Description

Summary: Goodyear is a manufacturing dinosaur from the last century that will take a hit from the current crisis but, well, we still have tires on our cars. Goodyear is currently priced as if it’s in serious distress, but the company has done some good things to improve long-term profitability. Its stock price has dropped about 75% since January 2018 (and 53% year-to-date) after two disappointing years, an uninspiring outlook for 2020, and, of course, the coronavirus crisis. While its earnings will take a hit in 2020, I think that 2021 and 2022 look much better and that Goodyear is probably near trough valuation. The stock is trading at an EV/EBITDA of only 4 times based on my 2022 EBITDA estimate, lower than the annual EBITDA reported by the company as recently as 2018. My 12- to 24-month price target is $16, more than double the current price. Goodyear currently has a dividend yield of almost 9%.

Profile: Goodyear Tire & Rubber is the largest manufacturer of tires in the U.S. and one of the three largest in the world (along with Bridgestone and Michelin). Goodyear has many different tire brands, the best-known of which are Dunlop, Kelly, and, of course, Goodyear itself. The company also has some non-core operations in rubber, plastics, and chemicals (all related to tire production) and operates about 1,000 tire and auto service retail stores. Goodyear has leading tire market share in North America, Latin America, China, and India and has 47 manufacturing facilities in 21 countries. The firm generates more than 50% of its sales in the Americas but Asia-Pacific is its most profitable region. In 2019, Goodyear sold 155.3 million tires, 74% of which were sold in the replacement market and the rest were sold to OEMs.

Note: Reports on Goodyear have been posted on VIC six times in the past, the two most recent of which were posted in 2015 (short) and 2014 (long). I suggest reading these reports for more background on Goodyear’s strategy and the cyclical nature of the business.

Liquidity

This is likely to be the primary concern, given the likelihood of recession in the U.S., Asia, and Europe due to COVID-19. At December 31, 2019, Goodyear had $908 million in cash and $3.6 billion in unused credit lines. The firm’s liabilities included long-term debt of $4.5 billion and short-term borrowings of about $900 million. Goodyear has $280 million in notes due in 2020, but no significant maturities until 2023, when it has debt maturities of $1.7 billion. Most of its long-term debt (about $2.15 billion in total) matures in 2025 or later. In 2020, Goodyear plans to spend $800 million on capex, $350-$375 million on interest, $125-150 million on restructuring, $150 million on dividends, and $25-$50 million in cash pension contributions. In 2019 (which was not a great year), Goodyear generated $1.2 billion in cash from operations, which led to levered free cash flow of about $400 million. Goodyear could, if necessary, eliminate its dividend and likely reduce its capex somewhat. Its annual capex was about $200 million higher in 2015-16 than today because it built a new factory in Mexico at a cost of about $500 million. Goodyear is not building an entirely new factories at present but is upgrading some plants. Given its available credit, cash on the balance sheet, and cash generation, I view Goodyear as in no danger of imminent default. S&P rates its bonds as BB-.

At the end of 2019, Goodyear had an unfunded pension of $684 million, mostly in non-U.S. plans. Goodyear plans $25-$50 million in cash contributions to its pension plans over the next few years. Goodyear’s unfunded pension situation was significantly worse a few years ago, but it made some large contributions which have reduced the risk. The company also eliminated health care benefits for retirees in 2008. Goodyear does not expect to pay cash taxes in the U.S. until at least 2025. Its annual cash taxes are around $130 million (mostly in the EU).

The Business / Tire Market

Tires sold into the replacement market are more profitable than those made for the car manufacturers (OEMs) and larger tires are more profitable than smaller ones. The OEM market is not as profitable as the replacement market because the automakers demand large volume discounts and can switch suppliers. Automakers will routinely go to tire makers and ask them to develop tires for new models. The real benefit to these OEM deals in that consumers often replace original tires with the same brand because they want to purchase tires with which they are familiar. The worldwide tire market is about ¼ OEM and about ¾ replacement. As for tire size, Goodyear classifies tires of 16 inches or less as commoditized and tires of 17 inches or more as premium. This is not a precise way to segment the market as some larger tires are commoditized, but it’s basically accurate. The profit margins on smaller tires have declined due to low-cost production from Asia. Goodyear has higher labor costs and other costs than many competitors and is not the low-cost producer. Its premium tires are mainly made for vehicles such as SUVs and light trucks.

Goodyear has long been working to lessen its exposure to low margin, commoditized tires and produce more advanced tires with better profit margins. According to the company, citing industry estimates, the profits margin of tires that are 16 inches or less is about $5 in the OEM market and about $7-$9 in the replacement market, while tires of 17 inches or more have profit margins of about $15 in the OEM market and about $28 in the replacement market. Goodyear has been losing market share in the 16-inch tire market but gaining market share for 17-inch tires. This is partly deliberate, as Goodyear has been reducing production of smaller tires. The company has scaled back production at plants in Alabama and Germany that produce the smaller tires while investing in equipment and capacity to produce more larger tires. These actions are causing some short-term pain but should begin to pay off over the next three years. In 2019, 17-inch (plus) tires accounted for 45% of Goodyear’s total units, up five percentage points from 2018. In the OEM market, larger tires comprised 55% of Goodyear’s total units, which should pay dividends later as more people replace their original tires with Goodyear tires. Moreover, the larger tire segment is growing while the smaller tire market is shrinking. According to Goodyear, citing industry statistics, the replacement markets for larger tires in 2019 grew 6% and 7% in the U.S. and Europe, respectively, but the replacement market for smaller tires declined 8% and 7% in the U.S. and Europe, respectively. In 2019, Goodyear gained market share in the replacement larger tire segment in the U.S. but lost market share in EMEA. The company’s market share in EMEA is declining because it is eliminating many smaller distributors in a very fragmented market to improve its productivity in the long run.

The tire market has been very slow in EMEA and Asia. Tires sales are affected by the economy as consumers buy more cars and drive more miles (which wears out their tires) when the economy is sound. Miles driven and car sales have been good in the U.S. but have been weak in Europe and Asia. Goodyear describes the tire market in these regions as “recessionary” – and this was before COVID-19. Moreover, Goodyear’s international business has been hurt by the trade war and the strong U.S. dollar. The ongoing coronavirus crisis is not going to help Goodyear’s international business and will probably push the U.S. (44% of Goodyear’s 2019 revenue) into a recession, as well. One silver lining (of a sort) is that oil price crash may have some positive impact on miles driven once the economy bottoms.

Goodyear’s profitability is affected by commodity costs, as raw materials comprise 44% of its cost of goods sold. Key inputs for tires include natural rubber, synthetic rubber, carbon black, fabric, wire, oil, and chemicals. Raw materials prices have been somewhat unfavorable over the past few years. In 2016-17, there was a big spike in rubber prices due to floods in Thailand (the world’s biggest producer) that increased Goodyear’s cost of goods sold by hundreds of millions of dollars. While Goodyear raised prices to account for the jump in rubber prices, it could not raise prices to fully offset the increase as producers of smaller tires chose to absorb the cost rather than lose share. Rubber prices have been lower and less volatile since 2018. In 2017, Goodyear spent about $725 million on raw materials, compared with about $278 million in 2019. Moreover, the recent downturn in oil prices should be beneficial to Goodyear as the company says that about 68% of its raw materials cost is affected by the price of oil. The benefit of lower inputs costs shows up in Goodyear’s results after a lag of one to two quarters (due to FIFO accounting). Goodyear says that raw materials cycles tend to last three years and that prices have not rebounded as much in the current cycle as they normally do. Also, the company has suffered some negative effects from currency translation and the trade war (remember that?). Imports of large tires from China have been hit with anti-dumping tariffs, which should have some positive benefit to Goodyear’s U.S. pricing. The company is pushing price increases in 2020 and these should positively affect its cost of goods sold over time.

Good and Bad Trends

                Goodyear had a very poor 2019, as adjusted EPS dropped to $1.08 from $2.32. Several issues affected Goodyear in 2019, many of which will probably continue throughout 2020. The positives included price increases to offset raw material costs, a strong U.S. consumer replacement business, double-digit replacement growth in Brazil, and several key OEM wins for high-margin tires. The negatives included weak light vehicle production, distribution restructuring in Europe, the strong U.S. dollar, weak commercial truck demand, cheap imports from Asia, ongoing expenses from closing some plants and unabsorbed overhead, and slow new car production. Goodyear’s immediate problem in the current environment is that lower volumes will likely lead to unabsorbed overhead.

There are some positive longer-term trends, assuming the current economic crisis is resolved in 2021. Goodyear has stated that it expects about $65 million in incremental annual revenue in EMEA by 2022 due to its distribution restructuring. This expectation is based on similar changes that it implemented in North America about a decade ago. Goodyear admits that its distribution in Europe has been a mess, with multiple distributors handling the same territories. Goodyear is giving exclusive distribution to companies that are willing to make investments to support the brand and is reducing wholesale distribution in some areas. Basically, in Europe, tires often pass through multiple hands before reaching their final destinations in the consumer replacement market. This system increases costs which cannot be passed on customers. Goodyear admits that cutting back on wholesale will cause European tire shipments to fall again in 2020. The company is taking some short-term pain for the long-term benefit.

Goodyear expects about $65-$70 million in annual expense savings in Europe and a similar amount in North America. Goodyear is reducing its labor expense through cuts at its U.S. and European plants while moving production to larger tires. In Germany, Goodyear is reducing total capacity by about 5.5 million units in two plants but is modernizing and upgrading the plants to produce higher-value tires. These changes will leave Goodyear with about 2.5 million units of capacity for tires with margins in the mid-$20s, rather than the current single-digit dollars per tire. The company says that the authorities and unions in Germany have been receptive to its plans. In Gadsen, Alabama, Goodyear has reduced its labor force to about 400 from about 1,250 over the past few months through buyouts and layoffs, which has, apparently, brought the plant down to the expected size. This plant is operating on a reduced schedule and is very inefficient at present. Goodyear is eliminating some smaller tire production and increasing automation at the factory. Goodyear has forecast that, beginning in 2021, its operating income in the Americas will increase about $40 million per year due to the downsizing and transition to higher-margin tires. A large amount of Goodyear’s North America production has been moved to its new factory in Mexico over the past four years.

Goodyear expects about an increase of about 20% in OEM shipments over time due to design wins on new vehicles. The company is investing in production of larger, more technically differentiated tires. These investments have resulted in design wins with OEMs that should, over time, result in greater replacement tire sales (about 80% of Goodyear’s revenue). Goodyear has launched 10 major product lines over the past three years in areas like winter tires and noise cancellation. In 2018, Goodyear introduced the first tire built specifically for electric vehicles, which can wear out tires quickly due to their high torque. This is a big focus for the company, which claims to win about 2/3 of the OEM contracts for EVs but has elevated costs as manufacturing changes are implemented. Goodyear has said that, in testing, tires on electric vehicles wear out 30% faster than on gas-powered cars. So, Goodyear will benefit when Tesla grows large enough to justify into its current market cap (which will probably happen…never) and / or EVs become more commonplace (more likely).

Capital Allocation

Goodyear, like so many other companies, did a horrible job in timing its share repurchases. It did not repurchase any shares in 2019 after spending about $1.1 billion on buybacks in 2016-18. Its average purchase price in 2017-18 was over $30 / share. The stock price is now $7.21. Great job. Anyway, Goodyear does pay a yearly dividend of $0.64 / share, so its current yield is almost 9%. I expect Goodyear will continue to pay its dividend, which is only about $150 million in annual expense, unless we get a full-blown Depression. Goodyear suspended its dividend from 2003-13 (when it was restructuring and dealing with debt and an unfunded pension) but has consistently increased it since 2013.

TireHub and Other Stuff

In 2018, Goodyear and archrival Bridgestone created a 50-50 joint venture company called TireHub, which combined the prior company-owned distribution businesses of both firms. Goodyear is recognizing about $5 million in quarterly losses from TireHub but view these losses as inconsequential relative to the strategic value. The idea is that one large distributor is more efficient than two competing distributors. TireHub operates 71 distribution centers in the U.S., covers virtually the entire country and is designed to improve distribution of premium Goodyear and Bridgestone tires. Most of the orders that TireHub receives are through its website or app, making it something of an e-commerce wholesaler for Goodyear and Bridgestone. Goodyear also has some chemical operations, all of which are related to tire production, and owns some other distribution assets and retail stores.

Coronavirus Effect on Supply

I haven’t seen any reports of the effects of the virus on Goodyear’s supply chain – yet. In February, it closed its Chinese headquarters in Shanghai and its production plant in Pulandian, China. Goodyear announced that the plant was reopened after a one-week shutdown but was operating at a limited capacity. This factory opened in 2011 and was expanded in 2016.

Valuation

Goodyear is trading at a P/E of 4.5x and 4x EV/EBITDA based on my earnings expectations for 2022. These ratios are well below 10-year averages. If Goodyear trades at about 6x EV/EBITDA based on 2022 earnings, then its stock price will trade at about $16, still well below early-2018 highs.

Income Statement

Goodyear had a terrible year in 2019 as sales dropped nearly 5% and adjusted EPS fell to $1.08 from $2.32 in 2018 and $3.11 in 2017. Goodyear is in a cyclical industry that has been in a down period. Prior to COVID-19, Goodyear was probably close to an inflection point with lower costs and stabilizing demand, especially in the consumer replacement market. Nobody knows, of course, how damaging COVID-19 will be, but it should pass by 2021. I assume Goodyear’s sales and EPS will fall again in 2020 but begin to rebound in 2021.

Unit volumes

Goodyear’s European volumes have been declining as it is restructuring its business by eliminating weaker distributors and overlapping territories. The company believes this will be the course of action for the long run. Goodyear did a similar restructuring in the U.S. about 10 years ago. Goodyear is also pulling back from some lower-margin tires in all regions.

Sales by Region

Goodyear’s sales have been affected by low priced tire competition coming from Asia, especially in Europe and Asia. The Americas, more half its total sales, have been better. The U.S. and Brazil have been two of Goodyear’s stronger markets. Still, in just four years, Goodyear’s segment operating income has dropped below $1 billion from $2 billion. This does suggest upside. Most likely, the company would only need to make up some of the difference to have a big impact on the stock price. Clearly, investors do not buy Goodyear’s cost cutting story at present or just believe volumes will continue to fall hard. Another consideration is that the 2015-16 period was unusually good, as high performance tires were introduced and sold well.

Balance Sheet

Cash Flow Statement

Goodyear continues to generate significant free cash flow despite weakness in its business in 2019.

Conclusion

Goodyear is a traditional manufacturer with an underfunded pension that competes in a crowded global market, making it an un-investable relic in the eyes of many investors. Its turnaround plan seems to be taking longer to work than expected, a situation exacerbated by the current coronavirus crisis. Yet, Goodyear has suffered and survived through one crisis after another over the past 122 years and I think it will survive this one as well. We may be near the point of maximum pessimism.

Catalyst

COVID-15 crisis ends, cost cuts are completed, new production of high-margin tires comes on line in 2021-22