Apollo Tyres. Buy. Growth trajectory coming back. Demand outlook in the domestic markets is improving

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1 March 31, 2017 Buy Apollo Tyres Industry: Auto Components Growth trajectory coming back We continue to remain sanguine on Apollo Tyres (Apollo) with an upgraded target of 275 ( 200 earlier), now valuing the company at 9x FY19E earnings. Our thesis is based on :- 1). Rapid recovery in the automobile demand post demonetization 2). Steadily increasing demand in the Passenger Car market on the back of constant inflow of new launches 3). Higher emphasis on the infrastructure and rural markets in the recent budget which may result into improved CV demand, thus improving product mix of Apollo 4). Ban on BSIII vehicles to result into higher demand for BSIV vehicles from April 1st, ). Capacity expansion to 2,300 MT/day (from 1,645 MT/Day) 6). Reifencom acquisition and recovery in European markets post a market share loss in FY16. Above all, high expectations of implementation of import duties/ban on Chinese tyres may significantly boost volumes along with offering a good pricing power and better margins to Apollo. The combined effect should translate into topline growth and a return to earnings growth. Demand outlook in the domestic markets is improving Demand for Apollo in Q3 increased by 7% yoy in a quarter where most of the auto OEMs witnessed a significant demand reduction post demonetization. However, in Q4, post our discussions with various managements and market players and analyzing the monthly sales figures, we infer that demand for the industry is getting back on track. On the PV side, the note ban hardly impacted the sales, while 2Ws and trucks were impacted the most. Going forward, we believe the pent up demand which was paused in Q3 will bounce back in FY18. New launches on the PV side (17% market share) will continue to fuel PCR demand for Apollo. On the trucks side (25% market share), due to BS IV implementation the demand may remain muted in Q1 FY18, post which hopes of good monsoons and GOI s higher emphasis on infrastructure and rural markets will keep the CV and tractors (collectively contribute 66% of product portfolio) demand buoyant. We estimate Apollo s domestic volumes to grow at a CAGR of 10% between FY16-FY19E. High probability of ban on Chinese tyre imports could be a blessing for the domestic tyre industry There is a very high possibility that there will be a ban or huge import duties on Chinese tyres as early as April Already the Chinese imports have gone down since November from 150,000 to 100,000 due to adverse impact of demonetization. Furthermore, the Chinese manufacturers (market share of about low teens in the PCR markets in India) have recently increased their prices by 10-15%, which has led to narrowing of the price gap between them and Indian manufacturers. This has resulted into the domestic players slowly gaining back their lost market shares. Thus a complete ban on Chinese tyre imports may act as a substantial trigger to the tyre industry with respect to market share gains, topline growth and profitability. Stock Data Company update Current Market Price ( ) month Target Price ( ) 275 Potential upside (%) 32 Market Cap ( bn) Week Range ( ) 235 /139 Face Value ( ) 1 Reuters Bloomberg APLO.BO APTY IN BSE / NSE Code APOLLOTYRE / Shareholding Pattern Mutual Funds 6.46% Financial Snapshot FY15 FY16 FY17E FY18E FY19E Revenues( bn) EBITDA (%) 15.1% 16.7% 15.9% 16.4% 16.7% PAT (%) 8.3% 9.7% 8.6% 8.8% 8.6% EPS ( ) EPS growth (%) -2.7% 11.8% 3.0% 15.4% 18.4% P/E (x) P/B(x) EV/EBITDA (x) ROCE(%) 26.5% 21.3% 19.2% 19.4% 19.9% ROE(%) 19.4% 17.7% 15.7% 15.6% 15.8% Div yield (%) 1.2% 1.2% 1.2% 1.4% 1.6% Relative Price Performance Promoter 44.15% FPI 32.92% Others 16.47% 40 Mar-16 Jun-16 Sep-16 Nov-16 Feb-17 Apollo Tyres S&P BSE Sensex Ashwin Patil ashwin_patil@lkpsec.com

2 European operations to get a boost from Hungary capacity expansion, Reifencom acquisition and recovery in Vredestein operations Apollo is investing 475 mn in greenfield operations in Hungary which is expected to get ramped up to its full capacity of 225 MT/day (emphasis on all season tyres) by FY19E. Hungary, the Eastern European country has labour costs 50% lower than the Netherlands. Also, the manufacturing and transportation costs over there are very low, which will benefit Apollo s margins as capacity ramp up gains momentum. Vredestein operations were under pressure in FY16 and H2FY17 due to less harsh winters and teething issues related with SAP implementation. However, with the technical issues sorted it has started witnessing recovery since Q3 FY17. Though the topline grew by 54% yoy, the margins came down a bit at 13.7% due to incorporation of the recently acquired Reifencom, a German distribution company having 37 outlets in Germany and few other countries. Hence, Vredestein numbers are incomparable yoy. However, with a good recovery in winter tyres and increasing demand for summer tyres in Q1, the business seems back on track now. Reifencom through its strong network has delivered 130 mn of topline in 9M FY17 and 4% EBITDA margins. Although this business is a low margin one, it has almost nil depreciation and interest rates and yields profits at the bottomline to its parent. With further expansion of the Apollo and Vredestein brands, this business is expected to perform better and provide good visibility and increase sales across Europe. Capacity expansion is well on track to add volumes thick and fast by FY19 Apart from the Hungary Greenfield expansion, the company is undertaking a brownfield expansion at Chennai. This will add 450 MT/day capacity in two phases starting from FY18 and ending in FY19. This will be catering to the TBR segment which is the buzz word now. The high margin TBR product will bolster margins for the company going forward. Additionally, the expectations of higher truck demand as mentioned above may improve the product mix as well. Implementation of BS IV norms and extinction of BS III engine vehicles may lead to a temporary disruption within the industry. This may lead to a lull in truck demand in short term. However, there needs to be a rapid replacement of the BS III fleet at the OEM s end which may fuel demand for tyres. Additionally, infrastructure requirement of the country will also augur well for truck demand, mainly in H2 FY18 after a soft H1. This bodes well with the brownfield Chennai expansion by Apollo. Estimated Capacity (MT / Day) Europe India ,445 1,495 1,695 1,830 1,835 FY 2016 FY 2017E FY 2018E FY 2019E FY 2020E Source: Company, LKP Research LKP Research 2

3 Profitability to remain high despite heavy capital expenditure and rising rubber prices Recovery in automobile industry coupled with new vehicle launches on the PCR side and strong demand on the TBB side on the back of mining revival may augur well for the margins. Expected ban on Chinese tyres may open new avenue for the Indian tyre makers to cater to the huge replacement market where Chinese players have a strong presence. Replacement segment which forms 76% of Apollo s domestic topline can see a significant up-move thus improving the margin performance. Expected higher demand for truck tyres in H2 when infrastructure activity is expected to gain momentum will lead to a better product mix thus improving margins. An expected 10-15% increase in natural rubber prices (40% of RM costs) may need a 6% hike in product prices, which the company may take hereon as demand gathers pace. Though the company is incurring higher capex in Chennai and Hungary, the Hungary plant ramp up may bring down the costs substantially. Low margin Reifencom may slightly bring the European margins downwards, but it being a small business and zero capital intensive, Vredestein improvement may absorb its shortcomings on the margin front. Strong capital structure does not hamper balance sheet strength Despite the capital intensiveness and cyclicality of the business, Apollo has managed to maintain decent balance sheet strength. With FY16, net D/E at comfortable ~0.1x levels, we believe this is the company s greatest strength is the good RoCE (21.3% in FY 16) business. We believe that as the company has a huge expansion plan of ~ 3.2 bn in FY17E-19E, debt levels are likely to increase, going forward. Despite this, we believe it would be maintained at a decent level of D/E of 0.2x-0.3x. This is since CFO (Cash From Operations) remains strong and would contribute to the bulk of the expenditure. This has been due to lower input cost (natural rubber) and more price discipline maintained by domestic players in the past. With OEM demand likely to revive, we expect volumes to improve, going forward. This would further sustain CFOs even as Apollo embarks on a capex FY17E onwards in Eastern Europe and on enhancing capacity in the domestic business. Outlook and Valuation Strong demand in the medium to long term on the truck side through levers such as infrastructure and rural growth, new launches on the PV business, a huge opportunity awaiting on the replacement business side through highly possible ban on Chinese tyre dumping provide an excellent opportunity for Apollo to leverage its volumes. Mining revival bodes well for TBB tyres. Radialization opportunity exists for Apollo as the company is expanding its Chennai TBR capacity. BS IV implementation may cause a short term lull in the auto industry, but long term demand drivers remain intact. On the European business, Vredestein is witnessing a steady recovery, while the Hungary greenfield is the biggest opportunity to ramp up sales and at the same time save bulk of the costs. Strong CFO, robust return ratios, low financial leverage despite capital intensive and cyclical business are the inherent strengths of the company. Any hike in NR prices may be negated by strong volumes, cost savings and price hikes as the company has pricing power in the replacement segment, being a market leader in the TB segment. On valuation front, the stock looks very attractive at 7x times FY19E earnings. In light of all these factors, we maintain our BUY rating on the stock with a target price of 275 (9x times FY19E earnings). LKP Research 3

4 All fig in mn Q3 FY17 Q2 FY17 % qoq Q3 FY16 % yoy 9M FY17 9M FY16 % yoy Total revenues 34,579 30,849 12% 29,569 17% 98,469 87,615 12% Raw material expenses 18,108 15,914 14% 14,494 25% 50,206 44,759 12% Operating & Manufacturing Expenses 6,971 6,212 12% 6,015 16% 20,182 16,887 20% Employee Cost 4,505 4,337 4% 3,980 13% 13,309 11,540 15% EBITDA 4,995 4,386 14% 5,080-2% 14,772 14,973-1% EBITDA margins 14.4% 14.2% 20 bps 17.2% (280 bps) 15.0% 17.1% (270 bps) Depreciation 1,134 1,057 7% 1,065 6% 3,251 3,026 7% Other income adjusted % % 1, % EBIT 4,234 3,758 13% 4,119 3% 12,592 12,470 1% Interest % % % PBT 3,951 3,496 13% 3,909 1% 11,778 11,762 0% Tax % 1,113-11% 3,061 3,722-18% Adj Profit After Tax 2,961 2,606 14% 2,796 6% 8,717 8,040 8% LKP Research 4

5 Strong tyre demand A proxy to the automobile industry 70 PCR segment - Domestic Demand (Mn No) FY 2015 FY 2016 FY 2017E FY 2018E FY 2019E FY 2020E Truck segment - Domestic Demand (Mn No) FY 2015 FY 2016 FY 2017E FY 2018E FY 2019E FY 2020E Apollo a market leader in Trucks segment and a strong player in Passenger Cars.. Trucks Rest 40% PCR Rest 75% Apollo 25% Apollo 17% MRF 24% Bridgestone 19% India, Replacement business and Trucks are the strong areas of Apollo Region Wise Market Wise Product Category Wise India 66% Rest of World 8% Replacement 76% OEM 24% Truck & Bus 48% LCV 7% Farm & Others 11% Europe 26% PV & Light Truck 34% Leading to strong performance across the financial parameters Net Sales EBIDTA EBIDTA Margin 14.1% 15.2% 16.8% 11.4% 9.6% FY 2012 FY 2013 FY 2014 FY 2015 FY % 16.0% 14.0% 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% ROCE (%) ROE (%) FY 2012 FY 2013 FY 2014 FY 2015 FY 2016 LKP Research 5

6 Financials (Consolidated) Income statement YE Mar (.mn) FY15 FY16 FY17E FY18E FY19E Total Revenues 128, , , , ,988 Raw Material Cost 70,753 59,633 64,460 71,758 81,502 Employee Cost 16,106 15,869 18,948 21,368 29,607 Other Exp 21,987 22,743 26,582 29,824 37,159 EBITDA 19,308 19,685 20,850 24,109 29,720 EBITDA Margin(%) 15.1% 16.7% 15.9% 16.4% 16.7% Other income Depreciation 3,882 4,238 4,778 5,360 7,616 Interest PBT 14,136 15,231 15,744 18,355 21,716 PBT Margin(%) 11.0% 12.9% 12.0% 12.5% 12.2% Tax 3,532 4,776 4,485 5,359 6,326 Adj PAT 10,604 11,409 11,259 12,996 15,390 Adj PAT Margins (%) 8.3% 9.7% 8.6% 8.8% 8.6% Exceptional items PAT 9,780 10,932 11,259 12,996 15,390 PAT Margin (%) 7.6% 9.3% 8.6% 8.8% 8.6% Key Ratios YE Mar FY15 FY16 FY17E FY18E FY19E Per Share Data ( ) Adj. EPS CEPS BVPS DPS Growth Ratios (%) Total revenues -4.4% -8.0% 10.9% 12.4% 21.0% EBITDA 2.9% 2.0% 5.9% 15.6% 23.3% PAT 0.8% 7.6% -1.3% 15.4% 18.4% EPS Growth -2.7% 11.8% 3.0% 15.4% 18.4% Valuation Ratios (x) PE P/CEPS P/BV EV/Sales EV/EBITDA Operating Ratios (Days) Inventory days Recievable Days Payables day Net Debt/Equity (x) Profitability Ratios (%) ROCE 26.5% 21.3% 19.2% 19.4% 19.9% ROE 19.4% 17.7% 15.7% 15.6% 15.8% Dividend payout -11.6% -10.7% -11.0% -11.0% -11.0% Dividend yield 1.2% 1.2% 1.2% 1.4% 1.6% Source: Company, LKP Research Balance sheet YE Mar (. mn) FY15 FY16 FY17E FY18E FY19E SOURCES OF FUNDS Equity Share Capital Reserves & Surplus 49,913 61,313 71,334 82,900 96,597 Total Networth 50,422 61,822 71,843 83,409 97,106 Total debt 4,668 8,113 9,793 11,473 13,153 Deferred tax liabilities 5,209 5,961 5,961 5,961 5,961 Current liabilities Short term borrowings 5,465 6,693 6,094 7,252 9,265 Trade payables 8,933 15,494 16,131 20,145 25,357 Other current liabilities 6,927 5,558 4,358 3,158 1,958 Short term provisions 5,465 6,693 6,094 7,252 9,265 Total Current Liabilities 25,991 35,145 35,483 40,955 48,480 Equity and Liabilities 86, , , , ,700 APPLICATION OF FUNDS Net block 41,559 41,092 41,314 40,954 38,338 Capital WIP 2,182 9,749 16,749 31,749 51,749 Intangible Assets 1,096 2,199 2,199 2,199 2,199 Long term Investments Goodwill 1,166 4,711 4,711 4,711 4,711 Deferred tax assets Long term loans and adv 2,267 7,447 8,447 9,447 10,447 Total non current assets 48,573 65,614 73,837 89, ,860 Current Assets Cash and Bank 5,945 5,941 8,350 6,863 3,056 Inventories 17,782 19,454 20,309 22,609 26,125 Sundry Debtors 9,589 10,843 11,112 12,490 15,604 Loan, Advances & others 2,534 6,886 7,169 8,058 9,753 Short term Loans and Advances 2,534 6,886 7,169 8,058 9,753 Other Current Assets 1,868 2,303 2,303 2,303 2,303 Assets 86, , , , ,700 Cash Flow YE Mar ( mn) FY15 FY16 FY17E FY18E FY19E PBT 13,308 15,704 15,744 18,355 21,716 Depreciation 3,882 4,238 4,778 5,360 7,616 Interest 3,882 4,238 4,778 5,360 7,616 Chng in working capital (2,181) 4,154 (2,570) (593) (2,301) Tax paid (2,954) (3,913) (4,485) (5,359) (6,326) Other operating activities Cash flow from operations 14,120 22,008 14,603 19,004 22,068 Capital expenditure (6,304) (17,097) (12,000) (20,000) (25,000) Chng in investments (796) (419) Other investing activities (400) (6,396) Cash flow from investing (7,500) (23,912) (12,000) (20,000) (25,000) Free cash flow (a+b) 6,620 (1,904) 2,603 (996) (2,932) Inc/dec in borrowings (7,283) 4,790 1,680 1,680 1,680 Dividend paid (incl. tax) (446) (1,301) (1,238) (1,430) (1,693) Other financing activities (1,923) (1,171) (2,099) (2,241) (2,363) Cash flow from financing (7,194) 1,444 (157) (490) (876) Net chng in cash (574) (460) 2,446 (1,486) (3,808) Foreign excg fluctutions Clsg cash & cash eqvts 6,448 5,900 5,903 8,350 6,863 Less: Unpaid div bank a/c Adj. Clsg cash & cash eqvts 5,861 5,903 8,350 6,863 3,056 LKP Research 6

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