Tyre makers were on a roll for the last two years. Stock prices rallied to mirror better operating performance on the back of falling rubber prices and strong cash flow generation. In fact, Apollo Tyres Ltd trades at about 10 times one-year forward earnings per share, up from seven a few quarters back. Likewise, valuations of JK Tyre and Industries Ltd and Ceat Ltd have doubled. That said, valuations seem to have peaked at these levels. For one, fiscal 2015 may see cost pressures rise. Analysts expect crude-linked inputs such as carbon black to rule firm although natural rubber prices may be soft. Note that rubber prices fell by about 20% last fiscal year. This was reflected in the March quarter results, when gross margin narrowed year-on-year contrary to analystsâ expectation, in spite of lower rubber prices.
Besides, marketing spends are likely to increase to garner a greater share of the replacement market where growth has simmered down. Passenger and commercial vehicle sales are likely to grow. But this implies higher original equipment sales in the revenue mix, which is not favourable for profitability. Those firms with higher exports or overseas revenue, such as Apollo Tyres, may be able to sustain profitability. Another reason coming in the way of further valuation expansion, in spite of better revenue prospects, is the capital expenditure (capex) plans announced by most firms. For instance, Apollo Tyres and Ceat may begin capacity expansion by the end of the current year itself, both in the country and outside. According to Surjit Arora, an analyst at Prabhudas Lilladher Pvt. Ltd, a recovery in the auto sector and the fact that most firms are operating at 75%-plus capacity utilization will soon kick-start the capex cycle in tyre makers.
Although tyre firms have healthy balance sheets that would support these expansions, this is likely to impact cash flows. A report by Antique Stock Broking Ltd says the next big capex cycle is likely to push free cash flows into negative territory. Hence, in spite of strong demand recovery from fiscal 2016, a re-rating of tyre stocks is unlikely from the current levels.