Following Goodyear's (GT) Q4 report, we reiterate our view (see our 29 January article) that the stock rerating is likely to continue thanks to still conservative expectations and low valuation levels. Goodyear is currently trading around 10x 2014 EPS, while it is expected to deliver double digit EPS growth over coming years, with risk on the upside (recent strength in North America, Europe potentially bottoming out).
Profitability and cash generation structurally improving in the industry
In the wake of Michelin's (OTCPK:MGDDY) solid report, Goodyear delivered strong Q4 EPS of $0.74 vs. consensus at $0.63. Despite a slightly disappointing top-line (-4% reported vs. -3% expected), Q4 EBIT margin improved an impressive 300bps year-on-year to 7.7% driven by input costs tailwinds and efficiencies.
This confirms in our view that tire manufacturers' efforts (capacities moved from developed economies to low-cost countries, cost savings initiatives) are paying off and that profitability and cash generation have structurally improved in the industry.
Interestingly, Goodyear and Michelin have been able to deliver sound 2013 performances against a tough backdrop (volumes flat to slightly up in 2013, strong pricing pressures), suggesting that the margin leverage potential remains significant if end-markets confirm their recovery.
End-markets recovery in full motion
Goodyear guides to volumes up 2-3%, in line with Michelin's expectation of a 3% volume growth in 2014. We believe that this leaves room for positive surprises and that a mid single digit volume growth is within reach as the December market data provided by Michelin pointed to an acceleration in aftermarket (c.70% of volumes). Most geographies and segments (Light Vehicles, Trucks) improved in December, notably +13% growth in LV replacement tires in the US. This suggests that the US market could grow mid to high single digits in 2014, while Europe is bottoming out: the aftermarket has been resilient in recent months (i.e. slightly positive for LV) and could soon benefit from a better macro, notably in Southern Europe. On the OEM side, new car sales in Europe rebounded at the end of 2013 after several tough quarters, with December sales up +12% (-2% over the FY). In view of easy comps in coming months and positive macro data, we believe that auto sales growth in Europe could trend high single digits or even double digits in the short-term.
Margin leverage potential still significant, double digit EPS growth in sight
Even if Goodyear is expected to pass on some of the savings on rubber (roughly -30% year-on-year) to customers, pricing pressures should ease compared to 2013 as capacity utilizations are on the rise globally, implying that Goodyear does not need to offer large discounts to customers to get volumes.
Improving gross margins and leverage on fixed costs thanks to rising volumes make us confident that margins will continue to improve at a high pace (at least +200bps over 2014-15), leading to EPS growth in the high teens. Against this backdrop, Goodyear's current valuation (around 10x 2014 EPS) is a bargain in our view.