Tyre companies' stocks could see more upsides

Falling natural rubber prices and expectations of higher demand are positives for the sector

Led by MRF, tyre stocks hit their fresh 52-week highs on Friday as falling natural rubber costs, crude oil prices, pricing power given falling Chinese imports and uptick in demand are expected to boost both the revenues and bottom lines of these companies. MRF, the highest priced stock on the bourse at Rs 72,835 and also the largest by market capitalisation in the tyre space, gained 2.6 per cent and hit a new high. Besides MRF, tyre stocks such as Ceat, Balkrishna Industries, Apollo and JK Tyre Industries have hit their life-time highs over the last week. 

The key triggers are natural rubber prices which have lost about 19 per cent since their highs in April. This comes as a relief as the prices had gone up in the March quarter, forcing the companies to hike their prices. This coupled with falling crude oil prices are also positive for tyre companies given that crude oil derivatives are used in tyre production. For tyre companies, about 70 per cent of their costs are accounted for by rubber and a decline in the price of this raw material improves margins. 

Analysts at HDFC Securities in a recent note said the tyre sector trades at low price-to-earnings multiple and there is a scope for rerating of the sector. They cite easing competitive intensity and price aggression leading to margin flexibility across cycles leading to the rerating. Tyre companies took price hikes repeatedly over the past three months. This was possible as Chinese imports have halved from earlier levels especially after demonetisation, leading to pricing power for Indian companies. 

Improving demand from auto companies, given the expectation of a normal monsoon and pick-up in the rural economy should help keep volume growth steady. Further, a high exposure to the lucrative after-market (over 60 per cent) of revenues is expected to boost profitability. This should help bridge the gap with other auto component plays (who supply to the after-market) such as the batteries sector which trade at 100 per cent premium. Thus, while Amara Raja trades at 20x its FY19 estimates, Apollo Tyres is trading at 12x. The trigger for Apollo Tyres according to analysts is better European performance on the back of the Hungarian plant expansion and market share gains, while for JK Tyre the commissioning of the Chennai plant and price hikes should aid profitability. Analysts at PhillipCapital expect margin improvement for Ceat on the back of strong price action, receding rubber prices and recovery in two wheeler segment. While the outlook is positive for the stocks including MRF, given the recent rally, investors should consider these stocks on dips.