JM Financial maintains Buy rating on Apollo Tyres and CEAT
JM Financial says gross margin expansion in FY21 is likely to sustain, robust demand recovery and low crude oil prices will keep the tyre sector rolling.
EPS CAGR FY20-23E for Apollo Tyres is 27%, JK Tyre 26%, Balkrishna Industries 13%, Ceat 11% and MRF 1%.
JM Financial has maintained Buy rating on Apollo Tyres and CEAT Tyres. The reasons are threefold -
a) Robust recovery in replacement market
b) Increasing OEM (Original equipment manufacturer) volumes
c) Sustainable margins
Raw material (RM) is the most critical cost component in tyre manufacturing, forming 55 - 65% of revenues. Typically, a tyre is made of natural rubber (NR (Natural Rubber) - 45% by weight) and crude derivatives such as carbon black (23%), nylon tyre cord fabric (12%), synthetic rubber (10%) and others (10%). The prices of these raw materials do not move in tandem, so they have constructed a JM Tyre RM Index to track the quarterly movement of the entire RM basket. When tested over the past six years, the Index showed a high correlation (0.8+) to the movement of RM cost (as a % of revenue) across tyre players. As per the Index, JM Financial expects gross margins to benefit by 200bps QoQ in 2Q. However, in Q3 FY21, the RM benefit is expected to reverse owing to an increase in international RM prices (since Aug’20) and a marginal uptick in crude derivatives. On a full year basis, FY21 gross margin is likely to post 200bps YoY improvement. FY22 gross margin would depend on the movement in the RM basket from Jan 21.
JM Financial expects:-
a) International NR price to settle back to normal (USD 1.5/kg)
b) Domestic NR price to be range-bound
c) Carbon black prices to remain benign driven by higher supply due to recent capacity addition domestically
JM Proprietary Tyre RM Index has a high correlation to the movement in RM costs:
Raw cost forms 55-65% of revenue for domestic tyre manufacturers. As outlined by the Automotive Tyre Manufacturers Association (ATMA), NR constitutes 45% of tyre weight, followed by crude derivatives such as carbon black (23%), nylon tyre cord fabric (12%) and synthetic rubber (10%). To capture the composite change in RM prices, JM Financial has constructed a JM proprietary Index (JM Tyre RM Index). The weight used for each RM in constructing the Index is based on the proportion outlined by ATMA. The actual mix may differ depending on the vehicle segment and quality of tyre. Tyre companies usually import 40-60% of their NR requirement depending on the prevalent price. The index has a high positive correlation (0.8+) with the movement in RM as a % of revenue for Apollo Tyres, CEAT and MRF.
International NR prices surge; domestic NR prices range-bound; crude derivative prices remain low:
International natural rubber (from Bangkok) prices have increased significantly since Aug’20 driven by high international rubber demand (from China) amid supply constraints due to labour shortages. In Q2 FY21, Bangkok NR prices increased 8% YoY to USD 1.7/kg, while current prices are higher at USD 2/kg. Historical trends suggest that such event-based price increases settle back to normal within 2-4 months. Domestic NR prices however have remained range-bound and are still 8% lower YoY at INR 131/kg in Q2 FY21. Brent crude prices have corrected 30% YoY in Q2 FY21 to USD 43/bbl. Crude derivatives prices have followed the trend with 2Q prices of carbon black /nylon tyre cord fabric /SBR (Styrene-Butadiene Rubber) /PBR (Polybutadiene Rubber ) declining by 24% /10% /16% /22% YoY. We expect carbon black (CB) prices to remain benign driven by higher supply due to recent capacity addition domestically. In Q2, except CB, prices of all RMs have increased marginally QoQ from lows.
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Gross margin expansion expected in 2Q; FY21 to witness 250bps expansion:
JM Tyre RM Index indicates that the RM basket consumption cost for Q2 FY21 has declined 15.6% YoY and 7.5% QoQ driven by a drop in all RM prices during Apr-Jun '20. As per long-term trends, a 1% change in Index impacts gross margin by 40bps for Apollo Tyres, CEAT and MRF. JM financial therefore estimates the gross margin to expand by 350bps YoY and 200bps+ QoQ in Q2cFY21. Driven by benign RM prices in CY20, we expect margins to expand 210bps YoY in FY21. Though Q3 FY21 may witness gross margin reduction owing to increase in international NR prices, JM Financial expects the FY21 gross margin gains to continue in FY22 based on the past price movement of NR. The Index value at current RM prices is 95 and the average value in the past 5 years has been at 90-96. If JM Financial assumes a mean reversion of all RM costs to their 5-yr averages, they get an index value of 92 (-3% vs. CMP). For FY22, they have provided a sensitivity of expected EBITDA margin at different values of Index. Their current margin assumption for Apollo Tyres and CEAT are based on the Index value remaining between 92 and 95.
(Authored by Rahul Kamdar)
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