>TYRE SECTOR (EMKAY)

SYNOPSIS: 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.

■ Pricing discipline - the biggest differentiator
The most important structural change (as compared to FY03-05 period) that lends support to our case is the almost 100% utilization in the truck and bus bias (TBB) tyre segment, which accounts for around 60% of the industry revenues. We have already witnessed pricing discipline in the industry since FY07, which has enabled the players to improve margins despite continuous increase in commodity prices.

■ Capacity additions - a necessity due to higher utilization levels
Our analysis of the tyre industry and its utilization indicates that the concerns with respect to excess capacity are overdone. Considering the long term growth rate of the Indian passenger car tyre (PC) and truck and bus tyre (T&B) segment of ~12.5% and ~5% respectively, the expansion is necessary. During FY09-FY13, PCR and T&B will add capacity at 12.6% and 7.4% CAGR respectively.

■ These are planned capacities - coming up in a phased manner
The recent wave of greenfield expansion, which will eventually add 29% to the current capacity, is likely to come up in a phased manner with intermediate review of capacity additions. We believe that the expansion will be curtailed if the situation so warrants, considering the gap between minimum economic size of the plant and the current expansion plans announced by the players.

■ Only radial capacity additions in T&B segment - is it a concern?
The T&B segment will be witnessing a capacity addition of ~6 mn tyres during FY09-FY13 in the truck and bus radial (TBR) tyre segment. If all the planned capacities are commissioned as per schedule, then TBR would account for 28% of T&B capacity by 2013. An analysis of trends in radialization in some of the other countries indicates that the demand for TBR in India is at an inflection point. Strong focus of the government on road development as well as ban on overloading (since November 2005) are the two most important structural changes that can ensure that India replicates the radialization witnessed in other countries.

■ Exports - can regain momentum
We expect exports to act as another support factor for ensuring higher capacity utilization levels. The share of exports (tyres sold) after reaching 8.5% in FY05 has declined to 7% in FY09 due to capacity constraints.

■ Pressure on account of raw material prices - already factored in valuations
Current valuations of ATL and JKT at PER of 6.5x and 2.8x our FY10 estimates are factoring in a sharp drop in earnings in FY11 due to the risk of continued uptrend in rubber prices (rubber is only 7% below its peak). Historically, rubber prices have corrected after such a sharp run up in the prices. Any correction in the prices presents potential upsides.

■ Rising raw material price does not necessarily mean pressure on profitability
Since FY06, rising raw material prices have not affected the margins significantly, except for the FY09 period. We attribute this to the strong volumes as well as pricing discipline since FY06. Infact, margins have witnessed an upward trend despite rising raw material prices. During FY06-FY08 period, 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.

■ Initiate coverage on ATL and JKT
We are initiating coverage on ATL and JKT with a BUY rating. 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 visible in FY11 and FY12

To read the full report: TYRE SECTOR