Description

Quick Case

I would buy Hankook Tire (161390 KS) here.

They are a Korean tire manufacturer currently occupying a challenger position in the global tire industry, having grown from an also-ran 15-20 years ago to a position around the top 5 today, with annual capacity of over 100m. The company has modern, efficient plants and, until last year, enjoyed margins well above competitors and second only to Nokian (premium pure play) due to the scale benefits that they enjoy.

They are conservatively financed, with net debt/EBITDA of about 0.7x. They net debt position could theoretically be knocked out with about a year and a half of free cash flow.

The shares have sold off about 30% from their peak, with the shares now trading at a 1y forward P/E of 7.7x. that compares to a historical range over the last four years of 7.1x-9.5x, so we are towards the lower end. The company trades at a considerable discount to peers. The global peers (I am using Bridgestone, Goodyear, Michelin, Conti) trade on a simple average forward P/E of 10.5x, putting the company on a 24% discount. It has generally always traded at a discount, but the range has been about 5% to 30% in recent years, so again we are closer to the lower end. This is despite a margin profile that is at least comparable to global peers and in many instances significantly better. In terms of gross margins, the should do 35%+ this year; this compares to the Japanese peers (Bridgestone, Sumitomo Rubber, Yokohama Rubber) at 35.7% on average, the European peers

In terms of why it is cheap, it is entirely driven by an earnings decline, the reasons for which are:

·         Weak demand out of the US driven by destocking relative to last year and some dealer consolidation

·         Elevated start-up costs from their US plant in Tennessee – peak capacity there will be about 12m units, which would eventually translate to about 100bn KRW of run rate operating profit. In 2017, however, the company took 80bn of charges related to the start-up, which should normalise over time – it will break even this year and be a profit centre from 2019

·         A decline in domestic sales, driven by a shutdown at one of their plants due to an accident, and aggressive price competition from a domestic peer, Kumho tire.

I believe that the last two issues in particular are likely to be issues that are now in the rear view mirror.

The US plant is now up and running as of October 2017. Obviously as they get better cost absorption, that should be a tailwind to profits going forward. The start-up costs hit group profits by 80bn KRW last year. The expectation is that the plant will be breakeven on a full year basis; I estimate that in “phase 1” (production of about 5m units per year), run rate profits would be about 50bn KRW, while in “phase 2” (around 100m), it would be about 100bn KRW. The swing factor is thus about 180bn KRW on the operating profit, which would be an increase of about 25% from the 2017 base.

The Korean domestic issues should largely be in the past as well. Kumho Tire is losing money hand over fist and is supposedly up for sale to a Chinese company – anyhow, it is not sustainable for them to continue to haemorrhage money like this forever. They are expected to lose 60bn KRW this year and have another year of negative FCF. Their net debt of ~3trn is 10x their EBITDA of ~300bn, so it is fair to say that it is not sustainable.

I believe that as the domestic situation stabilises and the US plant ramps up, sales should grow to ~7.5trn this year, while operating income should get back above 1trn. These estimates are about 3% or so ahead of consensus, but slightly below company guidance (they think they can get to 1.02trn this year). As the recovery gains ground, I think they will get to operating income of just under 1.2trn in 2019. EPS should grow to 6700 this year, rising to 7800 in 2019, putting the company on a 2018 P/E of 7.5x, falling to 6.5x in 2019, which I think looks attractive for a business with a ROIC of ~10% - I see it as a fair business trading at a very attractive valuation.

I should also note that the investment in the US plant has been a significant drain on the free cash flow of the company, and this situation is again in the rear view mirror. Capex should fall by a couple of hundred billion KRW going forward, and I expect the company to generate 550bn-600bn KRW of FCF on a sustainable basis, against a market cap of about 6.3trn, which I view as very attractive.

I value the company on a forward P/E of 9x, towards the higher end of the historical range, but in my view an undemanding multiple for a business with a ~10% ROIC and ~12% ROE. On the 2019 EPS of 7800, that gets me to a value of just over 70,200, while one is also entitled to a dividend of 400 in the meantime, for total upside of about 40%.

Strategy

Briefly, the strategy has been to grow profitably by improving overall quality and the mix of premium tires, which has a positive sales impact, while using scale efficiencies from relatively large and modern plants to ensure that the growth is profitable.

The company utilises a number of global scale plants that typically have annual capacity in excess of 5m tires (see graphic below which I took from Petra Capital Management’s presentation here: http://www.petracm.com/pdf/2016/20161222.pdf) .

As one can hopefully see in the graphic, they have a lot of production in their domestic market, where they enjoy a ~40% market share, but also have sizeable capacity in Europe via one large plant in Hungary with >15m annual capacity, rest of Asia via one large plant in Indonesia with >30m annual capacity, and the US via one large plant in Tennessee with >10m annual capacity.

In terms of the mix, they have made steady improvements in the mix of premium tires (more on the difference between standard and premium below), with the premium penetration as a percentage of sales up about 300bps in the last few years.

Tire Market

I would classify the industry as one of poor to average quality. One can see this from the fair gross margins (in the low 30’s globally) and modest returns on invested capital (Hankook has averaged about 10% over the last five years). The current opportunity lies in premium tires (more on this below), but in fact quite a bit of capacity is being added in this area, as referenced in another writeup.

Briefly, the tire market is split into original equipment (OE) and replacement equipment (RE). The total volumes of the two markets are ~450m and ~1.3bn, respectively, while the revenues are about $30bn and $110bn, respectively. I estimate that the RE market constitutes the entire profit pool. The analysis is complicated a bit by the existence of a premium tire segment in both OE and RE, but this is my simplifying assumption. There are meaningful differences in price between products for light vehicles, trucks, and speciality tires (for large excavators and so on), so I will just focus on the light vehicle segment for the sake of simplicity. I think the economics are about similar in the other segments FWIW, just with different numbers.

Looking at the light vehicle segment then, which is the largest, overall volumes are about 1.5bn tires, of which OE is 375m and RE is 1.125bn; the total segment sales are about $96bn, i.e. an ASP of $64, however the ASPs differ quite a bit – it would be about $55 for OE, $67 for RE. COGS per tyre would be about $42; rubber is about 60% of that, carbon black is about 15%, steel is 10%, fabrics (nylon) 10%, and then some miscellaneous other stuff. Gross profit per tyre would thus be about $13 of OE and $25 for RE, for gross margins of 23% and 37%, respectively. SG&A tends to be about 20%-24% of sales, i.e. about $13-$15 per tyre, which gives you operating profit per tyre for OE of -$0 to -$0 (-3.5% to 0%EBIT margin) and operating profit per tyre of $10-$12 (14%-18%) for RE.

I think that almost the entire profit pool is therefore RE. The analysis is complicated a bit by the existence of the premium segment, which has biased margins upwards in both OE and RE. Briefly speaking, the tires with a rim size above 17” are viewed as premium – they are growing faster, have much higher price points and are much more profitable. The slides below from Goodyear summarise the economics, and there’s more in their investor day presentations:

Catalyst

Soft catalyst will be earnings recovering from last year's declines