Demand, margin worries: A rough terrain for tyre firms till mid-FY23

The tyre sector has been one of the most-impacted segments within the auto-component space because of the surge in commodity prices. Stocks in the sector have seen the sharpest earnings per share cuts and de-rating. Leading tyre sector players have shed between 17 per cent and 30 per cent since their highs in January, before recovering a bit over the last couple of weeks. 

Highlighting the earnings sensitivity of the raw materials cost surge across sectors, analysts led by GV Giri of IIFL Research place tyre companies at the top of the list of companies that face the highest emerging risk. The earnings per share (EPS) impact on CEAT, Apollo Tyres, and MRF ranges from 56-114 per cent; the stocks (since February 23) have, however, not corrected by that quantum, they point out. 

The extent of the raw material risk is more for tyres as compared to others given the dependence on the crude oil derivatives. Inputs that go into the making of a tyre — such as rubber, steel, synthetic rubber, and carbon black — have seen a surge in prices. Mitul Shah, head of research at Reliance Securities, says: “Nearly 50 per cent of raw material is linked with crude oil prices. Therefore, the recent sharp climb in crude oil prices, by over 50 per cent, translates into a similar cost escalation for tyre companies. Moreover, the Russia-Ukraine war and sanctions on Russian products will keep prices high for some time, impacting costs to these companies.”

What will weigh on these stocks is the margin impact over the next couple of quarters, amid their inability to pass on the higher costs. Lack of pricing power is compounded by demand weakness. Tyre companies, according to analysts at JM Financial, will have to take further price hikes in the replacement segment, by 7-9 per cent. This is over and above the 12-18 per cent price hikes taken since the December quarter (Q3FY22). 

Commenting on the impact of raw material costs, Sanjeev Aggarwal, chief financial officer of JK Tyre & Industries, said the company was able to pass about 60 per cent of the unprecedented hike in costs and would gradually pass the rest. Part of the weakness on the domestic demand front was offset by a 50 per cent rise in exports over the past year. In the domestic market, even as demand is gradually recovering in the commercial and passenger vehicles segment, two-wheelers and tractors are lagging, he says.  

Given that price hikes lag raw material cost inflation, the impact of the recent surge in commodity costs will be prominent towards the end of the Q1FY23 (one quarter lag), while the March quarter margins will remain relatively stable. While cost pass-throughs in the contracts with automakers take care of the raw material inflation for that segment, for the replacement market, tyre companies are hoping for an improvement in demand which will enable price hikes. Cost-optimisation measures are the other factors that could help support margins. 

However, analysts at ICICI Securities believe that the sector is close to the cyclical bottom on three aspects, which drive free cash flow generation and have hit the sector over the last year — volume growth, profitability, and capital expenditure. They expect various segments in the auto sector to grow their volumes by 12-22 per cent over FY22-24; the replacement market is expected to grow by 9-10 per cent. Gross profit per kilogram is already below 10-year mean levels and shall go down further over the next couple of quarters, before moving up on the back of improving volumes. Given that the sector has invested in enhancing capacity over the past couple of years, spending on this account is expected to remain lower. 

Demand is expected to improve by mid-FY23 with easing semiconductor supply and better agri output, says Shah of Reliance Securities. He believes investors should start accumulating tyre stocks as their current valuation is 20-25 per cent below historic valuation. While there is valuation comfort, what may hit sentiment is any possible action by the Competition Commission of India on Apollo Tyres, MRF, and CEAT, on account of unfair trade practices. Companies have indicated that they are in compliance with all laws and that they follow the highest levels of corporate governance. Most brokerages have a buy call on Apollo Tyres, CEAT, and Balkrishna Industries.