Will higher production volumes improve Ceat’s profit margins?

Will higher production volumes improve Ceat’s profit margins?

Tyre makers face rising volumes on the one hand, but increasing raw material prices on the other. Sometimes, capacity ramp-up, if absorbed by an expanding market, can help better profitability as the fixed cost gets spread over higher volumes and revenue. That’s important because RPG Group tyre maker Ceat Ltd has increased production by one-fifth of its existing output, taking its total tonnage up to 600 tonnes per day over the next two years. In revenue terms, analysts reckon that this could add Rs1,000 crore to the Rs3,500 crore estimated for fiscal 2011.

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Ceat’s problem from the investor standpoint is its wafer-thin profit margins. For the December quarter, while the revenue grew 20% over the year-ago period, operating profit margin contracted by 200 basis points to 4.5% of sales. Net profit margin, too, was barely 2.8%.

Given this scenario and its high sensitivity to raw material price fluctuations, increased volumes could boost operating leverage in the medium term. Besides, two-thirds of its present revenue accrued from the truck and bus (T&B) segment, but mainly from cross-ply tyres. The expanded capacity is in radial tyres, which is in line with the growing shift in technology from cross-ply to radial tyres.

About half the new capacity will cater to the T&B segment, while the balance will cater to the passenger car segment. The uptrend forecast in both segments will buoy volumes.

Ceat, like its peers Apollo Tyres Ltd, caters mainly (about 75%) to the replacement market, where price realizations are better when compared with the original equipment market. Dealers say that margins are 15-20% higher in radial tyres, which is the preferred option even in the replacement market for new-generation vehicles across categories.

Meanwhile, a few months ago, Ceat spent Rs55 crore to completely acquire the brand from Pirelli and C. SpA of Spain. The firm can now export both radial and cross-ply tyres to any country with the Ceat brand, which is a breakthrough considering that it was hitherto entitled to export only to nine countries under the brand.

The above factors could have a favourable impact on profit margins, besides revenue accretion. Incidentally, Ceat had already rationalized staff costs through a one-time voluntary retirement scheme in the December quarter.

A concern that remains amid these positives is high working capital loans, which led to a 35% jump in interest costs in the December quarter over the preceding one. Its low profitability, along with the relentless rise in raw material costs, is the reason for the underperformance of the stock, when compared with the CNX Midcap Index. Only an improvement in margins will help lift Ceat’s share price.

Graphic by Yogesh Kumar/Mint

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