Tyre Companies a Good Bet Despite Record Rubber Price?

Analysts are bullish on Indian tyre makers as higher demand from the after-sales market is seen offsetting a margin squeeze due to unprecedented input cost rise and a likely slower demand growth from original equipment makers due to higher interest rates.

They expect the high-margin replacement market to yield higher volumes and sales, though not all of it may translate into earnings.

Natural rubber prices make up about half the cost of a tyre and the industry has been grappling with falling profit margins as rubber prices soar to a record high on a global supply crunch.

Auto sales in India grew a record 31 per cent in 2010, driven by a burgeoning middle class and easy access to financing.

Though the rising fuel and vehicle costs and a likely increase in interest rates may slow the momentum in the auto sector, analysts said tyre makers will continue to benefit from the robust replacement market.

Apollo Tyres, India’s second largest tyre maker, has emerged as the top pick for investors while smaller rival JK Tyre is also seen as a steady stock.

“Just observe the rise in rubber prices over the past eight years and how Apollo has still maintained its operating margins at an average 12-12.5 per cent during the period,” said Vijay Sarthy, analyst at Spark Capital.

He expects the company to raise tyre prices in short-term to pass on rise in rubber cost.

Out of 16 analysts covering Apollo Tyres, 11 have a ‘strong buy’ and ‘buy’ recommendation on the stock, Thomson Reuters data showed. All four analysts covering JK Tyre have a ‘strong buy’ rating.

“We are positive on the valuation front but in the near term due to the volatility in the commodity prices the stocks will be rangebound,” said Vaishali Jajoo, auto analyst at Angel Broking.

Analysts also said Apollo Tyre’s global reach will give it an edge over its rivals.

“We like Apollo Tyres in the tyre sector. All other players are domestic players whereas Apollo Tyres is now having significant presence in Europe and also in South Africa,” said Deepak Jain, assistant vice president and research analyst at Sharekhan.

Apollo Tyres through its Netherlands-based subsidiary Apollo Vredestein sells tyres in Europe. It has manufacturing units in South Africa as well.

Jain said Apollo’s international operations contribute almost 40 per cent of its EBITDA. This is helping the company as cost of raw materials to sales there is less than half of what it is in India.

“Valuations-wise, JK Tyre and Ceat are at a larger discount to Apollo but institutional people prefer Apollo as it is a low-risk stock and on the longer term, gives slightly better returns,” Jajoo said.

“While sales and volume growth would happen, it may not translate into much of an earnings growth for tyre companies ,” Sharekhan’s Jain said.

Galloping rubber costs have tyremakers worried and with little choice but to raise prices. But tyremakers such as Ceat and JK tyre have said that they would not be able to raise prices as much as required to protect their margins.

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