Although Michelin's (OTCPK:MGDDF) stock price has risen 17% year to date after reporting a very strong 2013, there still is a sound investment case to be made given the strong upside potential in the coming years driven by growth in the tire industry, especially in emerging markets. The company is coming off a high-investment phase, in which it has been able to maintain above-average cash flows and build down net debt to virtually zero. As capex falls and new factories start contributing to cash flow, management will have plenty of room to significantly increase shareholder cash returns. The above-average free cash flow (FCF) and dividend yield, and the most defensive profile in the industry, provide downside protection.
Michelin has a €16.6 billion ($23 billion) market cap and manufactures tires worldwide under multiple well-known brands such as Michelin, BFGoodrich, Uniroyal, Riken, Kleber, and Warrior. It offers tires for virtually every tire market, including cars, vans, trucks, farm machinery, earthmovers, mining and handling equipment, tramways, metros, aircraft, motorcycles, scooters, and bicycles. Michelin is not only one of the most diversified companies in the tire industry product-wise but also geographically. The company boosts a global market share of almost 15%.
Michelin's Push Into Emerging Markets
There are currently more than 1 billion motor vehicles on the road, and this number is expected to increase to 1.6 billion by 2030. This translates into an increase of automobile production of 35% between 2012 and 2018, and, importantly, emerging markets are expected to account for 80% of this growth. Michelin historically has had a weak presence in emerging markets, but this is about to change drastically as new high-capacity plants come online, which will aggressively expand revenue contribution from emerging markets.
By 2015, the company will have invested 60% of its 2011-15 capex in emerging markets, compared to only 10% in Europe, which currently accounts for over 40% of revenues. A total of €2.8 billion will have been spent on three greenfield high capacity factories in China, Brazil, and India, and another $750 million on an additional plant in South Carolina. The ramp-up of these factories will continue through 2014 and 2015, and will start to generate positive cash flow and 10%-plus return on capital thereafter. As such, Michelin should be perfectly positioned to capture future growth in the tire market, growing the top and bottom line substantially in the years to come.
Technological evolutions will determine the competitive landscape in the tire industry in the years to come, amid the secular trends of rising raw material prices and stricter safety and environmental regulations. The company is anticipating these forces by investing in product innovations, including the €270 million modernization of its global R&D center that houses 3,300 R&D personnel.
As Upside Is Significant, Downside Is Rather Limited
The tire market is less cyclical than many other consumer discretionary markets, including the automotive industry, as tire life spans are relatively short. For Michelin, replacement tires account for about 80% of revenue. Michelin also derives almost 30% of its operating profit from the specialty tires (mining, farming, construction, planes, and two-wheelers) segment, which is a growing, oligopolistic industry with high barriers to entry due to the necessary technologies, resulting in a defensible market position and margins double that of other segments.
This segment has, however, seen muted demand in the past years as miners significantly decreased capital spending amid commodity oversupply; however, the long-term trend on mining capex remains positive. Other segments of the tire market also have oligopolistic features, with only six companies accounting for over 50% of the global market (Michelin, Bridgestone (OTC:BRDCF), Goodyear (NYSE:GT), Pirelli (OTCPK:PPAMF), Hankook, and Continental (OTCPK:CTTAY)). Competition between these majors can be fierce at times.
Growing FCF, Underleveraged Balance Sheet Leave Room for Increasing Shareholder Returns
Even as Michelin has been in a high-investment phase in the past years, it has been able to generate an impressive FCF, supporting its attractive dividend. FCF is expected to further increase in the coming years given the drop-off in capex and the cash flow contribution from the new capacity in emerging markets.
The company doesn't seem to be highly valued based on a dividend yield of 2.8% and reported FCF yield of 6.8%, especially when one takes into account how well the dividend is covered by FCF (total dividends and share repurchases amounted to €671MM in 2013 compared to a reported FCF of €1.15 billion) and earnings (target is a 35% payout rate). In addition, Michelin's balance sheet is very conservative with a net debt/EBITDA ratio of about zero times. The combination of FCF growth, valuation, and the very conservative balance sheet supports a thesis where a significant increase in shareholder return can be expected in the coming years in the form of dividend growth and large share buyback programs, including the buyback program that was announced in 2013 for 10% of the outstanding shares.
Michelin has outperformed most of its peers with a year-to-date return of 17%. This has led to its P/E ratio to rise slightly above the mean of its closest peers. However, I believe Michelin deserves a premium because of its attractive growth profile, good positioning in the specialty and premium markets, strong brands, product and geographic diversification, strong FCF generation, high and very well-covered dividend, and conservative balance sheet which leaves room for share buybacks and further dividend increases. In any case, the Michelin investment case is appealing compared to the S&P 500, which is trading at a trailing P/E of about 18x and a forward P/E of 15.75x.
As with any investment, there are risks to the investment proposition, including:
- a further drop in the specialty tire division profit driven by unfavorable pricing and product mix and a potential further decrease in miners' capex;
- currency exposure as demand and production are not entirely balanced (production is currently skewed toward Europe);
- price swings in natural rubber prices, which can significantly impact profitability if Michelin would be unable to offset this in its pricing policy;
- the execution risks tied to the ramp-up of the new factories, which could lead to capex overruns and a delay in revenue and bottom line contribution;
- management deploys the available and future capital in a way that would destroy shareholder value, including ill-considered acquisitions; and
- an underwhelming volume growth and/or a weak pricing environment.
As the new capacity comes online in the next years, capex will fall and CFO will increase, leading to higher FCF and, subsequently, higher shareholder cash returns. Given that both the dividend and FCF yields are already above average, I believe the stock price is heading toward a couple of very strong years. In addition, the company's defensive profile provides for downside protection. In short, investors looking for a defensive dividend growth stock with a promising growth profile might want to consider adding Michelin to their portfolio.
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.