Bridgestone: the put option on the China auto market?

by SR on February 24, 2012

Conclusion: I expect Toyota, Honda and their related parts companies to have a good year in FY3/13 (the financial year ending in March 2013) but I feel that the tyre companies are going to see even stronger earnings growth. Bridgestone, one of the top two suppliers globally, would be my choice here and could be trading as low as 7.5x earnings for this year. (Related stocks: Bridgestone 5108; Sumitomo Rubber 5110; Yokohama Rubber 5101; Toyo Tire & Rubber 5105; Michelin; Goodyear; Cooper Tire; Hankook; Nexen).

  • Not a market for defensives. Bridgestone and Sumitomo Rubber (5110) have lagged autos and industrials significantly during the rally of the past two months. The Topix index bottomed on 24 November 2011, since which point the share price of Toyota (7203) has risen by 43%, Honda by 41% and Denso by 33%. Meanwhile, the share price of Bridgestone has gone up by just 11% over the same period. To a large extent that reflects the (self-fulfilling) perception that tyre stocks are defensives.
  • Still ahead longer term. Despite the recent rally in auto and parts stocks, measured from the earthquake to 24 February, Bridgestone’s share price has risen 8%, Nissan’s is up 4% and Toyota and Denso are both down more than 5%. Tyres have been a lucrative long-term bet.
  • Earnings growth should surprise. A preliminary look at Bridgestone’s guidance suggests that management is lowballing the market. While the revenue forecast seems not too pessimistic, I expect lower raw material prices to allow the company to easily beat the OP guidance of Y269bn – perhaps by as much as 15% or so, putting the stock well below its current PE multiple of 8.8x. That would make investors sit up.

bridgestone quarterly sales and op

What matters: tyres prices, rubber costs

Here’s a factlet for you: Bridgestone used 1.89m metric tons of rubber in 2011. Let’s assume that a bit more than half of that is natural, rather than synthetic rubber, call it 55%. At an average price through the year of $4.80 per kg, Bridgestone’s bill of materials for natural rubber alone would have been $5bn, or Y390bn at a rate of 78 yen to the US dollar. Bridgestone’s entire cost of goods sold in the December 2011 year was 2,092bn, so natural rubber likely accounted for 19% or so of total CoGS. (In reality management does not disclose exact figures, but I’m comfortable with these estimates.) What is interesting is the volatility of this particular cost element, as shown in this monthly chart of natural rubber prices (Thailand RSS3, FOB in US$ per kg) since 2005. Bridgestone does some hedging such that its prices are fixed for about three months in advance, but otherwise the price it pays for its natural rubber fluctuates with the market price. thai rubber price Currently RSS3 is trading at about $4.10/kg. If this turned out to be the average price for the whole of 2012 then (at the same forex rates and the same level of production as in 2011) Bridgestone’s natural rubber bill would fall by Y57bn. Given that management guidance for operating profit in 2012 is only Y269bn, this would be a very significant change. Practically speaking, the company should see higher rubber consumption in 2012 as it expects tyre sales to rise again, so the absolute amount spent on raw materials like natural rubber will almost certainly rise. Still, higher volumes do of course generate higher revenues and brings in the operating leverage effect and are thus a positive, not a negative, as we shall see later.

Speculative flows drive natural rubber

I do not believe that fundamental changes in demand and supply have driven the volatility in natural rubber prices over the past few years. Yes, we all know that emerging markets are consuming larger quantities of all kinds of commodities and that competition for finite resources has pushed up prices. I don’t dispute that this background trend is real. But that’s not the only issue to consider. Bear in mind that a tyre is a consumable product. The more it is used, the quicker it degenerates to a level at which it begins to have a negative effect on vehicle performance, fuel economy and safety. In most major markets, replacements are required by law when the tread is eroded to a specified depth. So while purchases of new tyres can be deferred, they cannot be postponed indefinitely without danger to oneself and potentially to one’s wallet. The tyre market is, therefore, essentially defensive in nature: for as long as people operate vehicles there should be a steady flow of demand for tyres. Replacement tyres comprise the bulk of the market.

The impact of new car sales

It’s a stable market, but growth in demand for rubber at the margin is provided by new cars being sold in emerging markets. We can have a go at quantifying this. Let’s assume that vehicle production will be 80m units at an average of 5 tyres per vehicle in 2012, this indicates new tyre demand of about 400m units. There is a lack of reliable statistics for global tyre sales and production, so we have to guesstimate here, but let’s take Bridgestone’s 2m tons of rubber as a starting point. Using data from the RMA’s scrap tire reports, a light vehicle tyre for the US market weighs on average 10.2kg, a commercial tyre (truck, bus etc) about 55kg, so despite the much lower volumes of commercial vehicle shipments, the average tyre weight is something like 16.9kg.
 
OK, let’s assume 50% of that weight is rubber, the remainder being various additives, carbon black, filler and of course tyre cord. That means a rubber weight of 8.4kg per average tyre, suggesting that Bridgestone manufactured around 240m tyres in 2011. Their global share is probably something like 16% on a revenue basis, but Bridgestone’s product mix will be heavily skewed to the high end, so I would say that their volume share is lower, maybe 14%. That in turn implies a global tyre market of 1.7bn units, which is congruent with estimates I have I have seen in the past for global production in 2006 of 1.35bn units, once you allow for some growth over the past five years. So new tyre demand is probably in the region of 25% (400m / 1.7bn) of the total in terms of volumes, and less than that in terms of revenues and very little in terms of profits. Tyre suppliers typically have very slim margins on the OE (new tyre) business. Incidentally, this 25% figure for OE tyres as a percentage of total sales and production is congruent with Bridgestone’s own guidance.

China commercials suck up rubber

Certainly then new vehicle production is enough to move the needle of tyre demand, and China has been a fast-growing market. This has been the case for passenger cars but also for commercial vehicles. The role of heavy vehicles is significant, because we have already seen that the average commercial vehicle tyre for a truck or a bus is 5 or 6 times heavier than the tyre of a light vehicle. Moreover, truck tyres use a higher proportion of natural rubber than car tyres: natural rubber does a better job of dissipating heat than synthetic rubber, although is less physically durable. The result is that a rapidly expanding commercial vehicle market will have an exaggerated influence on demand for natural rubber. What I’m getting at is that China is the biggest vehicle market in the world, it has been growing quickly over the past few years and truck demand has also soared. It seems obvious to me at least that investors hungry for returns did their homework and concluded that growth in China should mean significantly higher demand for natural rubber. The result has was tremendous capital inflows to the rubber markets, which explains the surge in the rubber price over the past few years.

Forget about rubber output

Tyre companies emphasise – not without annoyance – that there is no shortage of natural rubber. Despite all the analyst cant about rubber tree years-to-maturity and acreage wars with palm oil, the fact is that natural rubber is there if you want to pay for it. Personally I don’t even try to forecast rubber production. The biggest supplier countries are developing nations (Thailand, Indonesia, Malaysia) with often limited statistical resources and the producers tend to be smallholders rather than large companies. That level of fragmentation makes collating data more difficult. Conversely, forecasting corn output in the US, a developed nation with a closely watched market dominated by large-scale and heavily mechanised agribusiness is probably fairly straightforward (perhaps not easy, but straightforward). Forecasting rubber output in Indonesia is likely impossible. In fact, from what I can see, even confirming recent output in Indonesia is close to impossible. You could easily be out by 5%, and then how much value would remain in the precious forecast that you sweated over? It’s a very uncertain return on investment research time invested.

Follow the money instead

Let’s forget about forecasting supply and demand then, and instead let’s focus on finding what really drives the price of rubber: commodity price speculation. How can we forecast the moves of the speculators? Well, the movements of these people are going to be the net result of a complex interaction between price, alternative opportunities and economic factors. I say we can and should boil it down to one rule: if the China new vehicle market looks strong, natural rubber prices will rise as speculators pile into rubber. If China’s auto market looks weak, on the other hand, rubber prices will remain soft. 
china autos vs thai rubber What this means is that Bridgestone is partly a put on the China auto market. That’s because lower rubber costs are a significant positive for Bridgestone whereas a weak China auto market is only a modest negative due to Bridgestone’s relatively low exposure to that country (maybe 3-4% of revenues, mostly OEM).

Rational pricing at last

The other is product pricing. In many industries, such as electronics, there is little brand loyalty and little added-value, so price competition is fierce and the slightest mismatch between supply and demand sends prices plummeting. Conversely, shortages can result in rapid increases in prices. The tyre market was until about 8 years ago a market in which price competition mattered. (I am going to ignore, for today, the very important issue of brand.) Prices have a huge impact on profits, because a change in pricing is effectively a change in dollar revenue without a corresponding change in costs. If a widget costs 90 yen to produce and is sold for 100 yen, the profit is 10 yen. Now let’s assume that after this widget has been manufactured but before it is sold the market softens and the price falls to 95 yen per widget. Your profit is now 5 yen – it just halved. In the short term there isn’t much you can do about it other than possibly tweak product mix.

A better strategy in the long-run is to supply products in which you have some kind of edge for which customers are prepared to pay a little more – quality, functionality, brand and so on. That helps insulate the supplier from the vagaries of market pricing. In the case of tyres, about 5 years ago the major suppliers realised that despite a tradition of fierce competition, conducting price wars against a background of rising raw material costs did not make sense. Since then pricing discipline globally has held up very well, although the Japanese tyre suppliers do not give us quantitative data on what kind of price hikes they managed, on average, to achieve. The rate of price increases varies by market due to differences in market structure (such as distribution setups) and cultural outlook. Still, I think this CPI for tyres (or tires) from the US Bureau of Labor Statistics is representative of the global trend over the past few years. (This is non-seasonally adjusted data.) US tire CPI

Product prices likely to keep rising

One thing to note is that tyre prices seem to have increased by about 30% “point to point” since the start of 2005. Just eyeballing chart shown earlier, I’d say that the average cost of natural rubber in 2005 was about $1.50 and that in 2011 it was about $4.80. Now, rubber is only one part of the total bill of materials, but tyre suppliers in Japan at least feel very strongly that they have not yet been able to pass on to customers the higher costs they have been forced to pay over the past few years. This is important because it indicates that they are not prepared to give up on price hikes for tyres just yet. And it doesn’t have to be a large increase in price to generate a very significant rise in profits. If Bridgestone were to increase its selling prices on average by 1% in 2012, that would add about Y30bn to its operating profit (recall that management guidance is for OP of Y269bn this year). A 2% hike in product prices would add Y60bn, 3% would add Y90bn and so on. A few tens of billions here, a few tens of billions there and pretty soon you’re talking about real money.

The back-of-the-envelope figures

What do I expect from Bridgestone this year? This is a big subject so I will leave it for another post, but it does seem to me that even taking the management’s current guidance for volume growth, which doesn’t appear at all aggressive, the operating profit should be well north of guidance of Y269bn. That Y269bn translates to Y214.7 in EPS and puts the stock on a PE of 8.8x this year’s earnings. At 240-250 yen per share the stock would be on 7.7x. Not bad for a brand like Bridgestone.

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