Goodyear Tire (GT) has dealt with various issues over the past decade stemming from a near bankruptcy in 2003, large unfunded pension obligations and a struggling automotive market during the recession. However, a resurgence in the automotive industry and increased efficiencies for GT have led to a significant turnaround.
Goodyear derives about 73% of its revenues from the replacement market, and 27% from the OE (original equipment, or new cars) market. Increased global auto production and consumer activity has been a boon for cash flows; this trend appears likely to continue in 2013. However, at only 6.6 times 2013 EPS, market participants aren't buying the GT story.
Here's a variant view of the Goodyear investment story. I recommend investors consider buying the shares at current prices for the following reasons:
Deeply Discounted Valuation: By almost any metric, Goodyear is trading at a deep discount to broader market multiples. For 2013, GT is trading at 3.5x guidance for pre-tax net income of about $1 billion, while analysts' estimates call for $2.14 in EPS. At a 6.63 earnings multiple, investors are overestimating balance sheet risks, sub-par growth prospects, or a combination of the two.
Pension Obligations Worries Are Well-Reflected In The Stock: Given GT's valuation, it's plausible that a major concern for investors is the unfunded pension that Goodyear has been dealing with for quite some time. Even after $1.4 billion in contributions over the last five years, the gap for the North American pension has swelled to $2.7 billion as a result of lower discount rates and asset mismanagement. Global unfunded liabilities have topped $3.5 billion as the discount rate has dropped to a miserable 3.71%. GT has had a history of overstating expected returns on pension assets, delivering year after year of poor results driven by equity exposure.
GT appears to have finally given up on the equity-investment pension model, as it plans to begin pre-funding the pension obligations via newly issued debt and investing the proceeds solely in fixed income. This will eliminate discount rate risk and improve cash flows. While taking on more leverage sounds risky, today's ultra-low financing environment should enable GT to fill the gap at a relatively low cost, freeing up even more cash flow.
Guiding for $800-900 million in FCF, GT will be contributing another $300 million to the pension. This illustrates the magnitude of the drag that the pension has had on shareholder value; filling this obligation gap via fairly low-cost debt (that will be well covered by nearly $1 billion in annual FCF) will eliminate this major balance sheet risk.
Prospects For Increased Cash Flows Are Compelling: While this isn't a high-growth industry, the auto industry has arguably led the U.S. recovery and will continue to gain momentum over the next few years. While only about one-third of GT's revenues come directly from auto production, this is the segment that has been driving increased cash flow generation.
OE Unit volume in North America increased 9% in 2012, reflecting increased auto production. The EAME segment only made $252 million in 2012, compared to $627 million in 2011. This decrease was due to drastically lower unit sales in Europe; GT is dealing with this by closing its Amiens North factory in France, increasing its operating margin in that segment by $75 million. Goodyear is also exiting the farm tire production business in the EAME. The APAC region, largely a play on the Chinese auto market, produced $25 million in net income growth from 2011.
Most important for cash flows is the recently announced plan to pre-fund the pensions by issuing debt at attractive rates. Shifting the cash flow-sucking obligations to a smaller annual interest expense will free up significant cash flows, pushing annual FCF close to $1 billion.
It's likely best to approach an investment in Goodyear as a "cigar-butt" type investment. Expectations are low, and GT is producing a tremendous amount of cash flow, sowing the seeds for significant multiple expansion.
The reduction of European production will further cut expenses in struggling markets, while investments in China have begun to add incremental income to the bottom line. GT took about $.34 worth of charges in Q4 2012 related to cuts in Europe. The North American OE market looks set to grow at a mid-single digits rate in 2013, pushing company-wide operating income to at least $1.4 billion. FCF generation should continue to increase as the underlying business improves and pension obligations are met by debt issuance.
With such low expectations priced into the stock, GT has a highly favorable return profile.