MRF, Apollo Tyres and CEAT – IIFL Sec reveals key idea for investors to benefit from

IIFL Securities highlights that the tyre industry has been in a high capex phase, with capex as percentage of revenue averaging 11% over the past five years. It has also initiated coverage on MRF with Add rating with a target of Rs 63,500. Apollo Tyres is the top pick in the sector with a target of Rs 175. IIFL Securities expects volume growth to revive sharply, starting FY22. Replacement demand is seeing a strong recovery, while OE sales have also recovered. IIFL Securities expect both the replacement and OE segments (especially T&B) to see strong growth from FY22.

Demand and capex cycle turning favourable

The tyre industry was in a rare down cycle, after two decades of secular growth. IIFL Securities now expect the industry to see a sharp revival ahead, with pick-up in replacement demand and normalisation of new vehicle sales. Industry capacity utilisation has dropped substantially, after a high capex phase and recent volume contraction. Going forward, IIFL Securities expect capex to be low and cash-flows should surge. Given faster-than-expected revival in demand, IIFL Securities sharply upgraded their EPS for Apollo tyres / CEAT. Also, they initiate coverage on MRF with Add rating with a target of Rs 63,500. Apollo Tyres is the top pick in the sector with a target of Rs 175.

Industry demand to see strong recovery after a rare down-cycle:

The tyre industry has carved a secular growth story, with only two instances of volume declines in 2 decades, of only 1-2% each. FY20 & FY21 marked a departure from the norm, with sharp volume drop. IIFL Securities expects growth to revive from FY22. They believe that both, the replacement & OE (original equipment) segments (especially Top and bottom), would see strong growth FY22 onwards. On a quarterly basis, IIFL Securities expects industry to be flattish YoY in Q2 FY21, after a 40% YoY decline in 1QFY21. Replacement demand is seeing a recovery, with double-digit growth; OE sales have normalised.

Industry capex / FCFF (Free cash flow to the firm) cycle to turn favourable:

The tyre industry has been in a high capex phase, with capex as % of revenue averaging at 11% over the past five years. Significant rise in capacity in recent years and 2 consecutive years of volume decline will bring down Apollo tyre and CEAT’s capacity utilisation to 60% in FY21. IIFL securities believe this would be representative of the industry. They expect industry capex to come off sharply from hereon. This combined with an uptick in volumes, resultant margin improvement and debt reduction bodes well for sector earnings.

Lack of ASP growth – A structural problem:

Realisations per tonne (MT) almost doubled over FY 05-11, but they have been flattish during FY11-21, suppressing EBITDA/MT. This is a result of deflation in input costs and the industry’s unwillingness/inability to raise prices. Over FY11-21, capex per unit has more than doubled, structurally bringing down fixed asset turnover and return ratios. The only way out is to bring steady improvement in EBITDA/MT through periodic price increases, even in the absence of input cost inflation. In the near term, volume growth (operating leverage) and cost controls can do the job.

IIFL Securities Initiates coverage on MRF with an ADD rating:

IIFL Securities initiates coverage on MRF with an ADD rating and target price of Rs 63,500. Like the rest of the industry, MRF will benefit from the up-cycle in demand and lower capex intensity. However, MRF’s margin-lead over peers has come off substantially, due to moderation in profitability of the 2W tyre segment (higher competition from CEAT). MRF’s relatively weaker presence in TBR (Truck & Bus - radial) vs. Apollo is a disadvantage, as radialisation in the industry increases. MRF’s market leadership and cash rich balance sheet are largely priced in, at 21x FY22 and 17x FY23 P/E.

Increase estimates for Apollo tyres and CEAT, on better volume visibility:

IIFL Securities upgrade volume assumptions for Apollo tyres and CEAT by 6- 9% through FY21-FY23, in view of the strong revival in replacement sales and normalisation of OE demand. IIFL Securities now forecast tyre industry volume decline of 7% in FY21 vs. 14-15% fall earlier. IIFL Securities upgrade EBITDA by 2-9%, EPS upgrade is much sharper, due to significant leverage in the P&L and low expectations for FY21. IIFL Securities upgrade FY21 - 23 EPS for CEAT by 37%/29%/10% and for Apollo by 58%/11%/3%.

Apollo is our top pick in the sector:

IIFL Securities like Apollo Tyres for the following reasons:

i) Sharp demand recovery, with high exposure to CVs supporting faster growth
ii) End of the high capex cycle and strong FCFF generation over FY21 – 24
iii) Headcount reduction in Europe and resultant margin expansion
iv) Significantly cheaper valuation vs. peers. Over FY20-23, IIFL Securities forecast EPS CAGR of 20% for Apollo vs. 10% for CEAT and 14% for MRF.

Forecast sharp recovery after rare down-cycle

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The Indian tyre industry has carved a secular volume growth story. Over the past two decades, industry volumes had declined only twice, by only 1-2% on both occasions. The secular volume growth is primarily due to higher reliance on the replacement segment (i.e. after-market). Due to the continuous rise in vehicle population, replacement demand has continued to grow. Even in the years when new vehicle sales (OEM segment) have been weak, replacement has more than offset the decline. FY20 marked a departure from the norm, with industry volume decline of 11%. This was driven by a confluence of factors:

i) Extremely weak OE sales
ii) A weak economy
iii) Impact of the Covid-19 lockdown in March 2020

Expect sharp volume recovery from FY22

The tyre industry suffered back to back years of volume contraction (FY20 + FY21), a phenomenon not seen in the past two decades. IIFL Securities expects volume growth to revive sharply, starting FY22. In fact, on a quarterly basis, they expect flattish industry volumes YoY, in Q2 FY21, after a 40% YoY volume decline in Q1 FY21. Replacement demand is seeing a strong recovery, while OE sales have also recovered. IIFL Securities expect both, the replacement and OE segments (especially T&B) to see strong growth from FY22.

(Authored by Rahul Kamdar)