Description

Below is the recommendation I submitted on 10/1/11 for my VIC application.  While the shares have appreciated materially since that time, I believe that further upside exists and that an investment is compelling at these price levels.  Regarding fundamental developments since the below recommendation was written, the company reported very strong Q3 earnings, and they also announced another price increase effective November 1 of up to 10% on commercial tires.  Lastly, natural rubber prices have continued to decline, and butadiene prices have fallen sharply.

Goodyear Tire & Rubber (Ticker: GT)

Business Description:

Goodyear Tire & Rubber, based in Akron Ohio, manufactures, distributes and sells tires worldwide.  The company produces tires for the passenger, commercial, OTR (off the road), race and motorcycle markets.  The company also sells rubber-related chemicals to third parties.  Revenues are approximately 55% consumer markets, 19% commercial markets, 11% OTR/race/motorcycle, 9% retail (they own approximately 680 retail outlets in North America), and 7% chemical (they have a small chemical business that sells rubber-related chemicals to third parties).  Goodyear is largely a replacement business.  Approximately 74% of Goodyear’s unit sales are in the replacement market (both passenger and commercial), and approximately 26% of unit sales are in the OE market.  On a regional basis, approximately 44% of revenues are derived from North America, 34% from EMEA, 11% Latin America, and 11% Asia Pacific.

Why Goodyear is Misunderstood

Goodyear is widely regarded as a highly cyclical business that does not generate any meaningful free cash flow.  Looking back over the past 5-10 years I believe that this is actually a fair statement.  However, a large part of this unfortunate reality has been due to market conditions outside of the company’s control.  On the demand side, volumes have been challenged by the economic weakness resulting from the housing bubble ending in ’06-’07 and then leading to the financial crisis in ’08-’09.  On the raw materials side, the company has seen an environment of persistent raw material inflation which has been largely due to U.S. credit growth (we have a fractional reserve banking system and the dollar is the unit of account for commodities – so significant credit growth has been a major tailwind for commodity prices), and Chinese fixed asset investment.

Market conditions aside, the management team has actually executed quite well and has done a nice job reshaping the enterprise to be smaller and focused on higher value, more profitable segments of the tire market.  Over the period of time referenced above the company has gone from 29 plants to 16, and from selling 40% of its product at the low end of the market for about $60/tire, to 75% at the high end of the market for more than $130/tire.  The company has executed this transition through asset sales and negotiations of union labor agreements.  The company sold its North American farm tire business in 2005 and its European and Latin American farm tire business in 2010, both to Titan, and sold its Engineered Products business to the Carlyle Group in 2007.  The company has also taken the opportunity to use labor contract negotiations with the USW to remove plants from protected status and thus allow them to be closed.  In 2003 they closed the Huntsville, Alabama plant, in 2006 they closed they Tyler, Texas plant, and in 2011 they closed the Union City, Tennessee plant.  There have also been developed market closures outside of North America.

The result of the aforementioned actions undertaken by management is that the company has not only a better mix of product, but more pricing power than at any time in its history.  Goodyear, as well as other industry participants (Goodyear is not the only tire company that has rationalized production levels - Modern Tire Dealer estimates that tire manufacturing capacity fell from 387m units in 2005 to 320m units in 2009, and that was before the announcement of GT’s shuttering of another 12m units in Union City), have been consistently pushing through mid to upper single digit price increases over the past 18-24 months (higher in commercial vehicle).  Goodyear is currently recovering more in price per quarter than at any time in its history, and has increased price as recently as September (when economic concerns abounded and consumer sentiment had dropped to levels not seen since the spring of 2009) where Goodyear led a round of price increases which was subsequently followed by high-end competitors like Michelin and Bridgestone (who actually followed with higher price increases than Goodyear - +8-9% vs GT’s +5%).  Goodyear is a better company today than it was five and ten years ago.

Lastly, in addition to Goodyear being a better company today, I believe that the macro headwinds the company has been facing for the past 5-10 years could be stabilizing or subsiding.  On the demand side, despite a rebound from the lows, we are still below normal demand (relative to the long term trend line of passenger replacement tires as measured by the Rubber Manufacturers Association), so there is less downside than before the housing collapse, and we could even see more of a cyclical rebound.  On the cost side, I believe that the two major tailwinds for commodity prices that I discussed before (USD credit creation and Chinese demand) are set to slow considerably or reverse.  In the U.S. we are in a balance sheet recession that resulted from the ’08-’09 shock to our asset values.  This has left us with no demand for debt and that is reflected in our very low interest rates.  QE1 and QE2 managed to sustain the credit effect on commodities for a while, but as we saw in response to “Operation Twist” which will not enlarge our federal balance sheet, when this leg of the stool is removed (as it seems to have been due to the politicization of the Fed), commodity prices drop.  In China, they are now not only building fixed asset investment off of a larger base, but are experiencing persistent inflation due to employment levels that have risen over the past few decades.  On this note, most industrial companies I meet with talk about the challenges of double digit wage inflation in China (Dave Farr, the notoriously outspoken CEO of Emerson Electric, recently said that they are in fact moving manufacturing facilities out of China).  To shorten a long story, China can no longer grow at the same rate as it has in the past, and certainly not in terms of fixed asset investment.  The reversal of these forces is causing most raw material prices to decline.  I believe that this phenomenon is actually recognizable over the past several years but that it has just been distorted by temporary policy measures (namely the Fed’s QE and China’s post financial crisis stimulus).  Jeff Gundlach recently illustrated the issue when he pointed out that despite commodity price appreciation during QE’s 1 & 2, the DJ UBS Excess Returns Commodities Index is actually down 18.4% since September 19, 2008.  Again, because of the politicization of the Fed, and persistent inflation in China, the aforementioned temporary measures have faded and are not sustainable.  Commodity deflation is ensuing.  Not only will raw material deflation be beneficial to GT’s P&L, but it will also be meaningful in terms of the company’s ability to generate cash given the company’s working capital intensity.

In summary, what has depressed Goodyear investor sentiment for years looks set to finally reverse – the company is structurally more profitable, and massive headwinds look set to stabilize and potentially reverse.  The company’s returns on capital and cash flow dynamics should benefit as a result, and that should lead to a higher multiple on higher earnings.

At the company’s analyst day in March of this year, management laid out 2013 financial targets of $1,600m in segment operating income and $2,425 in EBITDAP.  The volume assumptions for these targets are annual increases in the 3-5% range.  The rest of the improvement comes mainly from North America, which they expect to go from $18m in segment operating income in 2010 to $450 in 2013.  The components of the increase in North American profitability are $150 of price/mix, $225m of footprint / unabsorbed overhead, $100m of benefit from pension funding, and a $43m headwind from inflation/other.  The pension component is a direct result of their planned funding levels, and the rest of the components are conservative.  On the price/mix benefit, I calculate that they will already meet the $150m improvement in the second half of this year and are on track for another $150m next year based on announced price increases (the most recent of which being the September announcements of +8% on commercial truck and +5% on passenger car tires).  With regard to the $225m of footprint / absorption benefit, $80m will come from the closure of the Union City plant which happened in Q2, and the remainder looks conservative relative to the $12/tire absorption benefit the company has been seeing over the past several quarters.  Lastly, while the targets factor in a $43m inflation / other headwind, I actually believe that raw material deflation could be a large benefit.

For my earnings power estimates I use a base case and a bull case.  For my base case I use the lower end of the company’s expected volume growth of 3-5% over the next three years, the impact of announced price increases, as well as current raw material prices.  The bulk of the difference between my base case #’s and current Street estimates are the Street’s underestimation of mix benefits, as well as the Street’s lack of inclusion of the most recent price increases (this has led to large beats vs consensus over the past two quarters, and should continue going forward).  My base case EPS for 2012 is $3.09 ($2,678 in EBITDAP – for reference against company EBITDAP targets, and what I use for valuation given the levered balance sheet).  For my bull case, I consider the fundamentals in my base case, but with the added benefit of some raw material deflation.  This could be a significant tailwind for the company – consider that in the early part of the last decade raw material cost per tire was in the mid $20s, it reached low to mid $30s in 2008, and has since surged to approximately $52.  While I believe that most components of GT’s raw material basket could be set to decline (outside of rubber, most correlate to crude prices fairly closely – synthetic rubber / butadiene, carbon black, chemicals, steel cord, etc.), I will focus on natural rubber, as it has had a huge impact over the pat few years, and there is a good micro case for lower prices.

For context, natural rubber prices have increased from ~$0.50 per pound in the early part of last decade, to a high of ~$1.50 and average of ~$1.20 in 2008, and then to a high of ~$2.75 this year.  I believe that natural rubber spiked in 2010 and into 2011 for several reasons, the main ones being 1) QE causing most commodities to appreciate materially, 2) reports of flooding in major SE Asia producing countries, and 3) accelerating demand from local tire producers in China.  The first point – financial speculation - has been the single biggest driver in my opinion.  Both Goodyear and Cooper Tire will tell you that despite what the record-high prices would imply, there is no availability problem with regard to natural rubber.  In addition, on their Q4’10 earnings call they noted that they “have seen local tire manufacturers in India and China petition their governments to intervene in futures trading given apparent speculation”.  In terms of the impact of flooding and Asian demand, we are rolling off the first, and the second has moderated substantially.  In addition to the fading of these three drivers, I also believe that incremental supply could be a significant headwind for prices over the next few years.  In 2004, acreage of new rubber plantings began to rise materially.  In Cambodia, China, India, Indonesia, Malaysia, the Philippines, Sri Lanka, Thailand and Vietnam (these countries taken together would account for a large amount of total production) new plantings were up ~370% in 2008 from 2003, with the ramp beginning in ’04 and increasing substantially in ’05.  Re-plantings also rose during the same period.  Given that the average tree takes 7 years to begin producing, we should begin to see this incremental supply hit the market over the next several years.

In terms of how I factor the potential for raw material declines into by bull case, I rely mainly on my confidence in softening natural rubber prices and incorporate that into my raw material cost per tire assumption in my model.  The current assumption of most tire manufacturers is a natural rubber price of $2.25 per pound (about where prices were before the decline in the past few weeks).  This price would sustain GT’s current raw material cost per tire at about $52.  To modify that number for my bull case I assume that the increased supply, in addition to moderating demand growth rates, less QE-induced financial speculation, and normal flooding levels, will drive prices back to the 2008 average of $1.20 per pound.  This would represent nearly a 50% reduction on the price of natural rubber versus GT’s current budgeting plans.  Assuming that natural rubber is 27% of raw materials, that translates into a raw material cost per tire of $45 (still well above 2008 and historical levels).  Declining to this level over the next few quarters (despite the fact that commodity corrections are typically more swift than gradual) results in EPS for 2012 of $4.92, and a corresponding level of EBITDAP of $3,370.

Finally, I would also note that there is further potential for improvement in the company’s cost structure through future labor contract negotiations.  The current labor contract with the USW expires in July of 2013.  As mentioned earlier in the write-up, Goodyear has used its political capital in past negotiations to focus on footprint reduction (as well as an important agreement on retiree health benefits made in the 2009 negotiations).  This has been a productive strategy in that it has lowered the company’s fixed cost base and allowed them to significantly improve their mix and pricing power.  However, the company still has very inflexible labor contracts.  In fact, the Big 3 currently have more flexible labor contracts than Goodyear does.  To illustrate a) the company’s current lack of flexibility and its detriments, and b) the flexibility that other suppliers have gained in labor negotiations, consider GT’s relationship with Harley Davidson.  GT produces motorcycle tires in an upstate New York plant to serve Harley Davidson.  This plant does not have labor flexibility, and neither did Harley’s plant historically.  However, over the past several years, Harley has gained labor flexibility through labor contract negotiations and they can now flex their production with the seasonal patterns of their business.  Goodyear, however, must still run its plant at capacity year-round, despite the change in its customer behavior.  Given that the company likely does not need to reduce its footprint further, I believe that the next round of labor contract negotiations will allow them to address the flexibility issue.  If addressed successfully, the outcome could be much better financial performance during industry downturns.  This reduction in profit cyclicality would lead to further improvement in financial returns and thus increase the company’s valuation multiple as well.

To arrive at valuation targets I use EV/EBITDAP due to the company’s financial leverage and pension obligations.  The company has typically traded at around 5x EBITDAP, so I use 5x in my base case and 5.5x in my bull case.  With regard to the capital structure, I am using a pension obligation of $3,080m (takes into account lower discount rate and asset return assumptions), and OPEB obligation of $597m, debt of $5,304m, minority interest of $638m, and cash of $2,515.  On my base and bull case 2012 EBITDAP assumptions of $2,678 and $3,370, respectively, I get to price targets of $22.37 (5x 2012 EBITDAP on 2011YE capital structure) and $40.68 (5.5x 2012 EBITDAP on 2011YE capital structure), representing upside of 122% and 303%, respectively, from the current share price of $10.09.  With regard to downside, I think in terms of the balance sheet and liquidity position, and where the stock bottomed in ’08-’09.  As discussed below, the company has an attractive liquidity position and maturity schedule, and is in a better position than in 2008.  In ’08-’09 the stock bottomed around ~$6/share, briefly hitting $3.50 during the depths of the financial crisis.  I believe that downside risk of this magnitude is acceptable given the fact that I don’t believe there is a high level of probability assigned to the scenario of permanent loss of capital, as well as the fact that my upside targets represent very attractive returns.

Balance Sheet & Liquidity

While the company has a substantial debt load, it also has a high level of liquidity and a non-threatening maturity schedule.  The company has $1.8b in cash, needs only $1b for operations, and will generate cash from working capital in the second half of the year due to seasonal factors (also note that the company would generate more case in a downturn due to lower production levels and inventories, and in my bull case cash conversion would improve due to the favorable working capital effects of lower commodity prices).  In terms of maturity schedule, the company’s next maturity is $1.2b in 2014, and the bulk after that are in 2019 and beyond.  This is in contrast to halfway through 2008 when the company was facing a $498m maturity in 2009 and another $975m in 2011.

Catalysts

Quarterly earnings:  I believe that Goodyear will deliver another substantial beat in Q3.  As it has been in the past two quarters, the beat will be driven by better price/mix performance, as well as resilient volumes.  Additionally, while everyone is very concerned about raw material cost inflation, prices of natural rubber, synthetic rubber, steel cord, and carbon black over the last several months lead me to believe that raw material cost inflation will be approximately $585m, which is in line with management’s guidance of no more than $600m, and likely at the low end of Street expectations.  On the volume side, there are three main drivers – 1) resilient consumer replacement volumes in North America as has been confirmed by the most recent Rubber Manufacturing Association data that showed a return to growth in August (after some channel inventory normalization in prior months), 2) strong winter tire sales in Europe that are being driven by low inventories and regulation-driven volume, and finally 3) continued strength in commercial vehicle volumes as confirmed by reports of continued strength in the trucking industry (LSTR has been the most recent company to confirm this).  On the price/mix side, expectations are calculated more on a straight price calculation based on announcements, however mix continues to surprise positively due to higher margin winter tires, and even higher margin commercial vehicle tires, and thee trends will persist in Q3.  I met with the company two weeks ago and they confirmed these trends, as they have done publicly at several conferences (JPMorgan and Deutsche Bank) over the past few months.  All of this leads me to an EPS estimate for the quarter of $0.49.  This is closer to Q1’s performance of $0.51 versus Q2’s performance of $0.65 (but well above consensus of $0.20), and not coincidentally, on the Q2 call management stated that “we believe that our Q1 earnings are more indicative of our current earnings run rate in North America”.

Lower raw materials:  I believe that raw material prices will continue to move lower and this will bolster not only earnings expectations, but more importantly free cash flow conversion as lower raw material prices will be very beneficial to the company’s working capital.  We have seen a sharp decline in natural rubber prices in the past few weeks, and as this was brought to investor attention in sell-side notes, the relative performance of GT shares vs other cyclicals has improved (despite a leveraged balance sheet in a difficult market environment).

Risks

The first big macro risk is either a) resumption of our federal balance sheet expansion by the Fed, or b) massive easing or fiscal stimulus in China.  Both of these would probably be positive for equities in the near term (as they have been in the past), but it would cause me to reassess this thesis, as it would mean that the profitability and cash flow challenges presented by consistently appreciating raw materials would remain.

The second big macro risk is a recession and the resulting decrease in volumes.  This is a high fixed cost business with a rather inflexible labor force, so profit cyclicality is intense.  I will, however, point out one offset, and a few differences from the last cyclical downturn in ’08-’09.  First, raw materials are a huge offset.  If we saw a severe recession, I would expect raw material prices to decline as they did in 2008, and that would be beneficial to Goodyear’s profitability (and cash flow) as I don’t believe they would have to give up much of anything in the way of prices (there was very little in the way of price reduction in 2008, and there has been a further contraction in production capacity since then).  In terms of differences versus ’08-’09, volumes are now below trend versus above trend pre-crisis, and inventories are lower now.  This would suggest a contraction today would be less severe than in ’08-‘09.

I think the biggest micro risk is probably the fundamentals in the company’s Latin American operations.  Latin America is really the only place in the world that the company still has a significant presence in the low end portion of the market, due to the unique characteristics of the distribution channels in Brazil.  Thus, as the Brazilian Real has strengthened, the company has seen increased competition in the low end of the market from imported tires.  The offset here is the translation effect of a stronger currency.  In addition, I think that too much was made of this risk in Street analysis of the second quarter results – start-up costs at a Chilean plant, and the sale of the company’s Latin American farm tire operations distorted results by $14m.  I believe that despite currency complications, results will actually improve in the second half.

Catalyst

Catalysts

Quarterly earnings:  I believe that Goodyear will deliver another substantial beat in Q3.  As it has been in the past two quarters, the beat will be driven by better price/mix performance, as well as resilient volumes.  Additionally, while everyone is very concerned about raw material cost inflation, prices of natural rubber, synthetic rubber, steel cord, and carbon black over the last several months lead me to believe that raw material cost inflation will be approximately $585m, which is in line with management’s guidance of no more than $600m, and likely at the low end of Street expectations.  On the volume side, there are three main drivers – 1) resilient consumer replacement volumes in North America as has been confirmed by the most recent Rubber Manufacturing Association data that showed a return to growth in August (after some channel inventory normalization in prior months), 2) strong winter tire sales in Europe that are being driven by low inventories and regulation-driven volume, and finally 3) continued strength in commercial vehicle volumes as confirmed by reports of continued strength in the trucking industry (LSTR has been the most recent company to confirm this).  On the price/mix side, expectations are calculated more on a straight price calculation based on announcements, however mix continues to surprise positively due to higher margin winter tires, and even higher margin commercial vehicle tires, and thee trends will persist in Q3.  I met with the company two weeks ago and they confirmed these trends, as they have done publicly at several conferences (JPMorgan and Deutsche Bank) over the past few months.  All of this leads me to an EPS estimate for the quarter of $0.49.  This is closer to Q1’s performance of $0.51 versus Q2’s performance of $0.65 (but well above consensus of $0.20), and not coincidentally, on the Q2 call management stated that “we believe that our Q1 earnings are more indicative of our current earnings run rate in North America”.

Lower raw materials:  I believe that raw material prices will continue to move lower and this will bolster not only earnings expectations, but more importantly free cash flow conversion as lower raw material prices will be very beneficial to the company’s working capital.  We have seen a sharp decline in natural rubber prices in the past few weeks, and as this was brought to investor attention in sell-side notes, the relative performance of GT shares vs other cyclicals has improved (despite a leveraged balance sheet in a difficult market environment).