Michelin (OTCPK:MGDDF)(ML.PA) is a global tire manufacturer based in Clermont-Ferrand, France founded in 1889. The company manufactures a wide range of tires for a diverse selection of uses, ranging from passenger vehicles to truck tire, but also including specialty uses, such as for farm machinery, mining equipment and aircraft tires. Today, the company has a 14.6% market share in the global tire market, which makes Michelin the second largest tire manufacturer, just behind Japan's Bridgestone (OTCPK:BRDCY). Favorable headwinds in the tire market and in the automotive sector, the company's low valuation multiples and its strong financial position makes Michelin an attractive investment opportunity.
The company has traditionally been heavily exposed to weak European markets; and today, the region still accounts for about 40% of its revenues. Michelin has continued to diversify its geographic footprint, and has recently focused on expanding into faster growing markets in Asia and South America; and has 80 production plants worldwide.
Jean-Dominique Senard succeeded Michel Rollier as chief executive of Michelin in May 2012, becoming the first person to take helm of the company who is not related the Michelin family. Senard joined the company in 2005 as Chief Financial Officer, and has played a significant role in reducing indebtedness, and delivering productivity improvements. Under Mr Senard's leadership, the company has continued with restructuring to re-position the company towards future growth opportunities outside Europe. Senard has an ambition to double sales in emerging markets by 2020, and has set a target for operating profit to rise to 2.9 billion euros ($3.95 billion) by 2015..
Michelin has historically suffered from very high levels of indebtedness, which hindered the company's ability to fund the necessary capital expenditure and research and development costs to maintain its competitive advantage. Michelin's net-debt to equity soared to over 400% following Michelin's $1.5 billion acquisition of Uniroyal Goodrich in 1989, and the subsequent modernisation costs. Since then, the company has substantially reduced its net-debt to equity ratio, which stood at just over 12%, at the end of the first half of 2013.
The EU's tire labeling requirements
The European Union's new tire labeling requirements should lead to greater adoption of higher performance tires; as consumers can more easily find out about how good a particular replacement tire is at breaking in wet conditions, how much noise the tires make and how fuel efficient they are. Although, early experience in the UK has shown that many consumers do not realize the information available to them, and that cost remains the principal deciding factor, it is most probably too early for consumers to change their behavior. It takes time for consumers to become aware of the benefits of higher performance tyres. With higher performance tires, consumers could save more money as some more expensive tires have lower rolling resistances, and significantly improves fuel economy. They may also benefit from greater braking performance, which also makes the tyres safer, by reducing stopping distances in wet and dry conditions.
With the new labeling requirements, tire manufacturing is likely to become even more research intensive; and many smaller low cost manufacturers in Asia would struggle to compete on higher performance tires. Although size does not guarantee success, scale does help to fund the cost of research. Michelin's huge scale in research and development, and its already strong market position in the premium tire segment; would help the company in this technological race to develop better performing tires. In addition, premium tyres also yield higher margins, as tyre performance becomes the principal deciding factor.
Recovering automotive market in Western Europe
The automotive market in Western Europe is expected to finally return to growth in 2014. Annual car sales in the region have fallen from its 2007 pre-recession peak of 16.8 million vehicles to an estimated 12.0 million for 2013. Although the recovery is unlikely to be swift, an increasing number of analysts are predicting that 2014 would bring about modest growth, as new car registrations in the region began to rise slightly since September. The Economist estimates new car sales in Western Europe would grow by 2.7% in 2014, whilst global car sales will grow by 6%.
There have been widespread concern that the strengthening euro would hurt Michelin's competitiveness. Whilst the company still produces a majority of its tires in Europe, its raw material costs, which represents almost half of the company's operating costs, are predominantly dollar denominated. So although a stronger euro would certainly not be beneficial on a competitiveness standpoint, its effect has generally been overstated. Furthermore, with the Fed tapering asset purchases, and with the ECB having cut its main refinancing rate to 0.25%; it is far from certain that the euro would appreciate notably in 2014.
Tire manufacturers and other OEM suppliers may be a better way to benefit from the expected recovery of the European automotive market, as many of Europe's ailing automotive manufacturers are saddled with chronic overcapacity and high debt levels. Car manufacturers, including Peugeot, Renault and Fiat have been slow and reluctant to cut production capacity substantially to a level where it meets near term demand; because of strong government and union pressures, high severance costs and overly-optimistic assumptions with regards to future demand. Much deeper cuts to production capacity is needed for the industry to return to sustainable profitability.
Unlike cars and trucks, which do not have to be replaced regularly, tires do need more frequent replacement because their performance drops notably when they become worn. Demand for replacement tires have already dipped and fleet inventories have consequently fallen. But stocks will inevitably need to become replenished, and especially so as transportation activity grows when the economic conditions improve. The tire market is therefore more defensive and less cyclical than automotive manufacturers and other OEM parts suppliers.
Specifically, Michelin is much better placed to benefit from a modest recovery in Europe, and from fast growing markets; because of its more comprehensive restructuring program which is generating substantial productivity improvements. Michelin has allocated 90% of its growth (i.e. not maintenance) capital expenditure on expanding production outside of Europe. The company has also been more successful at reducing headcount in France with relatively minimal disruption, because more of its employees have been near retirement age.
Michelin's valuation compared to its peers
Market capitalization ($ millions)
Adjusted EV/EBITDA (2013 estimated)
P/E (2013 estimated)
P/E (2014 estimated)
Continental (OTCPK:CTTAY) may seem like an unsuitable for comparison, as the company produces more than just tires, but as an OEM parts supplier, Continental's profitability is also highly dependent on the underlying automotive market in Europe and in the rest of the world. Although the company has shown strong sales growth in recent years, the stock seems fairly valued given the high capital expenditure requirements and as demand stabilizes. Italy's Pirelli and Japan's Bridgestone, which are more or less pure tire manufacturers, trade at higher valuation multiples than Michelin, and have significantly lower dividend yield.
The impact of higher raw material costs has been temporary, and profitability is expected to be much stronger in the second half of 2013. Unfortunately, weaker emerging market currencies would continue to weigh down on profitability growth. In October, the company reduced its full year operating profit guidance by 100 million euros. It had previously expected operating profit for the financial year to reach about 2.4 billion euros ($3.3 billion). The effect of weakness in emerging market currencies may persist in the near term, as the Fed tapers its asset purchases; but stronger volumes would begin to offset the currency effect.
Concerns with the company's specialty business have weighed down on Michelin's valuation
Net Sales (million euros)
Operating margins before non-recurring costs
Passenger Car and Light Truck Tires
Michelin has a much greater exposure to the specialty tires segment than many of its peers. Specialty tires command much wider profit margins, given the necessary technical specifications; and this market segment has been a very significant source of profitability in recent years. However, falling commodity prices have caused many miners to reduce their capital expenditure plans, which would likely reduce the demand for earthmover tires. However, the effect of this seems appears to have been overstated by many observers. Tires for new mining projects tend to have long lead times, which suggests that new orders are likely to persist for longer than expected.
Michelin's specialty business also produces tires for the agricultural uses, motorcycles and aircrafts. Although sales in this segment has fallen by 11.3% in the first half of 2013, the decline is likely temporary in the long term. Volumes had actually only fallen by 4.6%, and the decline was mainly attributed to price adjustments and currency effects. With population growth and increasing meat appetites in many emerging economies, demand for agricultural equipment will likely increase in the longer term. Strong demand for commercial airliners are likely to offset the decline in defense spending. Although, in the near term, the specialty business will continue to underperform, the long term outlook remains optimistic.
In the near term, declining margins in the specialty market segment would most likely be offset by improving margins in the passenger car and trucks segments, as demand for these tires are expected to improve, productivity enhancements and lower raw material costs are realized. Passenger car and truck tires still account for an overwhelming majority of sales, and so even a modest improvement in margins here could offset the decrease in the margins of specialty tires.
Favorable headwinds and Michelin's low valuation multiples outweigh concerns over its specialty business
With an improving automotive outlook in Western Europe, and as restructuring enhances Michelin's competitive position, we could expect to see the company's profitability continue to improve. With such improvement, we may see Michelin begin to close the valuation gap with other tire manufacturers and OEM automotive parts suppliers. Given the favorable headwinds, we could see Michelin trade at a more reasonable EV/EBITDA multiple of 5.5x, implying an upside potential of 32.5%. Even with a 32.5% potential upside, Michelin would still trade at a modest 12.2 times forecasted 2014 earnings, which is similar to the current valuation multiples of its peers.
Michelin's low level of indebtedness will provide the company with plentiful financial flexibility to invest in new technologies, expand production outside Europe, and allow the company to return more capital to shareholders. With a dividend yield of 3.2%, and a very low debt profile, Michelin has the flexibility to increase its dividend even further. Improving market conditions, in the new automotive market and replacement market would help demand for tires in 2014, and would likely more than offset weaker demand for specialty tires. As equity markets become more expensive, value opportunities become scarcer; but not non-existent. Michelin does appear to be one of them, given its low valuation multiples, high dividend yield and an improving market outlook. .