The worst fears of Dalal Street investors and India Inc of an earnings downgrade cycle, especially in sectors where there is margin cost pressure, seem to be coming true.
The latest sector to receive a downgrade is tyre. Kotak Institutional Equities cut its target on some of the key stocks in the sector and downgraded a couple of them, saying this was not the time to bottom fish.
“We believe escalating raw material (RM) prices along with subdued demand in the replacement segment will continue to put pressure on profitability,” said Rishi Vora of Kotak Institutional Equities.
Kotak cut its target on Apollo Tyres, MRF, and CEAT mainly on account of lower EBITDA (earnings before interest, tax, depreciation and amortisation) margin assumptions and higher finance costs.
Overall, it believes that the gross margins of domestic tire companies will continue to remain under pressure given the multiple headwinds.
It has downgraded Apollo Tyres to “reduce” from “add”, with a revised target of Rs 175, down from Rs 225. This amounts to a potential downside of 6 percent from the current level.
It also downgraded Ceat to “sell” from “reduce”, with a revised target of Rs 850, a potential downside of 10 percent.
The broker has maintained a “sell” rating on MRF with a revised target of Rs 55,000, translating into a potential downside of more than 20 percent.
Overall, some of these stocks have also witnessed downgrades by analysts. Data compiled by Bloomberg shows MRF now has six “sell” ratings compared to five at the start of this calendar year. “Buy” ratings have also decreased from five to four. The consensus target price is at Rs 69,096, meaning a flat return potential.
Similarly, Ceat has 13 “buy” ratings compared to 14 at the start of the year. “Sell” ratings, though, have come down to six from eight. The consensus target price is Rs 940, a potential upside of 24 percent.
Apollo Tyres seems to have had a better run. It has has four “sell” calls compared to five and 22 “buy” calls compared 21 at the start of the year. The consensus target is at Rs 185, a possible upside of 34 percent.
Surging crude oil price
The tyre industry is heavily dependent on crude oil as raw material and surging fuel prices are not helping. Over the past two quarters, dated Brent crude prices have almost doubled amid the Russia-Ukraine war.
“As a result, the profitability of tyre companies has continued to remain under pressure. Also, the competitive intensity has also increased with the market leader adopting an aggressive pricing strategy in select segments, which has made it difficult for the industry to recover the RM price inflation. As per our estimates, there is an under-recovery of 6-7 per cent at current prices for most of the tire companies,” Vora said.
Supply crunch in natural rubber
According to Kotak, the natural rubber supply is going to be tight in the coming months, as most rubber-producing countries enter the off-tapping season.
Moreover, reopening of China following Covid lockdown may led to a sharp increase in demand as the Asia’s biggest economy accounts for 37 percent of the global demand and thus the price of the commodity.
This will put additional cost pressure on companies. Vora said a 10 percent increase in natural rubber prices would require a 2 percent price hike by the tyre companies.
Low return ratio
Given RM headwinds and higher competitive intensity, Kotak said, return ratios for CEAT, MRF, and Apollo Tyres are expected to remain below 10 percent in FY2024, which is uninspiring.
MRF is likely to be most affected as it has been losing market share coupled with an aggressive pricing strategy.
At 12.53 pm, CEAT was trading at Rs 941.05, up 0.65 percent, Apollo Tyres was down 0.20 percent at Rs 186.70 and MRF was at Rs 69,184.5, gaining 1.4 percent, on NSE.
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