lower over a one-year period than in the last three months. Also, the effect of better auto sales and lower rubber prices may not be mirrored in the September quarter performance, as tyre firms may be carrying some high-cost inventory. In the last two quarters, the average of five leading tyre firms in the listed universe showed negligible growth in revenue and net profit.
At present, tyre stocks are trading at an average price-to-earning (PE) multiple of 6-8 for FY2018 estimated earnings, which is reasonable. Any revision in earnings or PE multiples would be triggered by sustainable changes in the two key variables—auto sales and rubber prices—which, in turn, will impact stock price movements from current levels. Any disappointment on these counts could puncture the joy ride.