Description

GT is viewed as a broken company.  It is NOT.  Even if you assume the market applies a punitive valuation, GT appears poised to rally 45-65% once 22 estimates have been properly adjusted for their Cooper Tire acquisition which I suspect is the next 3-5 months.  The rally will likely be even higher once the market starts to understand how strong of a position GT has through this upcycle.

In nearly all scenarios (including a recession), I see material upside to 2022 EPS of $2.28.  The stock today at $15.8/shr trades 6.9x EPS and 5.0x 22 EBITDA.   This stock has fallen so far off buy/sellside radar that nearly all analysts have failed to incorporate the acquisition of Cooper Tire into 22 figures.  Simply adding a conservative estimate for Cooper Tire in 22 gets you to $3.00/share.  However, the lack of attention means the market has failed to notice that today’s backdrop is as bullish as its almost ever been for GT.  GT has tremendous pricing power.  The company/industry is raising prices far faster than raw materials.  If you are looking for any evidence of this, look no further than 2Q where price net of raws was positive.  This is despite pricing having a modest lag and GT using LIFO accounting.  Since 2Q, tire pricing has continued while raw mat pressure has abated.  As the market starts to catch-up to this, I suspect 2022 estimates are >$3.0/share by early 1Q22.  Further, there will be a growing realization that the earnings power of GT is likely to normalize at $5.00+/share this cycle.  I assume that GT retains a value-trap valuation.  7-8x $3.25/share yields $22.75-$26.00/share – 44-65% upside in 5 months.  It is worth mentioning that the 5 year average PE on GT is 9.9x.  As such, I could easily see someone posting GT on the VIC at $25/share saying that it is going to $50/share.  Conversely, the only way I see sustained downside is if the economy is forced to lock down for a long time or the equity market has a severe correction.

What is going on today?  The industry is desperately short tires in NA and Europe.  Tire demand is 80-85% replacement and 15-20% OEM.  During the pandemic, many tire plants fully shut down for months.  Miles driven (proxy for tire replacement demand) dropped 25-30%.  While OEM production dropped more for a short period, it roared back.  The net impact of tire plant down-time versus demand led to a material de-stocking of inventory in the channel.  The industry appears to be falling further and further behind as opposed to catching up.  how is this possible? 

1)  On top of temporary plant idling, North America cut 2% of permanent capacity during the pandemic.  Europe cut 5%. 

2)  North America placed prohibitive tariffs on Chinese production in the mid 2010s.  Southeast Asia picked up a lot of that supply from mid-2010s until late in Trump’s presidency when he placed massive tariffs on Southeast Asia.  This effectively eliminated low-end tire imports from Asia which weren’t really missed during the early stages of the pandemic. 

3)  Tires are ground-zero for supply chain issues.  They are bulky and inefficient to transport.  Ocean freight costs are making it prohibitively expensive to send tires across the ocean if you can even get passage.  You CAN NOT airfreight tires economically.  Trucking expenses make it harder still.  The US imports 50% of its supply and Europe imports 35%. 

4)  Miles driven (proxy for tire replacement demand) in the US has eclipsed 2019 and should improve further as Delta abates.  This is true for passenger and truck traffic (less surprise for trucks).  Trucking is more profitable segment historically.  While OEM production has dropped, a 30% hit to 15-20% of demand is offset by 2-3% lift to 80-85%.

5)  Zero tolerance on Covid in Asia is forcing many tire plants down.  Once down – tire plants take 2-3 months to start back up.

GT is in the cat-bird seat now because it consolidated CTB on June 7^th – providing it with even more earnings power to North America where the supply shortages are most acute.

Why so cheap?  Most importantly, nobody is paying attention.  It is just drifting aimlessly with auto-part suppliers.  The market appears worried that OEM demand will drop due to the chip shortage – impacting numbers. While it will hit demand modestly and temporarily, this is more than offset by replacement tire demand and lack of supply.  The market appears worried that miles driven could roll due to Delta.  However, many signs suggest that Delta had no impact in August and has likely peaked.  What happens next year if we POTENTIALLY get relief from Covid and OEM production starts to come back due to the chip shortage abating?

Due to the freeze in the US Gulf, butadiene production was materially curtailed.  Butadiene is 40% of COGS and RIPPED in 2Q in North America. Despite this, GT’s NA margins exploded higher.  As I mentioned above, the pricing on tires has continued to rally while many raw material prices have modestly corrected.  These extremely tight conditions suggest that GT seems poised to beat nicely on 3Q and every quarter until numbers are increased. 

How does this opportunity exist?  GT is covered by auto-part suppliers on the sellside and nobody on the buyside.  There is one tire company in North America.  The marginal investor in this stock is algorithmic and passive.   Most sellside models have failed to incorporate the material uplift from CTB.  The interesting item here is that.  What plagues it today SHOULD also provide a quick remedy?  Once the sellside has fixed the estimates, I strongly suspect that algo/passives will quickly apply a 7-11x PE on $3.25.

Is GT a value-trap?  I owned GT at the dawn of the post-GFC recovery at roughly this price.  At the time, it had the following faults.  1)  Massive under-funded pension.  All FCF went to fixing this initially. 2) Over-levered balance sheet  3)  Material competitfckion from Cooper, China and SE Asia  4)  3^rd party distribution network in North America.  Since then, each of those risks have been extinguished.  GT generated CFFO-CAPEX in EVERY YEAR to fix these deficits.  Note:  I am excluding pension contributions in 2012 and 2013 from this calc.  Today, it owns CTB and will generate material synergies from this acquisition.  China and SE Asian have been frozen out of the US markets via tariffs.  Leverage is not an issue.  GT has a stock buy-back program.  GT spent $1.0bn building its own distribution channel in 2018/19 which was materially disruptive back then but add 200bps of normalized margin improvement – aided further by the CTB deal to enhance fixed cost leverage.  The pension is frozen and fully funded.  Is the company perfect?  No.  Should it trade at a premium to the 5 year average PE of 9.9x EPS given its ability to fix all of these issue over the past 10 years?  I associate 7-10x PE with structural decline or peak.  In 2012, perhaps GT was worthy of 7x PE because so much cashflow was required to fix its problems.  Today, FCF will go to modestly deleverage it while buying back shares.  As we get tire demand back to normal globally, this demand will combine with the synergies, tariffs, capacity cuts and other adjustments to generate $5/share of normalized EPS.  Is 7-8x EPS $3.25, the right multiple for a number that should prove to be well below mid-cycle? 

Competitive landscape/Other:  Industry is relatively fragmented.  Michellin is the market leader.  Continental, GT, Hankook and several other competitors are in various parts of the world.  GT competes on the power of its brand domestically and generates a premium here as a result.  In the rest of the world, this brand premium is less powerful.  Michellin’s brand is far more powerful and it obtains a premium worldwide.  As I mentioned above, US and Europe are large net importers of tires and both cut domestic capacity during the downturn.  Replacement is 80-85% of demand.  OEM is 15-20% of demand and much lower margin due to the volume of those contracts.  Trucking margins are much higher than passenger tires.  Many domestic manufacturers have moved to supply the high value add space.  These tires are wider rims >17inch.  They may have lower side-walls and offer different attributes like road noise, durability, MPG, etc…  This means that the departure of the SE Asian supply is particularly positive for CTB which leaned more heavily to lower-end.

Management:  They aren’t reviewed highly by the sellside.  However, they were dealt a pretty bad hand and have fixed a number of problems during their tenure.  It isn’t the best turnaround in the history but the company is greatly improved over the past 10 years.  Sellside says C-.  I am B/B+.

CTB Synergies:  CTB synergies are materially sandbagged.  There is a lot more opportunity than they suggest.  Overhead, purchasing power, distribution channel system leverage, advertising.

Scenario analysis:

1)      Global economy continues to recovery from covid:  Demand continues to move-up.  supply-chain bottleneck limits foreign supply.  Raw material cost pressure continues but at slower pace than 2Q.  Pricing>raw mats.  Synergy execution.  Sellside includes CTB in estimates.  Huge upward revision to estimates with plenty of room for further upside in 23/24.

2)      Global economy stagnates here.  Demand remains > supply.  Raw material pressure abates.  Pricing>>>>raw mats.  Synergy execution.  Sellside includes CTB in estimates.  Huge upward revision to estimates with plenty of room for further upside on demand normalization in 23/24.

3)      Economy forced to lock down again.  Some chance of a miss depending on severity but raw material tailwind is massive.

Catalyst

3Q & 4Q earning beats which force sellside to update models and incorporate realistic framework.