GOODYEAR TIRE & RUBBER CO GT S
December 15, 2015 - 3:44pm EST by
jessie993
2015 2016
Price: 32.85 EPS 3.05 300
Shares Out. (in M): 274 P/E 10.8 10.5
Market Cap (in $M): 9,001 P/FCF 0 0
Net Debt (in $M): 6,000 EBIT 0 0
TEV ($): 13,952 TEV/EBIT 0 0
Borrow Cost: General Collateral

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  • Manufacturer
  • Tire
  • Commodity exposure
  • Cyclical

Description

 

 

Goodyear Tire (GT) is currently generating margins/returns that belie the commodity nature of the business.  A collapse in input costs combined with relatively tight supply/demand situation has resulted in unsustainable margin expansion. This situation is set to reverse as capacity will grow dramatically over the next three years and input costs have likely bottomed out. While this will impact the entire industry, GT is particularly vulnerable as a strong USD attracts imports to the US, currently the strongest and most profitable market for tires.  We believe there is substantial downside based on our perception of the normalized earnings power of the business.

 

The thesis is pretty simple. Supply is set to grow much faster than demand while input costs have likely bottomed thereby beginning a signficant negative earnings estimate revision cycle and a bad business in a bad industry.

 

 

  • Since 2010, GT’s EBIT has more than doubled and EBIT per unit has increased from ~$4 to ~$10.  While we must give GT some credit for improving its cost structure, the majority of this increase stems from cyclical tightness in the supply/demand balance at the higher end of the market, which has allowed GT to retain >$7 in price/mix vs. raw materials. 

  • After over a decade of capacity rationalization in North America (-3% annually since 2000), tire companies have announced over 50 mm units of new capacity expected to come online by 2018 (+4% CAGR, +20% cumulative expansion).

  • Globally, we have identified capacity expansions totaling over 200 mm units through 2018, which represent 20% of 2014 global demand.

  • An HVA (high value-add) tire currently generates $10-$20 more EBIT than an LVA tire.  On capex ranging from ~$60 per tire for a greenfield plant to ~$30 for a conversion of LVA capacity or HVA plant expansion, the economics of HVA capacity are extremely attractive. 

  • The vast majority of new capacity will target higher margin HVA tires, and we see capacity growth outpacing demand by as much as 15% in 2018.  

  • As the industry moves into oversupply, we believe pricing will suffer and unit returns will decline substantially. There is already evidence of this happening OUS as pricing in APAC and EMEA regions has been weak.  The imposition of tariffs on Chinese imports to the US has supported pricing in the US, but imports from other geographies are already beginning to pick up the slack.  US profitability should begin to erode going forward.

 

Our variant perception stems from our focus on the unit economics of the business and the structure of the industry, which inescapably dictate a decline in profitability, whereas consensus is complacently extrapolating the current return profile.  Our base case calls for EBIT / tire to decline to ~$7 in 2017 from a peak of ~$10.50 in 2015, generating EBITDA of ~$1.2 billion (vs street expectations of ~$2 billion) and EPS of $1.80 (vs. street expectations of $3.80).  At 8x EPS (or 4-4.5x EBITDA), our target price is ~$14, or roughly 40%-50% below the current price.

 

 

Industry margins and returns have increased dramatically

 

  

 

 

 

These expanded returns are a result of the industry capturing a spread on the change in input costs, especially as raws declined following a big spike in 2011.

 

 

The benefit from the decline in raw materials should be around now based on the breakeven levels for most rubber producers. As/if oil ever rallies, this will accelerate the margin squeeze. But we believe that the industry’s ability to retain margin on recent declines in raw materials reflects cyclical factors rather than a structural change in the industry.  

 

  • In the financial crisis, companies took out significant capacity, which has led to tightness in supply as demand rebounded over the last 5 years.  Historical capacity information outside the US is scarce, but looking at NAFTA as a proxy we see this scenario play out. 

  • Through 2014, the industry collectively removed ~135 mm units since 2000 (-3.1% CAGR) while demand increased ~9 mm units (for a whopping +0.2% CAGR).

  • This situation is reversing as the industry starts to build new plants, with ~50 mm units to come online by 2018.

 

 

Capacity is being added across the globe, particularly in the APAC region (only half of which is in China).  We expect capacity additions to exceed demand growth by a wide margin.

 

Global capacity additions for the next few years will be substantially higher than at any time since the 1990s.

 

 

Note: historical figures are based on plant opening dates and current capacity, whereas forward estimates assume a ramp on new openings.  Actual historical additions were likely considerably smoother than they appear in the chart above.

 

 

We believe the change in supply / demand balance for HVA tires will be worse than for the overall market.  

 

  • We think the cyclical tightness outlined above is even more acute for HVA tires.

    • HVA tires have been gaining market share (growing 6-7% in flat mature markets) as consumer preference has favored larger rim sizes. 

    • Older plants were designed to produce tires for smaller rims, so the relative supply/demand balance has supported price/mix for the tire industry. 

  • We expect the majority of new capacity to come online in the next several years will address the HVA market.

    • The majority of capacity we have identified is concentrated with the top 11 brands.

    • Adding capacity to address the higher growth / higher margin segment of the market is rational.

    • Our research indicates that the equipment in newer plants is capable of producing most rim sizes on the same machine, so in theory most new capacity should be HVA.

    • An HVA tire is significantly more profitable than the average tire. The variable costs are only “a few dollars higher” and the incremental profit is +$10-$20.

    • The capital cost to greenfield an HVA plant is in the range of $60 / tire, providing supernormal ROIC potential given current ~$20 profitability on an HVA tire.  Plant expansions and LVA conversions cost ~$30 / tire.

    • Our numbers contemplate new plants and expansions only, but we would expect substantial conversions given the cost is ~2x EBIT

Business Description                                                                                                                                                                        

 

Based in Akron, Ohio, Goodyear Tire & Rubber Company is the largest tire manufacture in North America and third-largest in the World. It currently operates 50 manufacturing facilities in 22 countries and approximately 170 distribution centers, employing over 67,000 people worldwide.

 

  • Sales mix:

    • 56% personal / 21% commercial / 23% other (retail, OTR, other)

    • 30% OE / 70% replacement

    • ~70% HVA / ~30% LVA

  • #3 global market share (~10%) behind Bridgestone (~15%) and Michelin (~14.5%)

  • #2 US market share (~15.4%) behind Bridgestone (~18%) and Michelin (~14%)

     

 

 

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Within the next 2 quarters, supply growth (especially into the US) will be come evident and 2016 and out year estimates will begin to severely be downgraded.

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