Tyremakers are on a roll but watch out for bumps

Against this backdrop, shares of Apollo Tyres Ltd surged to a new 52-week high this month. Recall that shares of Ceat Ltd and JK Tyre & Industries Ltd scaled new 52-week highs in December.

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Investor excitement is understandable given that natural rubber and crude derivatives such as synthetic rubber and carbon black contribute around 70% of the sector’s total raw material cost basket. So, input price movements are a crucial determinant of earnings outlook.

With relief on this pain point, the important factor tyre investors need to focus on is the sector’s capital expenditure (capex) intensity, which has remained high lately. A ban on tyre imports is also among factors that have given the companies’ capex plans a boost.

An analysis of seven listed tyremakers by CareEdge showed that in the last five years, investment in capex pushed the sector’s gross block by two times (See chart). Gross block is the total value of all assets that a company owns. A major portion of this capex was greenfield in nature and capex as a percentage of revenue averaged 9-10%, showed the CareEdge study.

Rising capex bodes well for the sector’s long-term growth outlook. However, until that fructifies, it weighs on the companies’ balance sheet strength and return ratios, especially with fears of a global recession looming.

According to Nithya Debbadi, assistant vice president and sector head – corporate ratings, Icra Ltd, the estimated interest coverage ratio for Icra’s sample set of seven tyre companies for FY23 is around 5-7x and total debt/Opbitda at around 2x. Opbitda is operating profit before interest, taxes, depreciation and amortization. While the industry’s overall credit profile is currently at a comfortable level, a delayed recovery in margins, rising interest costs and debt-funded capex shall have some impact on the debt metrics, she cautioned.

Thankfully, considering the current global macroeconomic backdrop, companies are exercising caution. In the September quarter (Q2FY23) earnings conference call, the management of Apollo Tyres said it has been extremely judicious about capex and has curtailed it in the first half of FY23 given the challenging business environment.

“Elevated capex intensity has pushed the sector’s leverage higher and return ratios lower,” said Varun Baxi, an analyst at Nirmal Bang Institutional Equities.

Competitor Ceat’s management has said that it is tightly monitoring capex and cash flows. The guidance for FY23 project capex remains at Rs750 crore, which the company will review in Q3. The management expects its FY24 capex to be lower than FY23.

According to Baxi, peak capex is behind the sector and any incremental capex would be largely brownfield. So, lowering of capex intensity means that companies will have more money on the table which can be used for deleveraging and leaner balance sheets are a positive for tyre stocks, he said.“Going ahead, capex per tonne is likely to be at ~60-65%, much lower than seen in the previous capex cycle,” Baxi added.

Meanwhile, a key near-term lever for tyre stocks is the pace of margin improvement. Q3 results and management commentary should offer more clarity on this front. On the flip side, a fresh covid wave, global recession and lower-than-expected recovery in margins are the potential downside risks. As of now, tyre stocks seem to be capturing a good portion of the optimism.