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Things looking up for this sector, re-rating imminent; worth a look

Tyre stocks got de-rated in recent months due to continued margin pressure

Nov 29, 2018, 01.48 PM IST
India Inc’s earnings recovery once again remained elusive in second quarter, as the number of companies missing analysts’ estimates turned out to be higher than market expectations.

However, there are expectations that the tyre sector will start rolling, soon as earnings outlook for the companies has improved following the recent correction in crude oil prices.

Amid sustained selling in the midcap and smallcap stocks, this sector has failed to impress investors on Dalal Street so far in 2018. Except for Krypton Industries, whose shares are up 4 per cent, others like MRF, TVS Srichakra, Ceat, Balkrishna, Goodyear, Apollo Tyres, JK Tyre and Govind Rubber have seen their stocks tumble between 5 per cent and 71 per cent during this period.

Tyre stocks got de-rated in recent months due to continued margin pressure owing to a rise in input costs and lag in pass-through of these costs via price hikes. Continued strength in volumes, recent price hikes, relief from cost pressure and the resultant improved earnings visibility should drive a re-rating from current lows, according to market experts.

Price of the key input, natural rubber (NR), has been soft in recent times. The only concern for the industry has been the sharp rise in crude-linked commodities, including synthetic rubber, carbon black, chemicals, among others. Both natural rubber and crude derivatives comprise 80 per cent of raw material consumed for the tyre sector. With the recent correction in crude price, the earnings outlook for tyre-makers has improved substantially.

Crude oil price, which surpassed the $86 per barrel in early October, has since fallen near the $60 mark.

The domestic tyre industry is seeing strong volume growth (CEAT: over 15 per cent, Apollo: over 29 per cent in 1HFY19), driven by after-market demand, especially in the truck and bus (T&B) segment. The recent weakness in sales of original equipment makers (OEM) does not seem to be a huge concern as two-third of the industry demand comes from after-market sales.

The remaining one-third comes from OEMs. Over the past 10 years, the tyre industry has seen volumes decline even once, despite a sharp drop in OEM sales.

“With the recent correction in crude price, the earnings outlook for tyre-makers has improved substantially. Valuations came off with margin pressure and there is scope for re-rating due to better earnings visibility. Recent weakness in OEM sales is not a big concern. OEM segment is a small revenue contributor as against after market,” brokerage firm IIFL said in a report.

Chola Securities said while low crude prices will aid in keeping raw material prices in check along with lower freight costs and hence be favourable for sectors like tyre, paint and cement manufacturers.

On an aggregate basis, the tyre manufacturers reported 1.80 per cent fall in net profit despite 16.42 per cent year-on-year rise in net sales for the quarter ended September 2018. Company wise, MRF, TVS Srichakra, Ceat and Goodyear posted 12.30 per cent, 26.26 per cent, 17.55 per cent and 31.42 per cent YoY fall in bottom line figures in Q2FY19.

On the other hand, JK Tyre, Krypton, Balkrishna and Apollo reported 198 per cent, 373 per cent, 9.52 per cent and 4.19 per cent YoY rise in net profit for July-September quarter.

IIFL prefers Apollo Tyres (target price: Rs 300) over Ceat (target price: Rs 1,200) and MRF (not rated) due to higher earnings growth, lower exposure to the competitive two-wheeler tyre segment, earnings uplift in European operations (low-cost plant) and cheaper valuation. It has reduced rating on Balkrishna Industries with a target price of Rs 965.

In a recent interaction with ETNow, Sanjiv Bhasin, Executive VP-Markets & Corporate Affairs, IIFL said that it took 150 days for oil to reach its peak and in 45 days it has fallen 30 per cent. “There is too much pessimism and people are just caught in the whirlwind. The rupee and oil prices are definitely telling you that aviation, paints, tyre and some of the OMCs are going to be very strong sectors to play,” he said.

Market experts are cautious about domestic equity markets considering higher valuations and upcoming elections in the next six months.

Edelweiss Securities said high risk of earnings downgrades along with high absolute valuations and relative to emerging markets (65 per cent premium vs 10Y average of 40 per cent) renders us cautious on the market over the ensuing six months.

The brokerage sees Nifty in the 9,800-10,500 range till June 2019. The index hovered around the 10,800 mark on November 29.

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