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Return of growth, supported by timely capacity addition | APTY is our top pick

* The Indian Tyre industry is expected to recover from five years of weakness and be on a linear growth path (~12% CAGR over FY21-25E), supported by timely capacity expansion across companies. Improving demand, stable competitive intensity, and peak capex (capex of INR116b over FY22-24E v/s INR135.5b over FY19-21) augurs well for profitability.

* We estimate 2W/PCR/T&B tyre volumes to clock 8%/11%/13% CAGR over FY21-25E. This coupled with a reasonable pricing environment and operating leverage, will enable a recovery in profitability and capital efficiency.

* Against this favorable backdrop, we have built a Tyre Industry Investment (TII) framework to evaluate the attractiveness of various tyre segments as well as companies. Based on our analysis, 2Ws appear to be the best placed segment, followed by PCR. APTY tops our TII framework as it offers a good blend of strong earnings growth and cheap valuations.

* We initiate coverage on three stocks – APTY (Buy), BIL (Neutral), and MRF (Neutral). APTY is our top pick due to benefits from: a) ramp-up of new capacities, b) reduction in capex intensity, c) EU operation turnaround, and d) debt reduction. This translates in the best earnings growth for our Tyre sector universe, which is still available at very attractive valuations.

Recovery in volumes, stable competitive environment to support margins

* The Indian Tyre industry is expected to recover from five years of weakness and be on a linear growth path (~12% CAGR over FY21-25E), supported by timely capacity expansion across companies. Sustained recovery in demand from both replacement and OEM segment, coupled with increase in exports would drive 8%/11%/13% volume CAGR over FY21-25E for 2W/PCR/T&B tyres.

* The RM basket witnessed a sharp price decrease in 1HFY21 (~620bp over FY20 average), before the trend reversal from 3QFY21 (RM basket per kg increased by ~10pp in 2H over 1HFY21; the same in 1QFY22 is ~18% higher than its FY21 average). Since Dec’20, Tyre companies have taken a price hike of ~8% till Jun’21. We estimate gross margin for Tyre companies to decline by 80-110bp over FY21-23E.

* This coupled with operating leverage, will enable a recovery in profitability (after impact of higher RM cost in FY22E) and capital efficiency (~190bp over FY21E).

* Capex intensity has peaked out in our view, with cumulative capex for APTY, CEAT and MRF to reduce to ~INR116b over FY22-24E (v/s INR135.5b over FY19- 21). FY21 utilization across segments has been 63%-72% as large part of capacities are in ramp-up mode after start of operations over last 12-18 months

Consumer segments of 2W/PCR most preferable

Operating dynamics are different in each segment (T&B, PCR, and 2W/3W) of the Tyre industry. It depends on factors such as end-user mix/preferences, market share concentration, and demand-supply dynamics. For a relative analysis, we have a built a framework with growth potential, competitive intensity, incremental capacity, pricing power, customer stickiness, and profitability as key pillars.

* 2W segment ranks first, scoring high in terms of profitability/capital efficiency, customer stickiness, and competitive intensity. Though it enjoys the highest asset turnover and capital efficiency, it has the greatest capacity addition. 2Ws are at the forefront in terms of the Herfindahl-Hirschman index (HHI) score, indicating this segment enjoys high concentration, with the top three players accounting for 85-90% of the market.

* PCR segment ranks second. While the segment has a good growth potential (FY19-23E) and pricing power, it is witnessing a good amount of capacity addition in a fragmented segment (the lowest rank in the HHI Index).

* T&B segment ranks the lowest. While the T&B segment is likely to witness the highest growth and the lowest capacity addition, the inherent commercial functionality of the sector and the relevance of ‘total cost of ownership’ in purchasing decisions restrict customer stickiness, pricing power, and profitability. Also, the risk of imports is the highest in this segment.

APTY is our top pick among mainstream players, CEAT attractive too

We evaluate Tyre companies based on their brand ranking, revenue mix, pricing power, headroom for growth, cost competitiveness, and financial strength. Our framework ranks companies on their relative attractiveness on the aforementioned operating parameters. We assign a 75% weightage to these operating parameters (equal weight for each parameter) and 25% weightage to the valuation score to identify potential winners.

* APTY our top pick among mainstream players; initiate coverage with a Buy rating: APTY is geared for the next leg of growth, with sufficient capacity to cater to domestic/European demand. It would benefit from: a) ramp-up of new capacities, b) reduction in capex intensity, c) EU operation turnaround, and d) debt reduction. As compared to its peers, APTY offers the best blend of earnings growth and cheap valuations. The stock trades at 11.9x/9.7x FY22E/FY23E consolidated EPS. We initiate coverage on the stock with a Buy rating and a TP of INR300 (12x Sep-23 consolidated EPS v/s 16x/12x five/10 year average P/E).

* BIL – superior business model fully captured in premium valuations; initiate coverage with a Neutral rating: BIL ranks the highest among domestic peers in terms of cost competitiveness and financial strength. We expect BIL’s outperformance to the industry to continue, with the focus on strengthening its competitive positioning. With a current market share of ~6% in the USD15b global Specialty Tyre segment, BIL aspires to increase this to 10% over the next 4-5 years. We estimate 20%/22%/22% revenue/EBITDA/PAT growth over FY21- 23E. Current valuations fairly reflect for its industry leading margin, FCF, and capital efficiencies, the current valuation premium is excessive. We value BIL at 25x Sep-23 EPS (at a 25%/80% premium to its 5/10 year average P/E of 20x/14x) with a TP of INR2,425. Initiate coverage with a Neutral rating.

* CEAT – Highest potential for growth, maintain Buy: CEAT’s steadfast focus on the B2C segment continues, with a revenue target of 60-65% from the 2W, PCR, and OHT segments. It is backing its market share aspirations in 2W, PCR, and TBR with significant capacity additions. We expect revenue/EBITDA/PAT CAGR of ~16%/15%/7% over FY21-23E. Valuations at 10.9x FY23E consolidated EPS doesn’t fully capture ramp-up in new capacities in an improving demand environment, leading to a recovery in margin. We maintain our Buy rating with a TP of ~INR1,850 (~13x Sep-23 consolidated EPS).

* MRF – Dilution in competitive positioning not reflected in premium valuations; initiate coverage with a Neutral rating: MRF has managed to create a strong brand in major segments of T&B, 2W, and PCR over the years. However, aggressive competition has weakened its competitive positioning, which is also reflected in its dilution of pricing power in the PCR and TBR segments as well as in its superior return ratios. The current valuations at 24.7x/20.7x FY22E/FY23E EPS fairly capture the changing competitive dynamics for MRF. We initiate coverage on MRF with a Neutral rating and TP of INR84,000 (20x Sep-23 EPS).

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