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RM cost benefit to reflect from 3QFY23                                                    Expanded capacity can deliver a revenue of INR130b

We interacted with the management of CEAT as part of the RPG investor conference. The management said that: 1) demand remains stable (demand from OEM is growing, replacement demand is stable, while exports are weak); 2) RM costs are softening (benefit will reflect in 3QFY23); 3) capex is under control (as there is headroom to debottleneck capacity); and 4) debt will increase in FY23, but start to moderate in FY24. Here are the key takeaways from that interaction:

* Demand is stable on a MoM basis. OEMs are seeing a good recovery, replacement demand is stable, but exports are under pressure. While replacement demand in rural India remains weak (due to weak demand for Tractors and Motorcycles), the same in urban markets remains fine. T&B replacement demand is stable.

* Weakness in exports is primarily in two markets: a) EU (due to macro concerns), and b) Indonesia (on account of import quotas). The OTR segment remains unaffected.

* RM cost will increase by 2-3% on a QoQ basis. If RM cost remains stable at current levels, there will be cost savings from 3QFY23. 2QFY23 will also see a weaker mix (higher OEM demand, but lower exports).

* CEAT is not looking to pass on any RM cost benefits in the replacement market till EBITDA margin recovers to at least 10-12% (v/s 6% in 1QFY23 and 7.6% in FY22). Considering the under recovery of cost inflation, it is looking to raise prices by 1-1.5% in the next one-month.

* After seeing a 2pp/5pp expansion in market share in 2Ws/PCR in the last five years, CEAT aspires to further increase the same to 32-33%/20% (v/s 28%/13% in FY22).

* Based on full utilization of expanded capacity, which will entail a capex of INR7b (over and above INR9b in FY23), it can earn a revenue of ~INR130b (post expansion) (v/s a run-rate of ~INR113b based on 1Q revenue). A large part of this debottlenecking capex will be for the second phase of expansion at its PCR facility in Chennai. Except for OTR, it has headroom to boost capacity by over 20%. It will start the next phase of expansion after achieving 85-90% utilization as the brownfield expansion will take 10-12 months. The Chennai plant has sufficient land for increasing capacity to ~800tpd from 250tp at present.

* The OTR segment is seeing a good ramp-up. The management expects to rampup capacity to 80tpd by Oct’22 and 105tpd in the next 12 months from 60tpd at present.

* EV tyres will need to address: a) greater wear and tear (due to higher weight and torque), b) lower noise, and c) rolling resistance (to improve the battery range). CEAT’s market share in e-2W tyres (OEM) stands at 50% v/s 30% in ICE 2Ws. It has already launched EV tyres for all the three segments

* Its Sri Lankan operations have seen a 50-60% drop in demand over the last three months. It is still profitable as margin is intact, but volumes are down.

* It is looking to narrow the gap in EBITDA margin v/s its peers (~2.5pp in FY22) over the next five years, driven by: a) a mix, b) operating leverage, and c) narrowing of the pricing gap in the Truck segment.

* While its debt will rise in FY23E, the same will fall from FY24E onwards, based on our expectation of CFO and capex. Its debt/EBITDA ratio will remain below 3x.

Valuation and view: Recovery in demand and easing of commodity prices will drive a strong recovery from 2HFY23. Valuations, at 40.3x/13x FY23E/FY24E consolidated EPS, do not fully capture the ramp-up of new capacities and stabilization in RM cost. We maintain our Buy rating with a TP of INR1,630 (based on ~13x Sep’24 EPS).

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