Is the run-up in tyre stocks justified?

Incrementally speaking crude has come down from USD 110 to less than USD 100 a barrel. So if you see synthetic rubber and carbon black and several other small chemicals are all crude derivatives. So almost you can say 20-25 percent of input costs are all crude derivatives. So if you see an 8-10 percent fall in crude there will be a lag effect on margin definitely.

So these are the two reasons and other than that as you said overall optimism of demand coming back both in passenger car and commercial vehicles (CVs). So that should get reflected in better volume growth in forthcoming fiscal, so all these things combinely are getting reflected in the rubber price.

Menaka: Before we break this down stock wise what is your assessment of whether rubber prices will continue to drop or stabilise at these levels based on the global demand supply picture that you have drawn out?A: I doubt, because good times don’t last long. Similarly vice versa. We have worked upon long term gross margin cycle for the tyre industry. So typically the mean reversion happens definitely as it is a cyclical industry and for the last four to five quarters the margin for the industry is above one time standard deviation. So that won’t sustain long. So we are expecting this favourable margin scenario for tyre industry to reverse from fag end of FY16.Menaka: So still another year and half of gains to go?A: Yeah, but the thing is that fundamentally the stocks are valued on a forward basis.Menaka: So now we will get into what you like in tyres and what you don’t based on the variety of factors?A: On FY16 we are already taking care of this benign rubber prices and favourable margins. So it is not that we have taken higher rubber prices. So we expect that to go adverse from FY17. So the trap will be the moment the street rolls over to FY17 typically everybody will have a tendency of increasing margins and increasing earnings but for this tyre industry there can be a reversal in margin. So your FY17 based price targets can in fact be lower than FY16 based price targets.

Menaka: So we will start see that playing out next year itself as market started to discount this?A: Yes, next two quarters definitely margins are going to be fabulous across the industry. Stock prices have run up also fabulously. So those things might hold up for two more quarters but being a cyclical industry in terms of margin, in terms of capital expenditure (Capex) requirement because asset turn for this industry is not that high. So Capex requirement can be as high as Apollo Tyres requiring Rs 7,000 crore in next three years, so that is quite a big number.So Qualified Institutional Placement (QIPs), debt raising are the order of the day. Ceat Tyres looking out for a QIP down the line. Apollo has passed a board resolution for QIP down the line. So those will be the elements of dilution of earnings other than risk to the margin. So I will say make merry while things lasts good but be cautious.Senthil: So how long can this last, because as you said Ceat currently trading eight times FY16, Apollo trading at about ten times FY16 well above the historic averages. Can this sustain, has there been a rerating and how much can this take it up to?A: Rerating wise I will say one big factor for rerating of the whole tyre package in India is the management of balance sheet and cash flows. Historically if you see stock like Ceat entering a Capex cycle means its debt/equity will be as high as two times interest outgoing significantly denting its earnings but presently last two years courtesy good pricing discipline, all the players have pruned down their debt on books significantly, especially Apollo. Apollo debt/equity will be very much manageable even if they a decent amount of debt. So that is the positive part for the whole tyre pack. So capital efficiency has improved a bit. So rerating is happening presently but I will suggest everybody to remain a bit cautious rather than going gung-ho and fall in this trap significantly.Menaka: How is your view stock wise?A: Stock wise I would say, for example, a company like JK Tyre and Industries where close to 80 percent of standalone revenue is derived from CVs and if you see last three years CV demand in India has been pretty dismal.