Tyre producers get a grip as raw material prices ease, demand recovers

Tread with caution: Any discount/price cut in the replacement market could offset margin gains

Falling raw material prices and hopes of demand recovery ahead are expected to support the stocks of tyre makers. The listed players have delivered average returns of 48 per cent over the past year, riding on softening raw material costs and steady prices in the replacement market.

Given that crude oil and its derivatives account for about half of the raw material costs for tyre makers, there is a margin cushion for the top players.

Listed tyre players had registered a 141-basis point (bp) quarter-on-quarter improvement in operating profit margin to 19.7 per cent in the July–September quarter on the back of a soft raw material cost trend, according to Sharekhan Research.

They could see some pressure in the October-December quarter, given the 5 per cent sequential increase in the raw material basket during October and November.

Brokerages, however, expect the lower crude oil prices to benefit tyre makers from the January-March quarter onwards.

Analysts Ronak Mehta and Vivek Kumar of JM Financial Research say, “Recent softening in crude oil prices from $93 to the barrel to $78 a barrel is expected to favourably support margin performance during the fourth quarter of 2023–24 (FY24) and the first quarter (Q1) of 2024–25 (FY25).”

In addition to raw material costs, the other key factor would be demand from both the replacement and original equipment manufacturer (OEM) segments. While retail sales remain muted in December after the festival season, the ongoing marriage season is expected to support sales in the passenger vehicle and two-wheeler markets.

In wholesales (despatches to dealers), inventory management (clearing out inventory) on the back of additional discounts and annual plant shutdowns could, in a few cases, translate into lower production and supply.

The more important trigger for tyre makers is the traction in the replacement (after-sales) segment, as it accounts for over 60 per cent of sales. Increasing sales in this market allows companies to retain higher profits, given their pricing power and, therefore, higher margins.

Despite softening in raw material prices from the peak in Q1 of 2022–23 (FY23) by 12 percentage points, realisations in the domestic replacement market have largely remained stable, thereby driving the profitability of tyre companies over the past four to five quarters, according to JM Financial Research.

However, given the muted demand environment currently, a drop in prices or higher discounts by companies could hit their realisations going forward.

Among listed players, MRF Tyres expects good growth in OEM demand and a gradual recovery in replacement demand with an improvement in economic activity.

Anand Rathi Research expects the company to register a 9 per cent revenue growth over FY23 through 2025–26 (FY26). The brokerage expects return ratios to hit double digits. The return on capital employed (RoCE) after tax could double from 6 per cent in FY23 to 12 per cent in FY26 on the back of expanded margins and lower capital expenditure (capex). It has a ‘hold’ rating on the stock with a target price of Rs 1.18 lakh per share (the current price is Rs 1.19 lakh per share).

For Apollo Tyres, while demand in the country remains strong, exports are weak, with the European Union witnessing a decline. Thus, IIFL Research has forecast single-digit consolidated revenue growth for the company in FY24/FY25.

The company has surpassed its RoCE target of 12–15 per cent. While the free cash flow outlook is positive with high margins and control on capex, equity research analyst Joseph George of IIFL Research expects single-digit revenue growth.

Peaked-out margins imply muted earnings growth beyond FY24; the brokerage has an ‘add’ rating.

For Balkrishna Industries, which gets the majority of its revenues from export markets, there are near-term headwinds. Sales are likely to remain challenging due to global recessionary headwinds and heatwaves in Europe as well as the Americas. The management expects a stable growth trajectory for the rest of FY24.

Nirmal Bang Research believes that margins would expand by 600–670 bp in FY25/26 (over FY23) on the back of favourable raw material costs, a better hedge rate, and a complete normalisation of logistics costs.

For Ceat, while brokerages have maintained their earnings estimates for FY24 and FY25, some have given it a ‘neutral’ rating. YES Securities believes that valuations at 14.4 times factor in the positives (volume growth) with limited headroom for muted performance.