Description

Goodyear is a global leader of automobile tyre manufacturer with a new management team that took over in 2003 and has been doing a terrific job of cutting cost and turning despite difficult raw material cost challenges. If the management just modestly succeeds in improving its North America operating margin to 3.5% (vs. the management target @4-5%) by '07 from today's just under 2.5%, which would be still well below the peer group average of 6%, based on my conservative '07 NA revenue estimate of roughly $9BN, Goodyear could produce an incremental pretax earnings of over $135mm [=NA revenue @$9BN x margin improvement btw. 05-07 @ 100BP => $90 mm], or approximately $0.40+ per share (no tax due to $1BN NOL and on 215mm shrs o/s est. by 07). Added onto '05 EPS estimate of $1.60-1.70, it would produce '07 earnings power estimate of at minimum $2.00 per share. At a reasonable P/E multiple of 12-13x, the stock could rise to low-20 to mid-20 in 12 months. Each 10bp further margin improvement beyond the level I've assumed could drive incremental EPS of 4-5c/shr, or $0.5-1.0/shr incremental value.

I'll save the details about the industry and competitive landscape as such info can be easily available in GT's and its competitors' regulatory filings. Main competitors are Michellin and Bridgestone. Nevetheless, it's important to point out more than 70% of total demand is driven by replacement tires. Replacement demand is relatively stable as it is impacted by driving mileages. The rule of thumb is, since avg. life of a tire is four years old, each car need to replace one tire each year. Higher gasoline price could hurt replacement demand as people drive less but there has yet been any evidence proving that even during the most recent hurricane season that drove up retail gasoline price above $4/gallon in NE.


Good management/sound strategy

· During my most recent visit to their HQ in I met Bob Keegan (Chairman & CEO), Richard Kramer (EVP & CFO), Jon Rich (President of NA Tire) – all very impressive; honest and smart guys.
· At heart of GT’s turnaround strategy is marketing, which is be executing by a group of competent managers who all have consumer marketing background
o Key managers all have consumer product background
§ CEO – Eastman Kodak consumer product group
§ President of NA Tire operation – GE
§ President of Europe & Latin America – both from consumer product companies like P&G

· A big culture change within the organization since 2001 has led to

1) a strategy that is focused on winning share in targeted market;
2) a business portfolio whose mix is increasingly shifting towards high-end/high-performance tires;
3) a renewed focus of R&D effort that is accelerating new product rollout pace even though total R&D spending has not risen as much as its competitors have
o Previously, like every other tire company, GT just wanted to fill its capacity by producing as much as it can but paid no attention to customer needs. Dealers once complained GT had no new product and its marketing campaign had no impact on sales.
o Now, GT only participates in the categories that are identified to have profitable growth prospect and/or provide differentiating characteristics => sustained growth platform and opportunity to improve margin.
§ For example, in the OEM business, GT has intentionally exited from some businesses. The percentage of OEM business as of the total portfolio is now down to 28-29% from 32% five years ago. The remaining OEM contracts are all required to bring in significant replacement revenue, which is a more profitable business. DCX is now the largest OEM customer, followed by Ford and GM. But GM exposure is believed to be not significant.
§ Another example: truck business was ignored by the old management but now it has become an important pillar to GT’s growth story
o Trucks currently account for only 8% of volume but represent 20% of revenue
o Due to mining and construction boom worldwide, truck capacity is currently maxed out for both GT and its competitors, therefore giving GT tremendous pricing power in this category – each 10% truck tire price increase => 2% overall price increase eve with flat prices for the rest 80% of revenue, a very important piece of GT’s pricing increases.
· CEO’s own assessment of GT’s turnaround effort so far
o At a scale from 0 to 10, GT has come back from probably negative 2 (meaning previously bad enough to be even below 0 or the lowest-end of a normal range) to currently 4-5;
o CEO doesn’t believe to get to 10 from here is more difficult than getting to 4-5 from 0
§ The key reason is people
· Management change has been completed on all the levels
· Positive momentum is built and accelerating and team spirit is high
· By contrast, back in 2001 morale was low and negative issues such as liquidity problems needed to be addressed
· Indication of next step restructuring (details could be found on the company's website from its September analyst meeting presentation)
o More cost cutting in NA and in Europe
o More working capital reduction via portfolio mix optimization
o Selling non-core engineering business (my est.: $100mm EBIT @ 6-7x = > $600-700mm) to accelerate debt repayment and reduce SG&A
§ Engineering business has grown into $100mm EBIT from $10mm just 4 years ago, making it a more attractive selling candidate
o The renegotiation of NA labor contracts will start in July ’06 and the recent events at GM, Delphi and other sunset industries could actually enhance GT's position when dealing with union


Pricing flexibility

· NA
o Volume mix

OEM: 30mm
Private label (replacement): 30mm
Branded (replacement): 40mm
Total 100mm
o OEM: price might not be able to rise if OEM volume declines
o Private label: represented by WalMart – not easy to get price increase
o Branded: also include some value brands like Kelly
o Overall, pricing increase will likely be just enough to offset raw material cost
§ So far, it’s been demonstrated that competitors are having the same cost problems as GT has, and everybody is raising prices
§ However, to what extent pricing increase can continue if raw material cost rises further is an open question.
§ We notice that even WalMart is raising prices on some products.

· Europe
o No private label business
o Predominantly high-performance tire
o As a result, pricing increases are relatively easier in Europe

GT initiated +5-8% pricing increase in NA in September 2005, which was subsequently followed by most competitors - therefore these pricing increases are sticky.


The following earnings sensitivity analysis shows that in '06 and in '07 energy cost will be THE most important driver behind GT's earnings swing.

I. Each 1% rise in oil-related raw material cost (w/o offseting price increase)

Total raw material cost
NA $3.0 bn
Int'l $2.0 bn
Total $5 bn

Oil-dependent raw material (synthetic rubber, carbon black, fabrics & others): 70%
NA $2.1 bn
Int'l $1.4 bn
Total $3.5 bn

Each 1% rise
NA $21 mm
Int'l $14 mm
Total $35 mm

After tax
NA (0% tax rate) 21 mm
Int'l (35% tax rate) 9.1 mm
Total 30.1 mm

Per share
NA $0.10
Int'l $0.04
Total $0.14


II. Each 1% margin improvement from restructuring in NA

’05 Revenue base in NA $9.11 bn
1% margin improvement $91 mm

After tax $91 mm
Per share $0.44



III. Each 1% OEM volume decline (with replacement market flat)

Volume mix
OEM 30%
Replacement 70%
Total 100%

Volume change
OEM -1%
Replacement 0.0%
Combined average -0.3%

Earnings impact

Total NA volume 100 mm
Volume decline 0.3 mm
Avg. price ticket $77.5 mm
Revenue impact $23.25 mm
Incremental margin 37.50%
Incremental profit loss $8.72 mm

Per share $0.04

Implication:
1) Volume is not a significant concern. In a reasonable worst scenario in which NA OEM volume would drop by 10% while NA replacement volume is flat , earnings impact would be only 40c/shr – a manageable number to GT.
2) Further rise in raw material cost, particularly oil price, and GT’s ability to continually raise price to offset such cost increase, will be THE key to an investment in GT. In 2005, raw material cost is expected to rise by 10%. In my current model, I’ve assumed GT to be able to raise price to offset raw material cost, therefore net net no impact on margin. However, if GT is unable to raise price further or raw material price rises far beyond GT’s capability to raise price fast enough to fully offset cost increase, the negative impact on earnings will be significant. Each 3% rise in oil-dependent raw material cost, net of any offsetting price increase, could be approximately equal to 1% margin benefit from GT’s restructuring effort – a big headwind ahead if it really occurs.
3) Nevertheless, with oil already trading above $60/bbl, its impact on consumer economy has started to be felt. As a result, demand response could finally play a counterbalancing role in limiting oil price’s further rise, at least over the next 6 to 12 months. If this turns out to be true, a normal inflation environment could bode well for Goodyear’s pricing increase and margin expansion.


Risk:
1) Drop in NA and global automobile OEM production: OEM represents 30% of total volume, which is not making money (just breakeven) anyway. If OEM demand drops by 5-10%, which could prove to be an exaggerated concern, should have minimal impact on the profitability.
2) Irrational competitive behavior/pricing war: doesn't appear likely given the fact that top three manufacturers (Michellin/Bridgestone/Goodyear) control 55% of global market, and all of them have demonstrated the willingness to protect margin rather than compete for market share.
3) Rising raw material cost: $5BN raw material cost for GT per year, representing 35% of total cost. Key raw materials include synthetic rubber (25% of raw material), natural rubber (20%), carbon black (11%), steel, fabric, etc. However, GT has demonstrated during the last several quarters that they are capable of raising prices fast enough to offset raw material cost increase.
4) Competition from Asian cheaper supply: unlikely be significant given the difficulty of Asian players to penetrate NA dealership system with lack of saftety reporting capability.
5) Pension underfunded by $3.1Bn. Currently all the free cash flow is expected to be spent on contribution to pension funds. The firm is also contemplating a secondary equity offering to further enhance its pension fund but the management indicated that it will only do so at a stock price much higher than the current level.
6) Earnings dilution from a divestiure of engineering business: depending on how GT is going to spend the proceeds ($600-700mm as per my estimate), earnings dilution could be anywhere between 15-25c/shr as compared to the current 2006 st. consensus EPS est. of $1.65 (before adj. for divestiture).

Catalyst

Continued earnings improvement better than the St. consensus estimates.