Stock Recommendation | CEAT - ADD - Target price : 1,280

The competitive intensity in two-wheeler segment remains high due to (1) aggressiveness by market leader MRF and (2) entry of new players. While CEAT has taken 3-4% price increase in October 2018, as per our checks, MRF has not hiked prices as yet, which remains a concern for the segmental profitability. From medium-term perspective, it is imperative for CEAT to scale up presence in other segments. While, gaining share in truck-bus radial segment will be difficult, we believe that CEAT has the potential to gain some share in the PV OEM segment.

We have cut our FY2019-21E consolidated EBITDA estimates by 6-12% on (1) pricing pressures in two-wheeler segment, (2) delayed price increase in other segments and (3) cut in estimates for specialty tires subsidiary. The cut in EPS estimates is much higher at 9-20% due to higher fixed expenses below EBITDA. Valuations are not demanding at 11X FY2020E, which drives our ADD rating. TP revised to ₹1,280 (from ₹1,500), which is based on 13X September 2020E EPS.

▶ Strong revenue growth in MHCV and PV segments in 1HFY19. Overall volumes for the standalone entity increased by 12.4% yoy led by strong growth across major segments (MHCVs, PVs and two-wheeler) and were up 2% qoq. ASPs increased by 1.1% yoy largely due to price increases taken by the company even though mix was marginally negative on yoy basis in 1HFY19. The company has shared segmental revenue breakdown for 1HFY19; revenue growth of 15% yoy in 1HFY19 was driven by (1) 34% yoy growth in MHCV segment led by low base and strong growth in radial segment, (2) 31% yoy growth in passenger vehicles segment aided possibly by new order wins from OEMs, (3) 15% yoy revenue growth in two-wheeler segment, (4) 43% yoy growth in specialty tires segment and (5) 28-33% yoy decline in LCV and farm segments. In terms of endmarkets, OEM segment revenues increased by 28% yoy while replacement revenues increased by 9% yoy leading to negative mix (on yoy basis) in 1HFY19 (refer to Exhibit 3 for details).
▶ Raw material cost inching higher. RM cost per kg increased by 2.5% qoq in 2QFY19 due to increase in costs of crude derivatives such as carbon black, chemicals, fabric cord, etc. The company expects RM cost per kg to increase by 4% qoq in 3QFY19. We note that based on reported 2QFY19 financials, RM cost per kg has gone up by only 1% qoq; this is due to higher production levels leading to increase in finished goods inventory. Under full cost accounting, the cost of finished goods includes raw material cost, variable manufacturing expenses as well as other fixed manufacturing overheads. As a result, in a particular quarter, when production is greater than volumes sold by the company (implies increase in factory inventory), then there will be a positive impact on gross margins as closing inventory will include a part of fixed overheads which will reduce overall costs in that quarter. However, we note that this will not have any impact on EBITDA as employee cost and higher expenses will be inflated when production is higher than sales. This could be one of the reasons for higher-than-expected employee cost and other expenses in the quarter. The company highlighted continued increase in A&P spend and salary hikes also led to higher costs in the quarter. As per the management, employee cost also includes one-off cost of ₹70-100 mn pertaining to retrospective impact of increase in wages (pertaining to FY2017-18) at company’s two plants. Adjusted for one-off costs, standalone EBITDA margin was 9.7% in 2QFY19.
▶ Price increases in past two months to offset RM cost pressures. As per our checks, the company has taken around 2% price increase across segments (1% in two-wheeler segment) in 2QFY19 (in second half of the quarter so full benefit did not come in 2QFY19). Further, in October 2018, the company has taken 2% price increase in truck bus radial tire segment and 3-4% increase in two-wheeler segment. However, as per our checks, MRF has not taken price increase in two-wheeler segment as yet, which is a matter of concern. If MRF does not follow with price hikes, CEAT might need to roll back price hikes. Given price hikes (assuming 50% pass through of two-wheeler price hike taken by the company) and strong overall volume growth environment, we expect standalone EBITDA margin to improve to around 11% by 4QFY18.
▶ Competitive intensity to remain high in two-wheeler segment. As per our understanding, Maxxis has already started supplying tires to Honda and is appointing distributors aggressively in UP, Gujarat, Maharashtra and a few big cities in other major states. We believe that Maxxis can emerge as a formidable player in two-wheeler tire segment over the next five years.
▶ Lower-than-expected ramp-up of specialty tires plant. Ramp-up of production from new special tires plant in Ambernath is much lower than our expectations (even lower that company expectations). Revenues in 1HFY19 were only around ₹300 mn in 1HFY19, which implies only around 25-30% capacity utilization of initial 60 tons per day capacity installed by the company.
▶ Consolidated debt was ₹9.4 bn as of September 2018; up from ₹7.6 bn as of June 2018 and `8.7 bn as of March 2018. There was working capital savings of around ₹1.4 bn in 1HFY19 led by lower debtor and inventory days and higher payable days. Interest expenses declined qoq as debt increased only in September and with possible capitalization of interest expenses pertaining to under-construction plants.
▶ The company cut its FY2019E capex guidance to ₹13-15 bn (₹15-17 bn earlier) and it expects to incur another ₹15 bn capex in the standalone entity in FY2020E. The new truck bus radial tire plant will be commissioned by end-3QFY19 while new PV plant will come online in 2QFY20. Capacity expansion at Ambernath plant for specialty tires will likely be commissioned in FY2020E, one-year delay from earlier plans possibly due to slower-than-expected ramp-up of existing facility. The company has incurred capex of around ₹4.4 bn in 1HFY19, which appears quite low given the new truck tire plant will get commissioned this quarter itself. The management highlighted that ramp-up of plant will take around 4-5 quarters and capex will be phased out over this period.

Definitions of ratings

BUY	-	We expect this stock to deliver more than 15% returns over the next 12 months.
ADD	-	We expect this stock to deliver 5-15% returns over the next 12 months.
REDUCE	-	We expect this stock to deliver -5-+5% returns over the next 12 months.
SELL	-	We expect this stock to deliver

Our target prices are also on a 12-month horizon basis.

Other definitions

Coverage view. The coverage view represents each analyst's overall fundamental outlook on the Sector. The coverage view will consist of one of the following designations: Attractive, Neutral, Cautious.

Other ratings/identifiers

NR	=	Not Rated. The investment rating and target price, if any, have been suspended temporarily. Such suspension is in compliance with applicable regulation(s) and/or Kotak Securities policies in circumstances when Kotak Securities or its affiliates is acting in an advisory capacity in a merger or strategic transaction involving this company and in certain other circumstances.
CS	=	Coverage Suspended. Kotak Securities has suspended coverage of this company.
NC	=	Not Covered. Kotak Securities does not cover this company.
RS	=	Rating Suspended. Kotak Securities Research has suspended the investment rating and price target, if any, for this stock, because there is not a sufficient fundamental basis for determining an investment rating or target. The previous investment rating and price target, if any, are no longer in effect for this stock and should not be relied upon.
NA	=	Not Available or Not Applicable. The information is not available for display or is not applicable.
NM	=	Not Meaningful. The information is not meaningful and is therefore excluded.

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