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Automotive tyres: Margins to begin wearing out; re-rating traction limited

India’s automotive tyre space gross profit/kg improved from the Q1FY23 lows of ~INR 73 (in line with 10-year mean levels) to reach highs of ~INR 95 in the past couple of quarters (above mean + 1-standard deviation at INR 84). Going by historical trends, the industry has hardly sustained such profitability beyond three consecutive quarters and seen a mean reversion back to below mean + 1-SD levels. Thus, with Brent crude price appreciating ~20% over the past few months and natural rubber prices gaining ~5-7% over recent lows in July, we see mean reversion of GP/kg poised to play out from H2FY24. With replacement demand growth across key segments yet to find some grip, along with immense competitive pressure, we believe it would be tough for players in this space to sustain their elevated gross margin levels beyond Q2FY24.

Two quarters of elevated gross margin; couple more at best

Led by decline in RMB amidst limited price cuts in the replacement market over the past three quarters, GP/kg for the space has moved up above the 1-S.D. mark above the long-term mean levels, after operating at long-term mean levels from mid-FY22 to mid-FY23. Trend analysis suggests that GP/kg for the industry has hardly ever sustained for more than 2–3 quarters at 1-S.D. above mean levels. Post-consumption of the low-cost inventory, GP/kg is set to revert H2FY24 onwards, from current highs given crude oil’s ~20%-plus appreciation since July’s lows and natural rubber too gaining ~5–7% from its July’s lows. Additionally, we believe, the industry will find it hard to remain margin-neutral in a rising RMB environment given the backdrop of elusive demand in the replacement market coupled with elevated competitive intensity.

Volume growth inertia insufficient to protect EBITDAM

With key OEM segments of M&HCV/PV/2W expected to grow at a CAGR of ~7–8% in FY23–25E, we do not expect operating leverage to support EBITDAM for the space. Also from a pricing perspective, industry has hardly reduced replacement market pricing in the past three quarters, amidst slipping RMB costing. With that background, it would be tough to hike prices to maintain margins, that too with rising competitive intensity in the space

Downgrade APTY to HOLD; maintain SELL on CEAT

Both APTY and CEAT dished out returns to the tune of ~37% in trailing 12 months on the back of rising profitability, driving better cash flow visibility and in turn improving valuation multiples. We believe for the tyre space, it is a classic case of market prorating the present elevated margin on a forwardbasis and give up-cycle valuation multiples on that inflated earnings. At this juncture we are observing street is yet to take note of the potential mean reversion in profitability downwards, but when it does, cuts in forward earnings estimates and valuation multiples are imminent. Thus, on the back of recent inflation in RMB cost (~20% crude oil price increase), for both APTY and CEAT, we are cutting FY25E EBITDAM by ~100bps, resulting in ~12% cut in earnings. We are cutting APTY’s DCF-based price target by 10% to INR 381 (implying ~16x FY25E earnings) and downgrading it to HOLD from ADD. For CEAT, we have reduced the DCF based price target by 5% at INR 1,580 (implying ~15x FY25E earnings) – maintain SELL.

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