Goodyear Tire is in the middle of a turn-around, really the end of the beginning of a turn-around. The seminal event in this process occurred in Feb 2007 when management negotiated with the United Steel Workers a dramatic reduction in vested benefit obligations (PBOs and OPEBs). VBO which were $4.9b in 2006 were reduced to $2.6b in 2007; concurrently, salaried VBO were reduced by about $600m. Additionally, management has sold considerable assets, and substantially reduced debt, with the consequence of increasing the annual estimated run-rate EPS by $0.36. Our colleague, fw51, wrote a cogent piece on Goodyear on 2005-12-26 which I commend to you. Some current metrics @25: 2007 est PE= 18.7x, 2008 est PE= 8.6x, EV/ ltm EBITDA= 10.5x, price/ EBITDA= 3.7x, price/ sales= 0.2x, EBIT/ total interest expense= 1.3x, total debt/ EBITDA= 5.8x.

Paying-down debt is obviously paramount, and GT expects to have TD/ CF at 2.5x in 2008. Recently, the Company sold 22.7m net shares at 33 ($750m), closed the sale of the Engineered Products segment for $1.475b, and has extracted over $1.0b in operating efficiencies. Without being glib, the balance sheet is not the issue (with $2.3b of available cash equivalents, and $2.0b of unused credit facilities). The investment thesis hangs on earnings improvement.

 

Firstly, Goodyear makes a great product. In the recent past, not only did the competition make better tires, but also had the tires in stock when the customer showed-up. Goodyear has addressed, and resolved these issues. Additionally, the Company has ceased making private label products, which only diminished industry and Company margins. Peruse “tirerack.com” if you want a quick study on tire product and tire quality.

 

Secondly, the tire industry is an oligopoly, with Michelin, Bridgestone, and Goodyear each controlling about 20%. All three players have demonstrated price discipline, and marginally differentiated their products to consumers. There is no reason to believe that the recent pattern of price increases to offset cost of goods sold [COG] increases will be broken. Goodyear has imposed nine successful price increases since 2004. The Company sells tires employing three brands, each one differentiated in the mind of the consumer: Goodyear, Dunlap, and Kelly. The dealer networks have been in place for a long time, and are no longer hostile to management. (As in the automobile industry, the quality of the dealer network is a non-trivial factor in the consumers’ decision tree.)

 

Thirdly, discrete cost cutting will continue, and will be significantly accretive to earnings. The Company’s four-point plan now targets over $1.0b: continuous improvement is targeted at $350m-$450m (with nearly $300m realized to date), smaller footprint is targeted at $100m-$150m (with realized benefits of $135m), Asian sourcing is targeted at $150m-$200m (with realized benefits of $35m), and finally, SG&A [SAG] benefits targeted at $150m-$200m (with only $100m realized). Not only is the plan ahead of schedule, but there remain significant improvements to COG and SAG in future years. Additionally, legacy costs have been capped – and at discount to par of about 25%. Not only have costs been reduced by about $250m annually, but also the possibility of an ugly VBO charge has been eliminated. The Company’s Tyler plant will close at the end of 2007, and benefit earnings by about $50m.

 

Fourthly, significant capital structure improvements are substantially accretive to earnings. GT does not pay US taxes, and therefore receives no benefit for interest expense. Assuming the Company achieves its goal 2.5x TD/ CF, then the estimated annualized savings are about $140m. (Senior secured debt of $706m at 11.98%, and senior unsecured debt of $2.9b at 10.27% a/o 12/2006.) If as estimated, the Company achieves FCF/ debt of 8%-14%, and TD/ CF of 1.9x, then by 2009, it will be investment grade (but probably not rated investment grade).

 

Fifthly, raw material costs are about 35% of COG. The significant components are oil, natural rubber, and steel. All have risen substantially, and tire price increases have ameliorated them, but there is always a lag effect. If raw material costs decline, or merely stabilize, the benefits are obvious. From 2000 to 2005, commodity prices increased 3.5% annually, while tire prices increased 3.1% p.a.

 

Sixthly, Goodyear CF has a statistically insignificant correlation of light vehicle production. What is significant are vehicle population, and total miles driven – both of which should accrete for years to come (more than 70% of sales, and probably more than 85% of CF is derived from replacement tires, not original equipment tires). As the Company has focused on upgrading the customer to higher performance replacement tires, and as consumers are educated about the deficiencies of mud and snow rated tires [M&S], unit sales will grow at least 3% p.a.

 

Finally, the numbers: With the admonition that I prefer to be vaguely right than precisely wrong, and the caveat that I worship neither extrapolation nor conjecture, I append the following cash flow statements for all the VICers who require false comfort.