The tyre sector continues to reap the benefits of softening prices of inputs such as rubber and crude oil. This, coupled with product price hikes led to further sequential gross margin expansions for leading listed tyre companies in the June quarter (Q1FY24), which came as a positive surprise. The consistent improvement in profitability resulted in a significant re-rating of tyre stocks.
For instance, so far in 2023, shares of tyre companies, such as Apollo Tyres Ltd, Ceat Ltd and JK Tyres & Industries Ltd, have rallied 21-47%. Some stocks have beaten benchmark index Nifty Auto by a wide margin. The moot question now is whether this rally has more legs. Well, this would depend on a slew of factors. For one, it remains to be seen whether gross margins seen in Q1FY24 have peaked or there is more room for expansion. As such, lower-than-expected profitability could dampen investor sentiment. A 5% change in gross profitability assumptions can lead to 8-18% change in earnings per share of tyre companies, Kotak Institutional Equities said in a report.
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Second, overall demand trends do not lift spirits. In Q1, domestic demand growth in replacement and original equipment manufacturer (OEM) segments was subdued. Analysts said there would be some pain in demand for bus and truck tyres. Besides, export was in a dismal state due to demand pressure in the crucial export market of Europe.
“Tyre companies were able to beat margin expectations in Q1, primarily because they were able to retain pricing power,” said Aniket Mhatre, institutional research analyst, HDFC Securities Ltd. But incrementally, raw material prices are not coming down, so demand revival becomes a crucial stock trigger from hereon, he added.
The trends in demand and margins are critical, especially as competitive intensity in the sector is likely to rise. At a time when margins are improving and volume growth is subdued, companies may opt for price cuts to protect market share and propel growth.
The latest management commentaries of tyre firms indicate that demand could recover in the second half of the year. Even so, as things stand, analysts anticipate single-digit volume growth for key listed companies in FY24, at best.
Furthermore, the steep uptick in stocks has meant that valuations are relatively pricey. A concern is that the Street may be pricing-in a best-case scenario for the sector’s earnings growth. “The market is assuming an extended period of elevated margins and profitability irrespective of (1) demand-supply scenario, (2) nature of business and (3) disruption risks,” said Kotak’s analysts in a report dated 18 August. They further added that the current high multiples imply strong earnings growth, supported by a structural shift to higher industry profitability. “However, there has been no material improvement in the market structure, which can lead to better pricing power in future,” said the report.
At FY25 price-to-earnings, Apollo, Ceat, JK Tyres and MRF Ltd are trading at multiples of 10-22 times, showed Bloomberg data. To be sure, there are some comforting factors as well, which bode well for the companies’ balance sheet strength. “Tyre companies are seeing improvement in free cash flows on higher margin and moderation in capital expenditure intensity. For example, Apollo and Ceat are doing capital expenditure in a staggered manner and at same time they are focussing on de-bottlenecking,” said Raghunandhan NL, director, Nuvama Institutional Equities.
But given that valuations have run-up now, any earnings disappointment, could spoil the party as far as further upsides are concerned.
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Updated: 22 Aug 2023, 11:32 PM IST