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Result above estimate; margin recovery underway

Commodity inflation peaked out, expect gradual recovery ahead

* CEAT’s 2QFY23 performance was driven by healthy growth in OEM and better gross margins. Strong domestic demand coupled with softening RM prices from 3QFY23E would help drive healthy performance in the near term. Moreover, focus on key strategic areas such as PV/2W/OHT (to help margins) along with prudent capex plans (to benefit FCF) should be the long-term growth catalyst for the company.

* We upgrade our FY23E/FY24E EPS by 14%/7% to account for declining RM costs and aggressive price hikes. Maintain BUY with a TP of INR1,950 (based on ~13x Dec’24E EPS).

Gross margin improves sequentially after seven quarters of decline

* CEAT’s 2QFY23 revenue grew ~18% YoY to INR28.9b while EBITDA/Adj. PAT declined 8%/44% YoY to INR2b/INR237m, respectively. Revenue for 1HFY23 grew ~31% YoY while EBITDA/Adj. PAT declined ~5%/50% YoY.

* Overall volumes rose 7% YoY, entirely driven by the OEM segment. Gross margin expanded 80bp QoQ (-4.4pp YoY) to 32.5% (v/s est. 33%). RM basket grew ~4% QoQ, offset by avg. price hike of ~4%.

* EBITDA margin contracted 200bp YoY to 7% (v/s est. 6.7%). EBITDA declined 8% YoY to ~INR2.03b (v/s est. INR1.85b).

* CEAT’s 1HFY23 CFO improved to ~INR3.86b (v/s INR0.8b in 1HFY22), driven by a sharp reduction in W.C. and tax refund. Capex was largely similar at INR4.5b, leading to a negative FCF of just INR0.7b (v/s -INR3.9b in 1HFY22).

Highlights from the management commentary

* Domestic demand outlook steady: OEM demand should continue to remain healthy while replacement demand shall improve gradually.

* Exports demand adversely impacted by macro headwinds: There were challenges in international markets like Indonesia and sub-continents. Recessionary pressure in Europe is likely to dent demand. Hence, the management expects exports to be subdued over the near term.

* RM basket was higher by 4% QoQ but largely negated by price hikes. The management expects RM basket to decline 2.5-3.0% QoQ in 3QFY23.

* CEAT took an avg. price hike of ~4% in 2Q spread out between Jul’22 and Sep’22. Major price hike of 8-9% was taken for 2W replacement in the mid of Aug’22, as there were no material price hikes in the 2W segment.

Valuation and view

* Cyclical recovery in OEMs and stable replacement demand will enable faster absorption of new capacities and drive the benefit of operating leverage. This, coupled with softening RM prices, would help a partial recovery in margins in FY23E with full recovery expected in FY24.

* CEAT’s valuations at 40.4x/13.3x FY23E/FY24E consol. EPS do not fully capture the ramp-up of new capacities and softening RM cost. Maintain BUY with a TP of INR1,950 (based on ~13x Dec-24E EPS).

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