Puncture risk

Apollo Tyres' $2.5 bn takeover is piling up risks

Apollo Tyres' $2.5 billion takeover of its U.S. rival looks increasingly rickety. The Indian firm may need an agreement with unions at Cooper Tire and Rubber Co. after a US arbitrator ruled the workforce had the right to block part of the deal. If a solution raises costs, Apollo will have even less room for error when it comes to servicing the transaction's hefty debt.

The ruling affects two out of eight of Cooper's plants in the US, covering 2,500 employees or 19 per cent of the global workforce. It will also encourage resistance from workers in China. Laborers at Cooper's operation in the eastern Shandong province, which employs more than 5,000, have been on strike for three months. The U.S. firm's minority local partner has also filed a lawsuit to dissolve the Chinese joint venture.

Labour tensions stem largely from worries about Apollo's plan to pile debt onto the enlarged company as it tries to swallow a rival worth roughly four times its own market value. Apollo is borrowing an additional $450 million, while Cooper will take on $2.1 billion of non-recourse debt, mostly through a bond offering. The combined entity, which will be the world's seventh-largest tyre manufacturer, will have net debt worth around 3.8 times its earnings before interest, tax, depreciation and amortization.

If the deal goes ahead as planned, the combined company's Ebitda margin will be as much as 300 basis points higher than its interest payments, according to Kotak Securities. That will be even better if Apollo succeeds in extracting the benefits of combined scale, sourcing, and manufacturing improvements which it says could be worth an additional $120 million of annual EBITDA within three years.

Yet tyre-making is a volatile business. Margins at Cooper - which will contribute around 70 per cent of pro-forma Ebitda - are 13 per cent, their fattest in six years. They were around seven per cent as recently as 2011. If Apollo is forced to overcome its current difficulties by increasing wages for workers, margins will be squeezed. Cooper shares are trading at eight per cent below Apollo's $35-a-share cash offer. Given the deal's mounting risks, the discount is more than justified.