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Operationally in-line; need to focus on FCF ahead

Apollo Tyres’ (ATPY) Q2FY23 EBITDA margin at 12% (up 35bps QoQ) was ahead of our estimate (11.5%) despite an adverse raw material cost environment (RM/sales ratio was the highest in a decade). EU revenue at Rs17.6bn, up 10% QoQ, was a positive surprise largely led by: 1) market share gains, 2) growth in Spain/France, 3) rising mix of UHP tyres, and 4) price hikes. EU EBIDTA margin at 15% is likely to improve further with debottlenecking in Hungary plant, receding RM prices, further increase in mix of UHP/all-season tyres, and scale benefits. Standalone EBITDA margin at 10.3% was up 60bps QoQ as gross margin was stable QoQ with price hikes negating RM basket inflation. With improving replacement demand ahead and corresponding increase in India capacity utilisation (from ~76% currently), the limited need for significant capex is likely to aid APTY deliver FCF of Rs25bn in FY23E-FY24E (post reversing the recent rise in inventory). Maintain BUY with a revised DCF-based target price of Rs343 (earlier: Rs329), implying 14x FY24E EPS.

Key takeaways from Q2FY23 result:

* India volume growth at ~1% YoY was driven by ~10-12% growth in exports / OEMs and ~5-6% decline in domestic replacement segment. We believe the subdued numbers in the replacement business was due to a seasonally weak monsoon quarter with lower CV-related activities and a steep 5% price hike in Q2 to combat cost inflation. With key peers resorting to limited price hikes amidst input cost inflation to gain market share, APTY is open to lose some market share in order to pursue profitable growth, especially in the asset-intensive TBR segment. In the EU, volume growth was 10% YoY as against mix change (led by UHP mix rise) contributing ~5-6% of the value growth and rest ~15% growth being led by price hikes. UHP mix in the past 5 years has moved from ~20% of volume to ~40% currently, thus adding to value growth

* India gross margin was stable QoQ with price hikes meeting raw material basket (RMB) cost increase of ~3% QoQ along with meeting other cost escalations. In Q3, no price hikes are planned till date. RMB cost is down 3% QoQ paving the way for gross margin improvement. With replacement segment revival yet to take place, RMB cost set to turn favourable and operating leverage likely to come back with replacement demand, we expect India EBITDA margin to rise towards long-term average levels of ~12-14% in the coming quarters (from current ~10%). Similarly, in the EU, despite commodity and power cost inflation, APTY was able to hold on to ~15% EBITDA margin led by scale benefit and rising mix of UHP tyres. We expect EU EBITDAM to improve to ~17% in FY24E, with bulk of margin hurdles getting absorbed in the cost.

* Inventory increased in H1FY23 on the back of lower retails on account of steep price hikes in the domestic market other than pre-winter season inventory buildup, resulting in negative FCF despite benign capex. With margins set to improve and the increase in inventory set to come down, we expect FCF to recover in H2FY23E. With India capacity utilisation at ~76%, we do not see any urgency of major capacity addition, thus giving visibility of debt reduction in next couple of years.

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