Tire stocks fluctuate as margin pain persists

As per an analysis by JM Financial Institutional Securities Ltd, for the sector, the cost of consumption of raw materials has increased by over 5% sequentially in Q4FY22 (till February 28). Year-on-year, costs have increased by 22%. “Our analysis shows that to maintain healthy margins, tire companies will need to increase prices in the replacement segment by 6-8%,” analysts at JM Financial said in a report on March 8.

As such, auto subsidiaries can pass on commodity inflation directly through contracts with original equipment manufacturers (OEMs). Analysts believe that tire companies have resorted to hike in prices by around 15% so far in FY12 to deal with rising costs, though this weighs on already weak demand. Although, clearly, this will not be enough.

The ongoing Russia-Ukraine conflict has resulted in a jump in crude oil prices, which has affected tire makers, as a major part of the raw material they use for manufacturing is crude. According to ICICI Securities, for every 10% increase in the price of crude oil, an increase of about 200 basis points is required in the price to remain gross margin neutral. One basis point is one hundredth of a percentile.

On the positive side, a major input, natural rubber, has remained comparatively stable. Average domestic natural rubber prices have declined 8% sequentially in Q4FY22 (till February 28).

In the meantime, investors will be closely watching how demand moves amid such price hikes, as an improvement in demand remains to be seen. In Q3FY22, tire manufacturers experienced a slowdown in domestic OEM and agricultural demand and did not see any growth at that pace. Analysts at JM Financial pointed out that their tyre-focused channel checks at dealers indicate that replacement market demand for two-wheelers and passenger cars weakened during Q4FY22, while sales in the truck and bus segment remained muted. This is due to restrictions on personal mobility imposed in January to contain the spread of the coronavirus, financial stress among fleet operators and price hikes.

That being said, the demand for replacements is expected to improve as COVID cases go down. This would mean that schools, colleges and offices would reopen, necessitating mobility. Additionally, increasing awareness of personal hygiene will increase the demand for personal mobility in the OEM and replacement market. An expected healthy rabi crop season would mean an increase in rural cash flows, which would help boost demand in the agriculture segment. Also, exports are expected to maintain the strong trend seen in Q3.

In addition, rising inflation would mean there may be limited disposable income for consumers. This may to an extent favor the demand for replacement. “Amidst rising cost of ownership, sales of new vehicles may drop. But if customers defer their new vehicle purchases, replacement sales may remain relatively strong, said Jay Kale, analyst, Elara Securities (India) Pvt Ltd.

Meanwhile, escalation of conflict or supply chain disruptions in Ukraine could pose major risks to tire manufacturing sector stocks, while a fall in crude oil prices will provide relief. “We expect margins to recover to sustainable levels only in H2FY23 (if the cost of consumption of the raw material basket remains/moderate),” the JM Financial report said.