Time to start moving away from tyre stocks

by SR on January 16, 2013

  • Conclusion: Shift away from tire stocks. The Japan Automobile Tyre Manufacturers Association (JATMA) reported a decent set of figures for December 2012 on 15 January, completing a good year for the local tyre market. Japan’s tyre stocks mostly performed well in 2012, with market leader Bridgestone rising 27.4% for the year compared to an increase of 18% for the TOPIX market index. So far, so good, However, the environment for these companies looks likely to be less favourable in 2013; I suggest gradually reducing positions in tyre stocks and raising weights in machinery and other deep cyclicals. Bridgestone reports 2012 results on 18 February 2013 and the figures should be good.
  • Which machinery stock? With the US construction market recovering and mining and commodities potentially getting a fillip from improvements in China, I still think Komatsu is worth looking at. I know that the investment meme over the past 12 months has been that Komatsu and other CM suppliers are in structural decline but in my experience such pessimism at the bottom of the market is as overdone as optimism at the top of markets. Komatsu will grow again – but don’t expect great guidance at Q3 results next month.

Japan tyre stocks performance in calendar 2012

Japan tyre stocks performance since November 2012 low

The potential problems with tyre stocks

  • Risk: raw material costs. Bridgestone uses around a million tons of natural rubber a year, so if the rubber price changes significantly – say from an average of US$3.50/kg in 2012 to $4.00/kg in 2013 – then Bridgestone’s profit margins, and those of other tyre companies, will take a hit. Through 2012 I was skeptical that a recovery in natural rubber prices can be sustained and I was correct to take that view (see chart below). Now rubber prices are rising and this time I think they could go for a proper run. That would be a clear negative for tyre suppliers.

Thailand natural rubber prices in US dollars per kg

  • Risk: China autos. Why do I think rubber prices could drift higher this time round when I was rightly unconvinced in 2012? I believe that it is not a fundamental mismatch between supply and demand but speculators in the commodities markets that drive natural rubber prices and that these participants buy natural rubber when the Chinese auto market is growing. As the chart below shows, when China autos rise and fall, so do natural rubber prices. Given that recent data point to a modest recovery in the economic environment and a firmer market for autos in China in 2013, I’m concerned that we will see speculative inflows to the natural rubber market.

Index of China auto sales vs index of Thailand natural rubber prices

  • Risk: currency. Japanese companies buy their rubber in US dollars so the stronger yen reduces their raw material costs and a weaker yen (see chart below) increases those costs. I don’t believe that the weaker yen will do much to improve the competitiveness of Japanese tyre suppliers relative to, say, Korean suppliers because the Japanese (like Michelin, Continental and Pirelli) are operating in market driven largely by brand rather than price. A mild negative.

Japanese yen US dollar forex rate, daily for past 1 year

  • Risk: slower OEM growth. The figures for production of autos in Japan in December 2012 are not yet out, but production up to November 2012 was 9.24 million units and I estimate that production in December was 575 thousand units, give or take. So for calendar 2012 call it 9.815 million units, up 16.8% from the 8.4 million units manufactured in 2011. It was growth like this that pushed up Japan OEM tyre sales by 14.5% YoY (see chart below) in 2012 and helped all the Japanese tyre suppliers. The problem is that I expect the Japanese auto market to contract in 2013 (a consensus view) and even globally the Japanese standard bearer Toyota is only forecasting flat production of autos for this calendar year. Overall it doesn’t look as if we can expect much from OEM demand for tyres. Replacement tyres in Japan have had a good run for the past three years and will probably take a breather, while Europe is stagnant, China and Asia are too small to matter and only the US looks decent. So, compared to 2012 I think 2013 is a slower year. (In the chart below, the red line showing 2012 OEM tyre sales is far ahead of 2011 sales, which is the blue line, and was only just behind the very strong year of 2011, in purple.)

Japan OEM tyre sales, cumulative by year (million units)

  • Risk: valuations. When I discussed Bridgestone back in February 2012 and suggest that it was in effect a put on the Chinese auto market I pointed out that if the company were to beat its guidance and generate earnings per share of 240-250 yen (current guidance 219.8 yen) it would put the stock on less than 8x earnings for 2012 – not bad for the world’s biggest tyre supplier. However, the share price was 1,904 on that day and it closed at 2,328 today (+22%). I don’t think the outlook as improved over those 11 months; in fact it has probably deteriorated at the margin. And if revenue growth slows and costs rise the firm may struggle to impress in 2013, with little expansion in valuations.
  • Risk: tyre prices. Price competition in the tyre market has been on hold for nearly a decade. Sure, we have had a bit of price-cutting every now and again to clear inventory (as with Goodyear in May-June 2011), but not price-cutting as a weapon to gain or defend market share. This is not, as far as I can tell, cartel operation but a reflection of tyre companies’ decision to place a higher priority on recouping their losses on higher raw material costs. As you can see from the chart below, prices have risen dramatically since 2004 in the US and I believe most developed markets have followed a similar pattern. It is just possible that if raw material prices do not go up but instead fall (or stabilise below current levels) that a few suppliers will decide to go to the mattresses in a war to gain market share. I rank that as a low probability, but good to be aware of it.

Monthly CPI for US tires, seasonally adjusted

December 2012 tyre shipments

Here’s a quick run-down of December sales figures. Total sales of tyres in Japan came to 9.69 million units, falling 5.3% year-on-year and 24.9% month-on-month. Split by type, OEM tyres (for new cars) hit 3.43 million units, down 18% YoY and falling 7.5% MoM. Replacement tyres rose 3.6% YoY and fell 32% MoM. For the whole of 2012, total tyre sales in Japan were 119.61 million units, up 4.9% YoY. Note the difference between OEM and replacement though: OEM rose 14.5% YoY and replacement fell 0.8% YoY.

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