Description

Overview

Goodyear develops, manufactures, markets, and distributes tires to original equipment (OE) and replacement markets.  It is the #3 player in a consolidated industry (Bridgestone, Michelin, Goodyear have 40%+ market share of global tires).  Its brands include Goodyear, Kelly, Dunlop, Fulda, Sava, and Debica.  80% of sales are in the replacement market – which carry significantly higher margins than the OE market – giving the business a high level of stability. 

We like Goodyear mainly because: 1) we believe there are strong macro tailwinds for tire volumes across the world; 2) Goodyear has significantly improved the quality of its business over the past 5 years by restructuring its operations; 3) In February, the Company completed a pension funding which will be extremely accretive; 4) the Company’s target of 10 – 15% Segment Operating Income (“SOI”) growth through 2016 seems easily achievable to us; and 5) the valuation is attractive.

If Goodyear traded in line with its historical multiple of 6x EBITDA on our 2016 estimate, the stock would be worth $40+ / share, 60% higher than its recent share price of $25, over a ~2 year timeframe.

Investment Thesis

Strong Macro Tailwinds for Tire Volumes Globally

Goodyear’s sales are globally diversified (44% North America, 34% Europe/Middle East/Africa, 11% Latin America, 11% Asia Pacific), exposing it to industry recovery in developed markets and continued growth in emerging markets.

In North America, Goodyear’s OE business is closely tied to light vehicle production, and industry consultants IHS project North American production to grow 4% in 2014, tapering down to 2 – 3% for 2015 – 2017.  However, as mentioned above, >80% of Goodyear’s earnings come in the replacement market, so replacement volumes are more important for the Company.  While North American auto sales have rebounded nicely from financial crisis lows (from 10m SAAR in 2009 to current run rate of ~16m), replacement tire volumes are still running near trough levels.  We believe there is likely pent up demand for replacement tires in North America, and expect this to provide a volume tailwind over the next few years.  Historically, Goodyear’s replacement volumes have lagged its OE volumes by ~3 years, with a reasonably high correlation, likely reflecting the fact that consumers generally replace their tires when their vehicles hit 40,000 – 50,000 miles; given the snap back we’ve seen in new car sales over the past few years, it seems reasonable that the replacement tire market could see a pickup in demand on a lagged basis, over the next few years.  The best indicator of replacement tire demand is probably miles driven – historically, replacement volumes are very highly correlated with this number, which itself is highly correlated with total U.S. employment.  Both total U.S. employment, and miles driven in the U.S., are still below their pre-recession levels.  Miles driven is about 5% below its pre-recession trend.  We believe that as the economy continues to improve, miles driven will increase, resulting in a benefit to Goodyear’s North American replacement tire volumes. 

While we believe that pent-up demand will aid Goodyear’s North American volumes, its other geographies should benefit from positive volume developments as well.  In Europe, there is even more of a cyclical recovery story than in North America – the Company estimates European replacement tire volumes to be up 3 – 5% this year based on what it’s seen in the first four months of the year.  And in its other geographies (Latin America and Asia), Goodyear will benefit from secular growth over the next few years as the sizes of those overall tire markets continue to expand.  To give a sense of the Asian opportunity, we note that, in the mature markets of North America and Europe, the replacement tire market is 3x – 4x the size of the OE market, while in Asia, the replacement market is only 1.3x the size of the OE tire market, since there are so many relatively new cars on the road; over time, the replacement tire market should grow significantly in China specifically, and other emerging markets generally.

At its October investor day, Goodyear communicated an expectation for 2 – 3% annual volume growth from 2014 – 2016, based on LSD growth in mature markets and MSD growth in emerging markets.  That seems easily achievable to us, and we believe there could be upside to volumes if pent up demand actually does exist in North America and other mature markets.

Significantly Improved Business Through Restructuring

Goodyear has aggressively restructured its operations over the past few years.  This can best be seen in its North American segment, where SOI margins have gone from (1.9%) in 2008 to 8% in 2013.  The Company achieved these impressive results through a mix of closing plants, re-negotiating labor contracts, exiting unprofitable lines of business, and executing a mix shift to more High Value Added (“HVA”) tires.  Goodyear has 18 North American manufacturing facilities today vs. 22 in 2008, and coincidentally, its North American market share has also gone from 22% in 2008 to 18% today – while it optically appears that the Company has lost market share, by intentionally shutting down facilities and exiting Low Value Added tire business, Goodyear has improved its cost structure and become more profitable than ever.

In fact, all 3 of the big tire manufacturers have seen declining market share over time.  Goodyear has 10% global share today vs. 18% in 2001, Michelin has 14% vs 20% in 2001, and Bridgestone has 15% vs 19% in 2001.  While this might sound alarming, these companies have largely intentionally ceded market share to smaller, mostly Asian players, who compete in the more commoditized segments of the market – unbranded or private label tires.  This can be seen in the fact that Goodyear’s North American tire mix went from 56% branded in 2005 to 91% branded in 2013.  Executing this mix shift to HVA tires has let the Company consistently raise prices in excess of raw material cost inflation, further contributing to its margin improvement.  HVA tires generally offer consumers a good value proposition, in that each tire costs $25 – 50 more (so a set of 4 tires costs $100 – 200 more), but the fuel efficiency can result in fuel savings of $400 on average over the life of the tires.  Tire labels, which rate tires on their performance on metrics like fuel efficiency, noise, and wet grip, in order to help consumers differentiate among tires, should increase consumer education and focus in favor of HVA tires.  Tire labeling was mandated in Europe in 2012 and has had a positive effect on Goodyear’s business to date.  It could be implemented in Brazil in 2015 and the U.S. in 2016 as well.

It is also worth noting that Goodyear has limited exposure to volatility in raw material costs.  Although oil and natural rubber are large components of its cost of goods sold, Goodyear and the other major tire companies have reliably passed on changes in raw material costs to customers every year.  We believe this is one of the most impressive, and underappreciated aspects of the business – for the past 6 years, through very different raw materials environments, Goodyear has very consistently achieved price/mix better than its raw material impact to COGS.  The business has real pricing power, and the mix shift to HVA tires over this time frame has certainly helped as well.

As a result of all of the structural improvements Goodyear has made to its business, its leverage is currently lower and its free cash flow generation ability is currently higher than at any time in its recent history.  The Company is achieving record levels of profitability and free cash flow at lower tire volumes than before.

Recent Pension Funding Extremely Accretive

Goodyear’s pension liabilities have provided a consistent overhang on the Company for many years, obscuring the Company’s ability to generate powerful free cash flows.  From 2008 – 2013, we estimate that Goodyear contributed $4.4 billion of cash into its pension and employee benefit plans, such that it reported cumulative actual free cash flow over that time period of ($2.0bn), when its true, ex-pension free cash flow would have been +$2.4bn.    

On February 13 of this year, Goodyear announced a large pre-funding of its hourly U.S. pension plans; the Company contributed $1.15 billion of cash to fully fund the plans.  Given that the Company completed the funding using cash on its balance sheet, which was previously earning nothing, these actions were extremely accretive.  They immediately decreased Goodyear’s future required cash pension contributions by approximately $250m per year – we estimate this will increase the Company’s 2014 free cash flow by almost 90%, from $285m before prefunding to $535m after prefunding (excluding the $1.15bn prefunding itself).

After this recent pre-funding, Goodyear’s global pension obligations stand at only $700m, mostly international, down from $3.5bn as recently as 2012.  In addition to improving reported earnings and actual free cash flow, fully funding the U.S. pension also importantly removes a complicating factor that was obscuring the strength of GT’s underlying tire business in its reported financials.  Eradicating the pension issues should make that strength more transparent to investors. 

10 – 15% SOI Growth Seems Easily Achievable

At its October investor day, the Company laid out a plan for a 10 – 15% SOI CAGR through 2016.  We note that the last time it laid out a 3-year plan, at its 2011 investor day, it achieved its targets in 2013 (in spite of worldwide volumes being much worse than the Company assumed in 2011, it beat its 2013 SOI targets, mostly due to price/mix shift and cost cutting initiatives).  Given its $1.58bn SOI in 2013, we note that the low end of management’s guidance would result in 2016 SOI of $2.1bn, and the midpoint would result in $2.25bn of SOI. 

Notably, the Company’s plan does not assume any price/mix benefit greater than what will be required to exactly offset the impact of changes in raw materials, in spite of achieving price/mix > raw materials every year for the past 6 years.  Almost the entire 10 – 15% SOI CAGR can be accounted for based on 3 factors:

-          $175m of announced cost savings in Europe, $75 of which came from shutting down a plant in Amiens, France, earlier this year, and the remaining $100m to come from additional plant closures over the next 2 years

-          2 – 3% volume growth, which, as discussed above, we believe to be achievable

-          Absorbed overhead associated with the volume growth (i.e., significant operating leverage given that Goodyear’s plants only operated at 80% utilization globally in 2013)

We’d note that Latin America, in particular, has a tailwind over the next few years from continued HVA mix shift.  The Latin American OE tire market went through a significant mix shift recently, with HVA tires accounting for only 26% of OE tires in 2011, but estimated to account for 73% in 2014.  As we’ve seen in other markets like North America and Europe, this mix shift should flow through to the replacement market on a ~4 year lag, so we could begin seeing a significant positive mix shift in the Latin American replacement market beginning in 2015.

It’s also worth noting that Goodyear has an opportunity to boost its EPS growth through additional interest savings.  It has $995m of 8.25% bonds that become callable in 2015.  Given that its non-callable 8.75% bonds due 2020 are currently trading well above par to yield 5.3%, we believe Goodyear should be able to refinance its 8.25%s conservatively at 6%.  We estimate that those interest savings, combined with significant term loan paydown from free cash flow generated in 2014 – 2016, should save Goodyear at least $90m, or $0.32 cents per share, representing ~10% of its 2013 adjusted EPS.  We note that the Company has copious U.S. NOLs, and will not be a U.S. taxpayer for many years to come, so we do not tax-effect the interest savings; nevertheless, this provides the Company a nice EPS tailwind, in addition to all the operational tailwinds already in its favor.

Attractive Valuation

At a $25 stock price, Goodyear has a $7bn market cap, $13bn enterprise value, and $13.7bn pension-adjusted enterprise value.  We estimate EBITDAP (earnings before interest, taxes, depreciation & amortization, and pension expense) to be $2.4bn in 2014 (5.7x), growing to $2.7bn in 2016 (5.1x).  We estimate adjusted EPS (adding back restructuring costs and other non-recurring expenses) to be $3.11 in 2014 (i.e., an 8.1x P/E multiple on current year’s earnings), growing to $4.17 in 2016 (a 6x P/E multiple 2 years out).  We estimate adjusted free cash flow (adding back restructuring costs and the pension prefunding contribution) of $735m in 2014 (10.6% free cash flow yield to the equity), growing to $936m in 2016 (13.3% yield).  We estimate leverage (calculated as pension-adjusted debt to EBITDAP) to come down from 2.9x in 2014 to 2.2x by 2016.  We think these multiples are simply too cheap for a business with Goodyear’s strength and growth prospects.

If the Company simply traded in line with its historical 6x EBITDAP multiple on our 2016 EBITDAP estimate, the shares would be at $40 within ~2 years, representing 60% upside from the recent price of $25.  We note this would be only a 9.4x P/E multiple on our 2016 EPS estimate – a multiple we feel is more than reasonable, if not conservative.

Finally, we would note that, due to stronger than anticipated free cash flow generation last year (2013), Goodyear entered 2014 with more cash than it had contemplated as recently as its October 2013 investor day.  At the investor day, the Company laid out a capital allocation plan that showed it using much of its 2014 – 2016 free cash flow generation to prefund its pension plan.  However, it was able to execute the prefunding largely with its higher than anticipated 2013 free cash flow, much of which came from working capital savings.  As a result, Goodyear will be able to easily achieve its leverage target of 2.5x well in advance of 2016, and given its expected 2014 – 2016 free cash flow generation, should have > $1bn of extra cash, for which it has not articulated a plan.  At its Q1 earnings call, the Company said it would unveil an updated capital allocation plan at the Keybanc conference on May 29.  This likely will involve increased return of capital to shareholders, either through increased dividends, share repurchases, or both.  This should provide a positive catalyst to the stock, and to the extent share repurchases are involved, could raise our price target higher.

Catalyst