Automotive Tyres - Margins To Begin Wearing Out; Re-Rating Traction Limited: ICICI Securities

ICICI Securities Report

India’s automotive tyre space gross profit/kg improved from the Q1 FY23 lows of ~Rs 73 (in line with 10-year mean levels) to reach highs of ~Rs 95 in the past couple of quarters (above mean + 1-standard deviation at Rs 84).

Going by historical trends, the industry has hardly sustained such profitability beyond three consecutive quarters and seen a mean reversion back to below mean + 1-SD levels.

Thus, with Brent crude price appreciating ~20% over the past few months and natural rubber prices gaining ~5-7% over recent lows in July, we see mean reversion of gross profit/kg poised to play out from H2 FY24.

With replacement demand growth across key segments yet to find some grip, along with immense competitive pressure, we believe it would be tough for players in this space to sustain their elevated gross margin levels beyond Q2 FY24.

Both Apollo Tyres Ltd. and Ceat Ltd. dished out returns to the tune of ~37% in trailing 12 months on the back of rising profitability, driving better cash flow visibility and in turn improving valuation multiples.

We believe for the tyre space, it is a classic case of market prorating the present elevated margin on a forward basis and give up-cycle valuation multiples on that inflated earnings.

At this juncture we are observing street is yet to take note of the potential mean reversion in profitability downwards, but when it does, cuts in forward earnings estimates and valuation multiples are imminent. Thus, on the back of recent inflation in RMB cost (~20% crude oil price increase), for both Apollo Tyres and Ceat, we are cutting FY25E Ebitdam by ~100 bps, resulting in ~12% cut in earnings.

We are cutting Apollo Tyres’ discounted cash flow-based price target by 10% to Rs 381 (implying ~16 times FY25E earnings) and downgrading it to 'Hold' from 'Add'.

For CEAT, we have reduced the DCF based price target by 5% at Rs 1,580 (implying ~15 times FY25E earnings) – maintain 'Sell'.

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