COOPER TIRE & RUBBER CO CTB S W
January 16, 2014 - 12:40pm EST by
jwright44
2014 2015
Price: 24.81 EPS $1.80 $0.50
Shares Out. (in M): 64 P/E 13.8x 49.6x
Market Cap (in $M): 1,591 P/FCF N/A N/A
Net Debt (in $M): 83 EBIT 227 165
TEV ($): 1,673 TEV/EBIT 7.4x 10.1x
Borrow Cost: NA

Sign up for free guest access to view investment idea with a 45 days delay.

  • secular tailwinds
  • Tire
  • Competitive Threats

Description

 

Investment Thesis

I recommend a short position in Cooper Tire & Rubber (CTB) due to it over-earning from 2009-2012 as a function of a China-specific tire tariff. In June 2013, nine months following the tariff expiration and prior to CTB missing Q2 estimates (EPS $0.55 actual vs. $0.93 est.), CTB received a bid from Apollo Tyre (APTY:IN) for $35ps, a 43% premium to the pre-bid price of $24.50.  Fast forward to 12/30/13 when the merger was cancelled as a function of APTY:IN stock dropping by 28%, labor discord both at a CTB U.S. factory and a China JV, and delayed Q3 2013 financial statements, all serving as a fulcrum for APTY:IN to claim its financing had been withdrawn. Now largely orphaned, CTB trades at a slight premium ($24.90) to its pre-bid price while its fundamentals have continued to deteriorate due to increasing competition post-tariff. As of this week, CTB reports that it is now recovering its financial statements from the China JV (which had locked out CTB since last July) suggesting that CTB’s delayed Q3 10-Q is forthcoming.  In court documents filed by Apollo during the merger dispute, CTB reduced its 2013 proxy revenue estimates from $4.4b down to $3.4b  - a 23% drop in revenue. CTB's tier 2 replacement products face increasing price erosion and CTB’s private label tires are in much less demand given the glut of higher quality China products now available in the market. CTB is now challenged to stabilize its market share losses and rebalance inventories following the 15 month contentious merger effort. CTB currently trades around 14X my 2013 EPS estimate of $1.80 – a premium to Goodyear (GT) at 11X. For 2014, I expect EBIT margins to normalize with more challenging raw materials comps and market share losses to persist with weak demand in CTB’s tier 2/3 replacement segment and its private label business. With my 2014 EBITDA estimated in a range from $200-250m and an EV/EBITDA target of 4.3X conservatively in-line with GT, this implies that CTB is worth between $12.75-$16.25ps, the midpoint of which is a 42% return from current levels.

 **********************************************************

 

Company Background / Tariff History

Cooper Tire & Rubber was founded in 1930 and is based in Findlay OH. It operates 9 manufacturing facilities (U.S. (4), China (2), Mexico (1), U.K. (1) and Serbia (1)) with China and Mexico leading the shift to low-cost country production in 2006-2008 and the closure of the Albany GA plant in 2009. They were the 4th largest N.A. tire manufacturer and 9th largest in the world with $3.9b revenue (70% N.A. / 30% Int’l) and 47m tires in 2011. In 2013, they are now the 11th largest globally, losing 2 positions. Cooper manufactures passenger and light/medium truck replacement tires with only 5% original equipment (OE) tires. U.S. market share was 13%. Principal raw materials (50-55% of COGS) are natural rubber, synthetic rubber, carbon black, chemicals (butadiene), and reinforcement components (steel cord). Labor is 20-30% of COGS. U.S. light vehicle replacement shipments are stable and resilient, ranging from 208-238m from 1997-2012.  Their international segment is growing off a low base with performance currently hampered by pricing pressures from intense competition.

The short opportunity is furnished by the first ever use of Section 421 of the Trade Act of 1974.  The tariff enacted a China-specific light vehicle tire import duty of 35%, 30%, and 25%, respectively, for 3 consecutive years beginning 09/26/09.  It was a blatant effort by the United Steel Workers to “indict globalization”. Of note, no tire producer was on record advocating the tariff and Cooper management downplayed expectations by lamenting the payment on 2-3m of their own tires from China but “in the short term we could see some positives from the enactment of this legislation”. Post-tariff, CTB is now revisiting the same competitive threats that instigated its 2008 Strategic Plan and $145m restructuring charges and the benefits of the tariff that accured to CTB have reversed. 

 

Proposed Apollo/Cooper merger - likely ambitions of the 3rd generation heir apparent to Apollo

I don't believe the merger fall-out is very material to the current situation at CTB. My impression is the merger was largely the combination of an overly ambitous Neeraj Kanwar (40 y/o son to the Apollo chairman), CTB management eager to pass the baton (CTB CEO Armes sold $7.2m of his stock between 8/31/12 - 9/4/12 coincident with the tariff expiration AND while in discussion with Apollo), and a US bank consortium willing to LBO it with $2.1b debt. Much ink was spilled on the deal so I will provide some references (here, here, here, here) and in relation to the legal battle when CTB attempted to force the deal to close (here, here, here, here). I should note that I don't have M&A expertise as to whether CTB will win the break-fee of $112m ($1.75ps) now in legal limbo.
 
 
Positive tariff impacts on CTB are now reversing
 
The period from 2006 until Q3 2009 prior to the tariff depicts CTB's weakened relative strength with respect to industry volumes.  The chart below shows that Cooper had a relative strength deficit of 5.9% in the first 3 quarters for 2009 and then immediately after the 35% tariff was installed, they had +11.0% gain, for a 16.9% swing in a single quarter. Cooper misleads investors by attributing the increase in market share to ultra high performance (UHP) and light truck lines and continued strong dealer relationships.
 
After initiation of the 35% tariff in Q4 2009, this relative strength reverses and becomes positive. Cooper never discussed the drivers of this market share shift and misleadingly attributed the gain to higher market share of ultra high performance (UHP) and light truck tires and continued strong dealer relationships.
 
Although the tariff ended 9/30/12, the 4th quarter was included in the intra-tariff period below. Beginning Q1 2013, the relative strength of CTB reversed dramatically with relative strength of -13.4% and -16.6% for Q1 and Q2 respectively. 
 
 N.A. Tire Operations Segment - Unit Shipment Changes
 
  Pre-Tariff Intra-Tariff Post-Tariff
  2006 2007 2008 2009 Q1-Q3 2009 Q4 2010 2011 2012 Q1 2013 Q2 2013 Q3 2013
CTB -0.5% 0.8% -16.6% -13.8% 22.0% 9.0% 0.4% 3.4% -14.4% -13.4% ?
Industry -5.1% 2.5% -6.1% -7.9% 11.0% 5.7% -2.2% -1.9% -1.0% 3.2% ?
Relative Strength 4.6% -1.7% -10.5% -5.9% 11.0% 3.3% 2.6% 5.3% -13.4% -16.6% ?
Source: CTB 10-K, 10-Q
 
The above demand reversal was so abrupt that CTB has been very challenged to manage inventory levels. These levels are problematic because inventory imbalances are costly to correct given the high SKU counts. Moreover, many distributors with high inventories had to take significant inventory write-downs post-tariff - something that CTB has done done yet.
 
 
  Intra-Tariff Post-Tariff
  Q4 2011 Q1 2012 Q2 2012 Q3 2012 Q4 2012 Q1 2013 Q2 2013 Q3 2013
FINISHED GOODS                
Inventory Turnover 3.17 2.75 2.35 2.23 2.29 1.61 1.59 ?
Days Inventory 28.43 32.72 38.30 40.44 39.36 55.99 56.60 ?
y/y change        17.8% 38.5% 71.1% 47.8% ?
                 
TOTAL INVENTORY                
Inventory Turnover 2.00 1.79 1.58 1.53 1.55 1.07 1.12 ?
Days Inventory 44.94 50.32 56.88 58.76 58.06 84.27 80.20 ?
y/y change        6.3% 29.2% 67.5% 41.0% ?
 Source: CTB 10-K, 10-Q
 
Beginning Q3 2012, management cited tariff impacts leading to "near-term volume variability". However, management changed their tune by Q4 (concurrent with Apollo negotiations), and explained the inventory build was intentional in anticipation of an ERP system install and for planned production shutdowns for ERP system cutovers. Only by the Q1 2013 earning call did management more fully discuss that inventories were high because certain customers imported "a significant number of Chinese tires imported immediately following tariff expiration".
 
According the Findlay, OH newspaper, employees have frequently joked they are having to stuff tires in containers and park them in neighboring towns. For 1H 2013, I estimated that about 60 furlough days were taken at the Findlay plant through local restaurant contacts. Other public comments from union employees indicate weekend shifts were eliminated in other locations.
 
In a candid moment this fall at the Findlay, OH Rotary Club, CTB CEO Roy Armes stated "The reality is, Cooper Tire is becoming a smaller player in an increasingly competitive industry" and "The global intensity of the competition has grown immensley in just the last five years", and "scale has become more and more important on how we are going to survive". 
 
CTB's private label business uniquely benefited from the tariff and is now highly vulnerable
 
By way of background, CTB's US peers (Michelin, Goodyear, and Bridgestone) had all exited private label tire production by 2006 principally because they were transitioning to higher margin and higher performance tires increasingly common as OE fitments and offered desirable margins for US production. However, CTB elected to remain in the private-label, lower price-point replacement business to meet several market needs including; 1) questionable safey profiles of foreign-made replacement tires; 2) desire by US private branders to market "made in USA" product, and 3) near-source production flexibility around specialty fitments.  In its investor presentation, CTB names Hercules, PepBoys, Del-Nat Tire Corp, TBC Corporation, NTB, Sears, Les Schwab, Merchant's, Tire Kingdom, Big O Tires, Discount Tire, and Canadian Tire as examples of private label customers. The private lable business was not terrible until 2008-2009 when China manufactures took aim at the US market. According to industry contacts, when the tariff was enacted many buyers for these firms were challenged to source comparable and competitively priced product outside of China. Tire manufactures in Korea, Japan, Indonsesia, Phillipines, Thailand, Turkey and Mexico not only had capacity constraints to immediately supply US private branders but the U.S./China tariff merely raised the floor on global prices. Thus, CTB was well positioned to take this capacity and immediately increase capacity utilization from 65% in 1H 2009 to 90% in Q4 2009. Management commented that "we operated at a level very close to full practical capacity". CTB's Texarkana facility went from a 5 day week to 24/7 and added 250 workers. Tupelo and Findlay sites were upgraded and shut-down days were cancelled. CTB does not disclose details about its SKU mix between Cooper-brand, associate-brand (e.g. Mastercraft), and private label tires. The private label business was last cited at 38% of revenue in a 2007 investor presentation. However, the number of company-disclosed private label customer relationships had increased from 6 to 12 since that time. I estimate CTB's private brand business around 40-50% of global production and a key driver of intra-tariff peak operating margin from 4.2-8.4%.
 
According to industry contacts, beginning in Q1 2012, Chinese suppliers were preparing to re-enter the US replacement market upon tariff expiration 9/30/12. Importers established state-side free trade zones in which to store containers of tires to be released 10/1/12. Some market participants were immediately able to reduce wholesale prices on entry level tires by about 15-18% (tariff levels were 25% less 7% shipping cost) while others blended the lower cost inventory over a few quarters post tarriff expiration.
 
In summary, CTB's entire private label business is now subject to intensive competition that will impair price and mix. The Q2 10-Q finally addressed this issue: "As communicated following the first quarter, inventory adjustments by certain U.S. customers continued, which combined with increased competition from imports, did affect sales and production volumes in the second quarter. The effects were primarily on private label and lower value entry level consumer tires, while shipments of Cooper brand tires were consistent with the overall industry results for the quarter." In my view, CTB was finally forced to address the private label market share losses in an attempt to address a MAC in the merger that discusses market share losses that are independent of overall industry demand.
 
Chinese imports are back - in a big way!
 
Chinese imports came back much more quickly than most market participants expected. For example, in 2009, Chinese imports were 46.5m units and have already returned to 51m units in 2013. The difference now is that China has greatly modernized its tires plants in the last 3-4 years as China became the world's largest car market at 21.3m new units in 2013. An estimated 30-40 new tire factories have come on-line and are more modernized than older US plants. Product lines for new competitors like Sailun expanded from 2 lines / 50 SKUs to 7 lines / 150 SKUs post-tariff. Dealers attitudes towards Chinese product has changed dramatically in the last 3-4 years. They comment that tread designs are more modernized, warranties are improved and the tires runs truer than in the past. In summary, the US dealer stigma of a Chinese-made "inferior" tire has evaporated and they believe the product is greatly de-risked from a product liability standpoint (i.e. you don't want it on the public record you were the tire dealer that installed a 3rd rate tire that killed or injured anyone). 
 
Chinese product is also dramatically less expensive. For example, a popular tier 3 passenger tire (PCR) sized 205/55/16 made by Sailun has a wholesale price of $53 vs. a comparable Jetzon which is a private brand from TBC made by CTB that has a wholesale price of $71. This is an enormous pricing spread for tier 3 replacement tire shoppers who stand to save $72 for a set of 4 tires. Moreover, tire retailers have been starved for dollar margins in tires during the tariff where the traditional pricing spreads of $15-20 between each tier of tire product were compressed by tariff. PBY and MNRO both discuss resoration of tire margin and supply post-tariff.
 
 
EBIT margins likely to compress in Q3 despite favorable raw material trends  - Price/mix headwinds now take center stage.
 
As background : Cooper-branded tires are most commonly characterized as a tier 2 replacement product. CTB has very few OE fitments. Most of its Cooper-brand tires compete for mindshare with Goodyear, Hankook, Kumho, Nexxen, among many others. A small minority of consumers have brand awareness in this segment of the market. Most tire dealers believe they influence about 90% of tire purchases based on price and their recommendation to the consumer. As such, this segment of the market is highly commoditized. Tires SKUs are numerous and fairly complex between wheel size, tire width, aspect ratio, and speed ratings. SKU counts have really exploded in recent years. Tires pricing general adheres to a "good/better/best" and is roughly equivalent to "tier 3/tier 2/tier 1" producers. The retail pricing model usually assigns a $15-20 spread between each teir. The tariff raised the pricing floor for the value or entry level "good" tire and artificially inflated prices for all tires. One impact of the 2009 recession that has yet to completely normalize is that tread depth of tires on the road today remains at historical lows as consumers deferred replacement. The standard bull case for the industry is that this pent-up  demand will eventually pull forward. Given the strong new car sales in 2013 with an increase in credit, this demand has largely not materialized. Tire dealers generally struggled during the tariff because higher prices made it that much more difficult to sell tires. Many that I spoke with remarked one impact of the tariff was to reduce the spread between tier 3 and tier 2 product to $5-10 instead of the typical $15-20. This smaller price gap made it much easier for consumers to upgrade to a Cooper-brand or GT tier 2 tire and ending up being an unexpected benefit to tier 2 demand. Tire buyers now remark these traditional spreads have come back to the market and CTB is well positioned for more competition in its category by lower value "entry-level" products.  
 
CTB's LIFO accounting highlighted in Q1 2013 a $90m benefit from lower raw material costs against a total $97m EBIT. In Q2 2013, lower raw material costs conferred a $120m benefit against $69m in EBIT. These raw materials benefits alone suggest that trailing (and peak) EBIT margins of 11.8%, 8.4%, and 11.2% in Q4 2012, Q1 2013, and Q2 2013, respectively, are no longer sustainable. It is clear that CTB had strived to keep prices as sticky as possible post-tariff (building inventory all the while) given the company was apparantly trying to sell itself, of which Apollo was the only one who formally engaged in due diligence. Additionally, my conversations with purchasing agents also confirmed that CTB has a history of being slow to act to industry pricing trends - often lagging the market by 2-3 quarters. It appears history has repeated itself.
 
Indeed, CTB price reductions peristed in Q3 and serve to highlight the commoditized nature of the tier 2 segment. Below are the results of pricing checks of CTB product including both Cooper-brand (Trendsetter, Lifeliner, CS4, Discoverer) and Cooper associate brand (Mastercraft, Starfire) in 3 common tire sizes. I weighted the price changes according to rough estimates of CTB's unit mix based on plant output estimates from trade journals to estimate a 5.2% sequential decline in wholesale prices from Q2 to Q3. 
 
 
Tire Size / SKUs tracked Tire Description Q2 to Q3 Sequential Price Change Weight Weighted Price Drop
205_70_15 / 10 SKUs 15" - typically on older cards -1.9% 25.0% -0.5%
225_60_16 / 15 SKUs Most common tire size in market (3-4% all sales) -5.3% 50.0% -2.7%
245_70_17 / 11 SKUs Common truck tire -8.4% 25.0% -2.1%
     
 100.0%
-5.2%
 
Given that raw materials are about 50% of COGS, this pricing drop is offset by an estimated 10.9% sequential decline in rubber (RSS3; as a rough proxy for COGS) which translates to a 5.4% (10.9% X 50%) drop in COGS. With price down 5.2% vs. COGS down 5.4% suggest a 0.2% spread benefit. However, the drop in raw materials appears to have not kept pace with with price reductions.  In CTB's notification of late filing for Q3 2013: "Operating profit will be significantly lower than the corresponding period for the last fiscal year. The reduction will reflect lower unit volumes, including the effects from the actions at the Joint Venture, as well as price reductions partially offset by lower raw material costs. In addition, lower operating profit reflects production curtailments and transaction expenses related to the Merger." Thus, unit volumes (particularly private label product) are in sharp decline and price vs. raw materials spread are no longer able to prop up peak EBIT margins. 
 
I forecast EBIT margins for Q3 (excluding merger related costs) to be in the range of 5.7% (down 52% y/y from 11.8%) due primarily to a 23% drop in y/y revenue and Cooper-brand pricing pressure. I estimate Q3 revenue to be $842m. I forecast an operating profit of $48m vs. $130m from the prior year quarter - a 63% decline. Street (GS, MS, DB, BofA) FY operating profit was estimated at $391m prior to the merger when CTB traded at $24.50 - now, CTB itself has forecast $257m operating profit in an internal communication with Apollo (I have not reviewed the totality of the court filings to verify if CTB ever disputed the accuracy of these estimates). The following $3.4b full year revenue estimate uses what are likely best-case estimates provided by CTB in its letter to Apollo dated 10/4/13 as filed in the Delaware court pertaining to the merger - given the vested cash comp due to CTB management post-deal exceeded $30m.
 
Income Statement
  Q1 2013 Q2 2013 Q3 2013 E Q4 2013 E
 FY 2013 E
 FY 2014 E
             
Net Sales $862 $884.1 $841.9 $796.9 $3,385 $3,168
y/y change -12.5% -16.5% -23.2% -25.0% -19.4% -6.4%
COGS $703.80 $734.0 $725.0 $715.0 $2,945 $2,851
Gross Margin 18.3% 17.0% 13.9% 10.3% 13.0% 10.0%
GP $158 $150.2 $116.9 $81.9 $440.0 $316.8
SG&A $61.3 $81.0 $69.0 $69.0 $240.0 $232.0
Restructuring $0.0 $0.0 $0.0 $0.0 $0.0 $0.0
Settlements $0.0 $0.0 $0.0 $0.0 $0.0 $0.0
Impairment $0.0 $0.0 $0.0 $0.0 $0.0 $0.0
EBIT $96.6 $69.2 $47.9 $12.9 $226.6 $84.8
EBIT Margin 11.2% 7.8% 5.7% 1.6% 6.7% 2.7%
Interest Expense $7.1 $7.2 $7.2 $7.2 $28.8 $28.8
Interest Income -$0.3 $0.1 $0.1 $0.1 $0.1 $0.0
Other income (expense) -$0.6 $0.8 $0.8 $0.8 $1.9 $3.2
Income Tax Expense $27.6 $19.6 $12.7 $1.5 $61.5 $16.9
Net Income $62.8 $41.6 $27.3 $3.4 $134.5 $35.9
NI MI $6.8 $6.1 $4.0 $4.0 $24.0 $4.0
Net Income $56.0 $35.5 $23.3 -$0.6 $110.5 $31.9
Diluted EPS $0.89 $0.55 $0.36 -$0.01 $1.80 $0.50
             
 
Apollo expressed its point of view in the letter dated 10/4/13 as follows: 
 
"To avoid any misunderstanding on this point, let me detail just a few examples of how the Company’s obligations to deliver Required Information that is Compliant remains unsatisfied with respect to this most essential component of the Financing, and how the Company’s conduct has created the circumstances that cause us and our Financing Sources to require delivery of certified third quarter financial statements. On July 21, 2013, you confirmed an initial forecast for presentation to the rating agencies. Our respective representatives and those of our Financing Sources met with the rating agencies and presented this forecast the following day. This forecast included projections of $4.3 billion in revenues and $380 million in operating profit for 2013.Only a couple of weeks later, on August 9, 2013, we received a revised 2013 forecast, showing$3.9 billion in revenues and $363 million in operating profit. We immediately contacted the Company to discuss the implications of the weakening performance. We received assurances that the decline was attributable largely to deferred pricing actions in the second quarter that impacted sales volumes toward the end of the second quarter and would, in fact, be compensated by over performance later in the third quarter. During this period, we continued to work together with your chief financial officer to prepare a revised business plan on this basis, and for reasonst hat were inexplicable to us at the time, in the midst of this collaboration to prepare the business plan, we received your first notice purporting to claim that the Company “believes that it has provided the Required Information (as defined in the Merger Agreement) and such Required Information is Compliant (as defined in the Merger Agreement).”

 Thereafter, on September 9, 2013, we received a revised version of a business plan,showing further substantial reductions – $3.6 billion in revenues and $315 million in operating profit for 2013. In discussions with you, we received assurances similar to those we had received in August. In meetings on September 17, 2013, you provided yet another account of the situation at the Company, forecasting a nearly 33% decline in operating profit for September –your projected “catch-up” month – from the forecast delivered only days earlier. Now, we have just received yet another story of the Company’s third quarter forecast and this one reveals the most troubling shortfall yet – $3.4 billion in revenues and $257 million in operating profit for 2013 – in other words, 2013 revenues and operating profit as projected in July were 25% and 48% higher than your current estimates. Your most recent forecast also reflects an additional 25% decline in projected operating profit for September alone, revealing the promised recovery to be illusory and the Company’s current profitability, based on this most recent forecast, to behalf of what was projected little more than three weeks ago. The third quarter has come and gone, and we are saddled with a series of forecasts that leave us confused and deeply concerned over the reliability of the Company’s management and its internal reporting and financial forecasts."

 
Risks & Rebuttals
 
1) China JV labor strike since July has caused temporary loss of business to be recovered as soon as the JV resumes production of CTB tires in Q1 2014 - Some investors believe the China JV strike was instigated by the Chengshan leadership protesting the debt burden brought on by the $2.5b all debt deal. Similar concerns led the USW wanting to renegotiate production volume guarantees in the US and receive make-up payments for unfunded pension liabilities. In reality, I believe the labor unrest was precipitated by curtailments that were already in place ahead of the June merger announcement and not the merger announcement. Labor was agreeable with working less hours but they didn't also want to have the company leveraged in a way that would risk both their job and their pension. The Findlay plant had taken about 60 days out of production in 1H 2013 and the USW took no action. International segment intercompany reported revenues were down by 27% in Q1 & Q2 2013 suggesting they also were cutting production. This production curtailment was precipitated by the lack of competitiveness most especially in private label product first but as the spreads in tier 2 and tier 3 tire prices have come back into the market, all of CTB's production is facing a sharp demand shift. It is interesting that despite these work stoppages inventories continued to build further highlighting the severity of the situation. 
 
Moreover, given the requisite lead times of 60-90 days to receive shipments from tire producers in Asia and the increased industry capacity, I believe that most of CTB's private brand customers that have been unable to receive at least some product due to the China JV shutdown and have found alternate suppliers who are likely to perform as well as or better than CTB. US furlough days seems to have stopped when the China JV strike was initiated in July which indicates that at least some of the production was shifted back to the US. 
 
 
2) CTB will locate another strategic partner or receive a rebid from Apollo at a lower price - Given the way the current CTB management misrepresented the firms prospects at the time of the merger and the inability (or incompetance) on Apollo's part to complete due diligence, the near term revenue erosion makes this highly unlikely at this time. There is simply not sufficient forward visibility as to CTB's future earning power for any tire firm to consider buying CTB, at least at its current valuation. The correspondance between the two firms indicates the acrimony was so high they are not likely to reboot the deal.

 
 
 
 
 
 
 
 
I do not hold a position of employment, directorship, or consultancy with the issuer.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

 CTB is now accessing its financial statements from its China JV following a lock-out and will soon report delayed Q3 results
    sort by    
      Back to top