Saturday, Nov 26, 2022

Steep Fall In Raw Material Prices, Controlled Capex Could Benefit Tyre Makers Like CEAT, MRF, Says Motilal Oswal

The brokerage firm hints at a margin expansion from the third quarter of the current fiscal with the full benefit seen from next financial year

After witnessing hyperinflation in key input costs over the last 15-18 months, the tyre industry is currently seeing moderation in natural rubber as well as crude prices which augurs well for a margin recovery from the second half of the current financial year, brokerage firm Motilal Oswal recently said. 

Key input prices have seen an incessant increase of over 50 per cent since the first half of FY21 with the average raw material basket costing Rs 180/kg, resulting in an over 10 percentage point fall in gross margin.

However, natural rubber prices appear to have peaked in mid-June this year with spot prices of natural rubber now being 12.5 per cent lower than the prices in the first quarter of the current fiscal.

Synthetic rubber and carbon black prices are 6-7 per cent higher over their average price of the first quarter—a reflection of the delayed impact of crude oil price inflation in the first half of the current calendar year. Since the underlying crude oil prices have corrected by 22 per cent from the average of the first quarter price, it should reflect a lag in both synthetic rubber and carbon black prices, Motilal Oswal said.

As per the Mumbai-based brokerage firm’s estimates, for every 10 per cent change in natural rubber, synthetic rubber and carbon black prices, EBITDA margin or operating profit margin will change by 160 basis points, 80 basis points and 100 basis points, respectively.

It also hints at a margin expansion from the third quarter of the current fiscal with the full benefit seen from next financial year. On the basis of the previous fiscal, Motilal Oswal expects blended gross margin to expand by 190 basis points in FY24.

The Demand Game

The demand for tyres from the original equipment makers (OEMs) has improved across categories but the replacement demand has seen a mixed response. While it is holding up well for passenger cars and two-wheelers, it is relatively weak for trucks, buses and tractors, Motilal Oswal noted. 

Interactions with the industry participants suggest that the truck and bus segment demand should see a recovery from the next quarter as the noise around inflation tapers off, it said.

“Export demand, which was seeing a strong momentum for the last few quarters, has turned sluggish since the first quarter of the current fiscal due to several disruptions seen in global markets. This is particularly relevant for exports to Europe as it is impacting demand across segments,” Motilal Oswal said.

Control Over Numbers

The fall in raw material prices also comes along with tyre makers looking at asset sweating and controlled capital expenditure which will drive an improvement in free cash flows, financial gearing and return on capital employed (RoCE).

Since the breakout of geopolitical issues and tightening of interest rates, tyre makers are largely focused on sweating assets and controlling capex. This is reflected in capacity utilisation of 80-90 per cent across players in the first quarter.

Currently, there are no major ongoing greenfield or brownfield expansions by mainstream tyre companies whereas debottlenecking is the preferred mode to expand capacity to meet demand over the next one-two years, Motilal Oswal said.

“Aggregate absolute capex for the four listed mainstream players like Apollo Tyres, CEAT, JK Tyre and MRF is expected to remain stable at FY22 levels and lower than FY19 and FY20 levels. As a percentage of sales, capex is expected to reduce from an average of 10% over FY19-22,” it noted.

We expect a sharp improvement in free cash flow generation, reduction in financial gearing and an improvement in RoCE, it added. 

The brokerage firm has a buy call on Apollo Tyres and CEAT for target prices of Rs 325 and Rs 1,630 per share, respectively. It has a neutral call on MRF and Balkrishna Industries for target prices of Rs 82,000 and Rs 2,300 per share, respectively.