Apollo Tyres: Buy

At a time when new vehicle sales have slowed considerably, the sizeable market for tyre replacements in existing vehicles puts Apollo Tyres in a sweet spot. Benign prices of natural rubber and an encouraging outlook for its European operations are added positives.

Investors with a perspective of at least one year can buy the stock. At Rs 87, it trades at a price-to-earnings multiple of about 7.5 times its estimated consolidated earnings for the current year. Going by its historic valuations, this is not expensive.

Replacement Potential

Headwinds such as high inflation, interest rates and fuel prices and a general slowdown in the economy have weakened new vehicle sales currently. SIAM (Society of Indian Automobile Manufacturers) projects new vehicle sales volumes to grow at only 5-7 per cent for the whole of FY13.

However, tyre sales are not directly dependent on new vehicle offtake. Tyre manufacturers obtain a significant portion of their revenues from sales related to replacing these components during the lifetime of the vehicle.

The robust volume growth of 26 per cent in both 2009-10 and 2010-11 implies that the demand for replacing tyres for those vehicles will help now. About 70 per cent of Apollo Tyres’ revenue in India comes from replacement market sales, a majority of that from commercial vehicles.

The risk that truck owners might postpone replacing the tyres, given the rise in fuel prices and the lower availability of agricultural and industrial freight, is not unfounded.

Nevertheless, the company expects the lower offtake of new vehicles to result in existing vehicles running more, making tyre replacements imminent. Secondly, the recent policy measures to put the economy back on track might improve cargo availability in the months come.

Higher demand for plying goods will, in turn, help truck owners pass on the cost increases such as fixing new tyres, to customers.

In fact, after a lull last year, the company has seen an improvement in the replacement demand during the first quarter (April-June 2012). This bodes well for margin expansion as prices are usually higher in this segment. Another factor that will aid margins is the softening of natural rubber prices.

Soft input prices

With material costs accounting for as much as 70 per cent of the turnover for the tyre manufacturer, this industry is highly raw material-intensive. Of this, 45-50 per cent of the total inputs cost is accounted for by natural rubber.

Hence, the softening of natural rubber prices in recent times is a positive for Apollo Tyres. From a high of around Rs 210-Rs 220 per kg during the same time last year, prices of the RSS 4 variety of rubber has come down to around Rs 180-Rs 190 per kg currently.

As the company sources most of its requirements locally, this has partly played a role in bettering the margins in the Indian operations in the last few quarters.

Standalone operating margins, which were at 6.8 per cent in the September quarter of last year, have improved steadily to around 10 per cent in the June 2012 quarter. International rubber prices largely followed a similar trend, helping margins in the company’s overseas operations as well. Increased rubber production this year is expected to keep prices benign in the near future.

Support from Europe

In addition, what bodes well for Apollo is the stable support from its European operations (25 per cent of consolidated revenues).

The Vredestein brand, which Apollo acquired in May 2009, caters predominantly to the replacement market in Europe and is, hence, shielded from a slowdown in new vehicle sales. It specialises in selling high-margin winter tyres and tends to see better performance in the September and December quarters.

Financials

For the quarter ended June 2012, consolidated net sales rose by 12 per cent to Rs 3,165 crore while net profits, helped by softer raw material prices, higher replacement sales and a better product mix in Europe, grew by about 79 per cent to Rs 139 crore.

Risks

Higher crude oil prices could increase the cost of inputs such as carbon black, nylon tyre cord and synthetic rubber. However, considering that natural rubber forms bulk of the raw material, the impact of high crude prices on margins, could be lower.

The ongoing probe by the Competition Commission of India into cartelisation by tyre manufacturers is another risk. Penalties, if imposed, could impact profits and pricing power.

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