Automotive Time to re-look at tyre sector - DBS Vickers

Asian markets took another hit as fears of a nuclear meltdown in Japan affected sentiment. Although it is still too early to assess the full impact of the disaster on the global economy, fears that the global recovery could fade as Japan is threatened with demand destruction has driven oil and other commodity prices down.

While the earthquake is unfortunate and it is still too early to assess the full impact of the disaster, we believe that some regional car manufacturers such as Korea may benefit slightly from the temporary supply shortage. Also, production may ramp up in other non-Japan based Japanese manufacturing plants, such as Thailand or Indonesia . Overall, however, we still expect the impact from the Japanese disaster to be limited for most regional, non-Japanese car manufacturers.

That said, we believe it is time to focus more on the tyre sector. The current market environment is helping to improve overall profitability and sentiment in the sector, at least over the short term.

This is underpinned by the following.
Easing product spreads. Most tyre manufacturers have already gone through successive rounds of price increases in order to pass on higher raw material costs. It is worth noting that, historically, it is extremely rare for any sizeable tyre manufacturer to slash tyre prices despite meaningful decreases in input costs. It is also common knowledge within the tyre industry that the most important growth driver for any world class tyre manufacturer is to maintain a premium-pricing strategy (feasible due to the popularity of their brands). Since aggressive price cuts risk damaging the longer term perception of any tyre brand, most global tyre producers have therefore rarely reduced prices, merely in order to bump up sales. Thus, even after a sharp drop in demand for tyres, tyre manufacturers resisted price cuts and instead chose to lower utilization rates.

Given all of this, we believe the recent correction in raw material prices will have almost no effect on current tyre prices. Accordingly, the recent correction in natural rubber prices and other naphtha based tyre inputs (i.e synthetic rubber, carbon black) should help improve product spreads for the tyre industry

Only a minor impact on global tyre demand. Roughly around 75% of global tyre demand comes from the replacement market. Traditionally, replacement tyres (RE) are characterized as a necessity (or staple) product and thus not really prone to global economic swings (although the last recession was an exception). Of the remaining 25% of OEM tyre demand, we expect the devastation in Japan to cause only a limited impact. While it is still too early to assess the full impact of the disaster on global automotive demand, the pent-up car demand from the US, continued drive towards cars in emerging economies, and the still abundant market liquidity (to support auto financing) – are all expected to play a vital role in mitigating the impact.

Well hedged against potential forex fluctuations. Within the tyre sector, investors do not need to speculate on currency movements. This is because for many Asian tyre stocks, their exposure to currency fluctuations is relatively small (after deducting dollar-denominated costs) (i.e raw material procurement costs). For example, in case of Hankook Tire (000240 KS), for every 1% change in the KRW:USD rate or KRW:Euro rate, there would only be a 0.2% and a 0.6% impact on its FY11F EPS, respectively.

Previously, in anticipation of limited upside in product spreads, we were only recommending those tyre stocks poised to see major volume growth within this year. We were also only recommending the sector on a longer term basis. However, the sudden change in the operating environment described above is expected to renew interest in the tyre sector. Under our radar, the likely beneficiaries are: Hankook Tire (000240 KS), Kumho Tire (073240 KS), Nexen Tire (002350 KS), PT Gajah Tunggal (GJTL IJ) and Multistrada (MASA IJ).