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The recovery of automotive industry has resulted in an improved outlook for car manufacturers. The production and revenue results for recent months have suggested that US car manufacturers are outperforming their Asian competitors and are likely to show commendable results despite the economic slowdown in Europe. The improved outlook of car manufacturers has had a strong spillover effect on other sections of industrial manufacturing, particularly ones with a complementary relationship to cars. The future prospects of these complementary goods appear to be just as bright as we evaluate the performance of a tire manufacturing company.

(click to enlarge)

Source: Morningstar

The above chart represents the stock price of Goodyear (NASDAQ:GT) as compared to Rubber & Plastics industry, S&P 500 and the company's major competitor Bridgestone (OTCPK:BRDCY) since FY08. The chart clearly reflects that the appreciation in the industry and the overall market in general has not been reflected in the stock price of Goodyear as the share price has remained stagnant over the years. Therefore, the chart presents the notion of substantial undervaluation which will be investigated in the subsequent sections.

Exposure to European Market: Regional Diversification

The situation in Europe has had an adverse effect on all industrial manufacturers with a global market. It has been further suggested that the impact of economic slowdown in Europe will extend over a period of time resulting in the surplus supply of manufacturing products. As compared to Goodyear, the European region witnessed an annual decline of 16% as the demand for tires remained weak resulting in a decline in sales from the region. In this situation, Goodyear plans to adjust its focus and instead of waiting for the recovery of the economic situation, the company will focus on highly profitable segments such as run-flat and ultra-high performance. Furthermore, the company aims to focus on high growth areas for future improvements such as Eastern Europe and the Middle East. The company's exposure to the high risk markets is also limited as 36.5% of its operations in FY12 were based in North America making it less susceptible to volatility in Europe. Also, despite the uncertainty in European markets, the company reported increases in segment operating income. Operating income growth was reported in three of the company's businesses as North American Tire posted a 59% increase in earnings.

Valuation

The most important reason for investors to consider Goodyear is its cheap valuation. Goldman Sachs (NYSE:GS) recently posted a list of most undervalued stocks and Goodyear is reported to be ninth on that list. The list reported a 36% upside potential for Goodyear.

Data Source: Morningstar

The above chart compares valuation metrics of Goodyear with the Industry average and S&P500 average. The P/E ratio presents a clear undervaluation with respect to the industry. This shows that the earnings of Goodyear have remained untapped by investors as they have focused on other players in the industry. P/S and P/CF show similar levels of undervaluation. The real extent of undervaluation can be judged by the PEG ratio. This ratio adjusts the P/E ratio with respect the growth of earnings and the metric suggests a high degree of undervaluation. The market has completely ignored the earnings of the company as reflected in the previous chart.

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Source: YCharts

The above chart illustrates the quarterly revenues and the debt-to-equity ratio of Goodyear since FY09. There are two important points to be noticed here. Firstly, despite the undervaluation of the company, the revenues have shown robust growth. The quarterly revenues suggest a strong improvement over the past few years. The results for FY12 have reflected a slowdown due to the European crisis effect but even in this period, the earnings have shown an improvement. Secondly, the revenue growth has not occurred at the expense of financial stability. We see that the debt-to-equity ratio has been decreased. In early FY08, the company was operating at a debt to equity of approximately 1.2 which has now been reduced to 0.2. This stance is further supported by Fitch's rating of Goodyear which reflects the company's strong competitive positioning in some of the key areas for car manufacturing, as Goodyear maintains its position as the third largest tire manufacturer.

Risk Factors and Conclusion

The company's performance is subject to a number of risk factors. Already, a major threat has emerged in Europe as the company's reduction in volumes is seen as an unsustainable way to improve earnings. This clearly suggests that a slowdown in economic conditions results in reduced demand. If such circumstances begin to occur in areas in which Goodyear has a stronger exposure, this could result in a substantial decline in earnings.

Despite these risk factors, the company has shown remarkable stability and growth which has not been reflected in market prices. At the same time, the company aims to pursue its position with positive cash flows after stating that the volumes are admittedly expected to remain low. The company aims to maintain its volume at current levels for FY13 and step towards volume improvement in FY14. For these reasons, a hold stance is proposed for Goodyear.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Goodyear Is Highly Undervalued