Born Tough, Riding Rough - Ceat

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The impact of the hardening situation in the auto industry is now quite visible on the financial performance of tyre companies. There are two impacts that are affecting them. First, it is the rising input cost to  manufacture the tyre and second, the drying up of the demand from the user industry. In the  beginning of  September 2008, Ceat had to stop production at its Bhandup plant and gave a two-day layoff to its employees, as there was excess inventory. This clearly shows the state of affairs for the company. Sensing the critical scenario, the stock market  has turned  negative on  the counter, as the scrip is now available at  its  52-week low. We  are of  the opinion that there is more pain for the investors in the counter and hence would advise the investors to stay away from the same.

There are some primary factors that may not allow the scrip to surge on the bourses in the near future. The company, in the first quarter of the current  year, reported  losses of  Rs 10.67 crore (the only company among  tyre  manufacturing companies to report loss in the first quarter). We feel that the second quarter would spell further disaster for the company since the expectation is that  it  will report substantial loss in view of the fact that there is no positive change in the demand for its products. The company's major revenue comes from the heavy-duty trucks and buses that account for 65 per cent of the revenue. This segment would take a heavy beating due to the slowdown in the economy. The larger market in trucks and buses comes from replacement against the OEM segment. During  slowdown, the  replacement segment tends to postpone the change of tyres.

Last year, the  company reported smart growth in the profit level when it surged from Rs 39 crore to Rs 149 crore. This profit included an exceptional gain of Rs 80 crore. However, when you look at the cash flow from operations, it  took  a major beating coming down from Rs 105 crore last year to a mere Rs 16.60 crore. Looking at the present scenario, we have a strong feeling that this year's cash flow from operations would be negative. The company has lined up capex of Rs 1,000 crore of which Rs 900 crore would be spent on green-field expansion for specialty tyres and radial tyres for cars, utility vehicles and trucks. This would call for additional dilution of equity as the company is well leveraged (debt:equity ratio of 1:1 as on March 31, 2008). Any further equity dilution would affect its EPS significantly, while raising money through debt would put strain on the profitability.

Finally, yet importantly, we are expecting company to  report  losses for the year 2009 as the situation on the auto sector front would take some time before making a U-turn, thereby affecting the financials of Ceat. Our price target, based on the fundamentals and market sentiment, is at Rs 45. The company's present market price is Rs 55, suggesting downfall of 16 per cent from the present level. We feel that Rs 45 should be a good price to enter the counter.[PAGE BREAK]

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New Avtaar
Ceat, a part of the RPG Group, last year produced 7.8 million tyres enjoying a  market  share of  14  per cent. The company's major revenues come from the tyre business while the tubes and flaps business contribute only about 10 per cent. In the tyre business, HCV is the largest segment contributing 65 per cent of the revenue. The company also claims to be  the largest exporter of tyres with  last year exports figure pegged at Rs 505 crore. This year being the golden jubilee year for the company, it went for a make-over in which it  got rid of its famous tag line 'Born Tough' with a rhinoceros as its brand logo. At the same time, in order to focus on its core business, it demerged its investment  business to  CHI  Investment wherein the company issued new shares of  75  shares for  every   100 shares held in Ceat. It also sold,  last year,  surplus  seven acres   land  at Bhandup, a suburb in  Mumbai, for Rs 130 crore.

The major players in the organized tyre segment are MRF, Apollo Tyres, Ceat and JK Industries. The Indian tyre market is dominated by the cross ply tyres mainly used for commercial vehicles where only three per cent is radialised while in the passenger  car segment, the same stands at 95 per cent. The cross ply tyres continue to be favourites amongst the HCV segment due to the higher prices of radial tyres. The Indian tyre industry is estimated to be Rs 20,000 crore with 85 million tyre capacity. The major revenue for  tyre  companies comes from trucks and bus tyres as they account for 60 per cent of total sales by revenue. This is followed by cars and jeeps with 11 per cent followed by eight percent each for LCV and motorcycles. The balance 13 per cent is accounted for by tractors (7  per cent), scooters (3 per cent) and others (3 per cent).

The top four players of the industry are increasing their capacities. This is due to the optimistic outlook of the tyre and automobile industry by all the major players and an expectation of India becoming a major hub for the automobile industry. This is mainly due to India having a substantial cost advantage over its international peers. In the international market, the specialty segment is a lucrative high margin segment. As per the FY08 annual report of the company, it will invest Rs 900 crore in two new plants, one coming up near Mumbai and a radial tyres plant. In addition, Rs 100 crore will be plouged in to set up an R&D centre and in brand building. It  might fund this expansion partly from the proceeds of the land sale accrued last year and  the remaining may be from a mix of debt and  equity. It  had  31  acres of free land in  its Bhandup factory out  of which seven acres of land has been sold for Rs 130 crore. Further, Ceat is planning to  shift its tyre factory at Bhandup in suburban Mumbai to Patalganga that is 60 kms away from Thane  to  save on  octroi and  other manufacturing costs.

The Indian tyre industry is facing a double-edged sword with the domestic duty on the import of raw material being higher than the import duty on  raw materials. The custom duty on the raw materials required for tyre production, i.e. natural and synthetic rubber is 20 per cent along with a 14 per cent excise and 12.5 percent VAT, plus a 2 per cent CST and a 3 per cent education cess, making this situation favorable for the import of tyres than manufacturing them locally.[PAGE BREAK]

The tyre industry accounts for 55 per cent of the total rubber consumption. There is no domestic production of butyl rubber, polyester tyre cord and styrene butadiene rubber of tyre grades, and the production of nylon tyre cord fabric, polybutadiene rubber, rubber chemicals, and steel tyre cord is insufficient to meet domestic demand. Thus, it is important to import these raw materials. The raw material cost accounts for almost 75 per cent of the total operating cost for almost all the companies in  the  tyre industry. The natural rubber prices in the past two months have increased from Rs 103 per kg to Rs 135 per kg. This will hurt the tyre industry. The above table displays the cost break-up for tyre manufacturing companies and  how prices behaved over the past 10 months.

However, the main worry for the Indian tyre industry is the availability of  cheap imports  from  China.  The imports of the truck and bus tyres from  China   have  increased  from 88,000 tryes in 2003-04 to 12.17 lakh tyres in  2007-08. This  is a massive increase at a CAGR of 69.17 per cent in the last five years. In addition, these tyres are sold by the retailers at a price that is 30 per cent cheaper than Indian tyres. We need to draw our readers' attention  to  the  fact that  OEM  in trucks and bus segment accounts for only  19  per cent while replacement accounts  for  65  per  cent  so   that imported tyres at a cheaper rate  can make a great impact on Ceat.  Even though the industry has been demanding for anti-dumping duty,  there has been no action on that front so far.

For Q1FY09, the company's topline increased marginally by 10 per cent to Rs 657.36 crore (Rs 600.95 crore) while the bottomline recorded a loss of Rs 10.67 crore (Rs 30.35 crore). The enterprise value of the company is Rs 665 crore, while the EV/EBIDTA for the company stood at 3.21x. However, one should note  that  the current situation in the Indian tyre industry will take a longer time to settle down and production from the additional  capacity will  take  some more time to  come. Thus investors can enter the scrip at lower levels.