ANALYSIS: Market overreacting to Apollo Tyres' Cooper buy

Vishal Bhargava

Witnessing the assault on Apollo Tyres shares, one could be forgiven for thinking that the promoter had issued a Ramalinga Raju type letter confessing to his involvement in a scandal. The stock has shed one-third of its value over the last week since announcing its decision to acquire Ohio-based Cooper for USD 2.5 billion.
There are three major issues in this entire deal. The first is primarily psychological. Stock markets have learnt that big acquisitions rarely yield returns. Evidence globally suggests that 3 out of 4 M&As fail. Even domestically, the record is similar given the performance of companies like Aban Offshore. Suzlon, Sintex, Corus etc. The problem with that logic is that these generalizations can be applied anywhere. Most start-ups fail but does that mean no one should consider a new start-up? In business, as in life, transformations only take place when one takes a big risk. 
The second issue is with regards to the price. When the deal size is higher than Tata Motors buyout of JLR, there can be little doubt that this is not a cheap deal. The company has paid a premium of 40 percent over the market price.
This premium would generally be considered hefty if the acquisition target was a reasonably priced stock. But in the case of Cooper Tire, the stock even after the recent surge trades at a P/E multiple of 8 times compared to its peers across various geographies (Goodyear, Pirelli, Bridgestone) all which trade at 12 times and above. That is not unique in itself. Second-rung companies in ancillary sectors often see that discount - much like the gap that existed between Exide and Amara Raja. While investors give it the discount, a company looking to take it over doesn't mind paying a higher price.
But let us examine the valuation aspect in combination with the assets owned by Cooper Tire. It has manufacturing facilities in US, Mexico, Serbia and China which will be controlled by Apollo Tyres after this deal completion. What would be the investment needed to be made by Apollo Tyres if it had to set-up its own facilities currently? A quick parallel. In February 2013, Michelin began manufacturing tires in a Shenyang (China) facility that would have the capacity produce 12 million tires annually. The investment in the plant: USD1.5 billion.
 In comparison Cooper's (Cooper Chengshan) plant in China has a capacity of 15m tires per year and it pays USD 2.5 billion for that and all the other facilities owned by Cooper in US, China and Europe. (Yokohama announced in April it would invest USD300 million to set-up a facility in the US with a capacity to produce 1 million tires annually. Cooper has 4 plants in the US)      
Away from the target, but to the payment structure. Within the deal, there is apprehension regarding the structure of payment. The entire amount would be paid through debt pushing the debt/equity ratio to 1.35 times from 0.53 times. The debt will be for a 7-8 period having an interest of 10 percent per annum. This implies that interest expense for the company after tax will be around USD 175 m. Given that profits in CY12 were USD 215 million, it is likely to be EPS accretive. How it eventually shapes up will depend on the strategy and execution employed. 
One strategy is clear from this move. Apollo has taken one step further in becoming a diversified company that can withstand the shocks of the auto demand through this de-risked model, With the deal, it will have a robust presence in the key developed (US, Europe) and key emerging markets (India, China). Its peers like Bridgestone derived 78 percent of revenues from developed markets like Europe, Americas and Japan.
Similarly, 80 percent of the USD 21 billion revenues that Goodyear derives comes from North America and EMEA (Europe being the key within the EMEA). 
The other strategy may yet seem some unraveling over the coming years. That is the possibility of Apollo Tyres having strong captive sources of rubber. In 2011, the company announced its plan to lease 10000 hectares of land in Laos to grow rubber. While the produce from that in itself may be not significant, it has certainly indicated an intent that it wants to reduce the risk associated with volatile rubber prices. Even the Laos plantation will take years to mature.
Typically, trees get mature for tapping after about 5-6 years of plantation. When it is ready, it can be helpful to Apollo's operations, but may be even more useful to Cooper. Much like its competitors in the US, Cooper Tire is fully dependent on imported natural rubber for its requirements. (Natural rubber comprises about 50% of raw material expense for a tyre maker). So - could one see more such plans of captive sourcing by Apollo Tyres by acquisition of rubber plantations?
It is hard to completely rule it out. It is entirely conceivable that rubber from Laos (or any new destinations) can find its way into the markets most required and profitable for the entity. For eg: rubber from Laos being shipped to Cooper's China factory which will manufacture cheap tyres and be exported to the US. Witnessing the landscape of trade treaties, it is not unrealistic to believe that import duties to rubber consuming nations like China and India might be negligible in the coming years.  
The signal that the company has been lining up for a big move had been coming since the last few years. This deal is only the culmination. Results will not be seen immediately but look at it closely and a careful web of actions has poised Apollo to enter the big league. This is an entrepreneurial challenge, even if it is an analyst headache. 
(A former journalist and research analyst, Vishal is currently President, Achelous Advantage)