The price correction in Ceat is a good window for long-term investors with high risk appetite
Pressure on margins from rise in raw material costs and slowdown in new vehicle sales due to lockdowns to restrict the spread of Covid-19 are a bummer for auto and auto component stocks at this juncture.
Ceat, the tyre manufacturer, is no exception. However, the 27 per cent price correction in Ceat since it touched its one-year high in early February presents a good window for long-term investors with a high-risk appetite.Considering the see-sawing markets, investors can accumulate the stock in small quantities on dips, rather than buying at one go. The call is not absolutely contrarian as Ceat has a few factors working in its favour. One, apart from OE sales, tyre companies also have a huge replacement market sales in their revenue mix. This acts as a good diversifier as a pick-up in even one segment can support volumes and revenues.
Secondly, tyre manufacturers typically have good pricing power in the replacement segment which implies that though with a lag, the input price increase could be passed on to the buyers over the next two quarters. Three, the stock’s valuation is quite reasonable compared to peers. The stock now trades at about 12 times its trailing 12-month consolidated earnings. This is much cheaper than peers such as MRF, Apollo Tyres and Balkrishna Industries.
Favourable sales mix
Ceat has a well-diversified product and client mix, catering to all segments of the auto industry, be it light and heavy trucks, buses, cars and SUVs, bikes, farm or speciality tyres. For FY21, 21 per cent of the revenues came in from sale to auto manufacturers, 65 per cent from sale in the replacement market and 14 per cent from exports. Even as OE sales slackened in the first half of FY21, the company benefited from a double-digit growth in the replacement segment. In the second half, a pick-up in OE sales following the festival season helped the company fire on all cylinders.
The various forms of lockdown across States to curb the spread of the pandemic raise fresh uncertainties for both OE and replacement segments. However, the impact at best could be temporary. A low base for new vehicle sales in the early part of FY21 is an immediate tailwind. Even if new vehicle sales take more time to pick up meaningfully, demand for replacing tyres in existing vehicles due to wear and tear can keep the business going, once the lockdown restrictions are eased.
According to the company, about 85 per cent of the demand for truck tyres is from the replacement segment for the tyre industry as a whole. Truck and bus tyres is the biggest revenue segment for Ceat, bringing one-third of the revenues for FY21. A resumption in economic activity would increase the need for carriage of goods and agriculture produce across the length and breadth of the country, aiding replacement demand.
While two-wheelers bring in 30 per cent, cars and SUVs account for 15 per cent of the revenues for Ceat. The OE vs replacement demand in these segments is more evenly distributed. Over the years, Ceat has taken efforts to build its OE relationships in this space. This will come in handy when new vehicle sales recover and help bag orders for launches/refreshes. In the last year, for instance, the company has bagged orders for supplies to launches/refreshes such as Splendor iSmart (BS VI), HF Deluxe (BS VI) , Dare 125 and Duet E from Hero MotoCorp, Mahindra Thar, Nissan Magnite and Renault Kiger. Recent entries into existing models include Honda bikes till 125cc, Daimler BS VI trucks and Hyundai i20.
The strong OE relationship would help replacement demand also, as typically customers tend to replace with the same brand as the factory fitment.
Passing on input prices
Average natural rubber prices (RSS 4 variety) for April 2021 stood at ₹166 a kg, up steeply from an average price of ₹115 a kg, a year ago. International rubber prices have also followed a similar trend and are currently slightly above domestic prices. Brent crude price is at $68 now, more than double of what it was a year ago. This has led to a progressive fall in EBITDA margins in the last two quarters — from 15.5 per cent in Q2FY21 to 15.3 per cent in Q3 to 11.7 per cent in Q4. EBITDA margins stood at 12.9 per cent in Q4FY20.
While input cost escalations are passed on periodically in the OE and export segments, the company so far has taken only limited price hikes in the replacement market, which is why the margins are impacted. Ceat took about 3 per cent price hike in Q3 and another 3 per cent in Q4, which has partially covered the rise. Input prices have again gone up in the current June 2021 quarter. Given the lockdown and other restrictions, the company has not taken any increase as of now. Eventually, price hikes are expected to be implemented with a lag, when the situation normalises.
Ceat has been recording strong growth (year-on-year) in net sales and profits in last three quarters. In the quarter ended March 2021, net sales went up by 45.5 per cent to ₹2290 crore and adjusted profits more than doubled to ₹152. 8 crore, aided by good offtakes as well as the lower base of the same quarter a year ago. The company has deleveraged in FY21, bringing down debt to equity ratio from 0.66 in FY20 to 0.42 now, giving some room for fresh capex plans for truck radials over the next few years. Immediately though, lower interest costs hence have helped, along with the decision to shift to the lower corporate tax regime in FY21, which resulted in a tax credit of about ₹12 crore in Q4.